Silicon Valley’s software engineers are acting as the ultimate agents of creative destruction. They resemble M.C. Escher’s Drawing Hands, but with a twist: one hand holds the pencil eraser-side down, compulsively erasing its creator as it is being drawn. It is a profound paradox to watch an industry collectively race to build something they actively fear will replace them.

Mankind has long flirted with mechanized intelligence. However, the recent release of Claude Code catalyzed a convergence of creation, computation, and coding that triggered a broad stock sell-off amid a wave of hysteria. The emergence of multi-agent systems and reasoning models marks a rapidly evolving paradigm shift, unleashing LLMs as autonomous agents capable of planning, acting, and learning across tech ecosystems. While their success rate executing complex tasks remains very limited thus far, these agents can theoretically mirror the entire software development lifecycle on a compressed timescale—acting as architects, developers, code reviewers, and release managers.1 The ultimate real-world utility of this is still TBD. Yet, the aperture of economic uncertainty has undeniably widened for software firms, leaving the market to shoot first and maybe get around to asking questions later.

Most of the extreme trends building in the market are shadows cast in different directions from the same central theme: the future dominance of AI, agentic commerce removing all friction from society, and the data center build-out required to handle the unfathomable compute power needed to make it a reality. Instead of angels and devils, we have bulls and bears that have ‘poofed’ onto our shoulders. On one side, bulls whisper sweet nothings about an AI-led productivity boom and synchronized, cyclical industrial upswings globally. On the other shoulder, a chorus of AI-inspired doomerism regarding multiple compression, imminent mass layoffs, and IMF bailouts is building to a panicky crescendo. History teaches us that reality usually lands somewhere between the extremes.

With each new technological breakthrough or paradigm shift Luddites have cried “it’s over” for labor, yet here sit in 2026 with 4.3% unemployment and labor shortages across a vast swath of large industries, including a recent explosion of software development job openings (up ~15% in ~6 months).2 ChatGPT was released 39 months ago, and since then the US has created 4.5 million jobs, many of them high paying within healthcare.3

The composition of total employment is constantly shifting under the covers. More than 40% of the US economy and jobs were agriculture based around 1900. Fast forward to today with self-driving combines and tractors and that number is ~1%, yet we are still at full employment. There are no more switchboard operators or elevator attendants in the economy today, but there are estimated to be over 1.5 million full time “influencers” in the US. The creation of the loom and spreadsheet are other examples. Specific jobs and job categories were decimated, yet data entry and IT services jobs sit at an all-time high.

The Great Humiliator (“TGH”) is flexing his unique sense of humor as this memetic Neomania (obsession with the new) and conspicuous chronocentrism has ironically caused a renewed enthusiasm for some of the oldest industries known to man (no, not that one) such as digging basic materials out of the ground, making tools, and breaking up rocks. If an investor’s inclination compelled them to either ride the wave of the cutting-edge technologies or remain a stubborn technophobe, with a portfolio firmly tethered to weightier businesses, they’re sitting golden. However, if you’re caught anywhere between the two...oof!

Over the last few months, we have regrettably been unable to take advantage of this long-anticipated broadening out of returns and leadership shift to small cap value industries due to our significant overweight in software (which is collectively, ironically, much cheaper than our traditional value industrial exposure) outweighing our value industry gains. This has been a millstone around our neck, and it has no doubt been the biggest black eye on our 15-year track record.

One textbook definition of intelligence is the ability to draw distinctions between situations despite surface level similarities existing between them and vice versa, yet in its infinite wisdom with unlimited intelligence at its fingertips, the market is treating software as one giant monolith that is waiting idly by to be swallowed up by the giant blue whale of AI.

Meaningful AI adoption remains relatively slow across the broader corporate world, yielding limited efficiency gains thus far. By contrast, software firms are the fastest adopters. Historically, it is the early adopters of new productive technologies—not the infrastructure providers—who capture the lion’s share of long-term economic benefits.

Incumbents possess a distinct structural advantage. They have the engineering talent and access to the latest multi-agent tools, which they are rapidly deploying atop their mission-critical systems of record and proprietary data. They are only now beginning to cross-sell these integrated AI solutions to enterprise customers who are already inclined to consolidate their vendor lists. Ultimately, AI could be poised to accelerate this vendor concentration. In our view, dominant vertical software platforms that successfully reinvent themselves for an agentic world can not only survive, but thrive, easily fending off ankle-biting, AI-native start-ups.

“There’s a big gap between an AI model that works in a demo and one that works in a regulated industry, and if you want to close that gap, you need domain expertise.”

– Dario Amodei, CEO of Anthropic, February 17, 2026

Long PAR

Software has always been a hyper-competitive industry teeming with well-funded start-ups. Consider PAR Technology’s niche in restaurant point-of-sale (POS). Despite facing over 6,000 global competitors—including countless “free” alternatives requiring no subscription—PAR consistently wins mandates from Tier-1 restaurant chains. A prime example is their newly announced deal with Papa John’s, which abandoned its in-house software to migrate to PAR. This dynamic runs 180° counter to the prevailing market narrative.

AI will undoubtedly turn up the heat on this already intense global competition, but it will also accelerate PAR’s product velocity, broaden its capabilities, and vastly expand its TAM. Ultimately, the endgame for incumbents is unlikely to be the race to zero gross margins that so many software skeptics are predicting.

Long CLBT

On core long Cellebrite’s digital forensics turf, there are several major barriers to entry, and the software itself could be considered the least of them. Cellebrite is a hardware-enabled software solution that has become both a verb (to “Cellebrite” a device) and a noun (create a Cellebrite report) for its users across the globe.

A defensible moat for CLBT has been its exploit library. CLBT’s device unlock and extraction capability requires:

• Zero-day and N-day exploits for iOS and Android (often acquired from the vulnerability market or developed in-house)

• Hardware interposers and chip-off capabilities for physically damaged devices

  • A forensic technician physically de-solders the memory chip (the “brain” where your photos and messages live) right off the phone’s circuit board.

  • Once a damaged phone’s chip is removed, it is placed into this interposer. The interposer aligns the tiny, microscopic pins of the chip perfectly so it can be plugged into a forensic workstation.

  • Cellebrite provides the specific hardware (the adapters) and software (the “translators”) to help investigators make sense of that raw data and, in many cases, use proprietary exploits to help figure out the passcode even when the physical phone is wrecked.

• Bootloader exploits that survive OS updates

• Maintaining extraction support across tens of thousands of device models and firmware versions

This is expensive and requires ongoing R&D. Gaining access and conducting an extraction requires chaining together a series of vulnerability exploits and then adapting those exploits whenever new phone models and updates to the operating systems are periodically introduced. Numerous non-technical barriers also exist. Law enforcement agencies need tools that hold up in court under Daubert/Frye standards, and reaching that point requires formal testing, documentation, and a lengthy legal track record. Government procurement is slow (shocker), relationship-driven, and often dependent on a primary vendor such as Cellebrite for specialized technology. Displacing an incumbent takes years. Many competitors and even the agencies themselves have tried and failed to replicate Cellebrite’s capabilities. Agencies are conservative—a failed extraction or evidence challenge in court could be career-damaging for a detective or prosecutor. New entrants face deep skepticism while CLBT enjoys a multi-decade headstart of earned reputation and institutional level trust building. CLBT has only recently introduced AI functionality and modules that are expanding the TAM and fueling their next leg of growth. For instance, their soon to be released Guardian Investigate product is one of the most compelling use cases we have seen for an AI product. It takes all the data Cellebrite ingests from phones and triangulates with other data sources (such as telephony) to build out and potentially help investigative units solve cases. Imagine taking texts and pictures from a phone and combining that with time-based geolocation data to corroborate where and when people were at the time they were incriminating themselves on their phone. While Guardian Investigate represents a high-value system of record to transform an investigative unit’s mode of operations for case management, Cellebrite also plans to introduce a separate, stand-alone agentic AI application for individual ad hoc queries – creating two distinct paths to monetize the company’s AI-powered analytical capabilities.

Furthermore, with increased scrutiny on software company cash flows excluding stock based comp, CLBT “stands up” on an Enterprise Value/Free Cash Flow ex-SBC multiple (13.1x ‘27E), such that it is now at a >60% discount to the broader market and significantly cheaper than almost any small cap industrial stock we evaluate despite having a massive net cash position (as opposed to leverage), ~20% growth (as opposed to limited/cyclical growth) and 34% FCF margins.

Long FLYW

Our largest position remains Flywire (FLYW). Operating at the intersection of payments and software, FLYW targets high-value, complex verticals—such as healthcare, education, and travel—where payments are deeply entangled with core workflows, receivables, reconciliation, and compliance.

The company has dredged a formidable moat by building global payment capabilities through localized banking relationships and rails in practically every country. Because FLYW is so deeply embedded into hospital billing systems, university ERPs, and travel back-office tools, the switching costs are immense. Over 80% of FLYW’s revenue comes from processing fees (FX spreads and cross-border fees) rather than software. Because they charge customers only a nominal software subscription fee, even a “free” vibe-coded AI alternative is unlikely to warrant a second glance. Replicating this bespoke network of payment rails from scratch today would realistically take over five years and $100M+ in legal and compliance spending.

Despite this deep entrenchment and rapid scaling, a massive valuation disconnect exists. Competitors with a fraction of FLYW’s growth are being acquired at mid-to-high teens EBITDA multiples, whereas FLYW trades at just a 6x multiple on 2027 consensus EBITDA estimates. To put a finer point on it: a slightly larger private competitor, Airwallex, recently raised funds at an $8B valuation, making FLYW’s $1.1B enterprise value look remarkably compelling by comparison.4

New Core Long: Choice Hotels (CHH)

CHH is an asset-light, high-margin (60%+ EBITDA margin on revenue ex-pass-through costs) hotel franchisor trading at a distressed multiple due to cyclical top-line headwinds and KPI deterioration experienced in 2025, namely U.S. RevPAR declines and lack of U.S. room growth. The market has severely punished the stock—down from $154 in early 2025 to $106 today—now pricing in structural decline fears. However, the business is still growing earnings, is highly cash-generative, and may have the ability to unlock a significant amount of cash on the balance sheet to buy back shares at these historically low levels.

The consensus narrative that CHH is a struggling, low-end domestic motel brand has over-stayed its welcome. CHH is actively shifting its portfolio of 7,575 hotels toward higher revenue, stickier segments:

• Extended Stay: Now comprises 9% of total rooms and 11.5% of U.S. rooms (57,000 rooms) and growing, with room count +12% year-over-year and comprising 40% of CHH’s active pipeline. Extended Stay hotels benefit from longer average stays, more stable earnings for franchisees, and generate a juicy 6% royalty rate for CHH. This segment has been the portfolio bright spot, posting +3.1% ADR and flat RevPAR in 2025 vs an overall decline in RevPAR across the hotel industry. CHH currently accounts for 40% of all economy and mid-scale extended stay rooms under construction in the U.S.

• Small & Medium Business (SMB) & Demographic Tailwinds: CHH is highly leveraged to the “golden generation” and the blue-collar/SMB workforce. 30% of guests are over 60, a demographic projected to increase spending by 70% by 2030. SMB business for CHH was up 13% in 2025, driven by demand from the construction and utility sectors.

• International Inflection: International is still relatively small at 24% of CHH’s rooms but scaling rapidly and is the company’s highest growth opportunity. More profitable Direct franchising is now 41% of the international portfolio (up from 19% just three years ago). International EBITDA is targeted to double to $50 million by 2027, driven by recent expansions in Canada, EMEA, and LATAM. EBITDA per international unit has more than tripled from 2022 to 2025 due to more direct franchising, a higher average Revenue Per Available Room (RevPAR), and a rising average royalty rate.

• Overall, CHH is shifting its portfolio mix to longer average stays, higher margin direct franchising agreements internationally and higher rooms in general with 97% of the rooms in the current pipeline being non-economy rooms.

Notably, the company has been using its own balance sheet to fund the development of two new hotel brands, Cambria and Everhome Suites. As the ground-up development of these hotels is completed and they’re subsequently secured with 30-year franchise agreements and then sold, not only will CHH return to a purely asset-light model and slash capital outlays, but it will likely free up over $700 million of capital tied up on the balance sheet, the equivalent to 14% of the current market cap.

This large cash unlock could come at a very opportunistic moment for the Company to meaningfully buy back shares. CHH is currently trading around the bottom 2.5% of its historical valuation range over the past ten years at 10.7x EBITDA. To further put this in perspective, since 2006, CHH has only traded below 10x EBITDA for 48 weeks, almost all of which occurred during the Great Financial Crisis in 2008 - 2009.

From 2016 through 2023 (outside of earnings drops for the entire hotel comp set around COVID), CHH consistently traded at a premium to its peer group. This began to break down in 2024 and fully decoupled in 2025 as domestic RevPAR softened and became the market’s myopic focus as investors have sought ways to express bearish views on low-end consumers. We feel that CHH now guiding to a return to net room growth in the US, along with continued strong growth internationally and steadily growing earnings heavily dents the bear case.

We view the current setup as highly attractive. CHH is trading at a historic discount to both its own historical averages and its peer group. Combined with a massive 26% short interest, 40% insider ownership, and a recent change-in-control compensation amendment that is suggestive of M&A preparation, CHH offers multiple paths to a rapid re-rating.

If the stock reverts to its 20-year median valuation of 14x forward EBITDA (which would still be a 3-6x EBITDA discount to Hyatt, Hilton, and Marriott), the stock has ~50% upside.5

α α α α α α

Should you find yourself developing a sense of certainty in capital markets, you’re bound to soon be fumbling in the dark of TGH’s spiral labyrinth, where he waits for participants to grow complacent and lose themselves in its fearsome complexity. Creative destruction is a hallmark and necessity of capitalism. Naturally, our dynamic economic system experiences tumult at every major technological turning point.

We are, as always, in a free fall into an unknown future. This fluidity has always been disconcerting for many, and our present era—at the dawn of AI and agentic AI—is no exception. While we have outperformed passive benchmarks over the long term, we have dug ourselves a noticeable relative performance gap just in the last handful of months. The way out is sticking to what we’ve always done: striving for continual adaptation within a timeless and principled investing framework focused on value-oriented special situations.™

Sincerely,

Voss Team

Appendix:

There remains a significant gap between benchmark performance and real-world automation outcomes for current AI systems.

• Cornell University – “Our evaluation reveals a substantial performance gap: while LLMs achieve 84 to 89% correctness on synthetic benchmarks, they attain only 25 to 34% on real-world class tasks”¹

• Carnegie Mellon University – “We reveal substantial mismatches between agent development, which tends to be programming-centric, and the categories in which human labor and economic value are concentrated”6

Citadel Securities – Software engineering job postings are rising again, contradicting the narrative that AI is replacing developers.7

7

Source: Citadel Securities — The 2026 Global Intelligence Crisis, Citadel Securities Research (2026).

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Disclosures and Notices:

The information contained herein reflects the opinions and projections of Voss Capital, LP (“Voss”, “the Firm”, “the Voss Team”, “us”, “we”, and “our team”) as of the date of publication, which are subject to change without notice at any time subsequent to the date of issue. Voss does not represent that any opinion or projection will be realized. All information provided is for informational purposes only and should not be deemed as investment advice or a recommendation to purchase or sell any specific security. None of the information contained is either an offer to sell nor an offer to buy any securities, investment product or investment advisory services, including interests in Voss Value Master Fund (the “Master Fund” or “Long/Short Fund”) or the Voss Value-Oriented Special Situations Fund. 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“The Price of Time,” by Edward Chancellor, is almost two distinct books. The first third of the book is primarily a historical, even philosophical discussion of interest rates. How did our long-ago ancestors think about, rationalize, and sometimes demonize those who would wish to charge interest for lending them money? Why in most of history have we implicitly rationalized a charge for lending money, even on collateralized assets? What is the “right” natural rate of interest, and is there even a “right” natural rate of interest? Is charging interest even moral?

The second part of the book is more a modern, methodical, and sometimes repetitive critique of the incessant focus of modern-day monetary policy on low interest rates and tying interest rates explicitly to inflation. Indeed, if you wanted to summarize the whole book in one sentence fragment it could be: “low interest rates bad.”

There is a common throughline of the two sections of the book, as a decent chunk of the historical overview is dedicated to chronicling periods of abnormally low interest rates, and how history tends to at least rhyme if not exactly repeat with subsequent outcomes. The book does make several convincing and salient points that might fly in the face of “consensus,” and certainly would be refuted by the Federal Reserve. For instance:

1) Modern central bank policy makers have radically misinterpreted the lessons of major historical events from Josiah Child’s East India Company to John Law’s Mississippi Company to the Bagehot Law around financial crises, all the way through the Great Depression.

2) Tying inflation to monetary policy while also insisting on managing to 2% CPI is asinine. Indeed, there is nothing wrong with deflation as long as it’s the “good deflation” (productivity gains from technology) vs “bad deflation” (lack of demand), yet the Fed conflates the two.

3) Focusing on price stability ignores the true drivers of the boom/bust cycle (specifically credit growth and pockets of asset price inflation) because of the misinterpretation of #2 above.

4) Holding rates low for extended period exacerbates income inequality and consistently makes the rich richer and the poor poorer.

5) “Negative Rates” or even low rates distort the concept of capital and make it impossible to value assets.

6) Low rates beget more low rates due to many unintended consequences.

The book does a great job in my view of tying modern day thinking back to their historical derivations and astutely points out where modern-day thinkers may even be misinterpreting the thinking of previous economists. While a bit repetitive in parts, I overall found this book to be a great meditation on the philosophy around interest rates tied to modern practice.

Must Read Chapters: Chapters 1,4, 5, 6, 14, Conclusion/Postscript

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Chapter Summaries

Chapter 1 – Babylonian Birth

Chapter 1 takes us into the documented origins of interest as a concept. The book claims interest is older than the wheel, and that it existed well before coined money. Although there are various theories around the origination of interest, it does seem to be steeped in the concept of livestock. For instance, “capital” is from caput, which is a head of cattle. Rather than lend money, originally, one might lend seeds or livestock.

Documentation of loans was also a bit different than today, as records of it were on clay tablets. These tablets had similar information as they might today, including “names of creditor and debtor, the loan amount, the date of the loan, and when repayment is due, and, in most cases, the amount of interest to be charge.” (page 5) In some cases collateral was noted, including at least one case the “wife of the borrower.”

Interestingly, the book claims most of the records we have of these ancient debts are of unpaid debts, as the tablets were destroyed once the debt was paid off.

In the period of the Mesopotamians (~4000 BC), the wonders (and dangers) of compound interest were documented. For instance, two cities went to war over accumulated compound interest that had no hopes of ever being repaid. Chancellor notes, perhaps unsurprisingly, that this period had the first documented cases of debt cancellation. This was not intuitive at the time, as previously debt would often transfer even beyond death to next of kin or even relatives.

As it relates to the rate of debt, a major focus of the whole book, rates consistently moved down over time, but the first documented effective rates were in the 20-33% range (Babylonians, ~1700 BC, for silver and barley, respectively). These rates went effectively unchanged for centuries, implying something beyond growth or economic forces dictating them.

“The Greeks, who introduced the decimal system, charged a standard interest of 10 per cent per annum. Under the Roman duodecimal system, interest was usually at…8.33 per cent per year.” (page 12)

“In short, the ancient history of interest provides no strong support for any particular view as to how the rate of interest is formed. Law and custom obviously played an important role. Yet occasional changes in the quantity of money in circulation also appear to have influenced interest rates. Market forces were at play, to some extent at least.” (page 13)

Chapter 2 – Selling Time

For large parts of history, there was a debate about whether interest was even moral. For instance, an ancient Athenian text describes “bankers as a ‘pestilential tribe worse than malignant nurses, pedagogues, midwives, begging priests, and fishmongers’…of all these unclean trades, usury was deemed the lowest.” (page 18)

In fact, unofficially, interest was forbidden by Church law during the medieval periods (~1200-1570). A common refrain was it was “better to steal from the rich than to slay the poor by usury.”

A key principle that we take for granted today that was not then accepted was that time has value in of itself. It was unethical to ask for more than you’ve lent as money does “not reproduce itself”, as Thomas Aquinas wrote. (page 19)

However, this interest prohibition was probably a bit like the US prohibition of alcohol movement. It may have been technically illegal in practice, but was still practiced widely, with merchants finding “countless ways to evade clerical injunctions” (page 23)

And by the late 16^th century it was becoming more formally accepted that time indeed does have value:

“Wilson then goes on to provide a definition of interest: ‘Usurye is also said to be the price of tyme’…Interest has been described in many way over the years- it’s often referred to as the price of money. But Wilson knew better. Interest, he said, is the price of time. There is no better definition.” (page 27)

Chapter 3 – The Lowering of Interest

Chapter 3 grapples with the ongoing evolution of the moralities of overly high and low interest rates, and whether there is indeed a “natural interest rate.”

Once interest was “allowed”, there was still an ongoing moral tug that excessively higher interest rates were immoral (predatory lending is still a very real concept today, e.g. payday lending or excessive credit card rates). This led to an increasingly open mind towards managing interest rates lower and rationalizing these lower rates as good for everyone. It is with this chapter that the book begins planting the seeds of “low interest rates bad.”

Chancellor seems to point to 17^th century England as the first major instance of consciously using lower interest rates to stimulate economic growth. Josiah Child, future governor of the East India Company, laid out the virtues of low interest rates in “Brief Observations Concerning Trade and the Interest of Money (1668)”:

“For the abatement of interest will certainly and necessarily increase Industry and good Husbandry; it will as certainly multiply Traders and Stock in Trade, and in consequence the gain of the present Merchant who employs his own Stock, and lends to others, will be the less.” (page 35)

It is clear, though, that Child was a “most unlikely champion of the poor”, and in fact wanted lower interest rates to build his East India Company on the back of cheap credit. He used the guise of cheap credit for everyone to build his personal empire.

It is interesting that even back in these times there was a recognition by some thinkers/economists that extended periods of low interest might not in fact be virtuous for all. John Locke for instance, fiercely advocated against low interest, claiming that wealth disparity would increase, and the benefits would accrue primarily to the richest, which would compound:

‘Any reduction in interest will mightily increase the advantages of bankers and scriveners, and other such expert brokers…skilled in the arts of putting out money…it will be a gain to the borrowing merchant, for he borrows at 4 per cent, and his returns be twelve per cent, he will have eight per cent, and the lender four.’ (page 38)

Locke further believed that excessively low rates would cause people who otherwise did not want to borrow to seek out borrowing and increase their own risk beyond comfortable levels.

This chapter finally pontificates on the “natural rate of interest”. In other words, Locke and others began to formulate that there was some true interest rate independent of monetary factors and that monetary policy should not deviate from this natural rate of interest. Locke himself thought it was “above 4 per cent and probably closer to 6 per cent.” (page 41)

Chapter 4 – Chimera

Perhaps the most fascinating chapter in the book in that it attempts to connect a gigantic bubble (The Mississippi Company) with modern day accepted monetary policy. In other words, despite the ultimate disaster that John Law’s Mississippi Company (1718-1720) became, the policies that came from it are still inexplicably championed and accepted to this day:

“Law has been called the original monetarist- an eighteenth century forerunner to Milton Friedman. His monetary policy prescription for the basis for modern central banking. Yet Law’s System, as he called it, was a spectacular failure.” (page 46)

Law’s “System” was essentially the first subversion of money needing to be backed by gold or other precious metals (or indeed anything at all). The Bank of England opened in 1694 and the “Bank’s first issue of paper notes was backed not by gold but by a claim on the public credit.” (p 47)

Like Josiah Child of East India Company, John Law made similar proclamations about the virtues and benevolence of low rates driving productivity, in that the benefits would trickle down from top to bottom and ultimately benefit all because it would stimulate the economy and ultimately produce jobs for the people.

John Law was the first real proponent of quantitative easing. Per Chancellor:

“In modern language, Law was suggesting that a central bank could reduce interest rates by printing money; that this would alleviate the position of heavily indebted borrowers (in this case, French nobles), create jobs, and revive the economy. At the same time, the cost of servicing government debt would fall, and deflation come to an end.” (page 49)

Once Law convinced people this was the right course, Law was able to engineer one of the largest, original stock bubbles in world history, through his Mississippi Company investment. Law had all of the characteristics of a classic stock charlatan: telling a great story, getting government subsidies, and creating a sense of FOMO that built frothing- at-the-mouth demand.

The first “IPO” of the Mississippi Company was paid for effectively by Government printing presses, “the funny money of depreciated government debt.” (page 52) For subsequent funding rounds, it was highly advantageous to have owned shares from previous subscriptions to “get in” on the new issue. Further, it was pitched that one should “get in early” because each successive fund raise would be done at higher prices. As for hype, Chancellor describes it well:

“The prospects of the Mississippi Company were hyped by Law’s agents in the press. Louisiana was described as a new El Dorado, abundant with gold and other precious metals. Le Nouveau Mercure reported that its fertile land was populated with marsupial rats the size of cats that supposedly tasted like suckling pig. Settlers en route for the colony…were equipped with shiny new tools and paraded through the streets of Paris.” (page 52)

Chancellor goes on:

“The main stimulus for the bubble came from the Royal Bank’s printing press. Over the course of 1719, the amount of paper money in circulation increased by an estimated billion livres…by May 1720, the total circulation of notes exceeded 2 billion- an increase of fifty times on the earlier issuance of the General Bank, and roughly twice the quantity of gold and silver coins in circulation.” (page 56)

This made John Law fabulously wealthy, possibly the wealthiest person ever (relatively). His biographer stated that “in comparison, Apple Inc. is a rag-and bone shop.”

However, the monetary policies of aggressive press printing “produced wild inflation, evidenced by the near doubling of an index of commodity prices since the start of the year.” (p 56) This had the predictable effect of people losing confidence in the currency, and capital flight began to take hold. Once this happens, the jig is usually up, and this was no exception. The bubble imploded. Law tried both doubling down on inflation, which just exacerbated the problem, and ultimately had to deal with crippling deflation.

I focus on this piece of the book because of the ending, which Chancellor summarizes:

“The verdict on Law and his System provided by modern economists is surprisingly favourable. Some even deny that a bubble existed in 1719…despite the fact that Law’s policies produced a surge of inflation and a great stock market crash, Ivy League academics warmly applaud his monetary notions. Peter Garber, a professor of economics at Brown University, claims that Law’s credit theory is the ‘centerpiece of most money macroeconomic textbooks produced in the last two generations’. William Goetzmann of Yale credits Law’s belief that too little money constrains economics activity ‘as the essential principle underlying the decision by the US Federal Reserve Bank today’.” (page 61)

Law’s biographer notes that “From this perspective, it may be argued that, notwithstanding the failure of the Mississippi System, Law’s banking successors have been Ben Bernanke, Janet Yellen, and Mario Draghi.” (page 61)

Chapter 5 - John Bull Cannot Stand Two Per Cent

Provides ongoing evidence that perpetually and abnormally low interest rates create perversions in economies. From an article from Walter Bagehot (editor of The Economist), in 1856, he noted that:

“Whenever money becomes very cheap, experience teaches us to expect that it will be misspent. John Bull, as it has been wisely observed, can stand a good deal, but he cannot stand two per cent.” (page 69)

In this case John Bull (not to be confused with John Law), is just a generic name meant to represent the typical Englander. Bagehot is a focal point of the chapter, and the Bagehot Rule is often thought to have been linked to modern day monetary policy of the central bank being the lender of last resort:

“The Bagehot Rule, as it came to be known, formalized an approach to banking panics…although the Bank Charter Act of 1844 limited the amount of banknotes the Bank could issue in excess of its gold reserve, the law was always suspended at moments of financial distress.” (page 75)

What is interesting here is that while Bagehot’s original view is being accurately portrayed, its implementation now is completely different. Chancellor claims the outline of the policies “provided the cover” for Bernanke’s helicopter money:

“During panics the Bank of England should only lend for a short period, against high-quality collateral and should charge a high rate of interest for its money…Yet Bagehot’s stringent conditions were not followed…they do not lend at high interest but at the lowest rates. Their emergency loans are not provided for a short period, but for years on end. They do not lend against high-quality collateral but reach to the outer edges of the credit spectrum.” (page 76)

This is the prelude of the subsequent scorching modern central bankers will get in the book. Benanke, Yellen, Draghi and the lot have radically misinterpreted Bagehot despite citing him frequently, to the point Chancellor wonders whether “any of them has actually opened the pages of Lombard Street and encountered its ruminations on John Bull and his wild investment proclivities.” (page 81)

Chapter 6 – Un Petit Coup De Whisky

The final chapter before moving into more modern history, this chapter finishes with the United States Great Depression. It is here that Chancellor links the modern concept of managing interest policies by targeting inflation levels:

“The British, who were keen to return sterling to gold convertibility, wanted to avoid deflation because it involved politically contentious cuts in wages. Americans were keen to avoid a repeat experience of the severe deflation of 1921. Ben Strong at the New York Fed was converted to the new monetary policy orthodoxy, namely that interest-rate policy should be guided by the goal of price stability.” (page 86)

In this link Chancellor argues that going down this path created first the Roaring 20s and then ultimately the Great Depression. A key reason for this is that the Federal Reserve was far too focused on inflation, and less around growth. Despite the US economy roaring by 8% a year from 1923-1928, the “New York Fed’s discount rate averaged less than half that number.” (page 90)

The dogmatic principle of avoiding deflation is misguided. It is clear Chancellor admires Austrian economist Frederick Hayek, whom he quotes frequently throughout the book and notes made this argument in the 1920s (as opposed to his more famous peers John Maynard Keynes and Irving Fischer):

“In a capitalist economy, Hayek said, continuous advances in productivity mean that consumer prices have a natural tendency to decline. During periods of rapid technological development and commodity gluts, such as the 1920s, the price level might be expected to decline quite rapidly. The pursuit of stable prices by central bankers, however, worked against this natural tendency. Monetary policy directed at stabilizing prices, said Hayek, ‘administers an excessive stimulus to the expansion of output as cost of production’.” (page 96)

Thus Chancellor, who clearly agrees with Hayek, is arguing that the newly found myopic focus around price stabilization as the ultimate swing force for interest rates is misguided, as there is “good deflation” and “bad deflation”, while policy makers seem unable to distinguish between the two. Indeed, not identifying that good deflation requires higher interest rates would ultimately, inevitably lead to bad deflation:

“Hayek argued that the new technologies and efficiency improvements of the 1920s brought about good deflation…when policymakers ease monetary conditions to ward off such a benign decline in price level, people are incentivized to borrow more...debt deflation starts from a position of over indebtedness- a point which Bernanke in his writings on the subject conspicuously overlooks. Thus Hayek concluded that attempts to avoid good deflation make bad deflation more likely. Furthermore, the bad deflation that appears during a financial crisis should be viewed as a symptom, rather than a cause of economic malaise.” (page 100)

Chancellor finds it curious that those like Hayek, who seemed to have been proven right in his take on what should have been done to avoid the Great Depression, have been “air brushed” from history while those who lost most of their wealth and seemed to champion the policies leading to the Great Depression like Keynes are now championed.

Chapter 7 – Goodhart’s Law

More historical support and analysis around Chancelor’s opinion that trying to base everything around an inflation target is a faulty proposition.

Goodhart’s Law states that “any measure used for control is unreliable” and that “when a measure becomes a target, it ceases to be a good measure”. (pages 105 and 121). The chapter uses Japan in the 1980s as a corollary to the US in the 1920s:

“The BOJ’s actions in the second half of the 1980s are reminiscent of Federal Reserve policy during the 1920s. Both economies experienced robust growth combined with low inflation. Both central banks directed their attention to price stability and initially ignored strong credit growth and the appearance of speculative bubbles.” (page 108)

In both cases, the argument is that the central banks should have been paying more attention to underlying growth (credit/asset prices) rather than purely inflation as guideposts for interest rates.

Sharp criticism of Alan Greenspan is levied, as he notes that after the Tech bubble there became a disconnect between GDP growth and interest rates that began the real estate bubble later in the mid to late 2000s.

Finally, the chapter explores the curious notion that ultimately became global gospel that not only do you want some inflation, but for some reason 2% is the exact right inflation that everyone should pursue. This seemed to start in the early 1990s and has since become an obsession:

“Not only did the major central banks in the developed world now have a target, but they all coalesced around the same number: 2 percent acquired talismanic significance…the number was written into the ECB’s constitution. It was constantly invoked by central bankers.” (page 120)

Indeed, Chancellor is no friend of dogmatic metrics in general:

“Metrics serve to stifle innovation and creativity; they imitate science but resemble faith. When an institution is guided by some specific target, critical judgment is suspended…the more any quantitative social indicator is used for social decision-making, the more subject it will be to corruption pressures and the more likely it will be to distort and corrupt the social processes it is intended to monitor.” (page 120)

Chapter 8 – Secular Stagnation

A short chapter around the flawed argument that has been used for decades that low interest rates are necessary because of ultimate population decline, e.g. a “Secular stagnation”. Chancellor finds it curious that despite this argument being proven wrong again and again, it keeps resurfacing as justification for low interest rates.

Chapter 9 – The Raven of Basel

Another short chapter lays out arguments that it is credit growth and asset prices that should be monitored for interest rate adjustments, not inflation. In this chapter he cites the work of Claudio Borio and William White in the 2010s, who meticulously researched the relationship between interest rates and other factors like growth, savings rates, unemployment, etc.

The underlying thesis is that monetary policy can have significant impacts on economies, which to me seems obvious but Chancellor attempts to argue that many philosophers, economists, and historians (he cites David Hume in particular) argued that “monetary policy errors show up only as disturbances to the price level, without any further consequence.” (page 131)

Chapter 10 – Unnatural Selection

Strikes another blow to lengthy periods of low interest rates, arguing that the process of “Creative Destruction” that capitalism is known for gets significantly bogged down when low interest rates keep “zombie companies” alive.

The argument goes that the least efficient operators are kept alive in periods of low interest rates, as they can keep tapping capital, which subsequently keeps out better operators from even participating as the “dead weight” capital hurts everyone:

“Interest turns time into a cost of production. Time is money. Entrepreneurs who save time in production, who bring goods most quickly to market, emerge as winners in the game of creative destruction. Interest rations capital.” (page 141)

The concept of “zombie companies”, essentially companies kept alive by very low interest rates, is illustrated in the European banking sector in the 2012 timeframe, as well the as the cash burning “unicorns” in Silicon Valley, which multiplied dramatically in the 2011-2020 timeframe.

Chancellor argues these zombie companies, kept alive by low-interest rate policies, had significant detrimental effects to more healthy companies and hurt total productivity:

“An increasing body of research suggests that zombies lay behind the productivity debacle. Businesses that couldn’t service their debts invested less. Zombies discouraged other firms from investing too. Zombies hindered new business formation since entrepreneurs had little incentive to enter sectors with excess capacity and miserable returns. Zombies slowed the adoption of new technologies and business practices.” (page 153)

Perversely, Chancellor believes “central bankers saw the decline in productivity as a reason to extend unconventional monetary policy…low rates begot zombies, and zombies begot lower rates.”

Chapter 11 – The Promoter’s Profit

Attempts to show the perverse effect that lower rates of interest don’t particularly encourage productive investment, but actually encourage financial chicanery, specifically leveraging up through debt to buy back stock:

“From the turn of the century, the cost of debt in the United States was held below the cost of equity. This ‘funding gap’ provided the impetus for share buybacks…the monetary authorities had hoped that companies would use their access to cheap debt to boost investment. But a very low interest rate, combined with a tax structure that favoured debt over equity, noted the OECD, ‘works directly against long term investment’.” (page 164)

Chapter 12 – A Big Fat Ugly Bubble

Again, tying low interest rates to speculation and bubbles, it delves into the very recent bubble-like environment in the 2016-2020 timeframe, noting skyrocketing home prices and parabolic moves in more speculative stocks. This chapter taps into an important concept for why interest rates impact “highflyer” stocks, namely:

“Since most of their profits lie in the distant future, the valuation of technology companies (also known as ‘growth companies’) is inflated when the discount rate falls. During manias, speculators are said to engage in hyperbolic discounting’.” (page 176)

The chapter also attempts to define the “bubble economy”:

“The phrase came into popular usage in the late 1980s to describe Japan’s bubble-distorted economy. The baburu keiki (bubble economy) described the condition by which inflation in real estate and the stock market had entered deep into the sinews of Japan’s economy: corporate profits boosted by financial engineering; business investment fueled by warrant bonds, which linked the corporate cost of capital to the price of the issuer’s shares; and spending on luxuries…” (page 184).

Chapter 13 – Your Mother Needs to Die

Attacks low interest rates from yet another angle, this time from the vantage point that low interest rates essentially take away people’s choice to save and disrupt retiree’s planning, forcing them to invest more aggressively and reach for yield.

“In a world of ultra-low interest rates, most households have no hope of wealth accumulation, no matter how much they save. Indeed, they are better off being profligate.” (page 192)

This chapter notes the potential catastrophic damage that long term low rates can dole out to entities like pension funds, which rely on a certain asset yield to avoid large, implied pension deficits:

“Growing pension deficits elicited various responses. For a start, pension providers had to put more cash into the pot. In the United States, cities and towns cut public services and sacked workers to shore up their pensions. Private companies in a similar reduced investment and cut dividends.” (page 196).

Chapter 14 – Let Them Eat Credit

“Usury is defined as the charging of excessive interest. But no word exists to describe too little interest.” (page 201).

This sums up the chapter, as it inverts the historical thought that predatory interest rates need not be too high, but rather increase wealth disparity the most when they are too low.

This chapter turns back the clock more than other chapters, reminding us first about the morality of interest from a predatory perspective (e.g. usury), then reminding us that in fact the periods of greatest wealth disparity came during periods of low interest rates:

“In late sixteenth-century Europe, the entire wealth of Augsburg, a free city of the Holy Roman Empire, was concentrated in a few hands, mainly in those of the banker Jakob Fugger. The ‘astonishing feature’ of this era was the ‘lowness of the discount rates’.” (page 202)

In fact, Chancellor argues that a positive feature of the Great Depression was that it “kicked off a multi-decade decline in inequality, what economists refer to as the Great Compression.” (page 203). Chancellor argues the “turning point” of this period of lowering inequality was marked mostly by the ongoing decline in interest rates starting in the 1980s.

Chapter 15 – The Price of Anxiety

I believe this chapter is the first one to discuss an obvious component on the value of interest, namely that interest is necessary because of potential loss by the borrower, although it’s framed here as the “price of anxiety.” In other words, people need to be compensated for the anxiety they feel about potentially losing their loan.

The chapter, like the previous one, turns back the clock and traces the roots of higher interest of more risky loans back to the Babylonians, Greek and Romans, who “all charged higher premiums for loans on sea voyages.” (page 219) Sea voyages were thought to be much riskier than other forms of loans.

The chapter tries to tie a corollary between interest rate spreads and insurance premiums, stating “the spread between what the bank charges for its loans and pays on deposits is akin to an insurance premium. In fact, bonds can be replicated with insurance contracts, known as credit default swaps (CDS). (page 219) The premium increases due to the riskiness and anxiety level.

Once again, low rates are the bogeyman for periods of irrational exuberance:

“Credit booms occur at times of easy money, when financial risks are mispriced and market participants believe that the authorities will protect them from loss” (p 220), e.g. when the anxiety is lower because someone is ready to protect you in case of catastrophe (e.g. the Greenspan Put).

The remaining piece of the chapter outlines the natural outcome first introduced in chapter 13, whereby as yields stay unnaturally low, those who need returns/yield, will find increasingly absurd and unsustainable ways to achieve it. This gets at the “negative yield” phenomenon, and how that was possibly an acceptable outcome for a bond investor. For instance, in Japan:

“’Yields don’t matter’, declared a Tokyo insurance executive as the redemption yield on a thirty-year Japanese government bond turned negative. This comment was not as crazy as it may appear, since any loss of income experienced by the bondholder was more than offset by the prospect of capital gains as interest rates declined. As Japan embraced negative rates, its government bonds were delivering their best returns in decades. The prospect of further rate cuts, as interest rates moved deeper into negative territory, only whetted appetites.” (page 225)

This reminds me of the housing build up and ultimate bust in the 2003-2007 timeframe, where rental yields got increasingly microscopic, but all was well while prices continued to rise…until they didn’t. As should be obvious, the unwind of this trade and its level of pain will be proportional to how deep and prolonged the negative rates get.

Chapter 16 – Rusting Money

Continues the previous chapter’s discussion of negative rates. “Negative rates were intended, as Harvard’s Kenneth Rogoff put it, to ‘turbocharge the economy out of a deflationary recession’. But they failed to live up to that promise. In fact, they exacerbated the problems already produced by ultra-low rates.” (p 245). One idea was that money was essentially “rusting” in periods of negative rates, and consumers would not want to pay for their deposits, which would stimulate lending and then the economy at large.

One reason it failed to do so was it did not actually incentivize banks to lend, as would have been the hope. With very low rates across all duration spectrums, banks core business was essentially under attack, as the spread they could generate was increasingly low:

“Quantitative easing boosted asset prices and shrank credit spreads, but most of this newly created money wasn’t lent to consumers or businesses but was deposited by the banks at the Federal Reserve. That fact that the Fed in 2008 started paying interest on excess reserves (i.e. bank deposits at the central bank) gave banks even less reason to lend. The circulation of money through the economy slowed.” (page 236)

The final pages of this chapter make some interesting points about how consensus around what is crazy or even possible can change quickly, a good life lesson for those who fancy themselves contrarians (e.g. narratives can and do change radically even when it seems impossible for them to do so, just give people the right incentives to rationalize it).

“Up to this moment, the notion that interest could be charged at a negative rate had only been proposed by monetary cranks…or contemplated as a thought experiment by a handful of economists…the economists’ verdict was not positive…even the nineteenth century radical Henry George thought that capital could not be maintained if interest rates fell below zero. George’s contemporary Eugen von Bohm-Bawerk believed that negative interest rates were against human nature. The great Swedish economist Gustav Cassel…dismissed the absolute absurdity of thinking that the rate of interest could ever fall to zero or less. (page 247)

However, fast forward to 2009:

“The Riksbank’s Deputy of Governor, Lars Svensson, downplayed the move: ‘There is nothing strange about negative interest rates,’ Swenson told the Financial Times. Nothing strange perhaps to this ‘world-renowned expert on monetary policy theory.’” (page 247)

Chapter 17 – The Mother and Father of All Evil

The last two chapters look more closely at two countries, first the United States and then China.

Chancellor argues the United States is in a unique position in modern history as the owner of the Dollar Standard:

“Central bank reserves are mostly composed of dollar-denominated securities (US Treasury bonds and agency debt), which, unlike gold, can be issued without limit…there is no limit on how many dollars flow abroad nor how much the United States borrows from foreigners.” (page 251)

The US has unique power in that “when the United States adopts easy money it unleashes a global monetary plague.” (page 252)

The argument seems to go like this:

a) Artificially low yields on dollar assets (e.g. treasuries) produces demand for cross-border assets

b) “Carry Trade” demand surges in markets with higher yield

c) This creates overheating in Emerging Markets, e.g. inflation, which is hard to combat because by raising rates further it makes the carry trade even more attractive

This overheating/inflation dynamic can continue until there is a more severe currency crisis, acting as the crescendo to exit that country and move to another country with a good carry trade. This cycle seemed to manifest itself in certain higher growth emerging market countries like Brazil and Turkey, which had large boom/bust cycles in the 2010s.

A tertiary effect of this is that low US interest rates increased globalization. The chapter ends with an uneasy cautionary quote from Peter Thiel:

“All great historic bubbles, from the Mississippi Bubble to the current day, had coincided with advances in globalization. The previous quarter of a century had produced a string of bubbles and busts that ‘represent(ed) different facets of a single Great Boom of unprecedented size and duration.’ Either globalization would succeed, said Thiel, ‘or it is the final and greatest bubble in history.’ (page 263)

As we consider growing backlash to (illegal) immigration and many calling for an unwinding of globalization, as happened in the 1930s after the Great Depression, it does make one wonder what unanticipated consequences this “reshoring” narrative might have on both the US and the rest of the world.

Chapter 18 – Financial Repression with Chinese Characteristics

Chancellor is an equal opportunity monetary critic, and he certainly does not spare China of his wrath in the last main chapter in the book. Indeed, the implication is that China may be the worst offender of “financial repression” of any modern-day country (financial repression being defined as keeping interest rates below inflation, e.g. negative real savings rate).

Indeed, the chapter notes that “although paper money was invented in China…from having begun as a brilliant solution to a shortage of copper cash, paper money gradually turned into a bureaucratic monstrosity that hampered the productive forces whose growth it had originally done so much to foster.” (page 265)

The premise and contingency of financial repression in China starts with the idea that the country can, for the most part, control capital flight away from the country. In other words, interest rates can be implemented and controlled and, unlike in the United States, it is very difficult to take your money and invest elsewhere. He goes on:

“The ‘Big Four’ banks were majority owned and tightly controlled by the state. The central banks set the deposit rate below China’s rate of economic growth, and often below the rate of inflation. Banks lent to state enterprises at below market rates. Since the deposit rate was fixed even lower, the banks were guaranteed fat profits. Government-controlled corporations used the cheap credit they received, often favoring sectors selected by Beijing’s economic planners. Banks and state enterprises were the main beneficiaries of financial repression; household savers were the big losers.” (page 266)

As a household saver, your interest rate was fixed well below underlying growth and inflation, hence financial repression. This explains in part the frequent booms and busts in China, most notably in the real estate market (but also the stock market), as savings are accumulating rapidly but there is a desire to earn higher than a negative real rate. Chancellor notes there was “always a bubble in China”:

“Over the previous years a bewildering array of mini-bubbles had popped up across the country, ranging from a caterpillar fungus with aphrodisiac properties to garlic bulbs; from vintage art to fine china; and bubbles in just about every industrial commodity, from copper to iron ore.” (page 271)

To keep interest rates low the currency was manipulated, pegged to the dollar so that it would not appreciate rapidly, or at all (meaning China had to buy treasuries), so that China could feed its export machine, primarily to the United States. The effect of this was China was “lending indirectly to American consumers for them to buy its exports.” (page 267)

The cycles in China were intense, as the real estate bubbles would build rapidly and then need to be pricked by regulation. However, there then needed to be stimulus to keep the real estate implosion from massively disrupting the economy and (possibly) leading to social revolution. So, an ongoing theme was extraordinary build outs of cities, airports, trains, bridges, etc.

I believe the China ghost cities are fairly well known to people, so I won’t add quotes from the book on that, but it does get at the unsustainability of the entire strategy, namely that at a certain point incremental investment becomes incredibly inefficient:

“As investment climbed to unprecedented levels, the efficiency of investment- what economists call the ‘incremental capital to output ratio’- spiraled downwards. All those immense sums spent on bridges, high-speed trains and roads were failing to generate the much-touted improvements to productivity. The People’s Republic was trapped on an investment ‘treadmill to hell’. But stepping off the treadmill would amount to ‘drinking poison to cure the curse.’” (page 279)

The final part of this chapter highlights the similarities between the United States and China, in that both believed that central planning around specific monetary metrics was critical and, more notably, as unforeseen problems emerged, both believed they need to double down on said centralized planning:

“The legacy of China’s financial repression was, as President Xi told the National Congress in 2017, a ‘contradiction between unbalanced and inadequate [economic] development and the people’s ever-growing needs for a better life’, which, in turn, provided Xi with a rationale for further advancing the role of the state.” (page 289)

Conclusion

The goal of using monetary policy to flatten out economic cycles was/is riddled with unforeseen consequences, but the leaders either couldn’t attribute their own actions to those consequences or were simply fearful that the populace would not tolerate a more significant downturn, with each doubling down on policy producing a larger potential implosion. Chancellor here quotes his favorite economist, Frederick Hayek:

“The more we try to provide full security by interfering with the market system, the greater the insecurity becomes; and, what is worse, the greater becomes the contrast between the security of those to whom it is granted as a privilege and the over increasing insecurity of the underprivileged.” (page 296)

And here he finally ties it all back to the interest rate:

“Instead, central planning in the twenty-first century has involved manipulating the most important price in a market-based economy, the universal price, namely the rate of interest. Interest lies at the heart of capitalism. Interest rates are the traffic signals that guide the market economy…turn off those signals and pile ups occur.”

Taking the Conclusion (and Postscript) chapters in, it’s hard not to feel a little pessimistic about the odds that the Big One (economic blowup) has yet to occur, as the root problem of micromanaging interest rates to the downside still was not addressed, and by all accounts members of the Fed and global central banks still have not changed their thought process and instead are continuing down the path that John Law blazed, ultimately catastrophically.

Chancellor opines about the potential of cryptocurrencies, while acknowledging their current limitations, but seems intrigued by the concept of getting back to a system without the inherent temptations that “unlimited money printing” promotes:

“One advantage (of centralized digital currency) is that central bankers would no longer be able to pursue an active monetary policy. The cost of borrowing would more accurately reflect the supply and demand for actual savings. Guided by the market’s invisible hand, the rate of interest would find its natural level (page 312).

"We’re not competitor obsessed; we’re customer obsessed. We start with what the customer needs and we work backwards. And that’s the essence of the flywheel." – Jeff Bezos

"No matter how dramatic the end result, the good-to-great transformations never happened in one fell swoop. There was no single defining action... It was a cumulative process — step by step, action by action, decision by decision, turn by turn of the flywheel."
— Jim Collins

“The key to success is finding a flywheel that keeps spinning—and spinning faster—on its own energy.” – Warren Buffett

At ~$11/share, Flywire trades at ~2x sales, ~3x EV/Gross Profit, <9x EBITDA, and ~10x consensus 2026 FCF estimates. We believe this is far too cheap for a company that is capital light, cash rich, and technologically dominant in a couple of specific vertical niches with numerous material growth opportunities (both in cross-sell and new customer acquisition) that seem to be misunderstood by the market.

We believe Q2 (or at worst Q3) will represent the low point in the organic, constant currency revenue growth rate, and that a return to greater than 20% growth is a possibility entering 2026. While investors we speak with are obsessed with current, short-term regulatory and political headwinds (pertaining to student visa limitations and delays), we believe there is significant idiosyncratic developments in the adoption of Flywire’s Student Financial Services (SFS) offering, especially within the UK, that could more than offset a poor macro environment in Canada, Australia, and the United States while simultaneously diversifying the company from annual enrollment risk. If the macro situation in their core education business would just go from miserable-to-meh (as some data points suggest), 20% growth is imminently possible based on our assessment of the opportunity set. Combine that potential top line reacceleration with significant operating leverage, and you have a strong setup to get the stock at least back to where it was prior to their disastrous Q4 earnings call, which would represent over 50% upside.

In a Bull Case, where macro actually reverses to a tailwind and the company reverts closer to their historical growth rates of 25%, we believe the stock could get a multiple closer to other “technology led payment companies in vertical niches” such as Toast (TOST), which trades at ~15x NTM gross profit and over 40x NTM EBITDA, or higher growth payment pure plays like Paymentus (11x NTM gross profit).

In a Bear Case, where the US education market collapses more materially than we expect (or there are new developments in the UK market) and globally there is more of a subdued, longer-term narrative around foreign study, we still feel a price of $9 (or 10x FCF on significantly reduced revenue growth and FCF estimates) is a conservative estimate of intrinsic value given the company’s dominance in education and material balance sheet flexibility for a private equity transaction.

Flywire’s History and Management

Flywire was founded by Iker Marcaide in 2009 (originally called peerTransfer). It is a classic entrepreneurial success story, Facebook style, in that a student saw an issue (in this case, the challenges of paying tuition as an international student) on his MIT campus and built a business around it. Four years later, he handed the reins over to Mike Massaro as the company looked to scale to become a much larger company. Massaro was actually a relative unknown at the time, hired internally as CEO after spending a year as VP of Business Development. Although Massaro did not technically found the company, he is undoubtedly greatly responsible for the eventual breakthrough success of the company, as he presided over funding rounds of $22M in 2015, $100M in 2018, and $120M in 2020, when previous fundraising cumulatively totaled around $16M.

The feedback for Massaro from interviews we have both done and read is very enthusiastic, with this quote from a former employee summarizing the general perception:

“His obsession level is very high. So much so that I have to extract him. He is heavily focused on business and culture.”

Additionally, Mike has a borderline rockstar in CTO David King, who built infiNET in 2006 before selling it to Nelnet and then building it into one of the largest US EdTech platforms before joining Flywire in 2019. In other words, he has been working on simplifying tuition payments online since well before Flywire was even founded and seems to be unanimously thought of as a technical genius. Although the focus of many of the former calls we conducted and read about were geared towards Mike and other management, David’s name kept coming up. Here are a few samplings of comments:

“Dave King is amazing.”

“David King and the entire tech/product team are phenomenal.”

“He is a massive asset due to his PCI connections.”

Although talk can be cheap, we think these comments on management combined with customer comments on the product itself reflect an organization that is far likely to win more business from customers in the future, not less, and gives us more confidence in the next leg of their growth, which is likely to be a greater mixture of upsells and cross-sells, as well as geographic expansion.

Flywire Business Mix

Although the company could do a better job of more regular disclosures around regional and industry revenue exposure, we have pieced together what we believe is close to the industry revenue mix in 2024:

The numbers here tell a story but deserve more context because of the vastly different regional trajectories. Within education, the “shining star” has been the UK (within “Rest of Education”), which has grown so much already that it is now larger than Flywire's US education revenue. Canada has been a severe outlier laggard and represents the heart of the “macro” and regulatory issues the company started going through in 2024. For instance, as we understand it, the significant and draconian rules put in place targeting Indian students in Canada impacted the company by $30M in revenue in 2024 and is expected to hit 2025 revenue in Canada by another 30% (although is now small enough to be less impactful). We expect the overall trends to continue in 2025, with the UK leading growth and Canada lagging.

Outside of Education, it is also a tale of two segments. Healthcare has been a clear laggard since it was acquired in 2020, representing around $30M in revenues that have been stagnant from 2022-2024. Their Travel and B2B verticals, on the other hand, have been going gangbusters (off a relatively small base), growing from around $19M in revenue in 2022 to $76M in 2024. With the recent acquisition of Sertifi, along with ongoing forecasted robust growth, we expect this segment to continue to increase as a percentage of total company revenue.

Flywire also reports two types of revenue (Transaction and Platform), like other software/payments companies that have some revenues in payment processing and some revenues more akin to SaaS software.

For Flywire, their Transaction revenues represent revenues from currency conversions and other domestic payment processing, based on a total volume of payments. You can see below this has run in a very tight range between 130 and 140 bps, when looked at on a rolling 12-month basis (to account for seasonality). Transaction revenues still dominate total Flywire revenues, representing around 85% (although this will likely decline as a percentage with Sertfii).

We expect modest downward pressure on take rates as domestic payment processing is likely to grow faster than currency conversion. Offsetting this is that Travel, based on how they account for the revenue, is likely to have a higher take rate.

Given Sertifi is currently 75% SaaS revenues, and that the company continues to focus on growing this revenue stream, we expect Platform revenues to rise (modestly) as a percentage of total revenues.

The Market’s Perception of Flywire and Why the Opportunity Exists

Flywire has been a disastrous investment since their IPO in early 2021, coming out of the gate overcooked at >20x NTM sales while currently trading at 2x. Even if you factor in that virtually all “high flying” software IPOs in 2021 have done poorly, we note a steady and consistent erosion of multiple since the bear market bottom in 2022:

We believe there is a disillusioned investor base, with a bit of a “three strikes and you’re out” dynamic going on.

Strike 1 (2023)

Company issued a secondary in August, 2023, then materially missed the quarter right after the raise, a big no-no. We believe this was the beginning of the end for the previous CFO.

Strike 2 (2024)

Significantly underestimated Canadian headwinds in 2024, resulting in a downward revision to revenue after downplaying the issue initially.

Strike 3 (2025)

Disastrous Q4 earnings call combined with dilutive acquisition (described more below).

We believe “Strike 3” combined with seemingly darker clouds in the US had many of the most loyal investors abandoning the company, specifically those that are growth focused.

Although there may still be a bit more investor churn to move through, the previous investor base (primarily growth-oriented) has largely washed out and the company is moving into the hands of value investors, as shown below using Factset holder style categorization:

After management’s catastrophic Q4 call, which included initial 2025 revenue guidance well below consensus (12% growth vs ~20% consensus) and a pricey, seemingly dilutive acquisition that consumed half their net cash hoard, we believe the market was left confused as a full-fledged Bear Case seemingly reared its head.

Whereas management was previously viewed positively, the size and explanation of a major acquisition at a time when the rest of the business was struggling, combined with a major Reduction in Force (RIF) made the market reflect on whether perhaps this team’s talents and capital allocation were not as good as originally thought. We believe the messaging was confusing to both value and growth-oriented investors. Managment was simultaneously telling investors that they were aggressively curtailing spending through the workforce reduction while also splurging on a large, expensive, dilutive acquisition.

Voss Variant View

Although we acknowledge these missteps, which we view as a combination of poor messaging and, honestly, some plain ole bad luck, we still believe the operational execution remains strong and have developed variant views on what we view as current short-sighted consensus perceptions, summarized below.

Consensus Perception vs Voss Variant View:

The TAM in Education is Saturated

We believe their remains sizeable opportunities to add new clients outside of the top four markets (US, Canada, Australia, UK) but more importantly, we believe they have several more years of strong growth in moving more customers to their Student Financial Services (SFS) platform. This narrative will begin to emerge in the coming quarters as they roll out SFS in the UK more aggressively.

Extreme Vulnerability to Macro/Regulatory Environment

We believe they have gone through close to the potential worst-case scenario, and that things are likely to get better in the next 2 years (or at least not actively worse), but absent that they are quickly diversifying, not only into other verticals, but becoming less dependent on first year international students driving growth through their SFS launches. Our variant view (perhaps) is that there is not some secular change in demand/supply for study abroad, but rather there are ebbs and flows, and we are nearing the end of an ebb.

US/China Tension Can Materially Disrupt the Education Business

We acknowledge the potential cooling of demand in the US market given political rhetoric but believe the “nuclear option” (e.g. banning students from China or putting harder caps in place), is unlikely. Further, breaking down the actual impact of this risk suggests it is highly manageable.

Low Student Retention

SFS launches, as well as more proactive education from Flywire to universities, will significantly help solve this problem, as we don’t believe Flywire is more expensive than a bank wire. There would also seem to be potential partnerships with banks or neobanks that could help improve retention.

Management Are Questionable Capital Allocators and the Sertifi Acquisition Showed Desperation

We believe there are tangible, significant revenue synergies in the Sertifi deal that should make the acquisition closer to their blockbuster WPM acquisition in the UK as compared to their less successful Simplee acquisition in healthcare. Depending on priorities, the B2B segment also seems ripe for significant further expansion.

Healthcare Was a Failure

We don’t completely disagree, but we do see significant acceleration from this business in the back half of the year, and believe management is actively considering pruning it from the portfolio to focus on Education/Travel/Hospitality.

The Flywire Education Business

Despite growth in their Travel and B2B businesses, Education remains about 75% of total Flywire revenues and thus is still the primary driver of the stock. We think the market remains confused about Flywire’s education business, both in how they make money and how they retain both universities (customers) and users (students), with myopic focus on first year enrollment in various regions. If we are right on our thesis, the market is even more confused about the trajectory and potential growth.

The roots of Flywire’s products, and to this day what many universities primarily use them for, are an avenue for international students to pay their tuition from their home country. Paying tuition outside of one’s home country is a different workflow than paying domestically, with the primary difference being the need to convert the payment from one currency to another and dealing with various regulations around capital outflow from the originating country. It may seem simple, but there is substantial value in being able to do this seamlessly, both to the university (primarily around reconciliation and security) and to the student/student’s parents (for useability and flexibility).

For instance, in China, India, and other countries where capital flight is a concern, there are restrictions on how much and under what circumstances citizens can send money out of the country. Flywire and a small number of other companies have relationships with China, India, and most other countries to act as a Payment Service Provider (PSP), similar to companies like Square, Paypal, and Adyen but focused on specific verticals. Because of these relationships, it is far easier for a parent in China to utilize Flywire to pay a tuition bill than it would be for them to wire it to a bank in the United States and pay it from there. For the university, the currency conversion messiness can often result in slight discrepancies in what is paid versus what is owed, which can then become an administrative headache tracking down those discrepancies and getting full payment. Flywire’s basic “light” product does all this quite well, but it’s limited to those payments and only those payments. Flywire generates revenue here essentially by currency "off-ramping", pocketing a small percentage of the transaction (we estimate ~1.75% take rate for currency on average) during the currency conversion, while also charging the universities an annual software license fee.

We believe Flywire’s initial “land grab” of growth in Education was defined by establishing footholds in universities across the world (with a focus on US/UK/Canada/Australia) with a product that worked quite well and solved a real problem but was a bit limited and was susceptible to churn on the user (student) side as the international student eventually set up bank accounts in the destination country. In fact, you could make a short case around Flywire’s net revenue retention (NRR) numbers being inflated as much of it was simply a product of landing in a university and capturing freshman students, then retaining enough sophomore students to show strong “retention”.

For example, College A adopts Flywire and most international freshmen students use it in year 1. Further, let’s say in year 2 a full 75% of the now sophomore students churn off Flywire and pay using some other mechanism as they have established domestic bank accounts. If Flywire captures a similar number of first year students, their net retention would show up as 125% (e.g. 100% of replacement freshmen students plus 25% of sophomores). However, this song and dance can only last 4 years and by the fifth year you no longer have a “new year” to add and reported retention would likely go down. In other words, 25% user retention can look like 125% university revenue retention for a few years, then fall off a cliff (closer to 100% unless they can improve student retention), simply by the mechanics of the four-year university cycle.

The real prize for Flywire is the “land and expand” strategy of getting universities to use Flywire as the exclusive or semi-exclusive “payment portal” for what they call Student Financial Services (SFS). In this case, Flywire becomes much more enmeshed in the university workflow as now virtually all tuition payments (both international and domestic) are processed through Flywire. Not only that, because of the strong two-way integration between Flywire and the university ERP, Flywire’s software is often used by administrative staff as it’s more user friendly and intuitive than the ERP.

Landing an SFS contract results in multiples of revenue at the university, as previously Flywire might have been processing 10% of payments and with the adoption of SFS they process nearly 100%. However, a 10% to 100% jump is not as simple as a 10x revenue jump because processing domestic payments carries lower take rates than if the payment involves a currency conversion (they do not disclose this rate, but we estimate 1/3 the rate or less). The real one-two punch is if Flywire can simultaneously get the university to use their SFS product while also increasing the percentage of currency conversion transactions.

The SFS (R)evolution: Cracking the UK

In the UK, we believe Flywire has developed a unique template that not only provides a great value proposition for universities to use SFS but also encourages international students to “leave their currency at home” when paying through Flywire, maximizing both total payment volumes processed (~100% of students) while also maximizing the value of each student (international students paying from home).

While the UK has already become Flywire’s largest education market from a revenue standpoint (per management), it's a core part of our thesis that Flywire is still in the early innings of seeing the real uplift from SFS, as they just completed the first of several major ERP integrations and are seeing preliminary (but significant) success in the UK that can drive full Student Financial Services (SFS) adoption and thus increase revenues at the university from 2-25x, depending on where the university is starting from and the breadth of solutions they take.

We think there are four things Flywire is emphasizing that are helping them land significant contracts in the UK:

1. They educate the school and show them that by students “leaving their currency at home” and paying through Flywire, it saves the university substantially on fees. If a student pays through Flywire internationally, the fee for the university is zero, whereas if the student pays locally (even through Flywire), there are transaction fees the university incurs.

2. By building real time integration with the school’s ERP (for example, Unit4, which is in 50+ major UK universities), there is a significant reduction in manual labor and adjustments that allows the university to use their administrative staff more effectively or potentially reduce staff. They just completed Unit4 integration in Q4 2024, and by Q1 announced signing four UK universities, with a large pipeline of at least 50 additional schools. We believe some of the “macro pressures” could help accelerate adoption here as schools are looking to save money.

3. By using Flywire’s Collections Management System (CMS) software and Payables software, the university can save materially on paying collectors while receiving a 3x uplift on unpaid tuition recoveries, as well as receive lower rates on Payables fees compared to what banks offer.

4. Provide a profit share with the university upon certain retention thresholds.

We believe the first two items are most important as per our discussions with people on the ground in the UK, convincing and marketing students to “leave their currency at home” can save the university a substantial amount of money (hundreds of thousands for a large university). Here is a Manchester Metropolitan University Finance Head, one of a handful of SFS beta customers, describing the benefits they experienced by directing students to “pay from their home country”:

“The reason why it’s game-changing is because all those universities that still, in the main, encourage students to transfer the money to a UK bank account so they can collect in sterling don’t have to do this anymore. They can tell students to keep the money in their home country because this SFS product will engage them at the front end of the cycle…not only will you not have to pay anything for that transaction, but you’ll save about £200,000 (GBP) in transaction and acquirer fees because you’re no longer paying the bank charges, you’re no longer paying Visa or Mastercard, and you’re no longer paying handling fees. You’re no longer having to manage it yourself as an organization.”

The person quoted later clarified that the £200,000 (GBP) in savings was for around £20 million in processing, and that they process multiples of that, so they may ultimately save in the range of £800,000-£1 million pounds ($1.1-$1.3M USD) a year just in fees.

This individual further explained that by launching SFS with its seamless simplicity, they have cut down “student engagements” (e.g. calls/emails from students having issues paying and sorting their financial situation) by 90%:

“When we went live with Flywire’s SFS model in 2021, my finance team had engaged with students around 32,000 times…this year, and we’re pretty much towards the end of the academic year now, we’ve done 3,100 engagements. We’ve reduced our engagement since live with Flywire’s SFS model by 90%. That’s enabled us to refocus our staff in doing value-added stuff.”

Note this is the first of merely a handful of test sites, so they may have around 5% or less penetration with SFS for a market where they have 80%+ market share of international payments already. It is our understanding that there is no competitor that can even come close to matching this, specifically the intricate ERP integrations, and that the primary reason you won’t see all the schools just move to this is the generally glacial pace of change at bureaucratic UK universities administrations. Thus, we see an opportunity for the already sizeable UK business to become significantly bigger over the next 2-3 years.

You may be asking how the students feel about this. Is it a bit cheaper to move all your currency into a bank account in the UK and then pay the school rather than pay directly? We believe it might be slightly cheaper, but the degree of cheapness is a rounding error compared to the ease and flexibility of payment options that Flywire offers, and the slightly cheaper costs assumes you are not doing multiple transactions throughout the year. Using Flywire cuts the total number of transactions in half (e.g., move money into a bank which involves a currency charge, then pay domestically, which triggers other banking charges).

According to the people we have spoken to, the students embrace it because of the significant flexibility of choice in how to pay (e.g. Alipay, ApplePay), the breadth of currencies offered, and the slick flexibility in providing payment options (e.g. set up daily/weekly/monthly plans, pay from your bed, allow parents/sponsors/relatives to pay directly from the home country). Here is how it was framed to us in various snippets:

“I once got a load of Chinese students in a room and I said, ‘I need to understand something from you because you’ve all made payments through Flywire in the last six months, but you’ve not all chosen the cheapest Fx rate. I need to understand why you’re not choosing the cheapest Fx rate…this Chinese student got up and he said, ‘I’m speaking on behalf of all students who are in this room…it’s not for you to tell us what payment option I choose. It’s for you to give us the choice because you don’t know what kickbacks I’ve got in my country. You don’t know what financial incentives I’ve got by having that particular payment…you’ve done what we asked you for, and that is provide choice. Payment choice is what we want.’”

“We now have 94% uptake, so that is if you joined last year, we’ve still got 94% of students that are paying in [their home] currency in this year.”

In other words, by making Flywire a flywheel, it mutually benefits Flywire, the university, and the student as well.

Doing the math on this, we believe just moving 20-25 universities over to the SFS system in the next couple of years would grow UK revenues by $50M+, or over 50%. Could the uptake be even higher over the next couple of years? Well, the person we talked to was so excited about how his product was working for him, he is now presenting his experience (for free) to other universities on behalf of Flywire:

“I am being asked to present two universities a month at the moment, minimum. Actively, I have a project manager that works alongside me, and we are both happy to engage universities. We have a standard presentation that we deliver to universities. Almost every single time we present the FD or the CFO turned around and said, ‘That’s exactly what we were told by Flywire, but we needed to hear from a university’.”

For an industry that is generally reticent to change and particularly swayed by others’ experience, this is powerful to have an advocate running around making presentations on behalf of Flywire. Word of mouth will fuel the pipeline and help close deals, and we are quite optimistic about the opportunity set here, not only in the UK, but the potential to follow this same playbook across the rest of Europe as more ERP systems are fully integrated. Management cautioned us that the rest of Europe would likely not start this year, but partly this was because they “still have so much opportunity in the UK and want to make sure we get it right in other markets.”

Some of the company’s early SFS learnings in the UK can also be applied to the United States, specifically getting the school to actively market international students to pay remotely. While the United States is clearly more competitive, our conversations indicate strong satisfaction with Flywire while other vendors have more of a lukewarm reception. For instance, here is what a director at Stanford said about Flywire relative to the competition:

“I would say 90% of our payments and also bank transfers [go through Flywire]. We have a bank wire, and we’ve made a concentrated effort to move our students away from the bank wire and over to Flywire. Ultimately, we want all of our international payments to go through Flywire...I think that (competitor) Convera is a great option. I feel like just from experience and use with Flywire, Flywire is more seasoned. Their system, their platform, their service and also options for the students as far as the conversion options are more robust with Flywire than Convera. It’s just an overall easier process, it seems, for our students using Flywire. We have tried to market, you would say, Convera more, but the preference tends to be with Flywire.”

To summarize, we believe the narrative around Flywire hitting some kind of wall in education is very misguided and the fear is overblown. Even in their largest and “most penetrated” market of the UK, we believe there is a real opportunity to at least double their revenue base over the next few years. Many other markets with weak competition remain mostly untapped, while learnings from the UK can help growth in the largest potential market, the United States.

Potential Macro/Regulatory Pressures in the US and UK

Although we attempted to articulate that first year enrollments for students should play less of an issue for Flywire (because of diversification within education and the burgeoning Travel vertical), we can understand how investors are weary of additional issues after Canada caused such unanticipated disruption for the company, and now both Canada and Australia appear to be headwinds again in 2025. The concern is that the next “shoe to drop” is the United States or United Kingdom (or both), the biggest two markets for Flywire.

While we cannot eliminate this concern in the medium to long term, we do not yet see material signs of this being an issue in 2025, outside of some likely declines in the US market that in the context of guidance feels very manageable to us.

Looking at the UK first, it is true that the government has done some things to make studying abroad less desirable. Starting in 2024, the government no longer allowed family members to accompany students with them to the UK. This did appear to have an impact on total visa applications, as shown below:

While we don’t have exact UK revenue data for Flywire from 2023-2024, it’s pretty clear this decline in visas in 2024 did not slow Flywire’s UK growth down. In fact, it’s possible that by parents not coming with their child, it potentially increases currency conversion payments despite fewer total students.

Looking at 2025, while it is true July-September is where most student visas applications occur, thus far through June we have seen a near 20% rise in UK visa applications, with numbers bouncing back to 2022-2023 levels.

Management noted that their working assumption embedded within 2025 guidance is that the UK would have a similar drop as from 2023-2024, so things would really have to fall apart at this point to reach that level.

The reason this was the original guidance assumption was that the UK government was working on other specific items that could limit total visas. If we look at the original document from the government document titled “Restoring Control over the Immigration System- Technical Annex”, it outlines (with estimates) how it could impact total international students, with the potential changes impacting around 37,000 students when adding up the various components of the recommendations. This would be around 9% of visas at the current run-rate. We would note, however, that these are merely proposals and the only guideline implemented (increased skill level requirements) would have an estimated impact of only 9,000-14,000 students.

There are other early positive anecdotal data points. We recently broached this subject with a Director of Finance at the University of the Arts (in London), and he expected similar international enrollment this year as last year, emphasizing they were spending aggressively to market and work with international students because of how valuable they are:

“It’ll be relatively similar [this year versus last] ...the challenge here isn’t the fact that we don’t want UK students. That’s not actually the challenge. It’s because of the payment. Remember, we are forced to charge less than £10,000 (for domestic students). We don’t have a choice...our international students, they are actually subsidizing our domestic students.”

We think this is a key point. Universities are not just ambivalent about replacing a domestic student with an international student--they need international students to attend their university and will likely spend money on recruiting to drive international enrollments. This sentiment was reiterated recently by Unite Group, a REIT in the UK that focuses on student housing. On July 8^th this group noted that “student numbers are expected to increase for the 2025/2026 academic year due to improving trends in international student recruitment.”

Finally, there is a UK application called UCAS that puts out periodic summaries of acceptances which indicate that, through June, accepted international undergraduates were up 4% y/y.

Between these anecdotes and the run-rate data showing between 4 and 20% growth, combined with management setting a low bar in guidance, we feel reasonably confident in the UK setup.

United States Education Market

In the United States, it is admittedly harder to get a good read on trends, and we do think there is real risk that visas come in lower in 2025 than in 2024, perhaps materially so. For instance, a recent report from the International Institue of Education (IIE) suggests a higher percentage of schools expecting a decline in international students (albeit 32% still expect an increase and another 32% still expect “stable”). However, the “nightmare scenario” that started to emerge when the Trump administration was aggressively posturing to both China and major universities around their enrollment practices seems to have died down. In late May, there was a “temporary pause” on new visa interviews. As we understand it, this pause ended in late June, lasting less than a month, and was framed more as updating their social media criteria vetting process rather than any stance on restricting total visas.

Further, for the moment Trump seems to be OK with ongoing Chinese enrollments, tweeting out:

“WILL PROVIDE TO CHINA WHAT WAS AGREED TO, INCLUDING CHINESE STUDENTS USING OUR COLLEGES AND UNIVERSITIES (WHICH HAS ALWAYS BEEN GOOD WITH ME!)”

Yet given Trump’s long history of quickly reversing positions when it is expedient, we certainly cannot rule out a risk starting in 2026 that visas are limited more broadly or targeted at specific countries. It is our view that the most likely longer-term risk is that tensions escalate further with China. The shorter-term risk is that the rhetoric has a cooling on demand to study in the United States that the universities do not have time to counteract that in the 2025 recruitment period. Given the pause in interviews during most of June, we do expect miserable June visa estimates but would expect things to begin picking up substantially in July/August. Walking through the numbers with the CFO, this is how it was framed to us:

First, if we look at the entire US cross-border revenues, it’s about 15.5% of proforma revenues when including Sertifi ($82M versus $520M total proforma revenue). We believe roughly half of that is first year students, so around $41M. Hypothetically, if there was a 25% drop in first year enrollment, which seems very high but possible to us, we are talking about a revenue hit of roughly $10 million (2%) that would have to be made up in order for the company to achieve their “low single digit US growth” embedded within guidance. It seems plausible to us that this growth could be made up through a combination of SFS signings (5 in Q1 in the United States), new university signings (nearly 800 new customers announced last twelve months, although the total within US education is not known), and/or general retention initiatives between grade levels and across grad programs.

Or we can assume a more targeted hostility to China. Losing all first-year Chinese student revenues would be contained to a mere 2% drag on total FLYW revenues. If all Chinese students were banned at once (which would imply to us some kind of military confrontation with China), there would be a ~4% hit to revenues. Still manageable.

We also believe that students who bail out on studying in the US this year would likely apply and attend school elsewhere, as this is not a country-of-origin supply problem. The IIE report stated that “nearly three-quarters (71%) of U.S. institutions noted that prospective students may be choosing to enroll at universities outside the United States.” In this case, the NET impact to Flywire would likely be smaller as Flywire has a strong presence across the globe, and the likely alternatives (UK, Australia, Canada, and continental Europe) are areas of particular Flywire strength.

Having said that, we do view the degree of US enrollment decline as the biggest risk and unknown to our thesis as it is hard to quantify. We believe the bar has already been set very low and the actual impact is manageable as described above, but we cannot rule out either greater short term demand destruction than we are anticipating, new headlines, and/or policies that could threaten the long term health of the study abroad ecosystem in the United States. Given how important international students are to most United States university’s bottom line and in some cases sustainability, we would expect a rebound next year with more aggressive recruitment tactics to entice students to come (like what we are seeing in the UK), combined with aggressive lobbying on the political front.

Riches in Niches: Exotic Travel/B2B Travel and the Sertifi Acquisition

Flywire has historically focused on niches that involve larger, more complex payments across countries, and their push into Travel and B2B fits neatly into that framework. The growth here, which has been organic up until Sertifi, is impressive:

Note from their disclosures we believe Travel is about $60M while B2B is about $15M. The company is trying to position the Travel vertical’s success and potential as like Education, showing the “first five years” of each cohort, with Travel (allegedly) eclipsing Education in gross profit dollars by year 5:

When Flywire announced they were acquiring Sertifi, the timing and size of the acquisition was optically about as bad as it could get. Flywire, even prior to their collapse from $18 to $9, trading at around 3x sales, buying a Sertifi business that they claimed would add “$30-$40 million in revenues” for around $350 million. So, a 3x sales business buying a business at 10x forward sales while using more than half of their cash, right at the moment you announce a material RIF and lower guidance for the underlying business. Oof.

Given the vague guidance on EBITDA contribution from Sertifi, we were also left to wonder if this acquisition would burn additional cash. We estimate that the acquisition, given its size as a percentage of total enterprise value and minimal expected EBITDA contributions, increased the underlying EBITDA multiple of the stock by 2.5x turns, which significantly lowered the potential floor of the stock if an investor is trying to put a line in the sand on EBITDA multiples. In other words, if 8x EBITDA was our previous Bear Case floor, this acquisition just forced us to lower the Bear Case target substantially (this quarter was just bad news for both Value and Growth investors).

We also think the company did not do the best job on the initial conference call articulating the potential upside and value proposition, resulting in effective panic selling as regulatory clouds seemed to get darker and the value investors were ascribing to their cash hoard was lowered.

All that said, virtually every new piece of information we have learned about this acquisition since the announcement has put it in a much more flattering light. We still believe the cost was high and think the timing and communication was poor but now see a real possibility that this asset can drive material revenue synergies while also continuing to expand the TAM into natural adjacencies.

The first thing to know is that the $30-$40M of revenue was not Sertifi’s total revenue, but 10 months of revenue. Thus, instead of $35M in revenue we were actually looking at $42M in revenue at the midpoint (proforma), and closer to $50M on the upper end of guidance, lowering the implied sales multiple somewhat. Second, Q1 results indicated that at least for that quarter, Sertifi was not going to be a material margin drag. In fact, Sertifi was accretive to margins in the quarter:

We do expect Sertifi to be a modest drag on company margins as the company makes some investments and we get to the seasonally higher margin quarters of Flywire’s core business, but this was still much better than we were originally expecting.

More importantly, conversations we have had with hotel industry players suggest to us that not only is Sertifi a well-entrenched, high-quality, fast-growing SaaS asset in the enterprise hotel space, but the revenue synergies are straightforward and appear to have preliminary support from some of the largest chains using it like Hilton and Marriot.

A Hilton person we talked to was already intimately familiar with both Sertifi and Flywire functionality and explained how Flywire’s features were highly complementary to Sertifi:

“A few examples are Sertifi doesn’t have multi-currency support today, so it charges in USD and therefore, you’re subject to your bank’s foreign exchange rate. Flywire has that capability, and it also has its own built-in foreign exchange. As I understand, it’s better rates than the banks offer so that’s a cool additional capability. The other thing that Flywire has, Sertifi doesn’t, it has local integration to a lot of the regional payment processors so it just allows more extensive integration from a global perspective. You can do payment plans with Flywire, you can’t do that with Sertifi, and you can do split payments with Flywire, which you can’t do with Serfii…when I think of the integration and acquisition, I get excited about the payments aspects.”

In other words, Sertifi is strong on contract workflows (essentially a Docusign for hotels, with superior Property Management System integration) but is missing some specific payment functionality (especially for currency), which is precisely where Flywire thrives.

This person claimed “at least” 50% of Hiltons are using Sertifi, but this was strongly tilted to their American hotels where currency conversion was less necessary, so he also thought the acquisition would be a way to get Sertifi onto the rest of Hilton’s hotels:

“Just leveraging different currencies and that capability is going to make Sertifi a lot more attractive to our hotels internationally…Sertifi does not have much penetration in our APAC market…it’s good for us internally from a system perspective too because the more payments we get going through Sertifi, that means fewer payments going through the one-off integration or non-standard methods that we’ve set up. It streamlines processing on our side which reduces cost.”

To us, this is an explicit and unusually strong endorsement of an acquisition by a large enterprise customer. Although we would not expect Hilton to immediately adopt Flywire in all their hotels as it sounds like some integration between Sertifi and Flywire needs to occur, the 2–3-year opportunity seems to validate management’s rationale for doing the deal and perhaps paying a bit more than they might otherwise would have. Management has talked about how layering on payments with a Sertifi customer can increase revenues for Flywire “by multiples”, so they don’t need to cross-sell that many hotels on Flywire payments before the math of the acquisition starts to work.

Flywire’s Emerging Profitability

A criticism of Flywire coming out of the gate was their poor profitability. In fact, through 2022 they were still running at a negative incremental EBITDA margin. Since then, though, their incremental EBITDA margin has skyrocketed to above 40%, as shown below:

Because the company has significant net cash (e.g., positive interest income), very low capex (~1% of sales), and is a low taxpayer, their underlying FCF conversion is quite strong as well.

It is true their working capital is volatile (primarily because of “Funds Payable to Clients” and “Funds Receivable from Payment Partners”), so we believe looking at Funds from Operations (FFO)–Capex is a better gauge of underlying FCF. Looking at this metric, Flywire has converted at or around 100% of EBITDA:

While the Sertifi acquisition may hit these metrics modestly in the short term, and we would note that some of their Travel revenues come in at lower gross margins (which could modestly slow down additional gains in incremental EBITDA margins), we see no reason why the company cannot continue to run near 35-40% incremental EBITDA margins and 80-90% FCF conversion.

Trading Comps

At the risk of alienating people, we will compare Toast (~15x NTM consensus gross profit) to Flywire (3x). Before going further, we believe Toast should trade at a premium to Flywire because of their excellent, more consistent organic execution, still stronger growth profile at a larger scale, and likely larger more immediately addressable TAM.

However, we’d like to point out that the two companies really aren’t that different and, if Flywire had had just a neutral macro/regulatory environment the past year or so (as opposed to a nightmarish one), their growth profiles might look about the same. Moreover, we think Flywire’s customer base is almost certainly sturdier than Toast’s.

Toast is a technology company in the restaurant industry that leads with a strong software platform but monetizes primarily through payment processing.

Flywire is a technology company in the education and hospitality industries that leads with a strong software platform but monetizes primarily through payment processing.

Toast can be characterized as dominating in US SMB restaurants, with some fledgling but unproven success with larger restaurant chains and emerging potential with international restaurants, while also continuing to monetize their existing customer base.

Flywire can be characterized as dominating cross-border tuition payments around the globe, with emerging but still somewhat unproven success in capturing the larger education payment workflow through their Student Financial Services products and growing success in extending their technology platform to other verticals, namely travel and hospitality.

On the positive side of the ledger for Toast, their entrenched position with point of sales (POS), the “brain” of the tech stack, makes their offering more mission critical than Flywire. You could also argue Toast is working with a larger (more immediately addressable) TAM, although we would argue Flywire has numerous emerging opportunities with gigantic TAMs (like B2B payments).

Flywire has some relatively positive characteristics as well, though. For instance, Toast’s reliance on “mom and pop” and small chain restaurants means they will constantly have to spend some percentage of revenue on Sales & Marketing just to offset chunks of natural churn of restaurants going out of business (some estimates are that 60% of new restaurants fail within three years). Flywire is clearly more “enterprise” focused, with established universities, hospitals, and global hotel chains that lack the existential risk that one-off restaurants have. Further, Toast’s cyclicality is also underscored by payments levels dropping, directly impacting revenues, whereas Flywire's education business is counter cyclical. Finally, while acknowledging both companies have some regulatory risk on their payments “take rates”, we would also point out that Toast, which clearly charges smaller restaurants way more than what larger restaurant chains negotiate, could more easily come into the crosshairs of regulators looking to level the playing field.

We are homing in on Toast primarily because there simply are not that many good comps for Flywire. A lot of other transaction comps are more horizontal or SMB/consumer focused (e.g. Block, Global Payments, Bill.com), much more levered (Shift4, Global Payments) are smaller or unprofitable with no clear dominating vertical (i3, Lightspeed) or have radically different unit economics (e.g. Payoneer who generates a large % of EBITDA from interest income). Indeed, probably the next best comp was recently acquired (AvidXchange, see below).

Nevertheless, here is our comp group, using 2025 and 2026 consensus median estimates:

Transaction Comps

Corpay and TPG agreed to acquire AvidXchange (AVDX) for $10/share on May 6^th for $2.2 billion dollars. One day after the announcement, AVDX announced their Q1 numbers, missing EBITDA and revenues (2.2% revenue growth and flat EBITDA) which resulted in lowered 2025-2027 numbers from consensus, with 2026 EBITDA estimates around $96-$106M, implying a deal price of ~19x EBITDA.

Thus, this transaction valued AVDX at close to double the sales and EBITDA multiple of FLYW, for a company that just posted roughly flat EBITDA and revenue growth versus FLYW that is poised to grow EBITDA by over 30%.

We view AvidXchange as one of Flywire’s closest comps, as AvidXchange also has a similar mix of software and payments revenues and targets specific verticals like construction and real estate in processing B2B payables. Both companies are also of fairly comparable size, although Flywire is rapidly increasing their EBITDA and already has greater scale there. For the sake of conservatism, we use just 12x EBITDA in our base case for FLYW, a 37% discount to no-growth peer AVDX.

We would also point to Roper Technologies buying out Transact Campus in August 2024. Transact was projected to grow in the “high single digits.” They did have a 30%+ EBITDA margin but were purchased for 14x FY2 (2025) EBITDA including synergies with Roper's other education brand, CBORD. Although Transact did have a currency conversion tool launched in 2022, we believe Flywire is far ahead of it, with Flywire dominating other countries while Transact primarily operates in the United States.

Flywire as an Acquisition Candidate

Flywire has been repeatedly floated as an acquisition target, and for good reason in our opinion. In August, 2024, media reported that Flywire had been approached by suitors and had hired Qatalyst Partners to evaluate their options. Although apparently nothing came of these talks, Flywire strikes us as being potentially attractive to a number of industry players, ranging from strategics to private equity to software conglomerates like Roper.

Given Flywire’s strong access to and relationships with college students, we believe Flywire would be strategically interesting to any large bank (like say Capital One) or Neobank (e.g., Wise). In fact, we are surprised Flywire has not already partnered with banks and/or neobanks to drive retention. For instance, Flywire could refer their customers to a “preferred bank” who would help the student set up banking services so that the student could easily access spending money through Flywire. In fact, a former employee said a big reason they lose students after freshmen or sophomore year is the student needs outside funds anyway, and cannot use Flywire to achieve that, so they just go through a bank despite it being a giant hassle:

“Flywire only helps with tuition payments, but the student still needs money for the living expenses... A very big opportunity for Flywire will be to offer neobank capabilities like a wallet for students before they arrive to the US in a similar way to what TransferWise and Revolut companies are doing and capture those living expense flows. They’re looking into it, but they haven’t launched anything yet.”

We believe the synergies would be very obvious and that college students are viewed as high value marketing targets.

Additionally, with Flywire’s quickly burgeoning cash flow profile and strong balance sheet, private equity could easily LBO the company at 4-5x leverage and pay double the company’s current price while assuming only moderate growth levels (~12%) to achieve a 20% IRR.

Conclusion: Flywire’s Emerging Flywheel is Fixing to Flip the Faulty Narrative

Flywire is in a unique position of still aggressively adding customers in one emerging vertical (Travel/Hospitality), as noted by their ~200 new customers added in each of the last four quarters (off a base of 4,500 customers), while beginning in earnest the “expand” part of their “land and expand” strategy within Education. Thus, they still have strong customer growth while simultaneously showing burgeoning operating leverage through significant upselling and cross-selling. This is fairly unique in the space, as typically players are either in cross-sell/improve profitability mode, or are in cash-burn/aggressive customer acquisition mode.

We believe the market is not pricing in any of these positive dynamics and is instead agonizing over what “Trump might tweet next” or whether UK enrollments will be flat or down 5%. If you have a belief that there is a secular, global change in the attitude towards studying abroad (both supply and demand), Flywire is probably not the right investment for you. However, if you believe like we do that there are ebbs and flows in these dynamics, that the universities have huge incentives to retain and recruit as many international students as possible and that the value proposition of studying in the United States or the UK is still extremely strong, then you too can exploit the myopic short-termism going on in FLYW shares. In 12-18 months from now the stock could have a completely different narrative.

At 2x sales and near 10x 2026 FCF, Flywire is trading closer to the valuation of a company that is secularly declining versus one that is doing the disruption. In our Base Case, where investors develop a more neutral interpretation of their markets and competitive positioning, we believe the stock would move back to at least $18, representing around 5x EV/gross profit and 18x our 2026 FCF estimates. This multiple anticipates some reacceleration of growth in the back half of 2025 and into 2026. In a Bull Case, where the narrative flips closer to resemble that of a Toast or Paymentus, there would be materially more upside. In a Bear Case, where growth optionality does not pay off, regulatory issues continue, and the company focuses more on profitability, there is limited downside to around $9-10 (10x FCF on significantly reduced estimates).

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We believe PAR Technology Corporation (PAR) is worth more than $80/share today based on our expectation of margin expansion and growth acceleration becoming evident in the next couple of quarters, combined with the scaling of acquisitions that are both profitable and strategic while also expanding PAR’s total addressable market (TAM).  Software platform winners with large TAMs, low churn and concurrently accelerating revenue growth and rising margins at scale deserve to be valued at premium multiples and we believe PAR is at a tipping point in demonstrating all those things.  Our $84 base case price target is based on 27x 2026 EBITDA and 5.5x EV/Sales—which is a conservative discount to other vertical, scaled software platform winners. 

Key Thesis Points:

1. Accelerating organic ARR from large new wins and rapidly expanding ARPU

2. Significantly expanding margins from underappreciated cost discipline

3. Profitable and strategic M&A expands TAM while strengthening software platform

4. Divestiture of Government (finally) creates a pureplay

5. Gigantic RFP pipeline of large Tier 1 QSR restaurant chains

6. Competition at an all-time relative low

Introduction

We exited PAR Technologies throughout 2021 after years of it being a core long when it became apparent to us that the true growth and profitability inflection was going to take much longer than we had originally anticipated and buyside expectations got way ahead of themselves.  While we loved newly appointed CEO Savneet Singh (whom we pushed to get appointed to the board in 2018), we knew he was a very long-term thinker and was making investment/capital allocation decisions that would position the company ten years out, not one or two, and yet an immediate operational inflection point had already been more than priced into the stock.

With each passing quarter we were hopeful we would see signs of a growth/profitability inflection, yet each quarter there seemed to be some new issue that delayed that inflection.  First there was a ton of R&D debt that had to be cleaned up to make customers happier.  Then there were acquisitions that added upfront costs which obscured underlying progress (most recently the MENU acquisition).  Following that, there were seemingly some delays in getting growth drivers off the ground (Payments and Table Service).  A bizarre legacy contract with Arby’s involving an ARR stepdown had also obfuscated growth.  In all cases it seemed like there was a strong pipeline of large new wins just waiting to be realized, along with costs stabilizing, but it just was not quite showing up on the P&L, and there were no tangible customer wins to latch onto. PAR’s big inflection was like “waiting for Godot”--it was always just around the corner. 

We believe the wait is finally nearing an end and there are several significant tangible signs that the long-awaited upward inflection is about to occur.  This inflection may begin in conjunction with the beginning of the Burger King rollout, which we believe starts in earnest in Q2 of 2024 and continues through mid-2026.  However, there are several additional positive catalysts of note between now and then.

Over the next year we believe the company will simplify operationally (by selling their unrelated Government business, finally), revenue/ARR growth will begin to accelerate on the back of known contract wins (Burger King and others), and significant upfront investments will be harvested to show burgeoning margin expansion.  In this scenario we would get “Voss Sauce™” - accelerating revenue growth with concurrent rising margins - which usually leads to valuation multiple expansion, particularly when a company is going from unprofitable to profitable.  Pair that with the recently announced acquisitions of Stuzo and Task, and we believe you will have a more fully scaled, profitable pure-play company emerging that will begin getting the valuation credit that enterprise pure-play software companies like AGYS, APPF, MANH, GWRE, TYL, and others currently enjoy.

The competitive landscape is starting to get weaker just as demand gets stronger. In our view, competitive risks are now at an all-time low with Toast losing their largest customer (Jamba Juice) and Oracle/NCR still struggling, providing a bit of a tipping point whereby PAR could be a “winner take most.”  This coincides with larger restaurant chains considering moving away from “do it yourself” POS and many other Tier 1s realizing they desperately need to upgrade their technological infrastructure.  In other words, competition is weaker, and demand is stronger.  Additional burgeoning growth drivers for PAR like Table Service, Payment attach rates, and the long-hyped international expansion should further add building blocks of credibility to justify a premium multiple.

Obvious trading comp Agilysys (AGYS), which has a similar revenue base and does what PAR does but for hotels, trades at 8x sales, 12x Gross Profit, and 45x NTM EBITDA (~34x 2026 EBITDA).  We believe PAR’s profile over the next 12-18 months will make them look much more like AGYS (15% EBITDA margins with 20%+ sales growth), and thus the stock could garner a similar multiple (this can be corroborated with other similar companies like APPF, TYL, etc.).  In a Bull Case, PAR actually looks far more attractive than AGYS as instead of one giant customer win (Marriott for AGYS), PAR could likely be talking about several (Burger King, Popeye’s?, Wendy’s?, Chipotle? Subway?).

PAR’s path to $80+ is straightforward to us. We derive it by forecasting $125 million in EBITDA in 2026 with a 27x EBITDA multiple, based on adding $138 million in ARR (25.5% CAGR) organically with ~60% incremental margins based on well telegraphed expense discipline combined with the EBITDA from the two recently announced acquisitions.  This EBITDA multiple implies around an 8x ARR multiple, a 5.5x sales multiple and 10x EV/gross profit, still materially below the comp group.

PAR’s Business and Competition

For those new to the story, PAR’s primary business is selling hardware and software to restaurants, specifically Point of Sale (POS).  To further segment their focus, they have historically been most active in large, enterprise level accounts in the “Quick Service Restaurant” (QSR) or “fast casual” space, selling their hardware to McDonald’s, Yum! Brands, and many others for over 40 years now.  Over the past five years they have begun winning large software customers as well, first winning Five Guys Burgers, then Arby’s and Dairy Queen, and most recently, a full mandate for Burger King.  In addition to that, they also have a “who’s who” list of the fastest growing fast casual chains like Cava (350 locations), Sweet Green (1,000), Scooter’s (800), and MOD (500). They are winning both the largest “dinosaur” restaurant customers (who are durable and counter-cyclical) but also the fast growing, cutting edge, next generation restaurant leaders.

This compares to VC-funded competitors like Toast, Revel, Clover, and other players like Square and ShiftFour who focus on the SMB space and have more of a Table Service (e.g. Chili’s or your local Italian restaurant) focus.  These competitors are different from PAR as they often try to anchor a lot of their economics to payments processing rather than outright software sales.  It is challenging to move upmarket with this model because it’s much easier to charge higher payment rates to mom-and-pop stores than larger chains who will often negotiate in bulk. We would also argue these players’ ARR is of lower quality and deserving of a lower multiple given higher underlying churn (SMB) and payments models having secular “take rate” and volatility concerns.

Additionally, building an Enterprise level POS software platform that can stay up to date with thousands of stores and have significant menu management, reporting, and inventory management capabilities at the enterprise level requires an additional layer of R&D development.   PAR now has a full suite of products that we think more or less makes them a “complete” solution for a restaurant chain:

• Brink - the anchor cloud POS product

• Data Central- back office (inventory/accounting/analytics)

• Punchh - front end loyalty platform

• MENU - complimenting Punchh by offering a viable alternative to Olo by supporting online ordering.

They also offer a full payment processing suite but do not force customers onto it (currently only a small percentage of ARR though growing 100%+).  For larger fast casual restaurants we do not think PAR has any “holes” in their portfolio at this point, allowing them to deploy R&D resources towards Enterprise Table Service and begin to discuss international deployment to their captive Tier 1 customer base.

With the recently announced Task acquisition, they now have a credible international product they can begin positioning to their large North American Tier one players. Task is already being used by Starbucks in Australia and McDonald’s internationally.

Further, with Stuzo, they have a best of breed product in an adjacent vertical, “C-Stores” (convenience stores) where Punchh was already competing head-to-head.

What’s Changed Since 2021?

As we noted earlier, it’s always seemed like something has held this company back from truly inflecting.

We would cite five tangible things that have either occurred in the last 3-6 months or are being heavily suggested to be imminent, that give us confidence that this inflection is occurring soon.  Additionally, we think there are catalysts that will further elucidate these things.

1. Restaurant Brands International (RBI) and the Tier 1 “Tidal Wave”

RBI is a large ($40 billion in sales), publicly traded entity (ticker QSR) that represents Burger King, Popeyes, Tim Hortons, and Firehouse Subs. Globally, RBI represents over 30,000 stores in 100 countries, with ~17,000 of the stores in North America.

In early October, Burger King announced an exclusive contract with PAR for all 7,000 United States stores, with a mandate to be rolled out to all stores by April of 2026.  It’s our understanding that BK bought not only the core POS (Brink), but also a modified version of their MENU product. 

At what we estimate to be an ARR of $3,200/year/store with core POS and MENU, we believe the Burger King North American opportunity alone is worth $22 million in software ARR (total PAR ARR now= $137 mm).  This could expand rapidly if they were to add Punchh (~$900/year), Data Central ($1,500/year) or full MENU (MENU link is $500 while full MENU is closer to $1,500). 

We also put high odds that Popeyes will become a customer over the next several months.  While we have spoken to one individual who believed Popeyes was concerned being “second fiddle” in implementation priority to Burger King, we believe that ultimately RBI leadership will convince them to move to PAR.

Tim Hortons and Firehouse are a little less clear but we believe it’s ultimately the desire of RBI management to bring all their concepts under one POS roof.  There may be some “wait and see” approach to make sure Burger King goes smoothly, but ultimately if forced to bet we believe they will get all these chains.  Here is a summary of this single opportunity, including if they were to start moving their global base onto PAR:

We believe the North American probability-weighted ARR of $51 mm is a reasonable place to start.  On the one hand, they may not win all those customers but on the other, there are additional products that any of these brands could add to that could drive further upside.  We will leave international expansion completely off the table despite the Task acquisition and RBI’s desire to have their global base on one master system.

If they were to generate something close to this $50 mm over the next 3 years from RBI, this would be a 37% total ARR uplift from one entity alone.  Said another way, this opportunity alone could be nearly half the ARR PAR would need to match our Base Case model assumptions.

The importance of this needs to be explained further.  We believe MENU, which competes with Olo, was a material if not decisive reason RBI is pushing PAR.  Not only is this a significant shot at a potential long-term competitor, it also suggests the temporary cost pains that PAR went through integrating MENU was almost certainly worth the $18 mm or so they spent on the acquisition. 

Finally, a large, mandated win like this, with the pricing it’s getting (not heavily discounted), combined with a quick two year roll out, crystallizes the growth visibility significantly and validates PAR’s standing competitively.  Consider that PAR was averaging about 1,100 quarterly installs pre-Burger King.  For the next two years, Burger King alone will average 950 stores a quarter, with each store coming in at above average store ARPU.

We think there could be a lot more coming after this.  Starting in his Q3 conference call and continuing through Q4 and on the conference circuit recently, we have noticed a significant change in Savneet’s tone, almost in disbelief at the sheer number of opportunities coming to market as seemingly every Tier 1 chain wants to move to the cloud.

Here is a sampling from Q3:

“What makes us even more positive, is that we believe we’re just at the beginning of a tidal wave of large deals coming to market, which should provide for long-term sustainable growth…I’d say just in this quarter we’ve seen more RFPs and interest from the largest brands in the world than we have in my entire time at PAR as it relates to POS.  And we also see that in loyalty within Punchh… it seems to have kicked off.”

Then in Q4 in regard to the large QSR brands going through RFPs:

“So I can’t comment, I think, until we announce the press release.  But I’d say the number is now more than three, that the pipeline has really gotten far bigger than anything we’ve seen in the past.  I think we’ve got- we see three logos that are sort of what we call near-term within our funnel, and then another four that are sort of medium-term.  So, the funnel is large and it’s real…POS funnels- RFPs are really robust processes for the customers we work with.  Generally, they’re hiring consultants.  They spend hundreds of thousands of dollars on consultants, on surveys.  And so, when it gets to near-term, the decisions do come because they’ve already spent a ton of money to get to the point of making that decision.”

We spent some time trying to validate some of this, which is difficult.  We did speak to a Director of Enterprise Architecture at Inspire Brands, which is a lot like RBI, and owns Arby’s, Baskin Robbins, Buffalo Wild Wings, Jimmy John’s, Sonic, and Dunkin Donuts (>30,000 restaurants) and indicated they were going down a path similar to RBI.  We would also note that Roark Capital, the owners of Inspire Brands, recently purchased Subway and their 37,000 global stores.  Subway strikes us as a perfect candidate for PAR’s strategy as Subway was attempting to insource their IT but, from our understanding, having many challenges doing so (similar to Burger King).  We would expect Roark to outsource as they have with all their other brands. The remaining Inspire Brands are interesting in that currently each of their restaurants is on different competitive POS systems, ranging from NCR Aloha, Oracle Simphony, Infor, and PAR.

The person we spoke with told us their goal was to “have a common POS across all their brands” and that they were in an active RFP with Oracle and PAR being the primary brands they were evaluating.  At the time of the interview, they noted they did not have an active CTO and that the new hire would probably have to happen before any decision was made.  We then noticed an additional breadcrumb. A former high ranking PAR executive from Data Central left…

And became the Senior VP of Technology Operations at Inspire Brands…

Does this mean PAR is going to win Inspire Brands?  No.  But it does seem to validate what Savneet is saying, that Tier 1 brands are going through major decision-making processes and that PAR is at or near the top of the RFP process. This provides a credible thesis they will win at least a big share of the deals up for grabs.  Winning all of Inspire Brands is not built into our model.

Catalyst:  Burger King launch schedule at Q1 earnings, Popeyes/Other Tier 1 wins

2. Selling of Government

Speaking of waiting for Godot, this bullet has its own special version of that.  PAR’s stable, boring, Government services business that churns out ~$8 million in cash flows a year has seemingly been up for sale for 10 years now and was part of our original PAR pitch as early as 2016.  It’s been the thesis of many investors (including activists) that selling this business would “unlock” the value in their restaurant business by making PAR a simpler story and more direct transaction/trading comp to other pure plays.

So, after 10 years, why do we think this is happening now? 

Here is the language on raising capital in PAR’s 10-Q in May 2023:

And here is the additional language PAR added in its 10-K in February 2024:

On March 11, 2024, at their Task/Stuzo acquisition conference call, Savneet was asked how they would pay for Task, and he responded as follows:

“Given the timeline to close, we expect that we’ll have flexibility on our balance sheet from some of the initiatives we have that we talked about in our 10-K.  And I think that’s why we feel comfortable that as we get closer to the point of closing, we’ll be able to hopefully get this done without a meaningful change to our cap structure.  So we’re excited that we can potentially sell the majority of that or all of that from our balance sheet moving forward.”

So we now have 1) an official disclosure mentioning the sale of Government and 2) an expected timeline given the closing of the Task acquisition.

A reminder here, Government still represents about a third of revenues and comes in at around 8% gross margins while incremental SaaS revenue should come in at 80-90%+ gross margin. We believe a Government sale would signal to the investment world that the Restaurant business is ready to stand on its own and be a profitable, viable public company without the support of those Government cash flows.

Catalyst:  Announcement of Government Sale (anything above $125 mm would be a “win”)

3. Decline in Competitive Intensity

We took notice when Jamba Juice ditched Toast.  This was Toast’s one signature “win” over PAR and left a lingering sense of concern about whether Toast would renew a push up market.  With the loss of Jamba Juice, we believe the odds of Toast being an immediate competitor in enterprise fast casual is, well, toast.  Although Toast did announce a pilot with Caribou Coffee, and should be watched because of their size, we believe from our discussions with Tier 1 vendors that they are not even making final round RFPs.

Interestingly, it makes us wonder how well Toast will ultimately do in enterprise level Table Service restaurants, which has been their bread and butter at the SMB level.  If PAR can begin to penetrate that landscape as well, it would be another clear potential growth driver (note PAR’s recent win with Hooters).

When we look beyond Toast, the competition continues to seem weak to us.  Oracle’s Simphony and NCR’s Aloha do compete as legacy players (and Xenial to a lesser extent), but in our eyes have not exactly seized the opportunity within cloud.  It’s our understanding that Oracle offered a lower price to try and win Burger King, and Burger King still went with PAR.  We just are not seeing new wins or true innovation coming out of these organizations.  Perhaps with NCR’s spin-off from their ATM business they become more focused, but frankly they are covering a larger swath of aggregate retail, whereas PAR remains laser focused on food service. 

There is one smaller upstart called Qu that has won a couple of enterprise customers and is squarely aimed at PAR’s market.  For instance, they won Church’s Chicken.  We believe the roll out for Church’s has gone extremely slowly, and that Qu is only winning by aggressive price promotion, not any kind of technological leadership.  Additionally, we think many of their “wins” are merely a “hunting license”, not a mandate across franchised chains like PAR is winning.  We think their feature set is lacking relative to PAR (e.g. do not have an integrated offering that can compare to PAR) and that their actual ARR is a small fraction of PAR’s.  This is all to say that Qu is more of an annoyance right now than a truly disruptive competitor.

We believe PAR will only lose to competitors like Qu and Oracle when the customer is using pricing as their primary evaluation criteria, but that PAR will generally win on focus, customer service, and product quality. 

Competition can change quickly (for instance, if Toast bought Olo, that would likely be a negative), so that is something we are watching but for now competition is the weakest it’s been in years at a time when a “tidal wave of RFPs” is flowing like wine with customers instinctively flocking to PAR like the salmon of Capistrano.

Catalysts: Ongoing competitive wins

4. Margin and Growth Inflection

We believe PAR is about to meaningfully accelerate organic ARR growth coinciding with significant margin expansion, with organic growth potentially moving to 30% as profitability inflects well above zero.  This is generally a good recipe for underlying multiple expansion.

A pure comp like Agilysys operates at 15-20% EBITDA margins. It has been apparent their strategy has been significantly more balanced in terms of growth and profitability, compared to PAR’s aggressive spending and cash burn. You can see that PAR has burned a lot of cash over the last few years:

At the beginning of 2023, management drew a line in the sand and said they were going to hold operating costs flat throughout the year.  Complications arose immediately because they had to spend millions of extra dollars with MENU to try and win Burger King.  This continued the trend of “it’s always something” that gets in the way of a true inflection in profitability.

However, we do think that under the covers, costs have flattened out for a while now.

Here is total R&D (R&D expense + capitalized software costs) by quarter:

And here is non-GAAP SG&A:

Pretty flat.

So, the operating cost structure has held steady even as management notes they have made numerous new investments:

“Without MENU, our R&D expense as a percent of ARR would have been 400 basis points better.  But we think we’ll get that investment back in spades…these improvements have been layered on a G&A base that we’re continuing to hold tight on.  But what I think is hidden in our results is that we’ve been able to expand gross margin and hold operating expenses near flat, while making a tremendous investment in MENU, ramping head count rapidly for Burger King, and making a larger internal investment into IT systems.  These large investments are being made without adding to our operating expenses.  We estimate that while OpEx has been nearly flat for the last four quarters, we’ve actually made incremental investments of approximately $9 million in new internal IT, a Burger King ramp up, and the additional MENU investments needed for the US Market, all without adding to our OpEx base.”

So why haven’t things shown up more decisively?  Well, I would argue in Q3 and Q4 they started to, while Q1 and Q2 were impacted by a significant impact in MENU test deployments to Burger King and others.  Here is Adjusted EBITDA after removing our estimate of Government contributions:

Circled are what we believe are primarily a function of a couple quarters of intensive MENU and Payments infrastructure build out with MENU spend literally done to win Burger King.  In Q3 you got a slightly more normalized look before a couple million Burger King expenses hit in Q4.  Note, this all impacts the Subscription gross margin line, which is now as depressed as it will ever be and should be on a springboard going forward as ~100% incremental margin revenue starts layering on and some costs rolling off:

Singh reiterated in March, repeatedly, that the margin expansion is coming, likely starting in Q2 at the latest, as MENU and Burger King customers begin to onboard. 

“We took the cost basis down there pretty meaningfully just, like I said, two weeks ago because we kind of hit the goals we needed to.  As I mentioned, we had our first US go-live with Beef ‘O’ Brady’s two weeks ago…we had our second customer go live today.  I’ll talk about that later because it’s not public, but a really impressive 700, 800-store chain.  So, it’s coming.  And I know it’s been painful, because what kills me is the core business is running so much more efficiently.  We haven’t added head count in a long time.  It’s the MENU where we have the major loss.  And like I said, that’s reversing in 2024 as we have revenue coming on from MENU to offset that impact, plus these cost cuts that I mentioned.”

This theme is something he reiterates again and again, and he has recently started invoking the Rule of 40 as a goal:

“My confidence in our commitment to moving to the Rule of 40 is that we have absorbed the cost of MENU and Burger King in advance of the revenue impact. That will reverse in 2024. This gives me great confidence that there's more to squeeze from our expense base without risking our growth, making the set-up for 2024 exciting.”

Reading through the sell side notes and talking to investors, we believe this depressed margin, along with not having more specifics on Burger King, is why the stock sold off from nearly $50 to $42 over the subsequent weeks.  It’s the same “here we go again” that has plagued the stock the last couple of years, but we believe will once and for all start to reverse throughout 2024.

Quibbles aside, we thought Q4 was a low-key blowout quarter from a growth perspective, which gives us a lot more confidence in our 2024-2026 growth forecasts. To start with, let’s look at Brink bookings:

Upon seeing this, our first reaction was, “Oh, they booked a bunch of Burger King stores ahead of the rollout.”  Indeed, an analyst asked this exact question on the call:

William Blair Analyst: “Operator Solutions, you had a really good bookings quarter there.  I think 3,400 net new site bookings there.  Is Burger King in that at all, I guess?”

Savneet: Burger King is almost none of it, like maybe 100 or 150. I mean, it’s all other logos.

William Blair Analyst:  Wow.  OK.

So even ex-Burger King, this quarter had double the second higher bookings quarter Brink has ever had.  Although there may be some end of year deals that do not deploy as quickly as normal, and we do not necessarily expect a blowout deployment quarter in Q1 (our Base Case models under 1,000 a quarter ex-Burger King), this bulging backlog bodes quite well for the coming quarters in terms of ARR growth from Brink.  Since Brink is often the gateway to other products, it also bodes well for future cross-sell.

But even within the Q4 installs that did contribute to ARR, there was more encouragement.  We look at incremental ARPU of net new stores to determine how pricing is trending, and Q4 again had a massive blowout for incremental ARPU.

This means that, assuming a static base ARPU, the average new store was generating $8,000 in annual ARPU (taking the incremental ARR and comparing to incremental installs).  Now we don’t believe the Base was static.  We believe pricing increases are beginning to kick in, they have begun monetizing API connections with other products, and Payments revenue is beginning to ramp up.  Savneet confirms this, while also saying to expect more of the same in the future:

“It’s about 50/50 Payments and Price uplift, and that’s going to continue.  This is the exciting part of the model.  The size of the deals we’re in are much larger than before, also at higher ARPU.  And so, that’s going to continue.  So, we feel really good about the pricing of- Brink as the premium product is getting rewarded for the premium product in deals, and that will continue.  But I’d say right now, it’s about 50/50, call it, modules being primarily Payments, but also API monetization, and the other half being pure price increase.”

It’s important to note that their Payments revenue is being recognized on a net basis, not gross, as Olo and Toast recognize it (pre-interchange fees).  Thus, Payments revenue, which is doubling currently, comes in at very high incremental margins and will be a margin enhancer (again, looking at Olo you see it’s negatively impacting their gross margins).

Looking at their Operator Solutions segment (Brink + Payments), we are getting 45% ARR growth and that’s before they start onboarding their record high bookings in Q4 or any material number of Burger King stores.

The other major segment, Guest Engagement (which includes their Punchh acquisition plus pending MENU revenue), has been the drag on ARR growth, as shown below:

However, there are compelling reasons to believe it will materially reaccelerate over the next several quarters as well, perhaps closer to 15-20% growth.

1. MENU is contributing very little revenue thus far but has a large backlog of signed customers that are just now rolling out.

2. Burger King is using a slimmed down version of MENU (MENU Link) that will be part of every Burger King unit.

3. The company has called out some large new wins for Punchh (“700-800-unit stores”), some “boomerangs” (churned customers coming back, like Beef O Brady’s), as well as a large Tier 1 Win that at least one other investor believes is Wendy’s.   If accurate, this would be 6,500 stores for Punchh that would be nearly a $6 mm ARR contract by our calculations (6,500 stores x $900 annual).

CEO concurs:

 “Punchh is growing slower but is really starting to pick up momentum.  We announced a bunch of new wins.  We’ve got more wins coming this quarter.  We haven’t got the revenue for those wins yet.  So, Punchh will have an acceleration of growth this year.”

Catalyst:  Ongoing acceleration and margin expansion throughout the year; clarification of Burger King rollout

5. M&A

With Stuzo and Task, we believe PAR has come up with two cash flowing, strategic businesses that open up significant TAM within related markets that also solve some cost headaches.  From our diligence so far, both fit their MO of acquiring top end products that are growing and already at Rule of 40.  For $400 million in aggregate, they have acquired what we believe will be $100 million in ARR and >$25 million in EBITDA in 2024 on a >20% growth rate (collectively a Rule of 40 acquisition).

To start with Stuzo, it can be thought of as Punchh but geared toward C-Stores (convenience stores).  From our due diligence so far, Stuzo seems to be the industry leader, with the most effective competition often coming from Punchh.  So now PAR has the top two players in this space, and has large, emerging customers like Chevron, Marathon, Gulf, Circle K, and Delek.  This acquisition is attractive for a few different reasons:

1. Strong growth with strong pipeline:  56% revenue CAGR since 2020 with numerous large customers still in various stages of rolling out their products.

2. Very strong EBITDA/cash flow dynamics:  Off the >$40mm ARR in 2023, they generated $17mm in EBITDA (42.5% EBITDA margins even with limited scale), which as we understand it converts very strongly to FCF (including no stock-based comp).

3. Strong upsell potential with Brink. We believe the medium-term plan is to modify Brink to fit the Convenience store workflow, and then cross-sell an integrated solution to this segment. As we understand it, the POS in convenience stores is antiquated and ripe for disruption.

4. Price/Valuation: At $190mm, we think they acquired this business for under 10x 2024 EBITDA. We believe the private equity sellers desperately needed a portfolio “mark” as quickly as possible as they were pushing to raise their next fund and wanted to show a clean exit.

5. Management Distraction:  this may sound counterintuitive, but we believe Punchh’s push into C-stores was a cost headwind and a management distraction, as part of the reason they struggled with their subscription gross margin in Q2 was working through some issues with their largest onboarded C-store customer, Casey’s.  Having a more decisive game plan to merge all C-store customers onto the Stuzo platform, with the Stuzo team leading it, may in fact save costs and lower PAR C-suite management distraction. 

While we acknowledge some risk of venturing too far from core competency and distracting management, we would note that we believe Stuzo management will be incentivized to stay on (they took equity at a premium to PAR’s recent price) and are highly regarded.

Task is more exciting strategically while still being profitable.  Partly owned by McDonald’s before being sold to PAR, we view Task as the company’s international play, acquiring sub-scale but premium technology with large existing Tier 1 relationships (namely McDonald’s and Starbucks).  From our preliminary discussions, Task has a very impressive entrepreneurial management team and a very strong collection of products but was still trying to scale.  We believe they have an internationally ready POS product, complete with currency calculators and a platform already tested at scale with their international McDonald’s loyalty product.  Enter PAR with its growing roster of Tier 1 International QSRs.  PAR sums up the opportunity at a recent Needham conference when speaking about RBI international:

“I think if you were Burger King, this is just a guess, they would have been like, oh, gosh, I wish PAR had international.  We would have given them all 23,000 stores overnight and we would have made a $100 million contract.  And whatever it was, we didn’t have that.  We can’t deliver that.  I think there’s only so long we can hold off.  It also opens up a competitive threat, right?  Like what if- one, like our B minus competitors says, hey, we’ve got the perfect international solution.  Then somebody says, like I’ll take B minus across everything instead of a A plus and the C over there.  Like, I think we’ve got to figure that out.”   

We think this is their play to figure it out.  Task has been on their radar for “more than two years” because of the marquee relationships, quality of the software, and talented management team.  In addition, while not as profitable as Stuzo, Task was starting to scale itself, most recently growing 36% and demonstrating operating leverage by growing operating profits 75%.  We believe they will end 2024 at around $50 million of ARR and around $8-$10 million EBITDA, with potentially much larger/faster growth if they are able to cross-sell internationally.

Taking the two acquisitions together, we believe there is a nice mix of strategic fit, growth, profitability, and TAM expansion that accelerates their transformation to looking like larger comps such as AGYS, APPF, and MANH. 

Further, we do not think they are done just yet as the acquisition pipeline remains large and point products struggling to scale are trading at reasonable multiples.  If the stock can get some momentum, a virtuous cycle can commence whereby they can buy additional under scaled point solutions to beef up areas like Back Office for relatively cheap multiples.

Catalyst:  Additional Accretive M&A Announcements, Integration Announcements

Adding it All Up

We have put together a model that incorporates the following:

1. Underlying ARR growth ex-Burger King/Major Tier 1s of 24% (small acceleration from 2023), then 22% and 19% in 2025-2026.

2. Burger King adding five points of growth in 2024, six points of growth in 2025, and one point of growth in 2026, with one other major Tier 1 win adding 3 points of growth in 2026 but otherwise no other major Tier 1 wins assumed. 

3. Collectively this produces organic growth of ~26% through 2026 (actual yearly growth rates dependent on the cadence of the Burger King rollout).

4. 4% Core Operating Cost growth from 2024-2026, anchored around finishing 2026 with R&D at 25% of ARR and S&M at 15% of ARR, in line with management’s commentary.

5. Subscription Gross margins reverting to 73% in 2024 and then expanding to 77% through 2026.

6. Stuzo and Task growth at an 18% CAGR with very modest operating margin improvement through 2026. We have Task outgrowing Stuzo but are not incorporating any large Tier 1 contracts into our model.

7. Hardware/Maintenance Service pull through, with modest margin improvement for fixed cost absorption on the hardware side.

8. No additional M&A.

This produces the framework of the company that management has outlined as they scale into the $300-$400 million ARR range: a company at the Rule of 40 with margins similar to a company like Agilysys at similar scale, something we believe management is laser focused on:

Again, this does not assume a lot of major new Tier 1 wins, nor does it assume much/any success with growing their international business with Task or major uptake in Table Service.  Instead, it assumes an ongoing steady pace of ARPU expansion combined with their typical 1,000-1,200 units per quarter installed ex-Burger King.  If the company were to land most of Inspire Brands or other Tier 1s in their pipeline, and/or generate material international expansion, revenue/ARR growth could be significantly faster.

What Multiple Should PAR Trade At?

Over the years we have come to appreciate the kind of software company that garners high EV/Sales, Recurring Revenue, and EBITDA multiples, and believe PAR, with this inflection/transformation, will begin to check all these boxes:

1. Enterprise level customer with very low churn (~5-6% across total business line)

2. Owns a “mission critical” asset with a full-fledged platform (Brink POS surrounded by apps)

3. Clear niche industry leader with building operational momentum

4. Large TAM and long runway for growth

5. Multiple open-ended growth vectors (Payments doubling, massive new logo pipeline, international expansion, table service expansion, convenience stores, etc.)

6. Rapidly scaling gross and EBITDA margins

7. High quality management/CEO with prudent capital allocation and large M&A pipeline

8. Superior visibility to future growth

Once vertical niche software companies like this hit scale and sustain 25% growth for a couple years with rising margins (e.g. eclipse Rule of 40), they will likely get very nice EBITDA and sales multiples. 

For instance, below is a list of companies that roughly fit that description:

We would note PAR’s ARR CAGR will be higher than their total revenue CAGR due to hardware and other services which, while growing, won’t grow at the same pace as ARR.

AGYS is the most obvious comp in our view because it sells POS software/hardware, just in a different industry (hotels and casinos).  Also, perhaps akin to PAR winning Burger King, AGYS’s multiple took off when they won Marriott.  Finally, they are at a scale that will resemble PAR, and looking to their margin level at similar sizes makes sense, in our view.

Collectively these companies trade on average at ~32x 2026 and ~8x 2026 sales right now, despite only being projected to grow at around 14% and having a middling 63% gross margin.

We believe it is because of their other qualities (churn, industry leadership, pricing power, management) that they attain these multiples, and we see no reason why PAR cannot move closer to that group as their transformation becomes more apparent to the market.

What About Toast and Olo?

We do not think Toast (TOST) or Olo (OLO) are as good comps as the other companies listed above, for different reasons.  Toast is payment oriented and is in SMB.  Their churn will be consistently higher than PAR’s just from natural restaurant churn, is in much fiercer competition with the likes of Clover, ShiftFOUR, Square, etc. in addition to having lower switching cost than a 1000+ enterprise chain.  Second, and more importantly, Toast’s revenue model is primarily payments, which we believe are a lower quality form of revenue than PAR. In addition to being volume based, they are at the whims of a “take rate” for payments that seems likely to squeeze lower in the years to come.  And third, Toast is now in a clear deceleration phase of growth.  For these three reasons, we believe PAR should ultimately command a significantly higher multiple than Toast as they continue to scale.

That said, Toast trades at 12x NTM gross profit and 58x NTM EBITDA, with heavy stock-based comp, if you want to include them in your comp group.

We view Olo as the Bear Case for PAR.  Olo is more of a feature, in our view, than a platform like PAR, as PAR has demonstrated by buying MENU for $18 mm and then winning Burger King on the strength of that product.  We believe Olo has material existential risk as a feature to an overall ecosystem, as has been evident with several key customer losses over the last twelve months.  Their “growth” is also coming from their Payments initiatives, and they book that revenue gross as opposed to PAR’s net (so at ~25% margins). Revenue growth may look solid for Olo, but gross profit growth is in the single digits and is of lesser quality in our view.  Consider this conversation with a Senior IT Exec at Inspire Brands around PAR’s MENU potentially replacing Olo:

Analyst:  How has Olo performed for you?

Specialist:  Olo is in stores across all of Inspire, so not just Arby’s.  It’s basically stable.  Nothing special, nothing to write home about, nothing that we’re celebrating but also nothing that we’re complaining about.  It just is what it is.

Analyst:  What would it take for you to switch from Olo to that product (MENU)?

Specialist:  Probably competitive feature set and similar pricing.  As I mentioned earlier, Olo is just there.  I’m not in love with it, but I don’t hate it.  If that MENU product is competitive and I can consolidate vendors, that’s a win.

Analyst:  If PAR offered MENU at a lower price, say 10-20% lower, would that be a no-brainer or would it still be a pretty complicated switching process?

Specialist:  No, that would basically be a no-brainer.

Analyst:  Are the switching costs low?

Specialist:  For most of the stuff, yes.

We would note Olo costs around $2,000 a year, while a full MENU product has been coming in at $1,500 a year.

Target Price

We take our Base Case model and apply a 27x 2026 EBITDA multiple. We assume their $45 strike price convertible debt converts to equity while their other debt remains.

This multiple at $84 (>100% upside) would imply 5.5x sales and 8.4x ARR.  Based on this framework we would argue PAR is worth this right now but only expect the market to come around as the catalysts described earlier play out over the coming months/years.  We are giving a 5-turn EBITDA multiple discount and 2-turns on EV/sales given moderately lower scale/margins to some members of the peer group and because of more challenging execution risk.  We would note that with the increased share count from their recent PIPE that we expect trading volumes to improve over time, which generally improves any liquidity discount the company may have.

Bear/Bull Cases

There are clearly numerous execution risks that remain here: 

• They need to successfully roll out Burger King to validate that they can handle stronger implementation volumes.

• They need to avoid that lingering hiccup that delays margin expansion.

• Major new competition needs to not emerge.

• Stuzo and Task need to roughly maintain their Rule of 40 profile post-acquisition.

Our Bear Case target is predicated on slashing our revenue growth, gross margin, and EBITDA margin forecasts across the board, and giving the company a lowly 3.2x 2026 ARR multiple and 2.2x sales multiple to arrive at $25/share.  Essentially, we are comping to Olo, whose total gross profit growth has deteriorated, along with massive stock-based comp expense, low profitability, and a deteriorating strategic position evidenced by the loss of major customers and the lack of a “mission critical” POS infrastructure that PAR has. This valuation would imply a new competitive dynamic emerging that is not currently present in the market and would likely imply some level of challenge of comparable multiple degradation (e.g., software multiples retract).

On the flip side, if PAR starts announcing Popeye’s, other Inspire Brands, Wendy’s, Chipotle, etc. as customer wins, starts getting large new table service wins like Buffalo Wild Wings, or shows success in cross-selling Task to their International Tier 1 base, and becomes dominant within C-stores, our estimates will end up being way too low.  These are gigantic, growing markets that we expect to remain durable during recessions and stay relevant in the gig economy. If the flywheel is truly starting to turn as we think, PAR could be a much larger company in the next 3-5 years and in that case our target price can move materially higher, into the mid $100s.

In our Bull Case, the company would achieve a 3-year proforma ARR growth of 28% and get the EBITDA multiple in-line with more high-flying peers, e.g., 35x 2026 EBITDA with a 9x sales multiple and 11.5x ARR multiple.  Our case summaries are below:

Please see important disclosures here

Company Overview

In 1970, Cement Limited and Roadstone Limited, two Irish infrastructure-focused companies, combined to form Cement and Roadstone Holdings, or "CRH.” An investment of $1 million into CRH upon its founding 53 years ago would have turned into $1.5 billion by mid-year 2023, an annualized total return to investors of 15.0%, a high rate of compounding we think can continue.

Half a century of success at CRH has been driven by disciplined operations and capital allocation that we believe derives from a company culture built around appropriate financial incentives. CRH’s M&A playbook has proven to be successful as an acquisitive company like CRH can't compound at a rate of 15% over 50 years unless acquisitions and divestitures have been executed at attractive prices. Over the last five years, CRH has spent $10.3 billion on acquisitions while receiving $10.5 billion in proceeds from divestitures across dozens of transactions, with the average acquisition multiple ranging from 7x – 8x EBITDA and the average exit multiple clocking in at 11x EBITDA.

The Company reports under four segments split by geograhy and product category: Europe Materials, Europe Building Solutions, North America Materials, and North America Building Solutions.

Approximately 75% of EBITDA is generated from the North American divisions (10% higher than the average S&P 500 company) with the company guiding for this to rise to 90% by the end of the decade.

Infrastructure represents the largest end market for CRH at 40% of revenue and Repair, Maintenance and Improvement accounts for just over half of end market use.

Materials

The Materials segments are vertically integrated as CRH produces and supplies aggregates, cement, ready-mix concrete, and asphalt, as well as providing related services such as road paving.

The aggregates business in particular has terrific economics as most operate as local oligopolies or monopolies. If you are a user of aggregates, you will almost certainly use quarry closest to your project given the costs to transport are so high. Given this dynamic, the industry has historically enjoyed stable annual pricing increases and over the last 52 years, aggregates annual pricing has only dropped in three of those years (and only -1.5% on average). CRH is sitting pretty with the largest aggregates mineral reserves in North America at 19 billion tons – comfortably more than Martin Marietta (17 billion tons) and Vulcan Materials (16 billion tons).

On the cement side of the business, industry dynamics are much like Greg Focker’s portfolio—strong to quite strong - and CRH has about 11% market share across its 12 plants in North America. It is very difficult to add cement capacity in the United States because of stringent environmental regulations so the domestically produced supply is maxed out at around 100M metric tons per year. At the same time, even with depressed residential development as of late, US demand is currently running at ~120M metric tons per year. Excess demand is supplied by imports, which come at a significantly higher cost than domestically supplied cement. To state the obvious, this supply/demand dynamic has been very favorable for cement pricing, a trend we see continuing.

CRH is also among the largest asphalt manufacturing and paving companies in the United States and has clear advantages of scale that help the Company produce best-in-class margins on its product. Bitumen is a key component in producing asphalt and due to CRH's massive size, they have a "winter-fill" program that allows the Company to acquire bitumen cheaply in the winter months and store it for use during warmer construction months. Smaller competitors lack access to the kind of infrastructure needed to do this.

Building Solutions

The Building Solutions segments manufacture and supply outdoor products such as hardscapes, fencing, railing, masonry, packaged products, lawn and garden, pool finishes, and composite decking, in addition to concrete infrastructure, precast products, drainage systems, water management, and other construction components.

The first subsegment of Building Solutions is the Outdoor Living business. This business has one of the broadest offerings of products for public and private outdoor spaces including Pebble Tech pool finishes, MoistureShield composite decking, Barrette railing and fencing, and Belgard paver stones and outdoor kitchens. If you have recently remodeled your backyard, it is highly probable that you’ve installed at least one of their products.

The other subsegment of the Building Solutions segment is the Building & Infrastructure business. This business provides critical infrastructure for connecting, protecting, and transporting water, energy, and telecommunications infrastructure. This segment thrives on large complex projects.

The key differentiator for CRH is its vertical integration. Materials produced in the upstream aggregates and cement business are supplied as components to downstream businesses like asphalt and ready-mix concrete.

This integration between the Materials business and the Building Solutions business provides customers with end-to-end solutions whereby they only must deal with one vendor instead of multiple. This helps projects get completed on time and on budget. CRH can construct components off-site and deliver them on an as needed basis, reducing labor on-site and idle time from unorganized logistics scheduling between disparate third party vendors.and as mentioned, is fully integrated with the upstream Materials business. CRH is heavily involved early in a project's lifecycle, beginning with the design phase, and they develop customized solutions given their expertise and broad capabilities.

US Infrastructure Tailwinds

As one of the largest building materials businesses in North America, CRH may be the single largest beneficiary of the recent unprecedented government infrastructure spending programs, including the Infrastructure Investment and Jobs Act (IIJA), CHIPS and Science Act (CHIPS), and the Inflation Reduction Act (IRA). For instance, of the $1.2 trillion in IIJA funds, about $350B is allocated to Highway funding, and CRH is the #1 road paver in the U.S. Throughout the 5- year life of the spending bill, it is estimated that annual federal spending on highways will increase by 50% above the baseline 2021 spend from $47 billion per year to north of $70B per year. The IIJA has been touted as the most transformative public investment program since the 1930's.

Perhaps equally as important as the IIJA spending is the onshoring of manufacturing that is occurring in the United States, with the support of the CHIPS and IRA. This has led to $200B+ of major commercial projects that have already been announced to bring critical manufacturing back to the US. These "mega projects" are squarely in the sweet spot for CRH, and they offer significant visibility for the infrastructure business through 2030. The Company has quantified the expected increase in annual manufacturing-related spending in the US as 2.5x higher than previous levels.

Below are estimates from TRG Research on the combined increase in annual spend across the 3 major bills by vertical.

Additionally, many of CRH's top markets are benefiting from ongoing interstate migration and strong job growth, with three of CRH's top states ranking among the top four in terms of employment growth since 2019. Not only will strong local economies help to keep state budgets flush at their current record levels, but this growth necessitates increased infrastructure investment, and a significant piece of IIJA funding will go to these states.

Q3 2023 Comments from Competitors

We can also look to recent commentary on Q3 earnings calls from CRH comps to get a sense for what the public infrastructure side is looking like heading into 2024.

Vulcan Materials

• “On the public side, leading indicators remain supportive of continued growth in both highway and infrastructure. Trailing 12-month highway starts are up 18%, and 2024 state budgets are at record levels. We continue to expect accelerating growth in public construction activity into next year and continued growth for the next several years.”

Summit Materials:

• “ Let's start first with what we know, and that is 2024 is setting up to be another strong year for pricing.”

• “ For public [end markets]… our leading indicators for future activity are flashing green. Fiscal 2024 DOT budgets for our top five public states are up 14%, lettings on a trailing 12-month basis are up nearly 26%… our public backlogs in key markets are nearly double prior year, as demand is robust and accelerating for infrastructure projects.”

• “I always use Texas as our bellwether state on how we're doing on backlogs. They're nearly double what we had last year and they're building. So bottom line for all that data I gave you was public [infrastructure] is very strong. We continue to see that into 2024.”

Martin Marietta

• “The value of state and local government highway, bridge and tunnel contract awards a leading indicator for our future product demand is meaningfully higher year-over-year. These infrastructure contract awards grew 18% to a record $114 billion for the 12-month period ending September 30, 2022"

Relisting

As noted above, CRH completed a relisting to the US on September 25th and now maintains a primary listing on the NYSE, with a secondary listing on the London Stock Exchange. This relisting will entice more investors over the coming year to rerate the stock much closer to US peer valuations rather than languishing at European peer valuations. Once the sell side and US-based investors grow familiar with the name, we believe the inexplicable valuation gap will be too hard to ignore and the market will do its job of appropriately valuing CRH as the best-of-breed operator within an advantageous industry.

In addition to increased investor awareness, the Company has cited increased business opportunities as CRH will appeal more to customers who favor dealing with US-based companies, not the least of which are state and local governments. It will also provide better opportunities on the M&A side through better visibility and a strong currency in US company stock for potential acquirees.

CRH aims to being well represented in US-based indices and once the Company files its 2023 10-K around March 2024, it will be eligible to be included in the S&P 500, which provides another major catalyst from passive flows and index-constrained active managers alike. As of Q2 2023, prior to the re-listing, CRH’s ownership base included a fraction of the amount of U.S. insitutions and funds relative to U.S. listed comps.

Valuation

We believe the current valuation of CRH provides for limited downside and is significantly cheaper than peers despite being a best-in-class operator across all the business segments the Company competes in. CRH trades at an 11.5x P/E based on the '24 consensus and 7.0x EV/EBITDA (6.4x our estimate). As shown below, the most relevant peers are trading around 10x - 15x 2024 EV/EBITDA and around 18x - 28x on an earnings basis.

CRH currently trades at this significant discount despite having much lower leverage as well as better cash flow conversion and higher ROIC than the materials only pure plays given CRH’s vertically integrated business model.

It is also worth highlighting the fact that the Company has provided guidance for $35B of cash generation over the next five years, an amount equal to >90% of the Company's current market cap. We estimate this is comprised of $25B of FCF generation and $10B from re-levering the balance sheet from 0.8x net debt/EBITDA to about ~2.0x.

These assumptions are conservative relative to historical comparable company valuations of around 20x – 30x NTM P/E.

We think US investors will soon recognize that a company with this level of stability, cash flow generation, capital allocation track record, and robust earnings growth visibility is a value too great to ignore at 11.0x earnings.

Disclaimer: https://www.vosscap.com/disclaimer

At Voss we have historically steered our investments more towards value-oriented software stocks within the Tech universe, and have generally been apathetic towards semiconductor names, as we believe it’s uniquely hard to know when a company might gain or lose a socket in a smart phone, or whose technology might catch on and become the industry standard. The industry feels very speculative and momentum based, not our preferred modus operandi. That said, with several of our portfolio companies having hardware and chip exposure (e.g., EXTR), and some getting hit (or helped) by “supply chain disruptions” by COVID, we are trying to get a better grip on the landscape by reading various vantage points and historical contexts.

In Chip Wars, by Chris Miller, we get a well written and accessible history of the semiconductor industry viewed through a geopolitical lens, starting in the late 1940s and ending at the present-day Russia-Ukraine war and China-Taiwan tensions. The book makes a credible case that much of the history of the industry has been heavily influenced by geopolitical strategy, with silicon supply becoming the new oil as a strategic advantage for countries.

It further insists (credibly in our opinion), that one of the larger Black Swans (or perhaps a known unknown) out there is if Taiwan were to be disrupted in some way that would shut down or hinder perhaps the most strategically important company in the world, Taiwan Semiconductor Manufacturing Co Ltd. (TSMC). TSMC is at this moment by far the largest semiconductor fabrication company, producing some 37% of the world’s logic chips (logic chips being the “brains” of a device as opposed to memory chips) and an even higher percentage of the most cutting-edge chips. These chips don’t just power computers, they power washing machines, industrial machines, and hundreds of other products. Perhaps most importantly, the most cutting edge of these chips power advanced military apparatus like guided missiles.

The author posits silicon and technology leadership as the actual drivers of essentially all the major Superpowers and rising Superpower conflicts since World War II, and that the United States fending off these aspiring Superpowers has been largely a product of them maintaining technological leadership while the other country slips up in some way (from Russia to Japan to Russia again to, now, China).

The overall takeaway of the book is that the United States, while still in a quite dominating technological leadership position when considering the full life cycle of chips (design in particular), especially when combined with its allies, is also in a precarious position and has less leverage than it may seem by being so dependent on Taiwan (TSMC and others) and China (for final assembly of products like say, the iPhone).

The conclusion is that all relationships are quite tenuous, and while China would also be (massively) negatively impacted by “rocking the boat” in Taiwan, it may come to a point where they believe they have no choice. From an investment perspective, it makes us consider a couple of things:

• For our existing positions, where are critical products actually being assembled and is there any “Plan B” if that assembly option was no longer available?

• Given the tensions, are there companies that could potentially be strategically valuable to countries that are currently being hurt by globalization and China in particular? For instance, it may be interesting to explore hardware/semi areas where China has hurt the industry and even removed competitors from the Western World market, as geopolitical retaliation could benefit companies like that.

Note: at the bottom of this article see a short update on what has transpired just over the fast few weeks.

Summary

The book is broken into eight parts, each of which has a geopolitical motivation for advancement in technology.

Part 1: Cold Chip Wars (1945-1965)

Geopolitical Angle:  The Russians Launched Sputnik, We Need to Respond

This chronicles major initial innovations in semiconductor technology.  It starts with the basics about semiconductor materials, which one typically thinks of as silicon but can also be germanium and other materials. What’s unique about these materials is that with a little modification they can be used to turn an electrical current “on” and “off”, as opposed to other materials like copper which is always on or glass which is always off.

One can then place what are called transistors onto silicon to direct and turn the current on or off.  The transistor was announced by Bell Labs in 1948 and was compared to neurons (brain cells). It took another ten years to build the first “integrated circuit”:

“Multiple transistors could be built into a single slab of silicon of geranium.  Kilby called his invention an integrated circuit, but it became known colloquially as a ‘chip’, because each integrated circuit was made from a piece of silicon chipped off a circular silicon wafer.”

The inventors of these “chips” needed to find a market and they were able to initially find that market in NASA:

“Across America, the Soviet space program caused a crisis of confidence…John F. Kennedy declared the US would send a man to the moon.  Bob Noyce suddenly had a market for his integrated circuits: rockets.”

Applications quickly turned to the military:

“In fall 1962, the Air Force began looking for a new computer to guide its Minuteman II missile, which was designed to hurl nuclear warheads through space before striking the Soviet Union.”

In 1965, we got the now famous Moore’s Law, which Gordon Moore first wrote about in Electronics magazine, essentially predicting that the number of components that could fit on a chip would double every year for at least the next decade.

It was in this context of first getting funded by NASA and then by the military that more significant advancements were made, and the industry was ready to start considering the mass consumer.

Part 2: The Circuitry of the American World (1960s-1970s)

Geopolitical Angle: Russians Lose Edge by “Copying” Strategy

As Silicon Valley was being coined in 1971, there was an ongoing battle for technology supremacy between the Soviet Union and the United States. The Soviets recognized that the United States had a lead so began deploying various strategies to catch up. Khruschev/Russia essentially attempted a “copy” strategy, first attempting to build a Silicon Valley in Moscow dubbed Zelenograd.

Additionally, spies began to attempt to steal trade secrets from American companies. 

However, the book argues that the “copy it” strategy was not effective because the technology was moving so quickly.  Essentially, starting from a position behind the US, rote copying would ultimately get them to a similar point, but by the time they got there the US was again far ahead:

“Soviet leaders never comprehended how the ‘copy it” strategy condemned them to backwardness…the USSR started several years behind the US in transistor technology and never caught up…the pathways of innovation in Soviet semiconductors were set by the United States.  One of the most sensitive and secretive industries in the USSR therefore functioned like a poorly run outpost of Silicon Valley.”

Part 3: Leadership Lost? (1980s)

Geopolitical Angle:  Japan Becomes a Major Threat

Unlike the Soviet Union, which operated in secret and attempted to steal and copy, Japan tried a different, more successful tactic. While both nations used government support aggressively, Japan befriended American innovators and essentially made itself useful, receiving some degree of intellectual property in exchange for building fab plants that could ship products back to US consumers.

However, primarily through the rise of Sony, Japan went from having a “cheap” perception to one of innovation and quality, not unlike their rise in the auto industry.  Japan aggressively subsidized semiconductors with much cheaper loans than American companies were able to get, and their workers were allegedly far more efficient than their US counterparts.  Because the Japanese were more privy to the latest cutting edge technology and worked with Americans, they also became significantly more innovative their Russian peers:

“The US had supported Japan’s postwar transformation into a transistor salesman.  US occupation authorities transferred knowledge about the invention of the transistor to Japanese physicists, while policymakers in Washington ensure Japanese firms like Sony could easily sell into US Markets.  The aim of turning Japan into a country of democratic capitalist had worked.  Now some Americans were asking whether it worked too well.”

Almost immediately, there were concerns that “Silicon Valley would end up like Detroit”, and it didn’t help that the Reagan administration was initially lukewarm to the idea of providing support, famously comparing silicon chip subsidies to potato chips.  However, as the Japanese threat intensified, various congressional actions ultimately did amp up American competitiveness.

Loosening financial regulations and cutting the capital gains tax generated a flood of VC money into Silicon Valley, which did generate additional innovation but still didn’t solve the price issue (Japan could produce the same product at the same quality more cheaply).  Ultimately there are areas that the US lost to Japan that they never quite got back.  For instance, DRAM is an area that Asian countries (primarily Korea now) still dominate to this day.

Part 4:  America Resurgent (Late 1980s/Early 90s)

Geopolitical Angle: “The Empire Strikes Back” with US Dominating Microprocessors, Japan’s Economy Crashes, Russia Falls Further Behind, and the US Displaying Military Superiority in Iraq

This section is a bit of a transition and sequel to Part 3, whereby the US does begin generating some “wins.”  This happens not only in the DRAM market with Micron carving out a real niche, but more significantly with Intel beginning to dominate the microprocessor market and companies like Qualcomm rising in the telecom market.

Part 4 also details the rise of South Korea (now the dominant DRAM player along with Micron) with the beginnings of Samsung, who began following a similar playbook as Japan but had the effect of hurting Japan.  Japan had everything hit them all at once: resurgent US protectionism, an overheated economy, and new Asian competition:

“Thanks to the Sony Walkman and other consumer electronics, Japan had become prosperous…then in 1990 crisis hit.  Japan’s financial markets crashed.  The economy slumped into a deep recession…as the stock market crashed, the country’s vaunted long term thinking no longer looked so visionary.  Japan’s seeming dominance had been built on an unsustainable foundation of government-backed overinvestment.  Cheap capital had underwritten the construction of new semiconductor fabs, but also encouraged chipmakers to think less about profit and more about output.  Japan’s biggest semiconductor firms doubled down on DRAM production even as lower cost producers like Micron and South Korea’s Samsung undercut Japanese rivals.”

As a final American “success” the US was able to flash their military superiority in Iraq as their chip embedded missiles produced “shock and awe.”

Between the dissolving of the Soviet Union, Japan collapsing, and the Iraq War, the US was entering a period of being the only undisputed superpower, and many credit semiconductor/technological superiority to that:

“The new technologies Perry had pushed the Pentagon to develop during the late 1970s performed even beyond his expectations.  The Iraq military- armed with some of the best equipment the Soviet Union’s defense industry produced- was helpless in the face of the American assault…it’s the ‘triumph of silicon over steel’ declared a New York Times headline.  ‘War Hero Status Possible for the Computer Chip,’ read another.”

Part 5: Integrated Circuits, Integrated World? (Early 1990s to early 2000s)

Geopolitical Angle: Globalization Drives the Rise of Taiwan and China, Intel Misses Mobile

Part 5 could be considered the beginning of the modern-day climate for geopolitical technology leadership as it is chronicles the beginnings of Taiwan and China’s ascendance.  Taiwan’s rapid growth to global technological criticality is a marvel to behold, and much of the credit seems to go to Morris Chang and his creation of Taiwan Semiconductor Manufacturing Company (TSMC). 

Chang had already had incredible career success in the United States, spending 25 years at Texas Instruments (starting in 1958) until leaving in the early 1980s “after being passed over for the CEO job and ‘put out to pasture’.”  Chang was recruited by the Taiwanese government to build out their technological capabilities, and Chang’s unique insight, which proved to be extraordinarily powerful, is that you didn’t have to both design and build chips.  Rather a company could save a ton of costs simply designing chips, then leaving the actual production to Taiwan.  Thus the “foundry” and “fabless” models were born:

“In the chip industry, by lowering startup costs, Chang’s foundry model gave birth to dozens of new ‘authors’- fabless chip design firms- that transformed the tech sector by putting computing power in all sorts of devices.”

The underlying brilliance of this strategy was that it had a bit of a network effect, as scale proved to be everything for chip manufacturing.  Thus, the more TSMC came to be relied upon by fabless semiconductor companies, the larger its advantage became because they could act as the low-cost producer:

“The economics of chip manufacturing required relentless consolidation.  Whichever company produced the most chips had a built-in advantage, improving its yield and spreading capital investment costs over more customers.  TSMC’s business boomed during the 1990s and its manufacturing processes improved relentlessly.  Morris Chang wanted to become the Gutenberg of the digital era.”

China also began to develop its capabilities, but throughout the 90s and early 2000s was relegated to more of an assembly role, as they had suppressed their scientist’s ability to innovate and had made some of the same mistakes Russia made by attempting to copy rather than partner.  However, they did begin carving out a significant niche in device assembly…ultimately think of the Foxconn plant that is a major iPhone assembler.

The workflow that is enacted to this day was beginning to take form:  US maintained a strong lead in cutting edge chip design (including software and tools to create semiconductors), Taiwan became a powerhouse in building the actual chips, and assembly was completed in China and sent to the US consumer to enjoy.

The only exception to this, and it’s an important one, is in the lithography process, which is a critical component of extending Moore’s Law.  Put in the simplest terms (for a crazy complex process), lithography involves shooting light at chemicals that ultimately will carve out nano-sized shapes on a piece of silicon.  The technology here is truly state of the art and honestly a bit mind-boggling.  State of the art lithography machines can cost hundreds of millions of dollars and are critical to ongoing chip shrinkage.

The book argues that this is now essentially a monopoly in the hands of a company in the Netherlands of all places, ASML.  Although Japanese companies like Canon and Nikon initially competed, and still do provide lower-level machines, all cutting-edge machines now run through ASML.  The unlikely connection between ASML and TSMC may have been decisive here:

“ASML’s history of being spun out of Philips helped in a surprising way, too, facilitating a deep relationship with Taiwan’s TSMC.  Philips had been the cornerstone investor in TSMC, transferring its manufacturing process technology, and intellectual property to the young foundry.  This gave ASML a built-in market, because TSMC’s fabs were designed around Philip’s manufacturing process.”

Although the Netherlands is a close ally to the US and the Western World, the unique relationship between Taiwan and ASML adds a fascinating wrinkle to things that still provide geopolitical leverage to this day.  TSMC absolutely needs ASML to continue to stay at the cutting edge of semiconductor fabrication.  Without it, innovation and chip shrinkage would slow down significantly and many of TSMC’s advantages would erode. 

Part 6:  Offshoring Innovation? (2000-2015)

Geopolitical Angle: A Continuation of Part 5, Whereby Asia Continues its Chip Manufacturing Domination

This section hammers home all the trends from Part 5, namely the ongoing domination of Asia in chip manufacturing while the US maintains a tenuous (but still dominating) lead in chip design.  Although Intel continued to maintain domination in certain types of chips (the server market, for example), and a third kind of chip (analog/sensor chips) does have some US manufacturing presence, the memory market remain dominated by Asia while cell phone chips are fabricated primarily at TSMC/Samsung.

The book argues that Nvidia may be the single biggest “fabless” success story, as their specialty chips, graphics processor units (GPUs), are completely ubiquitous. The symbiotic relationship between Nvidia and TSMC is hammered home as TSMC is the primary manufacturer of Nvidia chips:

“Today’s Nvidia’s chips, largely manufactured by TSMC, are found in the most advanced data centers.  It’s a good thing the company didn’t need to build its own fab.  At the startup stage, it would probably have been impossible to raise the necessary sums…betting over a hundred million dollars- the cost of a new fab at the time- would have been a stretch even for Silicon Valley’s most adventurous investors.”

The final chapter in this part gets at just how badly Intel screwed up after potentially owning a leadership position in the next age of silicon innovation. The frustrating part for Intel and their investors is they were on the right track, investing $200M in ASML’s new cutting edge lithography technology, extreme ultraviolet (EUV):

“Now, after billions of dollars in investment- a substantial portion of which had come from Intel- ASML had finally made the technology a reality.  Yet rather than capitalizing on this new ear of shrinking transistors, Intel squandered its lead, missing major shifts in semiconductor architecture needed for artificial intelligence, then bungling its manufacturing processes and failing to keep up with Moore’s Law.”

On Intel, the author concludes:

“It still has a shot at regaining its leadership position over the next half decade, but it could just as easily end up defunct.  What’s at stake isn’t simply one company, but the future of America’s chip fabrication industry.  Without Intel, there won’t be a single US company- or a single facility outside of Taiwan or South Korea- capable of manufacturing cutting-edge processors.”

The book notes that by 2020, half of all EUV lithography tools, “funded and nurtured by Intel”, are installed at TSMC.

From a geopolitical perspective, having TSMC and Samsung being the only two companies in the world that can manufacture high end processors is a tough conundrum for the US to be in, and one wonders if at some point the US government might try and reinvigorate Intel to keep some balance and leverage.

Part 7: China’s Challenge (2016-present)

Geopolitical Angle: China’s Push Towards Relevance and/or Dominance

Part 7 is a deeper dive into how China is trying to recreate itself as a relevant and ultimately dominant player in the ongoing technology wars, as the world looks to future tech like AI and advanced war machines.  China’s problem is described succinctly here:

“Across the entire semiconductor supply chain, aggregating the impact of chip design, intellectual property, tools, fabrication, and other steps, Chinese firms have a 6 percent market share, compared to America’s 39 percent, South Korea’s 16 percent, and Taiwan’s 12 precent.”

While President Xi talked a big game on globalization and partnerships publicly, the book suggests that behind the scenes there was a strong push to become less and less dependent on others’ technology andan attempt to assume technology leadership in as many areas as possible:

“The Made in China 2025 plan didn’t advocate economic integration but the opposite.  It called for slashing China’s dependence on imported chips.”

The book goes through various methods by which China would get to this point, from large subsidies for Chinese companies to what is kindly called “technology transfer” by which US companies might reveal trade secrets for money or access to the Chinese market.  For instance, IBM attempted to woo China in various ways:

“Rather than trying to sell chips and servers to Chinese customers, she (CEO Rometty) announced, IBM would open its chip technology to Chinese partners, enabling them to create a new and vibrant ecosystem of Chinese companies producing homegrown computer systems for the local and international markets.”

Similar partnerships and deals from the likes of Qualcomm and AMD are also discussed.  China seems to go after companies that were struggling or were not in a leadership position, thinking they might be more amenable to providing trade secrets for market access.

Additionally, China attempted to build investments in large Taiwanese companies like MediaTek and, of course, TSMC. A Chinese company that was closely linked to the Chinese government, Tsinghua Unigroup, began making overtures to buy a significant stake in TSMC, which as the book points out, “put TSMC and MediaTek in a bind.  Both companies were crucially reliant on the Chinese market.  Most of the chips TSMC produced were assembled into electronics goods in workshops across China.”

After ultimately getting rebuffed on those overtures, there were some additional shady dealings with US companies, including Lattice Semiconductors, where Tsinghua Unigroup initially bought 6% of the company, then seemingly sold their shares before Lattice received a buyout offer from a US company called Canyon Bridge.  It turned out Canyon Bridge was a Chinese-backed company with close ties to the government and the deal was nixed.

Finally, the book details the rise of Huawei, which was China’s attempt to replicate some of the success that companies like Samsung had experienced.

Between subsidizing innovation abroad, buying technology from US firms, attempting to acquire US firms, and launching global companies from within, China was pretty clearly focused on increasing their 6% share in any way possible.  However, at this point it doesn’t seem that a clear leadership transition has occurred, or is close to occurring, which continues to make a battleground like Taiwan extremely relevant. 

Part 8:  Chip Choke (2020-present)

Geopolitical Angle: Trump Administration’s More Hostile Approach to China, War Games Hypotheticals

The author argues that since Trump took over the White House in 2016, there has been a notable counterattack played out by the US.  Before that, with Obama, things were moving and reacting quite slowly:

“Most people in Washington barely knew what a semiconductor was.  The Obama administration moved slowly on semiconductors, one person involved in the effort recalled, because many senior officials simply didn’t see chips as an important issue.”

Generally critical of the Obama administration, the author notes that its perception that globalization had occurred and was unstoppable was a bit of a misnomer:

“However, globalization of chip fabrication hadn’t occurred; ‘Taiwanization’ had.  Technology hadn’t diffused.  It was monopolized by a handful of irreplaceable companies.  American tech policy was held hostage to banalities about globalization that were easily seen to be false.”

Indeed, the Obama administration is characterized as kind of throwing up their hands and saying, “semiconductor mastery is really important but there’s not much you can do.”

The Trump administration clearly took a different view and approach and the actions taken ultimately reflect that.  The author  highlights three examples of aggressive actions the administration took that curbed Chinese companies:

1. ZTE, a smaller Huawei, was severely restricted on what goods it could buy from US companies, on the basis that it sold telecom equipment to Iran and North Korea, in addition to being fined nearly a billion dollars.

2. Fujian Jinhua, a DRAM producer, was throttled after it was determined they stole trade secrets from Micron.  They essentially made it impossible for Jinhua to buy the equipment they needed from US and Japanese suppliers.

3. Huawei, the biggest example, was also choked in what they could buy and sell:

“In May 2020, the administration tightened restrictions on Huawei further…the new Commerce Departments rules didn’t simply stop the sale of US-produced goods to Huawei.  They restricted any goods made with US produced technology from being sold to Huawei, too.  In a chip industry full of choke points, this meant almost any chip.  TSMC can’t fabricate advanced chips for Huawei without using US manufacturing equipment.  Huawei can’t design chips without US produced software…Huawei was simply cut off from the world’s entire chipmaking infrastructure.”

Ultimately, it seems these tactics were successful in slowing down China, and perhaps made China realize there was no realistic way they could do things all on their own:

“This is why, despite the rhetoric, China’s not actually pursuing an all-domestic supply chain.  Beijing recognizes this is simply impossible.  China would like a non-US supply chain, but because of America’s heft in the chip industry, and the extraterritorial power of its export regulations, a non-American supply chain is also unrealistic, except perhaps in the distant future…what is plausible is for China to reduce its reliance on the United States in certain spheres…”

The prime example they use is ASML and EUV technology.  They note that “replicating just the laser in an EUV system requires perfectly identifying and assembling 457,329 parts.  A single defect could cause debilitating delays or reliability problems.”  Additionally, even if China spent tens of billions of dollars and a decade or more replicating the technology, by that time ASML will have rolled out its own new technology, “high-aperture EUV,” which is supposed to be ready in the mid-2020s.

The book reinforces that there is currently a tense and delicate standoff between the US, Taiwan, and China, as Taiwan is an obvious swing factor across the entire industry and is in fact very close (geographically) to China (in addition to dispute over whether Taiwan is a part of China).  Getting into game theory in the last couple chapters, the author argues, as a base case, that the current relationship should continue on a status quo basis.

If tensions were to continue and perhaps ratchet up, the idea is that China could “seize TSMC.” While it seems like this would not be in China’s (or the US’s) best interest as a conflict like this could potentially result in TSMC and its infrastructure being destroyed (which would likely plunge the globe in a deep recession), there are paths of escalation that might lead to that outcome. For instance, there is a small island between Taiwan and mainland China that is garrisoned by Taiwan. If China took that island as an initial escalation point, “Taiwan and the US would face the difficult choice of starting a war over an irrelevant atoll or establishing precedent that China can slice off chunks of Taiwanese territory.”

The point is that while game theory dictates it is in neither country’s interest to push the envelope, either country might decide that a confrontation is inevitable, lob the first offensive, and off we would go to a major World War. While that shouldn’t happen in theory, wars are sometimes started by seemingly poor, non-logical choices. 

The book does offer some final food for thought, which has so far been disproven but might eventually come to pass: What if Moore’s Law finally dies? It notes:

“At some point, the laws of physics will make it impossible to shrink transistors further. Even before then, it could become too costly to manufacture them. The rate of costs declines has already significantly slowed.”

This would add a new wrinkle as it might make laggards like China to believe they could ultimately catch up on their own, if innovation itself was slowing.

Conclusion:  Investment Implications

While making geopolitical predictions and how they might or might not benefit companies seems challenging and perhaps foolhardy, a couple things do come to mind as an investor.

1. Intel is likely to be viewed as a strategic asset and might in the future get government assistance to regain former glory, unless a viable replacement emerges.

2. ASML is a complete monopoly and, so long as Moore’s Law continues, is likely remain extremely successful and one of the most strategically important companies in the world.

3. There are likely to be additional mini-escalations in the same vein as what happened to Huawei. One area we are exploring is cellular modules. This industry in North America was gutted when cheap Chinese competitors (most notably Quectel) entered and undercut pricing. There is a growing drumbeat that China should probably not be providing these sensitive items as there are ways data could be captured and sent to China. For instance, from a recent Spectator article:

“In January the security services took apart a UK government car because data was being transferred via a ‘Chinese e-sim (they meant a cellular module) inside.  The government has been tight-lipped about who used the car- or if it ever transported the Prime Minister.  But we know from a separate Tesla scandal that it would be perfectly possible for a Chinese engineer to record a private conversation in a car like this with a cellular module.”

In late November 2022, it appears the FCC queued up a policy to quickly ban Chinese equipment it deems posing a threat to national security. Although Quectel has not been put on this list, the infrastructure is in place for a quick strike. If that happens, a large beneficiary would be SMTC, which purchased Sierra Wireless at the end of the year. Sierra Wireless is essentially the last module player standing in North America, and a ban of Quectel would immediately provide it access to the $500M a year in revenues Quectel generates in the United States, while also likely significantly improving margins on said modules.

It will be interesting to see how the “Chip Wars” all play out over the coming years and decades.

Update As of September 9^th:

Since we began writing this summary, events have been unfolding at a fast and furious pace.  Consider the following:

1)     Apple banned in China for government employees

If this is just a one-time thing and only applies to China’s government workers, perhaps it’s not a huge deal.  However, if it’s the beginning of China phasing out Apple entirely, it’s a huge deal as Apple manufactures nearly all of its iPhones in China at their enormous Foxconn facility.  Would China do this unless they thought they were closer to semiconductor independence than the US anticipates?  Well, see below:

2)     Huawei introduces phone with significantly higher technological capabilities than anticipated

We are still trying to understand just how close this new Kirin 9000s stacks up against the most cutting edge chips, but our preliminary understanding is it places Huawei just a little bit behind Western technologies, at least in terms of nanometers. 

It appears Qualcomm may be the initial loser here, but geopolitically it implies Western countries have less leverage over China than perhaps thought.

3)     US escalates messaging on a ban of Quectel and others

As discussed above, we noted that the US had fast-tracked a potential ban on Chinese module producers like Quectel.  Now, the language is again escalating towards an all out ban.

In assessing how attractive the industry was, we pointed out that at that time, growth expectations were significantly higher than average, above 20%.  As we look at our dataset now, things have changed materially and we make the following arguments in this post:

• SBC as a percent of revnue remains historically high.

• “True” Rule of 40 (Adjusted EBITDA margin - SBC margin + expected NTM revenue growth) is down across the board.

• Revenue growth has deteriorated while margins have not rebounded sufficiently to make up for the growth slowdown.

• Smaller companies (under $1 billion in revenue) are showing the worst of the deterioration in “true” Rule of 40 while the very largest companies are not as impacted yet. This may explain the recent dominance of the few mega cap software stocks as the fundamentals at least partially justify outperformance.

• Despite large declines in 2022, software stocks still seem very expensive versus almost any other point in history.

A Brief Historical Note on Stock Based Compensation (SBC)

We won’t belabor and bore you with the nuances of SBC accounting here but we did want to point out one interesting item we uncovered as we attempted to build a credible dataset back to 1998.  One reason it is hard to normalize SBC for companies, specifically before 2006, is that prior to that year companies generally utilized what they called the “intrinsic value” method of expensing SBC.  As noted by Oracle in their 2006 10-K, “We generally did not recognize any compensation expense for stock options as the exercise price of our options was equivalent to the market price of our common stock on the date of the grant.”  This is the intrinsic method --intrinsically, at that moment, the option doesn’t have any value.  At the time SBC was almost all options, not restricted stock units (RSUs), so the intrinsic value was generally zero.  Although no expense was recognized on the income statement utilizing this method, companies were required to report a “pro forma net income” that estimated a fair value of SBC under the more familiar Black-Scholes model.  For instance, if you look at Oracle’s 2002 10-K, you can calculate what SBC was by subtracting their GAAP net income from their pro forma net income:

For those interested in learning more about fair value versus intrinsic value of SBC, the relevant guideline (Standard No. 123, Revised) from the FASB is linked here.

Our overall observation of this is that software companies had an even bigger racket going on then than they do now.  We can’t conclusively verify this, but we believe what ultimately kicked off the concept of “Adjusted EBITDA” was tech companies effectively pouting, “we weren’t recognizing SBC before and we refuse to now, so here is a new metric to get around that requirement.”

With all that in mind, we were able to construct the median SBC as a percentage of revenue going all the way back to 1998 (through May 30, 2023):

This chart was interesting to us because we didn’t have a good sense of just how much the price action of stocks was accelerating the stock comp expense rates, versus companies just handing out more shares to employees.  You can see that during the 2000 Tech Bubble, SBC did grow substantially, which we believe was primarily fueled by stock price appreciation.  One thing to point out, though, is that a much larger percentage of SBC today is RSUs, which don’t have the same kind of expense leverage that options do.  In other words, appreciation/depreciation in stock price in today’s environment may impact SBC less than it did back in the Tech Bubble.  Also notable is that we have not really seen SBC as a percentage of revenue decline yet despite a major sell off in software stocks, which means software companies are diluting existing shareholders at an even greater rate now.

For the rest of this article, we will use Next Twelve Months (NTM) data for revenue and EBITDA.

Rule of 40 is Down Across the Board

You can see below that if you use Adjusted EBITDA and revenue growth to build a Rule of 40 score, currently the median software stock is on the lower end of its 15-year range, but certainly still within a longer term trend (although down from a year ago).  However, if you factor in SBC, Rule of 40 is closer to Rule of 20 for the average software stock, and the gap between Adjusted EBITDA and what we call “True EBITDA” (adj. EBITDA less SBC) has almost never been higher:

Revenue Growth is Driving the Recent Deterioration in Rule of 40

When we wrote our article last year, expected growth was still above 20% but over the past year growth expectations have come down significantly for software stocks, and just recently broke below their long-term average growth of 16%:

15% is of note because in periods when growth is above 15%, the median EV/NTM Sales ratio has averaged nearly 5x.  When growth is below 15%, it has averaged closer to 3x.  Currently the median is 4.5x.

On the other hand, EBITDA margin expectations have recently improved, both on an Adjusted and “True” basis, just not enough to compensate for the decline in growth.  Below you can see that since our last update, margin expectations have improved at the median by 300-400 bps.  Companies are reacting to this lower growth environment, just (arguably) not enough:

Scale Considerations

To be clear, there are significant differences in how much or little fundamental deterioration has occurred.  If we bucket software companies into four tiers of revenue base, and compare 2015 to present day, you can see there has been True EBITDA margin improvement for the largest cohort (>$10 billion in revenue), while every other group has experienced significant margin degradation:

Doing the same exercise but adding in revenue growth to produce a Rule of 40, we can see the biggest of the big have 55% Rule of 40 scores even after accounting for SBC, which is an improvement and near a new high since 2015. Meanwhile, very large companies ($1-$10 billion) have only seen modest declines in Rule of 40 while the real drop has occurred in the smaller companies:

The collapse in software stock prices since early 2022 has been harsh on all size cohorts, but given this context, it makes it somewhat easier to swallow that the largest companies (MSFT, ORCL, etc.) have appreciated the most YTD in 2023 and breadth has become miserable. 

EBITDA Multiples

Looking at companies with revenue bases greater than $1 billion, which in our minds should have significant operating scale, EV/NTM EBITDA multiples are still highly elevated relative to history with or without stock based comp added back. As you can see below, these supposedly “scaled” companies are still trading at 36x NTM EBITDA despite growth expectations imploding.  Indeed, from 2008-2016, the median software stock traded in a tight valuation range of 8-12x EBITDA, with or without SBC.  Even if we don’t apply any penalty to SBC, we are still nearly double that today:

Another way to perhaps visualize how SBC has made software companies implicitly more and more expensive is to show how many EBITDA multiple turns more expensive the median stock is without SBC.

Again, this is only for software companies with greater than $1 billion in revenue (currently there are 58 of them).

Conclusion

Software in aggregate continues to look expensive in a historical context when comparing growth and profitability (Rule of 40) to valuation, specifically when factoring in SBC and overwhelmingly when removing the largest of the large, whose fundamentals have held up well.  While our general thinking is that software as an industry now has higher quality recurring revenue and is more resilient to recession, and thus potentially deserving of a higher than historical average multiple, the steep decline in growth expectations with only modest margin improvements causes us to remain quite cautious on the space in general. We are, however, still finding plenty of attractively valued bottom-up opportunities within vertical niche SaaS stocks.

A concern we have is that the amount of VC money and the sheer number of companies now out there competing, along with the cloud lowering switching costs, will make the 40%+ margins many people assume are possible for software companies quite challenging (unless you have giant scale and a real moat like Microsoft).  Combine that with much higher interest rates and it’s not inconceivable to us that stocks could drop back closer to 3x sales at the median.

Furthermore, AI is still in its infancy and while we believe there are reasons it could be a tailwind for margins (eliminating the need for certain coders, more rapid innovation), there are also reasons to be concerned that AI could create a more commoditized product over time and could endanger certain companies (low code/no code, call centers, etc.). 

Note on Methodology

In our previous article we were using Factet’s Packaged Software nomenclature, running it through their Alpha Tester product to ensure point-in-time accuracy.  Since then, we have begun sourcing our data from Refinitiv’s database platform (using IBES forward estimates), which we believe have better classifications and more robust data.  In this case, our universe includes: all stocks whose industry is labeled as “software” at the point in time we were reviewing it, not be an ADR, trade on a U.S. or Canadian exchange, have forward sales estimates, and have a market cap >$250 million.

Measures that are often emphasized to highlight the potential downside risks include:

• Median home sale price up 36.5% in 2022 Q2 from 2019 Q2

• Existing home sales down 5.9% sequentially in July from June

• Elevated measures of median home price to median income

• 30-year fixed-rate mortgage rose to a weekly average of 6.02% on 2022-09-15. 

• Various macro fears including the looming possibility of a recession, inflation concerns and a struggling stock market. 

However, there are just as many reasons that fundamentally explain the home price rise and provide arguments for why home prices in most markets could hold or even continue to rise, albeit at a slower rate:

• Wages have risen by 16.1% nationwide in 2022 Q1 since 2019 Q1, and 6.7% year over year.

• Employment has now surpassed pre-COVID levels

• Remote work has shifted personal preferences and may have caused half of the rise in home prices, according to a working paper by the National Bureau of Economic Research.

• New single family home supply is slowing, and the focus is shifting to building multifamily to meet the growing housing demand. New single family home permits were down 11.7% in July 2022 on a seasonally adjusted year-over-year basis, while multifamily unit permits were up 26.2% year over year. 

  • From NAR’s report: "’We're witnessing a housing recession in terms of declining home sales and home building,’ Yun added. ‘However, it's not a recession in home prices. Inventory remains tight and prices continue to rise nationally with nearly 40% of homes still commanding the full list price.’"

• Millennials continue to buy their first homes as they now comprise the 26-41 age range in 2022 with a generational cohort roughly 10% (6 to 7 million people) larger than their Gen X predecessors, providing a large source of home buying demand.

  • A deeper dive into the various demand drivers can be found in our previous article here.

In terms of median home price to median income ratios, in our last post, we showed that while home prices have risen substantially over the past 3 years, home buying is still within reach for many potential home buyers (within the actual home buying income deciles) in most markets, and broad national measures using median home prices and median incomes are flawed. This holds true even if 30-year mortgage rates pass the 6.5% mark.

Nevertheless, many potential homebuyers have surely seemed to move to the sidelines to watch the current volatility settle out. However, there are also signs that home buying interest overall hasn’t lessened. According to a UBS Consumer Labs Research report, “This year search interest increased +1.6% for existing homes (EH) and +22.1% for new homes (NH) from the end of May'22 through Aug'22”.

What Drives Home Prices

With that background, we’re back to the question: where are home prices going and when? Simply looking at a nationwide aggregate requires the consideration of many variables and leads Zillow to forecast a year over year increase of 1.4% while Moody’s sees a  0% up to a -5% decline.

However, the complexity lessens when the question is approached from the MSA level where a few key local market metrics can paint a clear picture of what to expect. Each local market has a unique story that will vary from the nationwide average.  We use historic data to set our baseline expectations with Zillow’s ZHVI metric providing reliable approximations for the typical home price in each major market going back to 2008. 

We find that from 2010 to 2019 one variable was the dominant explanatory variable for Y/Y home price change in an MSA: the change in the number of employed people over the previous two years within that market. For example, if you wanted to know how home prices were going to change in a given city from 2015 to 2016, you would want to look at the increase or decrease in the number of people with jobs in that city in 2015 relative to 2013. This one leading indicator predicted 64% of the home price growth variance in markets with over 400,000 workers in a simple linear regression model using data from 2010 - 2019. This size threshold covers markets roughly the size of Tulsa, Oklahoma and larger.

Having one variable that covers 64% of the total variance is huge. After accounting for this 2-year employment growth, other variables such as changes in home supply, demographics, wage growth, etc. all had relevant, but small, impacts when predicting year over year price change. We know that considering all the variables available in a complex, non-linear, multi-variable, model will yield a more complete prediction. However, it’s often beneficial to avoid creating a black box when you have one predictive variable this strong. Focusing effort instead on understanding that one variable while filling in the remaining gaps with expert knowledge is often a better alternative.

In the regression above, we only checked in on the data once per year. An easy way to improve the model would be to also consider rolling 1-year and 90-day employment changes and update the forecasts more frequently. For example, in the 2015-2016 hypothetical, if you were in a given market in early 2016 and your expectations of 2016 home prices were set by strong employment changes from 2013 to 2015, but you then observed the employment situation drastically worsen, you would logically lower your expectations. So, while rolling 2-year employment change is the single most important predictor, when you build out the model and augment it with rolling 1-year and 90-day measures, model predictability improves to ~70%. While we do expect that wages, housing supply, demographics and other similar variables have an impact on prices over longer time horizons, it’s very clearly all about workers in the short term. 

How Did This Predictor Hold Up Through Covid? 

Putting aside 2020 for a second and looking at 2021, the employment metric works ok, but not as well as it did historically. This makes sense given that the employment was severely impacted by unprecedented factors like shutdowns and restrictions. However, with enhanced unemployment benefits, stimulus checks, paused student loan payments and other government benefits both employed and unemployed individuals kept local economies strong. Taking this into account and adjusting the metric slightly we can look at total labor force instead of employment, where labor force is defined as the number of both employed workers and unemployed workers looking for a job. Historically, changes in the employment count were the better predictor, but both have always been similar. During the COVID years, looking at changes in an MSA’s labor force became the better predictor and showed that the trends discovered pre-COVID held true.  

Note that even in markets with 0% change in the labor force, home prices grew ~20%. 

Though many markets will continue to experience home price volatility in the short term, over the next year and beyond we believe that any market currently experiencing strong labor and employment growth trends will see resiliency in home prices while markets with a struggling labor force have serious questions whether current prices can hold. The most obvious way we see widespread nationwide decreases in home prices is if we enter a bad recession and see a broad spike in unemployment across MSAs.

Rent vs Own

The big asterisk here that is true for all statistics is: Past correlations do not necessarily hold true into the future. The key is to identify why past trends are going to break. 

First, consider two reasons why home prices recently rose so rapidly:

1) historically low mortgage rates which made homes more affordable to borrowers

2) remote work shifted personal preference and may have accounted for half of the rise in home prices, according to a working paper by the National Bureau of Economic.

Both reasons have reverted to some extent and may continue to backtrack. Mortgage rates are increasing, and more workers are returning to offices as employers and employees look to find a new balance. 

Secondly, and we think most importantly over the next few months and year, is the fact that home price growth has far outpaced rental price growth over the past 3 years. This makes renting currently more attractive than it has been in a long time. Consider the ratio Monthly Rent/Monthly Mortgage Services. It’s a metric many households are likely consider to varying degrees of precision before any action. For example, if renting a house cost $2,000 per month and the monthly mortgage, insurance, and tax cost to buy a comparable home was $2,000 per month, the ratio would be 1.0. If rent was instead $1,000/month, and the mortgage servicing cost was $2,000 the ratio would be 0.5. Historically there has been some natural equilibrium to this metric for each MSA but now, in nearly every market we’ve looked at, the current rent/own ratio is far from the historic norm.  

Using Austin, Texas as a case study, we constructed this metric using both Zillow data (ZHVI and ZORI) and MLS data. MLS data is more exact and allows for apples-to-apples comparisons. The parameters we set were home sales and rents where the home was a 3 bed, 2 bath, with lot sizes of 4,000 - 15,000 sq ft and home sizes in the 1,200 - 2,000 sq ft range. Notice that while the graphic below is dual axis as we are using two different data sources the shapes of the data are the same, confirming the trends. The lower the ratio is, the more favorable renting is and the higher the ratio is, the more favorable it is to buy.

Continuing with Austin as our example, below are three homes. The first for sale and the next two are for rent. All three houses are in northern Austin neighborhoods and are less than a 10-minute drive from each other. All are 3 beds, 2 baths and under 2,000 sq ft. The house for sale ($570,000) is in a slightly better neighborhood. The first house for rent is a little larger. The estimated monthly total mortgage services payment for the house for sale is ~$3,900 with a 20% down payment. The larger house for rent is $2,375 per month. That's a $18,000+ per year choice for the household who may have an income around $150,000 pre-tax. The second for rent house is even less at $2,000/month, saving an additional $4,500 per year.

Some households will choose to buy no matter what because there are definite benefits to homeownership, but others will see that larger rental property and having extra $18,000 at their disposal as the better choice for them. While they aren’t building wealth through homeownership, they can use that money for something else and any home repairs needed are not their financial responsibility. They also have greater choice and flexibility to move in the future and can continue to search for the right house on their terms. 

Seeing that the Zillow data works well to highlight the underlying trends we can look across many more markets and the U.S. as a whole. In the graphic below we see that each MSA has its own natural equilibrium in the rent/own ratio, e.g., cities like LA are also much more attractive to rent. We also see that all the major markets have followed similar trends over time including the large and quick increase in the attractiveness of renting from summer 2021 to summer 2022.

How does this rent/own ratio effect available supply? In markets where renting is currently more attractive relative to its pre-covid baseline, we are seeing a faster increase in available home inventory using Realtor.com data. This increase in available homes takes the advantage away from the sellers and gives it to the buyers, putting lots of downward pressure on home prices. 

For this ratio to come back into balance without a drastic change to mortgage rates, it requires either rents to rise or for home prices to fall. In reality, it will likely be a combination of both, which is already occurring. Using Zillow data through August we’re seeing a rapid upward shift in the rent/own ratio has begun as home prices have started to dip a little in some expensive markets and rents are continuing to rise just about everywhere. 

It is important to note that this ratio does fluctuate over time. With the major increase in remote work, quickly increasing demand and slowly increasing supply, it’s very plausible that this ratio going forward will not go back to the 2019 levels (without a deep recession). It’s possible that the new equilibrium for a given MSA will be somewhere between where this ratio is now and where it was pre-COVID. However, there is one caveat, if 30-year mortgage rates were to drop back under 4%, this imbalance would largely evaporate with most MSAs quickly returning to their pre-COVID baseline.

We estimate rent in the top MSAs needs to rise an average of 30% to return to its pre-COVID equilibrium, holding current rates and home prices steady

Conclusion

The vast majority of recent housing related headlines are pure doom and gloom, but as with most things in markets and life, nothing is black and white, nothing is all positive or all negative. Job growth remains robust, new housing inventory growth has slowed to a trickle or stopped altogether, and consumer balance sheets are still just about their strongest in modern history1. Furthermore, the demographic tailwinds remain powerful as surveys reveal that a vast majority of young people that don’t already own a home are still waiting for a price dip to buy2. The housing exposure in our portfolio remains almost entirely geared towards Repair & Remodel spending, which is demonstrating remarkable resilience the last few months which we believe is poised to continue.

Extreme Networks (EXTR) is now the Voss Value Fund’s third largest position (behind GFF and SWIR). EXTR is a leader in wireless and wired networking equipment (switches, access points, routers), particularly in large scale, complex wi-fi deployments such as hospitals and sprawling university campuses. The Fund has owned EXTR since the middle of 2020 and have previously shared our research on it publicly (see the Voss Q3 2020 Quarterly Letter). At the start of 2020, the company had a >3.0x net leverage ratio and new product orders briefly collapsed around the Covid-related shutdowns. Fast forward to today and leverage is under 1.0x and the shares are even cheaper at 9.5x our next twelve months free cash flow estimate (as of the middle of July), despite their product order backlog being nearly 25x higher than pre-covid levels. In other words, right as its valuation hits a historic low on a free cash flow basis, we believe the company’s visibility has never been higher.

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As EXTR’s backlog is realized over the next ~10 quarters, combined with its burgeoning software platform that is just now hitting significant scale (generating >$100 million in recurring revenue while growing 40% year over-year), we believe the company will generate over $750 million in free cash flow over the next three years, which compares favorably to a current market cap of just $1.8 billion and an enterprise value of $1.9 billion. In our view, consensus estimates are far too low for each of the next three years. Even as we heavily discount management’s long-term guidance and assume a slower fiscal 2024 from a bookings (signed contracts) perspective, we get the following profile.

With the stock’s valuation and risk/reward profile arguably much more attractive now than at the time of our first purchases when the stock was $4, why does the opportunity exist? First, to state the obvious, almost all small cap tech stocks have been brutally bludgeoned—dragged down by the non-profitable tech stock bubble bursting.1 Furthermore, from our vantage point the market is suffering from a combination of short-termism and lack of faith in management’s detailed outlook that was presented recently at their analyst day on June 2nd. If the management team is even near the ballpark of executing on their 3-year vision, the stock will be trading at 4x FCF given the enormous amounts of cash we expect to accrue on the balance sheet between now and FY 2025 (ended June 2025).

From discussions with resellers/channel partners and competitors, to attending their user conference and speaking with customers, converging lines of evidence from multiple independent sources support the plausibility that EXTR is taking market share in real-time from Cisco and is poised to show robust growth— even through a hypothetical industry downturn that exceeds the magnitude of 2009’s.

EXTR’s hardware order backlog is typically $20 - $40 million in any given quarter comprised solely of orders that came in near the end of the quarter as they normally ship every order they get immediately. Today that backlog stands at $513 million, and their lead times are the lowest in the industry (certainly ahead of Cisco, who is prioritizing their largest customers). The vast majority of the orders are wanted “as soon as possible.”2

Additionally, it appears management has enough visibility in the sales pipeline and order trends to publicly state they believe the backlog will continue to grow through Fiscal Year 2023:

“Next year, we talked about adding – growing the top line because of releasing supply chain. But we'll still be constrained. So, we'll add another – we expect maybe $150 million, call it in backlog.” -CEO Ed Meyercord, Needham Tech and Media, May 19th, 2022

If that does indeed come to fruition, we estimate the Product backlog would be around $600 million a year from now when their Fiscal 2023 ends. Key to remember is that these are non-cancellable orders.

The backlog going from $105 million to $513 million in FY 2022 means that over the last 12 months EXTR has temporarily foregone over $400 million of high incremental margin revenue that they would have recognized if they weren’t supply constrained. There is also significant service and software revenue tied to this hardware backlog, as customers will sign software deals once the hardware ships. Thus, we estimate these forthcoming hardware sales will provide an additional $75 million in recurring software and services revenue.

By our calculations, if backlog had remained static over the last four quarters, revenue growth would have been > 45% over the past year, rather than the 10% they reported. SaaS subscription revenue, already impressive at $100 million ARR and growing at 40%, would be closer to $150 million. While we don’t expect 45% growth to be sustainable, in our view the company is being valued as a 10% (or lower) grower rather than the market share taker in a positively trending industry with secular growth tailwinds.

The company should also have some additional hardware revenue buffers in FY2024 and 2025 after they work through the current backlog, as they have two major projects with Verizon and Ericsson that could generate an incremental $75-$100 million in revenue a year for several years in a row. And although we are not currently modeling it, we also expect them to continue to take market share from Cisco. This is important because each 1% market share gain is quite impactful to Extreme, i.e., ~$200 million in incremental revenues, and ~$75 million in annual FCF. With our channel checks indicating that Cisco has “all but abandoned” the middle market, we think EXTR has a timely window of opportunity to take more market share.

ExtremeCloud IQ

The second major driver that is increasing visibility is the emergent scaling of the ExtremeCloud IQ platform. Back in 2020, while the company was growing their cloud bookings at a strong pace, it was off a low (and undisclosed) base. The company was moving a lot of their customer base, particularly their wireless equipment base, to subscription contracts. Now, even as the company has passed $100 million in ARR for their Cloud Management software, there are several credible growth drivers that we believe make management’s seemingly aggressive forecast (+40% ARR CAGR 2022-2025) realistic and maybe even conservative. Here are the main drivers as we see them:

1. Backlog - As mentioned, there is significant Cloud IQ revenue coming from the giant hardware backlog, likely in the range of $50 million of subscription revenue just in the current backlog (in addition to another ~$25 million of annual maintenance revenue).3

2. Renewals: The most common duration of a subscription contract is three years. Of note, customers were put on “teaser” rates initially, with the expectation that pricing would rise at the time of renewal. The company is just now beginning to enter a period of large potential renewals (really ramping in 3-4 quarters from now as we lap three years for customers who signed in 2020) and expects 90%+ gross customer retention, with net revenue retention moving towards 100%. Given the large discount given initially and the hassle of a “rip and replace,” we think this 100% bar seems attainable and likely conservative.

3. Copilot/Digital Twin: The company has also been beta testing the “next generation” of features that automates the network in the form of new modules called Copilot and Digital Twin. Copilot adds significant additional features that allows for network automation, while Digital Twin is a cloud oriented solution that allows for more robust, virtualized testing infrastructure. In addition to getting higher base prices on their renewals, EXTR’s sales force will be attempting to upsell these new modules, which carry 50-60% ARPU increases.4

4. SD-WAN: The company has fully integrated and launched their SD-WAN (software defined wide area network) product into the market that they acquired last year (Ipanema). SD-WAN, when deployed, will carry a very significant uplift to ARPU. It’s our understanding that to hit their growth targets, they need only penetrate about 2% of their 50,000 customers over three years, and only are targeting 250 SD-WAN customers in 2023. This would represent ~20% of their total estimated ARR growth over the next few years.

All four of these drivers seem to be quite significant and it appears reasonable to us that ARR could move from ~$105 million at the end of June 2022 to $250 million by 2025 (matching the midpoint of the 40% CAGR management is guiding to). However, for now we are modeling 34% cloud revenue growth as we are taking what we believe to be a conservative approach on renewals until we see more evidence of solid sales execution.

We would also note in our view that most of the cannibalization in moving some of their software revenue to ExtremeCloud IQ has already occurred. Their software license/maintenance was around $40 million a year and it has now dropped to under $12 million a year, so one will soon see a positive inflection in total Recurring Revenue dollars and thus the stock will likely screen better and potentially begin to attract more growth focused software investors.

Management has said that expedited shipping and elevated freight rates have knocked down product gross margins by an incredible 700-900 bps, and that as freight rates return to earth, they will start to reap the benefits of their significant SKU count reduction and product consolidation onto their Universal Hardware platform.5 However, for the sake of conservatism, we assume hardware gross margins do not rise above 60% vs management’s guidance of 64% as it is possible they have to give back some of their recent price hikes as industry supply constraints ease.

EXTR shares look incredibly attractive on a relative value basis versus its larger networking equipment peers, as well as on an absolute basis at 9.5x our NTM FCF estimates (our FCF estimate is ~50% above the consensus estimate), even after the stock’s recent run from $8.50 to $13.00.

Bear Case: 8x our bear case FCF estimate = $9.00/share (-30% downside). Hence our significant upsizing of the position recently under $9).

Bull Case: 15x our bull case 2025 FCF estimate = $40/share (210% upside).

We take comfort in the fact that in 2008, EXTR’s product revenue grew and in 2009 it declined by only 9.5%.6 Given their product order backlog is currently ~25x the size it was at the end of 2019, we are comfortable that EXTR can grow even through an economic depression. The risks for Extreme mostly revolve around timing and management credibility on forecasts. At times they have been overly optimistic, particularly around forecasts from acquisitions, as well as recently around gross margins. However, if management loses additional credibility and the stock gets stuck in a penalty box, we believe there would be strategic suitors who would be interested in acquiring the company for its customer base and industry-leading cloud technology, along with significant sales and marketing and R&D synergies. Valued at an enterprise value of just 2x gross profit and 9.5x FCF, the risk feels highly asymmetric to the upside.

Disclaimer: https://www.vosscap.com/disclaimer

Since that time, expected revenue growth has remained elevated while multiples have continued to collapse, going from 4.7x when we wrote the note in March to 3.2x now for the “median” software company.

Adjusted EBITDA margins have also stayed fairly static meaning the traditional Rule of 40 score for the median software stock has stayed relatively constant at 34%.

It occurred to us that there could be other variables potentially masking the true change in underlying profitability of software companies.  To investigate, we looked at two tricks I’m aware of that management teams employ to overstate their EBITDA margins:

1)       Capitalization of Research and Development (R&D)

2)       Stock-based Comp (SBC)

There is some discretion over how companies classify their R&D expenditures. Some companies report all of their R&D as an operating expense while others capitalize some of their R&D cost and then depreciate it over time.  If a company chooses to capitalize the R&D it will never show up in EBITDA because well… EBITDA is earnings before depreciation.  For this reason, we often prefer EBITDA - Capex or EBIT when doing apples to apples comparison of companies.

As for SBC, this expense is typically added back in the calculation for Adjusted EBITDA to inflate the number.  While it is true that stock compensation is not a cash cost it is still a very real (and consistent) cost to the company as one of two things will ultimately happen:

1. Dilution will increase as shares are issued to pay employees.

2. The company will buy back shares to avoid dilution and keep the share count flat, which of course uses cash, effectively making it a direct cash cost.

Depending on the level of the stock comp, this can really dent a company’s underlying margins, and since it’s an annual exercise of granting shares to compensate employees, it’s usually not a “one time” thing that will go away.

So, the question is, have software companies been utilizing this trick more recently to mask underlying profitability behind the guise of Adjusted EBITDA?

Here is the median Capex/Sales for software companies:

Well, so far so good.  While we are currently slightly elevated versus the 2% - 2.5% level we saw during the 2000s, we are down from a peak of 5% in 2015-2016.

Now what about stock comp as % of sales:

Now this is interesting.  Since 2016, the median software company has increased their stock comp rate as % of sales from 4% to 9%.  That’s effectively 500 bps of hidden margin compression.

If we compare the median Adjusted EBITDA margin vs. what we might call the “True” Operating margin (Adjusted EBITDA- Capex - SBC), we can see that not only has there been a persistent decline in both numbers, but the gap has been widening. As illustrated by the gray bars, the gap between Adjusted EBITDA and True Operating margin has been as low as 4% historically, but now sits at a record high of 12%.

Perhaps evem more jarring, the median software company’s underlying True Operating margin is only 1%.

Below we show the Rule of 40 using traditional Adjusted EBITDA vs True Operating margin.  You can see the slope of the line is steeper for True Operating margin, implying that even after accounting for growth, there has been underlying deterioration masked by increasingly exorbitant stock comp.

While in a perfect world we would do more analysis around actual new stock grants, as opposed to just SBC expense which is amortized and can be driven by stock price movement, we believe this is likely still directionally correct.  Perhaps more importantly, we can identify some of the biggest offenders while highlighting names that have stronger underlying “True” margins.

Who Are the Biggest Offenders?

We took a representative sample of pure software names and show their difference between Adjusted EBITDA margin and “True” EBITDA, which we show below:

One offender is Bill.com.  They trade at 14x NTM sales and have a traditional Rule of 40 score around 44%.  However, their stock -based comp is 34% of sales, along with capex at 3%, meaning they only have a True Rule of 40 score of 7%.

Zscaler, another high-flier, still trades at ~15x sales with 38% growth and 15% headline EBITDA margins.  However, they have 39% of their sales in stock-based comp and 8% on capex, meaning their modified Rule of 40 is only 7%.  Should this still get a 16x sales multiple?

Other material offenders include Confluent, Coupa, Okta, SentintelOne, Palantir, and Snowflake, among many others.

Who Still Holds Up?

On the other hand, companies like Datadog stand up reasonably well.  Yes, they are at 18x NTM sales, but their 46% projected sales growth is supplemented by a headline 19% EBITDA margin and “only” 17% of sales as SBC, meaning they still have a Modified Rule of 40 of over 44%.  Other higher multiple names that still hold up well include Paycom, Veeva Systems, and Qualys.

Conclusion

The EV/Sales multiple is ultimately a short-hand proxy for earnings (assuming some kind of steady state operating margin).   The traditional thought is that software companies at some level of scale can hit 30% - 40% operating margins in a lower growth environment, hence the Rule of 40 (trade off from growth to profitability).  If you’re trading at 10x sales but you can double your sales in three years and then hit 40% operating margins at 0% growth, you are effectively trading at 12.5x EBIT on a plateaued sales level, not quite as insane as might first appear.

However, what this appears to show is that, on average, there has been an underlying deterioration in growth adjusted profitability in the sector.  This in turn should impact what EV/Sales ratio an investor is willing to pay, given the implied lower margins.  Ultimately, as investors become more discerning and realize that their operating profits are increasingly and subtly going to employees rather than them, there may be a reckoning on egregious levels of stock comp.  If there is a sustained recession, we would expect margins to rise as they did post 2008:

Until then, we believe it’s prudent to be cognizant of the major implied differences in valuations at a stock level and whether we need to be a bit more conservative in assumed EV/Sales multiples as proxy for earnings shorthand.

Please see all relevant disclosures at: https://www.vosscap.com/disclaimer

Loss hurts more than gain rewards, emotionally speaking1. At a 2:1 ratio, in fact, for most Americans.  For Voss, losses are the equivalent of Medieval bloodletting. Like many painful rites of passage that are ubiquitous across many cultures and time periods2, The Great Humiliator must first (or eventually) inflict suffering upon you in order to bestow its wisdom and greatest lessons. There was far too much “easy money” made for too long and now many new investors have finally encountered their first excruciating rite of passage following the selloff this year. Time will tell if the majority cry uncle and bow out of markets entirely for many years or if, like me post-2008, the chaos seals their love for markets and they find a renewed religious-like devotion, but with a value-oriented framework.

It has been a difficult time to reconcile the macro and the micro. At the macro level, inflation is at a 40-year high3, the prospect of WW3 has been dangling over us like the Sword of Damocles, the Fed is raising short term interest rates “expeditiously,” China is locking down some of the largest cities in the world, US government officials are doing their best to prolong supply chain disruptions and inflation (e.g., attack oil and gas companies, talk about price controls, etc.), and so understandably the angst and ongoing investor worries could be characterized by us as hysterical negativity. Indeed, retail investor sentiment has only been worse during a few weeks in all of history, including parts of 1990, parts of 2008, and March 2009. Ditto for consumer sentiment, having only been worse than it is currently in early 1980, June 2008, and March 2009.4 On the opposite side of the coin at the micro level, dozens if not hundreds of companies across a wide range of industries paint a picture of widespread economic strength and are providing extremely positive forward-looking commentary. Contrary to popular belief, S&P 500 2022 EPS estimate revisions are rising at a high single digit growth rate so far this year and they are rising across all 11 sectors.5

As is usual, the Voss view of the whole is more informed by a detailed bottom-up view of many of the parts. And because we are finding so many fast-growing companies with good operating visibility and low leverage at very high FCF yields, we have not become too bearish on the market as a whole. Of course, the same could have been said several months ago and it hasn’t stopped most of these sorts of stocks from getting a lot cheaper as macro fears and the tech bubble burst contagion trounce bottom-up fundamental developments.

Statistically cheap and expensive stocks have de-rated in near equal proportion during this correction so far as of the date of this letter, leaving the cheapest decile of stocks the cheapest they have ever been relative to the market as a whole. We at Voss think as (if) the correction progresses, there will be an increasingly noticeable positive divergence between stocks at low absolute valuations that are aggressively returning capital to shareholders and the perpetually cash-burning bubble stocks that still lack any valuation support. As of the middle of May, using our Base Case price targets, which are calculated using a detailed analysis of the fundamentals of our portfolio companies, we estimate that the upside to our long book exceeds 100% in the next 12-18 months, which compares very favorably to our historical average estimate of closer to 30%.6

New Core Long: Williams Sonoma (WSM)

We believe shorting furniture retailers has arguably become a consensus view on the back of widely known tough comps from early 2021 (+26% and +40% SSS Comps for WSM in calendar Q1/Q2 ‘21) and fear of pull forward of demand, which seems to be corroborated by weak credit card data in the category the last few weeks and a poor outlook from furniture e-Commerce giant Wayfair, not to mention a panic-inducing, rambling conference call from the oft colorful CEO of Restoration Hardware. Lazy thematic macro analysis that stops there, however, paints an incomplete picture of what has transpired at many individual companies like WSM that have been deemed COVID beneficiaries that are now at all-time low valuations.

WSM is a furniture and home décor retailer that owns several well-known brands: William Sonoma, Pottery Barn, Rejuvenation, Mark & Graham, and most importantly, west elm. While perhaps thought of as a dying mall-based brick & mortar retailer, WSM derives the vast majority (66%+) of its revenue from e-Commerce and has been a remarkably steady performer, remaining free cash flow positive every year since at least 2007 and achieving positive same store sales comps since 2010, including +17% in 2020, +22% in 2021 with guidance for a further mid-to-high single digit growth again this year. Within the overall positive sales trends, west elm’s consistent growth has been even more impressive, with a 16% average annual same-store sales growth rate since 2012. To little fanfare, by our calculation, WSM has become the single highest quality retailer in public markets with a 58% return on invested capital (ROIC) in 2021 and a 39% ROIC on average over the past 3 years.7

With WSM the 5th most shorted retail stock and the consensus that furniture demand was pulled forward, it’s important to point out that furniture spending as a percentage of total personal expenditures is still far below the long-term average and remains lower than any single quarter from 1990-2006. The depressed furniture market post-GFC due to weak new home sales was the historical anomaly as opposed to the beginning of an upward reversion that kicked off in 2020. In 2020 the average annual expenditure on furniture per affluent household (top 20% by income) was still below 2015 levels.8 Furthermore, WSM’s growth has outpaced the furniture market overall by an > 8% CAGR since 2012. So even with a moderate industry slowdown, they are likely to continue taking market share at a fast clip as they did in 2020, growing 15% while the home furnishing industry overall declined 23%.9

With the stock trading at an all-time low valuation currently, at 5.5x EV/EBIT (vs. 12x historical average), it is at a nearly 60% discount to a basket of slower growth, lower margin, lower e-commerce penetrated, lower ROIC retailers and is clearly pricing in some severe margin compression and revenue declines.

By our calculation, WSM’s current stock price is pricing in no revenue growth despite guidance for mid to high single digit growth and for operating margins to get cut in half, from 17.6% to less than 9%. However, the Voss variant view is that there are several reasons to believe that majority of WSM’s margin gains post COVID lockdown will be more sustainable than the consensus thinks.

B2B

While we like the core WSM business and collection of brands by themselves, the company has an entirely new initiative that began in mid-2019 that almost no one is talking about despite its valuation potentially eclipsing the entire current enterprise value on its own within a couple of years.

In this relatively fledgling business-to-business (B2B) segment, WSM acts as full-service interior designer and furniture outfitter for large commercial clients and hospitality chains such as Marriott, Salesforce, Disney, and the Golden State Warriors. This business faces little competition from players who can operate at the same scale WSM does or who can provide the “one-stop-shop” experience of sourcing from a single vendor. Across WSM’s 8 brands customers can select everything from couches to outdoor furniture to bedsheets to light fixtures. The business is currently growing at over 100% y/y doing $753 million in revenue last year at an estimated 25% - 30% operating margin. Even assuming a revenue growth slowdown to 40% per year, at 30% operating margins we think WSM’s B2B business can generate over $600M of EBIT by 2024. Using a valuation multiple comparable to a basket of the top tier public retailers (as measured by margins and ROIC) we estimate just this one segment alone could be worth 100% of the current enterprise value, or $7.2 billion, within the next 2 – 3 years.10

The beauty of the B2B business is that it's a natural extension of what WSM does best with its in-house design team and sourcing. It simply opens the door to a previously untapped $80 billion, highly-fragmented market opportunity, which WSM has quickly captured 1% of. The business fully launched in 2019 with management initially setting out the target of $1 billion in revenue by 2024. The growth has exceeded all expectations and we estimate B2B's Q4 2021 revenue run rate already easily exceeds $1 billion. As the CEO said on the Q4 earnings call, “B2B just continues to go. I think I've revised my estimates every time I've gotten on this call. I decided not to give estimates anymore because I keep undershooting it. And that's embarrassing as well."

Despite the rapid success, the B2B business is still relatively nascent in our view. For example, the company just began designing restaurant and hotel-specific furniture in mid-2021. Prior to this, the company was simply making contract-grade versions of its existing furniture line. Now the company leverages its industry-leading, sustainable manufacturing operations to cater to specific types of commercial customers with WSM, the CEO noting in May 2021, "our win rates on large projects continue to improve."

In addition to the triple-digit growth driving overall company comps, B2B sales also come at a higher gross and operating margin relative to the core business. While margins aren’t specifically disclosed, the CEO says the margins are "incredibly accretive" since each B2B salesperson does “a ton of volume” working on large commercial accounts. There is also a high amount of repeat and replacement purchases which come at a low incremental cost to WSM. For example, of the $280 million in B2B sales in the first half of 2021, 70% of it came from repeat customers. The company has suggested that this is because once they land a commercial customer, they then have visibility to a pipeline of continued business:

"We're seeing the Marriott pipeline continue... we're seeing good internal indicators that the pipeline is only going to get stronger." – WSM President & CEO, November 2020

"We continue to see repeat business from some of our key customers like Salesforce, and we have a growing number of new projects currently underway." – WSM President & CEO, May 2021

"Our B2B sales are accelerating week after week as our project pipeline continues to expand" – WSM President & CEO, May 2021

The growth and margin profiles of B2B have required relatively little incremental minimal investment and will continue to bolster WSM's already industry-leading ROIC. While B2B sales are currently only around 10.5% of total WSM revenue, we estimate it already accounts for a mid-teens percent of operating income. By 2024, we think B2B can grow to become >30% of WSM's operating income and at 12x EBIT be worth $8 billion, easily above the entire company's current enterprise value of $7.5 billion.

Maintaining Margins

In addition to B2B, other new initiatives include International Franchising and Marketplace. These are also both higher margin than WSM’s core retail furniture sales with faster growth and as they become a larger percentage of the sales mix, they should help to maintain WSM’s mid-teens margins.

Marketplace is where WSM sells third-party vendors’ merchandise without holding inventory or taking ownership of it. They simply use their website to list the vendors’ products and take a fee. Global Franchise is a similarly high margin opportunity and is showing early success, particularly within India.

In addition to these new initiatives, over the last few years, WSM has been shutting less profitable stores (with the exception of unit growth in west elm) and has renegotiated leases on 90% of the remaining stores which has helped lower their occupancy cost (rent as a % of revenue) by over 500 bps.

While investors are currently in a state of what we believe could only be characterized as negative hysteria on durable purchases, if one looks beyond the lapping of tough 20-40% comps, we see the longer-term outlook as positive for WSM to continue profitably take market share in a growing industry. One of the best leading indicators for demand for WSM’s furniture is the sale of homes that cost >$750,000, which are running at +68% y/y on a LTM basis.11 WSM’s gem asset, west elm, does particularly well with Millennials and Gen-Z who are just now aging into their prime homebuying years and will need to furnish entire homes as millions migrate out of smaller multifamily units. 

As of this letter, the stock is at an all-time-low valuation of 3.8x EV/EBITDA and 6.7x earnings with a clean balance sheet, zero debt, $850 million in cash, and a $1.5B buyback authorization (20% of shares outstanding at current prices). The company has consistently returned capital to shareholders and when they complete the current buyback, they will have repurchased 1/3 of the shares outstanding since 2015. We are happy to be buying more WSM at these levels. The stock has >100% upside in our base case price target, which would just put it in line with its 10-year average P/E and a 20% discount to its long-term average when ROIC and margins were much lower.

Conclusion

Inflation. Interest rates. Recession. This trifecta of worries dominates investors’ collective psyche and ambiguity, uncertainty, and fear reign supreme. Nearly every talking head’s commentary can be summed up as “just how bad can it get?” and “How much lower will we go from here?” Much can be said of this point of view, and we don’t want to risk sounding Pollyannish; however, we would point out that the average small-cap stock is already down ~50% at the time of this writing with most of our portfolio at all time low valuations (including March 2009). We think the fear of recession in the near term is overblown and is creating attractive opportunities in cyclicals that appear to have already more than priced in a severe economic contraction. The rate of inflation could be peaking soon, too, as long-term inflation expectations already have reverted below even 2013 levels. Also, it is important to remember that plenty of historical market pullbacks have ended during growth slowdowns and without rate cuts, and conversely, plenty of bear markets have raged on despite aggressive cuts.

“…in Itself can make a heaven out of hell or a hell out heaven.” The “it” John Milton is referring to here in Paradise Lost, of course, is the three pounds of ~86 billion neurons in between our ears. We have cultivated a high tolerance for uncertainty thanks to participation in markets since the early 2000s. Poise in the face of paradox and the ability to be at ease with ambiguity is an essential part of long-term investing success in public equities. Having conviction in our individual stock valuations also helps reduce our sensitivity to market drawdowns.

We can now choose to view the market’s correction as an irrational, unfair punishment, or we can lengthen our outlook and view it as another painful rite of passage on our lifelong Alpha Odyssey and a terrific opportunity to reload our return pipeline with mispriced securities. We see this as a target-rich environment, and we are optimistic about our forward-looking returns.

Sincerely,

Voss Team

This clash of supply and demand resulted in an imbalance which led to the bidding wars and skyrocketing home prices we’ve seen since 2020. While it’s been the result of basic economics and not rampant speculation, these price increases along with the more recent spike in mortgage rates have created affordability concerns.

Affordability has a clear effect on the feasibility of home ownership for many. The chart below shows home ownership rates vs estimated home ownership cost for the top MSAs (defined as over 1 million people) which captures nearly 60% of the US population. Home ownership cost here is estimated as the monthly mortgage + tax + insurance cost for the median listed home in an MSA as a percent of the 75th percentile household income within that MSA. With an r-squared of 45%, this affordability metric alone explains almost half the variance in the home ownership rate by MSA.

We like to use the median estimated home cost as a percent of the 75th household income because it is a closer representation of the true median home buyer. Too often, people cite median home price vs median income, and sometimes even more egregiously, do so on a national level. We believe this is an incredibly flawed way to view housing affordability for a few reasons.

First, the median US household is not the same as the median homebuyer. The median household income in the US is around $67,500. The median homebuyer income is over $100,000 with 76% of homebuyers earning more than $65,000. In other words, the median US household is not the one buying the median home so to compare those two as a metric for affordability is misleading. For example, the median homebuyer in Texas in 2021 had a household income of $107,500 which is equivalent to the 70th percentile household income in the state2. Second, incomes and home prices vary vastly by state and city, and as we’ll examine later, this distinction is more important than ever with the increased ability to work remotely.

I’ll also note that the income numbers we’re using are the most recently available at this level of granularity and are from early 2021 while the home prices we’re using are median listing prices February - April 2022, so in a way we’re assuming zero earnings growth since early 2021 which seems conservative.

Buy vs. Rent

People need somewhere to live and the choice most people have is to buy or rent. Among the factors that influence this decision are the need for more space for a family, the desire to have a yard, living in good school district, and of course, cost. The chart below illustrates the cost tradeoff specifically between renting and buying by MSA by comparing how much incremental income it would take to buy the median house vs rent the median 2-bedroom apartment for a household in the 75th percentile. Positive means more expensive to buy, negative means more expensive to rent.

On the left side of the graph there are cities like Austin, San Jose and Salt Lake City where it would cost an additional 12% - 15% of a the 75th percentile household’s income to buy the median house vs rent a 2-bedroom apartment in that city. On the right side, there are cities like Cleveland, Memphis, Miami, and Pittsburgh where it is actually cheaper to buy a home vs rent a comparable apartment.

As home prices have shot up over the past couple years, rents have as well, and the point of this exercise is to frame the decision millions of people are actively making. So, although it is more expensive to buy vs rent in most major cities, outside of the top few cities on the far left, it isn’t that much more expensive, especially when considering other factors important to people. Look at booming cities like Atlanta, Richmond, Charlotte, Phoenix and Raleigh. It’s not unreasonable to think that people in those cities or moving to those cities decide that having more space, a yard, being in a better school district and owning their own home is worth spending an additional 2% - 6% more of their current income vs renting an apartment. Especially when considering the attractiveness of locking in a fixed housing cost vs. being at the whim of future rent increases.

Rate Sensitivity Analysis

With the average 30-year fixed rate mortgage in the US now at 5.3% as of May 2022 many are getting nervous about overall housing affordability. Of course, as with all things housing, things need to be looked at granularly and locally.

Below we look at affordability by MSA at various mortgage rate levels. For this exercise, we draw the “unaffordable” line at 30% of household income. Again, we’re using the estimated median monthly housing cost (mortgage, tax, insurance) for a local market as a percent of the 75th percentile household income within that MSA.

5.5% Rate

At 5.5% mortgage rates, only 8 of the top 56 cities hit the 30% threshold and they are mostly the cities you would expect - five California cities, New York City, Miami and Honolulu. It’s also not a surprise that most of these cities have been experiencing large net outflows of people since 2020.

In the middle of the chart highlighted in green are many of the cities seeing the greatest inflows of people since 2020 (with the exception of Seattle and New Orleans). Among this group of “popular cities”, housing affordability ranges from 20% - 26%, with an average of 22%. We don’t view this as an unhealthy level. This would be the equivalent of a household making $135,000 per year having a $2,500/month combined mortgage, tax and insurance payment. As such, we don’t believe 5.0% - 5.5% mortgage rates are poised to topple the housing market.

6.5% Rate

­­­­At 6.5% rates, cities like Sacramento, Salt Lake City, Austin, Denver, Boston, and Las Vegas hit the 30% threshold. We’ll explain why this may not be as much of an issue for cities like Sacramento and Las Vegas in the Migration section later on. At 6.5% mortgage rates the estimated affordability of the “popular city” group moves up to 25% on average and over half of the top 56 cities overall are still below 25%.

7.5% Rate

At 7.5% mortgage rates nearly 40% of the 56 cities cross the 30% line and now include cities like Phoenix, Portland, Seattle, San Antonio and Nashville. The “popular city” group now has five cities hitting 30% and the group average is at 27%.

7.5% mortgage rates would seem to push the affordability limits on many of these cities; however, we don’t believe it necessarily triggers a broad US housing market collapse. It would push certainly push cities like San Diego, Riverside, Honolulu, New York and San Jose above what would seem like an unsustainable 35% level. But many of these cities are already seeing large net outflows of people and a move like this may only further accelerate those outflows to lower cost areas. To also put things in perspective, L.A. is already well above 40% at 5.5% rates. We’re not saying L.A. is an example of a healthy housing market by any means, but the city’s home prices aren’t exactly crashing.

Migration

To this point, we’ve been comparing incomes, home prices and rents within cities. We’ll now look at the important dynamic of affordability across cities. Below we show the ten cities which saw the biggest influx of people from June 2020 – July 2021, according to Redfin.com, along with the main origin city of these domestic migrants. We use the same affordability metric as above, the estimated cost of the median home as a percent of the 75th percentile household income. The affordability differences for people moving are striking.

The average housing cost as a percent of the 75th percentile income within the origin cities is 33% while the average cost in the destination cities as a percent of those same incomes is only 22%. In other words, the people in that income bracket who move between these cities potentially save >10% of their income on average by moving, assuming they kept the same income. In some cases such as moving from LA to Dallas, LA to Vegas or LA to Phoenix, the savings are even greater at 20%+ of their income.

While some of these moves over the past couple years were sparked by factors beyond affordability such as the severity of COVID restrictions, there are a few specific cases where affordability seems to be the main driving factor. Look at popular moves like San Francisco to Sacramento and Austin to San Antonio. These are both moves within the state and only about 1.5 hours down the road but result in substantial savings. For example, an Austin income as % of the median Austin home cost is 29%. But an Austin income as percent of the median San Antonio home cost is only 17%. The new, flexible work-from-home environments of many companies has enabled moves like these which historically would have been more difficult, if not impossible, to make.

We believe this cross-city affordability analysis is important because it’s representative of what is actually going on. According to Redfin, 37% of people currently searching for houses in Phoenix don’t live in the city and 23% of them are searching from Los Angeles specifically. For Tampa, the percent of searches from outside of the city is 50%, for San Antonio it’s 44%, Charleston 45%, Las Vegas 44% and for cities like Asheville, North Port and Cape Coral it’s over 66% of all home searches3. While an unfortunate side effect of this is that existing local residents of cities can find themselves priced out of homes, it’s a dynamic in the housing affordability analysis which can’t be ignored.

Need More Supply to Solve the Affordability Issue

Ultimately, we don’t see how the supply/demand imbalance exacerbating home affordability concerns by driving up prices through bidding wars is solved in anyway other than by increasing the supply of homes. Thus, we believe it is key to understand where home builders are building and which markets seemed best positioned to see some welcome relief.

When deciding where to build, home builders prioritize labor force growth & domestic migration. These factors are of course themselves correlated but when you merge them they explain 70% of the variance in new home permits by MSA, independent of any other variables.

Another factor that seems to matter to builders is the percent of population age 35-49. As we’ve discussed in previous articles, the lower end of that age range is where home ownership rates increase significantly.

By combining factors like domestic migration and the age of the population we can group MSAs by their attractiveness to builders and thus estimate which cities should be seeing the greatest improvement in new home supply and price relief. In the top right corner in the “most desirable” quadrant you see many of the cities in the “popular city” group from earlier, cities like Phoenix, Dallas, San Antonio, Raleigh and Las Vegas. Sure enough, go read through public home builders’ commentary and you’ll hear most of them mentioning these areas.

One additional factor is current affordability within an area as measured by the same affordability metric we’ve using. While not as significant as the factors mentioned above it does seem to need to be within 1 standard deviation of average, or within the 17% - 30% range to be attractive for builders. For MSAs within that range there is little preference for builders, however, MSAs outside of that range seem to be penalized. Sure enough, that “popular city” group falls well within this range.

Taken all together, these four factors (net migration, employment growth, population age, and affordability) explain 80% of the variance in the number housing permits issued by MSA. And as you can throughout the charts above, the “popular city” group where it would be most concerning if housing was to become prohibitively unaffordable ranks high on each of these four factors. What does this mean? It means this key group of cities which are still currently affordable, and should be for the most part up until around 7.5% mortgage rates, are also the ones positioned to see the largest increase in new home supply over the next couple years.

Conclusion

While we agree that affordability is something to keep an eye on and quickly becoming a concern in some markets, much of it stems from the supply/demand imbalance we entered 2020 with rather than rampant speculation or anything of the sort. The good news is that homebuilders are building where people want to live, where the demographics support it and where employment is growing. Despite persistent supply chain issues continuing to slow down the pace of completions there are currently more than 800,000 single family home under construction.4 This provides a line of sight to much needed new supply which should serve to help correct the supply/demand imbalance and ease the rapid home price increases in the most in demand cities.

Griffon is a mini conglomerate with a hidden gem asset that we think may finally be on the path to realizing value for its shareholders. For years, Griffon has existed as an inefficient conglomerate with three unrelated business lines: Consumer, Home & Building Products, and Defense Electronics. In April, the company announced it had reached an agreement to sell the Defense Electronics business for $330 million or $300 million in after-tax cash proceeds or $5.62/share.

GFF currently trades at $23.00 per share with a market cap of $1.2 billion. With $1.5 billion in net debt pro forma for the cash from the Defense Electronics segment sale, GFF has an enterprise value of $2.7 billion.

The Consumer business consists of a collection of brands that manufacture and sell long-handled tools like shovels and rakes to consumers and professionals, as well as the recently acquired Hunter ceiling fan business. The Consumer segment will likely do $1.5 billion in revenue and $170 million in EBITDA (12% margins) in FY 2023 (ending September). While Consumer is a solid business and likely worth $1.2 - $1.5 billion itself, today we want to highlight what we believe is Griffon’s “hidden gem” asset and prime buyout candidate, the Home and Building Products business.

Home and Building Products

The Home and Building Products business is the largest garage door manufacturing business in North America and serves both the residential and commercial end markets through two brands - Clopay and CornellCookson. The business is fully independent from the rest of Griffon with its own management team and headquarters and, as we understand it, full finance, tax, and legal teams. Thus, the reported segment earnings aren’t just a segment contribution figure that is supported by a ton of additional costs at the Griffon corporate level but is instead approximately equivalent to the earnings of the business if it were fully standalone.

HPB’s revenue by end market is as follows:

• 48% - residential repair and remodel

• 41% - commercial

• 11% - residential new construction

We view this as a favorable revenue mix for a few reasons. First, residential repair and remodel spend is significantly less volatile than new home construction. Second, replacement garage doors carry far higher prices and margins than the typical low margin doors bought in bulk by home builders to outfit a neighborhood of tract homes. And finally, the commercial end market includes a range of building types from warehouses to retail stores to government buildings, along with a range of uses cases from security and thermal resistant doors, to climate control. This range of applications provides a much more diversified end market exposure and revenue base than something like pure new home construction.

Residential

HBP’s Clopay brand leads the residential repair and remodel market with an estimated 30% market share of the residential market overall. The business weathered 2020 well with only a slight decline in revenue in Q3 2020. More recently, revenue growth has been in the double digits in four of the last five quarters including 43% for the three months ended March 2022. Price increases finally hit this last quarter and helped to further accelerate revenue growth.

From our channel checks, garage door prices are up anywhere from 60% - 100% versus recent years. The good thing about replacement garage doors is no one really knows what the average prices had been recently because they’re bought so infrequently. If a contractor quotes you $3,200 for a new door or $4,200 most people don’t have a frame a reference to know if that’s a typical price or not (current average is $4,000). Plus, relative to other home remodel projects that can easily run into the tens of thousands of dollars, garage doors are relatively inexpensive.

Unlike new homes sales and construction, home improvement spend is significantly less cyclical and not correlated with interest rates, with a statistically insignificant 0.15 R2 on a 14-month lag. Home improvement spend is instead driven by home price appreciation with a 0.52 R2 with no lag1. As of the end of 2021, U.S. home values and home equity were up 27% and 35%, respectively, since 2019. This bodes incredibly well for continued home improvement spend. If you’ve tried to book a contractor for a home remodel project recently, you’ll have noticed that most are booked out well into 2023 or are completely turning work down if the projected spend amount is less than six figures.

According to Remodeling Magazine, replacing a home’s garage door(s) ranks as the highest ROI project a homeowner can do in 20222. This is the 3rd time in four years that garage door replacement ranked the #1 ROI home improvement project. Given this, it’s not a surprise that Google searches for “garage door replacement” have trended up and are currently near an all-time high, a positive forward indicator for HBP.

Commercial

HBP’s CornellCookson brand similarly dominates its space as the largest rolling steel door manufacturer in North America with ~40% market share and is the “undisputed leader” in the industry according to a competitor we spoke with. Commercial sales held up well in 2020, never declining, and they have been accelerating for six quarters now including 66% growth last quarter with no signs of slowing down that we can see. Griffon says the backlog is currently “significantly greater than historical levels.”

Third-party leading indicators point not only to continued strength but an acceleration in commercial construction activity. The Architectural Billings Index is a 9 – 12-month leading indicator for commercial construction projects. ABI scores accelerated in March with a Billings score of 58, up from 51 in February, and Design Contract score of 60.5, up from 55.2 in February (anything over 50 signals an increase in work). ABI stated, “Indicators of future work strengthened this month… firms’ backlogs stood at an average of 7.2 months. This was an increase of more a month from one year ago and a new all-time high since we began collecting data on backlogs in 2010.”3

HBP’s margins have now reached >20% despite rising steel costs and supply chain issues, a level which competitors in the industry have told us should be a normalized level for HBP. LTM margins as of Q2 2022 were 21% with the company guiding for margins in the second half of 2022 equal to the first half (23%).

Given the revenue growth (despite continued supply chain issues) and margin improvement, we believe the company may finally be beginning to achieve its true earnings potential. EBITDA for the last 12 months was $253 million with the company’s recent increased guidance implying ~$330 million for the fiscal year ended September 2022. The business is highly cash generative with relatively low capex requirements. Since 2015, capex has averaged just $13 million per year and ranged from $8 to $23 million on a rolling LTM basis.

HBP is the type of business private equity should be snatching up right now. Over the past few years there have been a host of acquisitions in the building product space and specifically the garage door industry. These acquisitions have ranged from 11-15x, averaging 12.8x EBITDA. Given its growth prospects, leading market share position, high cash generation, and likely room for operational improvements, we see no reason why HBP wouldn’t also garner 12x. However, given the current valuation disconnect in the public market thanks to GFF’s inefficient conglomerate structure, we wouldn’t be surprised to see a buyer try to steal it for closer to 10x.

9x – 12x EV/EBITDA would value HBP at $3 - $4 billion, net of estimated taxes from a sale. To put this in perspective, Griffon’s current enterprise value is $2.7 billion at a stock price of $23/share. And remember, there is still the entire Consumer business doing $1.5 billion in revenue and $180 million in EBITDA likely worth an additional $1.2 - $1.5 billion. Taken altogether, we think GFF’s stock could have 150% upside to $60/share should the sum of the parts/conglomerate discount be unlocked.

Disclaimer: https://www.vosscap.com/disclaimer

While these types of headlines and posts no doubt generate clicks, it conflicts not only with our own assessment of the data but also with what the actual operators within the housing ecosystem have been saying. As such, this week we wanted to let the words of the business operators speak for themselves.

Below is a compilation of recent quotes from the management teams of homebuilders and other housing-related businesses over the past few weeks.

Century Communities – April 27th, 2022

"The elevated interest rate environment has not eliminated the demand drivers propelling the housing market over the last several years, including the ongoing shortage of both new and resale homes available for purchase, millions of millennials, the largest generational group in the country, reaching the prime age for new household formation and the increased desire for homeownership brought about by the pandemic.”

“The amount of traffic that we are getting and the amount of demand that we're seeing far exceeds the supply of homes that we have available."

"We're continuing to be able to sell our homes before they're complete. And if we start seeing that changes in the market, then we'll adjust how we market, sell and price our homes. But we've not reached that point yet."

"We've really seen no pushback on pricing. As we said in our prepared remarks, each month during the quarter, the sales actually increased. And throughout the quarter, we continue to raise pricing. And we have not seen any push back from that. Now at some point, that's going to stop... But at this point, everything remains very positive."

Taylor Morrison Homes – April 27th, 2022

"From a demand perspective, activity was healthy, and shoppers were engaged across our markets and consumer groups in the first quarter. We raised based house prices in effectively all of our communities… The positive sales momentum has continued thus far into April, and our sales teams across the country continue to report that activity overall remains resilient."

“Below-average cancellation rates, which were among all-time lows at approximately 6% last quarter.”

“Of our borrowers in backlog, average credit scores are among all-time highs at 752, and average down payments of 24% are higher than a year ago on a larger loan amount."

“Looking at first quarter closings, we estimate our conventional borrowers could have qualified at an interest rate nearly 650 basis points higher than their actual rate. This strength extends into our backlog where the 82% of borrowers qualify for conventional loan have similarly strong financial positions to absorb higher rates before adjusting loan terms or other offsets.”

“Only a single-digit percentage of all respondents (in a survey of 1,500 home buyers) said they would stop their home search if affordability became a constraint, instead opting to modify their plans either by reducing square footage, increasing their down payment or slowing down their search. This is quite different from what surveys indicated as rates increased in 2018 when shoppers were twice as likely to say they would stop their home search at that time, suggesting current demand is much more determined to move ahead.”

“we're seeing really robust demand in all consumer sets through the quarter. And no real difference in April... there's no trends that are worthy of kind of speaking to. It's generally pretty good across the board.”

Tri Pointe Homes – April 21st, 2022

“Demand continued to remain robust in all of our markets in the first quarter even as mortgage rates have moved materially higher. The homebuyers in our backlog are well qualified and are prequalified through our mortgage affiliate prior to purchasing a home. They have an average debt-to-income ratio of 39% and an average FICO score of 749, an average loan-to-value of 82% and average annual household income of $189,000. The majority of our homebuyers are millennials, and this cohort continues to be a strong source of demand for the industry, driven by needs based, life-changing events such as marriage, a growing family or a job relocation."

“This sizable population of buyers is in the prime home buying phase of their lives, and the homebuilding industry stands to benefit from their participation in the markets for years to come.”

“This supply-demand imbalance for both new and existing homes will persist for some time, providing the new home industry with a healthy fundamental backdrop for the foreseeable future."

"The biggest thing they say also is the supply. I mean everybody wants to compare to prior year cycles, but there is just no supply… go back to 2018… we had a lot more supply. The resale market was much greater…There [was] a lot of product available. Mortgage rates got into the low 5%, 5.5% range back in those days… it really tampered - kind of pulled back demand. So, all these cycles we go through are different. I continue to believe on a macro basis that there's more demand in this millennial group that we're still just tapping into, and there's just no supply."

M/I Home – April 27th, 2022

"The quality of our buyers continues to be very strong with average credit scores of 747 and average down payments above 16%. Basically, the quality of buyers that we're seeing in terms of creditworthiness is the best we've ever seen."

“Demand has held up considerably better than I think many of us would have predicted. If like I said earlier, if we were told 60 days ago, rates are going to be 5.5%, what will happen to, demand. I think a lot of people would not have predicted that it would still be as strong as it is, notwithstanding the historically low levels of inventory. And I think the historically low levels of inventory remain a very important metric that is helping to drive demand… millennials continue to move from renting to owning and are getting closer to maybe about where they should be as a home ownership rate, still below, I think, some of the previous generations. And the Gen Zs are beginning to jump into the pool. So that's a good thing, too."

Meritage Homes – April 28th, 2022

“Demand is still healthy today. In addition to early month sellouts from January to April, our cancellation rate of 9.6% this quarter is similar to the last 8 quarters and low compared to our historical levels and what is typically expected for entry-level products. The credit profile of our homebuyers remain stable and consistent at historical average of high 30s for DTIs and high 730 for FICO scores.”

“Entry-level comprised 83% of quarterly orders, up from 76% in the first quarter last year.”

“All the leading indicators around traffic and web activity, contact center activity, those are all very, very strong as well. They certainly come off of their peaks given the rise in rates, but still very, very strong flow of inbound interest in our homes."

Beazer Homes – April 28th, 2022

"There continues to be a structural gap between the demand for housing and the total supply of housing. The age and ownership preferences of the demographics are compelling. But there is no practical way for the supply of lots, labor, or materials to meaningfully reduce this gap in the next several years. Second, the level of unsold inventory of both new and used homes is at historically low levels. In fact, there's only 1/4 of the unsold inventory that existed in 2006.”

"The mortgage market is in a very healthy place. The credit quality of the loan book is high, loan-to-value ratios are near historical lows, and importantly, there are almost no adjustable-rate loans with looming pricing resets. So, considering demand, supply, and the mortgage market, we think the multiyear context for new home activity is pretty positive."

M.D.C. Holdings – April 28th, 2022

"Demand was broad based from both a geographic and pricing standpoint as the millennial age buyer continues to be the driving force behind our sales success. This large population of buyers has reached a prime phase in their lives when homeownership became a much higher priority, whether due to changing family dynamics, a chance to build equity or the desire to put down routes. Another driving factor that we have witnessed in our markets is the ongoing migration from high to low-cost areas by both companies and individuals. Factors, including taxes, affordability and overall quality of life are weighing more heavily into where business operates."

"Though we have noticed that the sales process is taking a little longer, most buyer seem to be adjusting to the higher rate environment as well and continue to be motivated to move forward with their purchase. Additionally, we have seen very little change in cancellation rates among our buyers already in backlog. As such, our general sense is that market dynamics remain healthy, and the demand continues to outstrip supply"

D.R. Horton – April 26th, 2022

“We still have more people, qualified buyers, trying to buy homes than we can produce today. One of the things that really has impressed me is back in 2018 when you saw a rapid rise in rates, demand was significantly reduced. And then after the rate shock was kind of mitigated, we saw demand come back and come back strong. But through this cycle, which is an even more rapid rate increase, yes, we've had people that don't qualify anymore, but the demand side is still very strong.”

“We look at a 1% change in our cancellation rate as essentially flat. It's still abnormally low -- historically low. We typically run in the high teens to low 20% and that's a rate we're very comfortable running at... 15%, 16%, 17% wherever it falls out each quarter, really no concerns from us on that end... for those buyers that do unfortunately fall out because they can't qualify, there's no shortage of buyers behind them to take their place.”

Home Depot – April 7th, 2022

“The homeowner's balance sheet has never been healthier, and our consumers and our Pros tell us that their backlogs have never been healthier. So I think that any uncertainty in the short term, there's a counterbalance here, which is just the underlying health of what underpins home improvement demand.”

“What we're really seeing on the demand side and as we think of transactions in units is it's not dissimilar to a storm environment... particularly in Pro-oriented categories, when we receive the goods and get them on our shelves, they go.”

“We just don't think it's very sensitive [home improvement spend relative to interest rates] …. all this home activity, regardless of interest rates, seems to be feeding into remodeling more than it ever has. If I can't find a home, chances are I'm going to remodel. Again, my balance sheet has never been healthier. And so our customers tell us, "Hey, you know what? I can't move right now. And so I'm not going to, so I'm going to remodel. Because I know that I will recoup a return on whatever investment it is I put in my home. It's one of the safest investments I can make” …  when they do buy a house, they're also more likely to undertake a remodeling project. And again, our market is made up of a great number of people for whom interest rates don't mean much. "

Lowe’s – February 23, 2022

“Pro customers say their book of business is more robust than they've ever seen it. They have projects lined out for the balance of this year. Some projects may carry over into '23. And health of that business is very strong.”

"Trends remain favorable, including baby boomers' increasing preference to-age-in-place. And with the extension of remote work for some employees, we're expecting a permanent step-up in repair and maintenance cycle. And as a reminder, 50% of the homes in the U.S. are over 40 years old and will continue to require investments for upkeep and approximately 2/3 of Lowe's annual sales are generated from repair and maintenance activity. Therefore, we're encouraged that the macro environment for home improvement remains very supportive."

"If you go back and historically look at periods of time when interest rates have risen at the same time that we had a really good economic backdrop... The home improvement sector has actually benefited from that... You see that same economic climate in 2022."

"Home improvement oftentimes gets combined with home building relative to interest rates. And obviously, the sectors are entirely different... historical trends show convincingly that high interest rates, combined with other positive macro indicators, do not have a negative impact on home improvement.”

Masco – April 27th, 2022

"International markets, including Europe, remains strong, and customers report continued pent-up demand and a strong backlog of projects"

"Numerous structural factors to housing such as demographics, age of housing stock and how consumers view their homes that will be supportive of increased repair-and-remodel activity even in a rising interest rate environment... 2.7 million more homes will reach the prime remodeling ages of between 20 and 39 years old over the next 3 years."

"We continue to see strong demand really across our main countries of Germany, France, U.K., where we do a significant amount of our volume. And that's continued to be robust. And the consumer traffic, the health of the consumer and our demand patterns continue to be strong."

[on doing an accelerated share repurchase] “it comes down to value creation, right? We've seen the share price retreat a little bit this year.... So because of where we see the share price, the strength we're continuing to see in our business, we think it’s a pretty realistic view as to how we see the repair/remodel market developing even in this rising rate environment. We feel that this is the appropriate time and the right time to put our balance sheet to use to be a little bit more aggressive on share repurchases and further enhance shareholder value. We've always said that our share repurchase program would be programmatic. But we always said that we would be opportunistic if we saw a little bit of a dislocation. And we think this is one of those times."

"As we've consistently said through this call and last quarter, demand remained solid and strong. And that is broad-based across our geographies, across our channels and across, as we talked about with regards to mix, our price points.”

“Our backlogs remain strong, international markets are performing well, backlogs at 30 weeks, Pro paint is doing extremely well.”

“The home price appreciation, the consumers' balance sheet, all those things really are, we would call, cyclical factors that are tailwinds to us. And then you add on to that the structural factors around age of the housing stock and the millennials coming into the market. We think this is set up for a very strong several years of demand for us. So we're looking good through '22, and we like the backdrop."

Sherwin Williams – April 26th, 2022

"We continue to see very strong demand in North America pro architectural end markets"

"Rising mortgage rates have not made an appreciable dent in the demand for our new residential customers to this point. Should new residential demand slow, we remain extremely well positioned in multiple architectural segments, including residential repaint and property management, which have proven to be more defensive in nature. We expect industrial demand will remain strong as the year progresses based on the outlook our customers have shared with us."

"Within residential repaint I’ll tell you that our customers are experiencing really strong backlogs. There's a positive mix shift in quality that's also taking place"

"You would clearly see home appreciation driving demand. LIRA, the forecasting for the growth in 2022 is in double digits."

"If you look at the NAHB remodeling index, it is strong, well above 50. And existing home sales have slowed year-over-year against a very strong comp and lack of inventory. But overall, it's a very strong market for us. So we expect to continue to see a good strong demand market in residential repaint from what our contractors are telling us. As I mentioned, many of them are looking through the end of the year with a pretty solid backlog of projects"

"Commercial, I would say the underlying demand here is also solid. Projects are resuming, albeit at varying paces, but the starts are positive… Dodge Momentum Index here is strong, as is the Architectural Billing Index, which has been positive for straight months. And as you know, that tracks the current billing by architects, which generally leads to the commercial construction spending 9 to 12 months out."

"Property maintenance is -- really, underlying demand is solid here as well. There's been delayed maintenance that's now being addressed, and we see improved areas in apartment turns, along with a return to travel, office, even school that's driving demand."

Mohawk – April 29th, 2022

“Market conditions for flooring remain favorable, even as governments raise interest rates to combat inflation. Employment is at high levels and wages are increasing in most of our markets. Millions of millennials in their late 20s and early 30s are forming households and desire home ownership. Unlike past cycles, U.S. housing inventory is historically low, more single-family homes are under construction and the U.S. home deficit will require years to align supply with demand. Remodeling should remain strong with rising home equity and buyers of existing homes still completing long-term projects that they initiated over the past few years. Commercial new construction and remodeling continue to strengthen as business conditions improve and projects that were delayed due to the pandemic are initiated."

Owens Corning – April 27th, 2022

“We continue to see high demand in our key geographies and building and construction end markets. Residential remodeling and new construction in both the U.S. and Europe remain robust, and we continue to see strong backlogs for our commercial construction products, including renewable energy and infrastructure… from a demand perspective in the second quarter, we expect U.S. residential and commercial markets as well as our global building and construction end markets to remain strong."

“In terms of our backlogs and our demand profile, we continue to see really favorable demand trends throughout our Insulation business on both the residential and commercial and technical side… So we continue to run on extended cycles in a lot of those product lines… we think that's going to continue into the foreseeable future.”

“Housing has been underbuilt in the United States for the last decade. So we think there's a lot of catch-up that needs to take place. And we continue to see, even with these high starts, completion rates lagging. So we think there's a lot of tailwinds inside of the U.S. residential insulation business to carry us through for quite a while even in this rising rate environment.”

Hayward – April 28th, 2022

"What we're seeing right now is… continued new [pool] construction permitting into '23. We continue to see builders talk about strong backlogs."

"We're still seeing robust demand and the order file on the books is still very strong and seems to be pressure tested, and product is going to be installed in the backyard."

"What we're hearing is still a really strong book for 2022. Most builders are quoting out into 2023."

Whirlpool – April 26th, 2022

"Demand is strong, very strong. Demand outstrips supply be a wide margin and that has been going on for several quarters"

"We don't see it going away. Replacement is strong and housing will also be strong."

"Demand remains at sustained strong levels and all indicators point to multiyear growth beyond these levels… This is, in large part, due to the fact that housing [construction] remained well below historical and structurally needed levels for over a decade. This is still the case today, which we are seeing play out with housing demand that is constrained by supply... We see demand as even further room to grow.  In summary, we remain unwavering in our confidence in multiyear demand expansion in North America."

"In all honesty, I don't see where you see the uncertainty of demand. I said earlier, the demand clearly and has for the last 2 years outstripped supply by a wide margin… our outlook on the fundamental long-term consumer trends in North America are as bullish as we've ever been. So honestly, I just don't see that slowing down. Also on the housing side, I know we're just talking about mortgages, if you look at the fundamental demographic trends, the age of the housing stock, the demand out there, I wouldn't bet against U.S. housing. And we're certainly very optimistic about the long-term U.S. housing trends."

Conclusion

While these operators remain quite optimistic, this isn’t to say everything is perfect, as we have yet to come across a single management team that doesn’t mention inflation and supply chain problems as limiting factors and serious, albeit currently manageable, concerns. But as you can see from the commentary above, demand and backlogs continue to be historically strong with management teams confident in their lines of sight to continued strong demand.

We couldn’t leave you without one chart, so below we show the number of times “record backlog” was mentioned on earnings calls by U.S. homebuilders and building products companies from 2012 - Q1 2022.

In our next article we will look in depth at housing affordability, a timely and key debate within housing.

As Ben Carlson says in his excellent recent article, “following the 2008 financial crisis, a lot of people came around to the idea that housing crashes were normal.” He poses the question “…many are waiting for the next shoe to drop. Eventually housing prices have to crash, right?”.

Homeowner Balance Sheets

Since the previous peak of the housing market in 2006/2007, U.S. home values have soared while mortgage debt has stayed relatively flat.  Mortgage debt now stands at $11.7 trillion, up just $1 trillion from its prior peak in 2008. Over roughly the same period home values have increased by $14.1 trillion to $38.1 trillion. This has resulted in total home equity growth of $12 trillion since late 2005 to $26.4 trillion today. It’s interesting to note that homeowner equity didn't fully recover its 2005 peak until mid-2016, a sign of just how devastating the housing crash was.

Looking at just the past couple years, the rise in home values and home equity since 2019 have outpaced the growth in mortgage debt by over 2x and nearly 3x, respectively.

Since 2019:

• Total home values: +$8.1 trillion, +27%

• Mortgage debt: +$1.3 trillion, +12%

• Home equity: + $6.9 trillion, +35%

The elimination of the excess that accumulated leading up the housing peak in 2006 combined with continued mortgage paydowns, tighter lending standards and rising home values has resulted in a total U.S. mortgage debt to home equity ratio of 46% today, just 1% off the low since 1965 and 14% below the 56-year average.

One way to think about this is that assuming flat mortgage debt, nationwide home values would have to crash 18% for the mortgage debt/home equity ratio to just return to its historical average of 60%.

As another comparison, at the peak of the housing bubble in late 2006, the mortgage debt/home equity ratio stood at 70%, 10% above the historical average and 24% higher than today. A return to this level would require a 25% crash in home prices, matching the severity of the 2007 crash (in the next section we’ll look at just how common a widespread drop in U.S. home values like that is).

As it stands today, U.S. homeowners balance sheets are strong and rarely have people owned more of their homes than they do right now with home equity as a % of home value just shy of an all-time high at 69%.

Historical Drawdowns

The argument of many calling for a crash in home prices can be summarized as “home prices are up a lot over the past two years, thus they have to come down.” Anecdotally, many potential buyers seem to be thinking the same and waiting for a drop in prices before buying.

Unfortunately for these buyers waiting, this highly anticipated crash may not come. Broad nationwide declines in U.S. home values are incredibly rare historically. The unprecedentedly low supply after a decade of underbuilding makes a drop in home prices perhaps even less likely. Outside of the financial crisis there aren’t really any nationwide drops in home values to speak of since at least the 1950s.

Below are the nine worst drops in home values since 1951 (we tried to do top ten but there's only nine on record). The crash of -25.5% during the financial crisis was over 10x worse than the next closest drawdown. The disastrous 2007 crash took 21 quarters to bottom (Q1 2012) and another 18 quarters for overall U.S. home prices to return to a new high (Q3 2016). The second worst drawdown in 1974 of 2.1% bottomed after 2 quarters and made a new high 2 quarters later.

In fact, there are only 30 quarters in the past 70 years (281 quarters) where overall U.S. home values declined q/q. Of these 30, 21 were during the 2007 – 2012 time period.

Conclusion

In our view, many of the bearish housing arguments tend to look at things too simplistically and/or on an aggregate national basis. For example, looking at overall national population growth and total U.S. median home price/median income. In all things real estate related one almost always needs to evaluate the state of the market on a more granular level. So while we don’t want to fall prey to this analytical mistake of looking at things too broadly either, we did want to point to some historical data to counter the vaguely bearish tweets and articles calling for a nationwide crash in home prices.

The overall U.S. housing market isn’t the stock market, broad 10%, 20%, etc. corrections in home values are not common. Outside of 2007 – 2012, there has been only one 2% decline in the past 70 years, and this period includes every kind of economic regime imaginable. This isn’t to say it can’t happen, it did in 2007 when bulls and mortgage underwriters were making the same claims that price have rarely declined historically and that didn’t turn out so well. However, the two environments are vastly different given the lack of supply, demographically driven demand trends, and strong balance sheets and buyer credit profiles. This makes it hard to see any widespread significant drop in overall U.S. home values, let alone one on par with or worse than 2007.

In our next couple articles we will dive into housing affordability on an MSA-by-MSA basis and look at the outlook for repair & remodel spending.

Migration

Net migration within the US represents a form of shifting demand for housing, not necessarily new demand creation overall. Some people will look at the U.S. as a whole and say there’s 130 million households and 142 million housing units, we’re over built and don’t need new homes. But the overall numbers don’t tell the full story, as the common refrain in real estate goes, “location, location, location.” For example, if there are 50 people living in 50 homes in California and 25 people living in 25 homes in Texas then there is equilibrium with 75 people total in 75 homes. However, when 25 of the people in California people move to Texas, it doesn't matter that cumulatively you have 75 homes for 75 people. You now need to build 25 more housing units in Texas. In other words, demand has shifted geographically, and supply needs to follow. While a simplistic example, the numbers bear this out.

Looking at the Top 50 MSAs, 60% of the decline in available homes for sale in each city can be explained by the net migration flows to those MSAs from July 2020 to June 2021. The most popular cities to move to during COVID now have less available homes for sale.

This is the most recent migration data we have but there’s reason to believe this acute intrastate migration trend isn’t behind us. According to Redfin, in Q1 2022, a record high 32.3% of Redfin.com users were currently searching for homes outside of their current metro areas.

We believe one of the main reasons for this migration is clear - politics. Rightly or wrongly, states and cities’ response to COVID became highly politicized along party lines. The level of restrictions implemented seem to have been what pushed some people over the edge in determining to leave a state. Looking at the 20 most populous states, the severity of the COVID-related restrictions put in place explains half the variance in domestic migration. I.e., the more restrictive a state was, the more people left.

There are other factors when one is deciding to move from one state to another: state taxes, weather, and increasingly important – housing affordability. However, looking at the table below (showing the top ten and bottom ten net migration states color coded by the Governor’s political affiliation), we believe it’s safe to say the restrictions put in place by municipal and state government were the most important facet.

In some cases, the migration from 2020 to 2021 was just an acceleration of ongoing trends, like the outflow from the Northeast, and inflow to the South. But looking at the West region, the reversal in trend is shocking. In the year leading up to COVID (July 2019 – June 2020) the region saw net inflows of people. In the year when restrictions were put in place (June 2020 – July 2021) there was a massive net outflow of people.

First Time Homebuyers

Net migration provided a form of shifting demand that has contributed to the few homes available for purchase in many areas. But more importantly, this depletion of supply happened ahead of what we believe will be an acceleration in a source of new housing demand with the largest cohort of the population currently entering their prime first-time home buying age.

An estimated 4.7 million millennials turned 30 years old in 2020 and another 4.8 million turned 30 in 2021. Over the next three years, there will be an additional 4.8 million entering their 30s each year.1

Why is 30 a magic number? The median age of first time home buyers has shifted over time, increasing from their late 20s in 1980 to 33 years old in 2021. One reason for this is that people are getting married later in life than they used to. The percent of people aged 25 – 29 years old who are married has dropped from 60% in the 1980s to just under 30% now. However, and this is why 30 is the magic number, the percent married jumps to 50% in the early 30s and continues to climb to 62% by the late 30s/early 40s.

For most people, buying a first home is sparked by life events rather than being a financially driven decision, and getting married is commonly what spurs that first purchase. This is shown by the home ownership rates by marital status and age group. Even in their late 20s, over half of married couples own a home compared to about 1 in 4 single people in the same age group.

In 2022 weddings in the US are expected to top 2.4 million, the highest in forty years.2 While we think it’s reasonable to argue a lot of these weddings are just catch up after all the postponements the last couple years due to COVID restrictions, the fact remains that millions of people are now hitting this pivotal life moment just as factors like migration and second home purchases have depleted available supply around the country over the past two years.

With nearly 5 million people entering their 30s per year for the next three years, we estimate there will be over 2.2 million first time home buyers entering the market to buy a home over the next three years. To be clear, this is new incremental demand for about 740,000 first homes per year just from people turning 30. This wave could easily maintain the high levels of home buying demand we’ve witnessed recently, all while starting from a historically unprecedented low level of supply.

For another broader estimate of coming demand, according to a recent Zonda poll, 29% of all millennials who have not yet purchased a home are aiming to purchase within the next 1-3 years, and 14% are currently trying to buy right now. There are 72 million millennials with a current home ownership rate of 43%. This means that there are over 5.7 million millennials trying to buy a home right now compared to available inventory of ~280,000 homes nationwide. This explains bidding wars that have been ongoing across wide swaths of the country. To us, it’s hard to see how this supply/demand dynamic plays out without necessitating the construction of millions of more homes.

Given these demographic trends, it’s probably not a coincidence that the number of subscribers to the Reddit thread r/FirstTimeHomeBuyer is up 11x since March 2020.

While marriage is a big demand driver, it isn’t the only factor that drives first home purchases. Single people also buy at homes at a certain age. Single women specifically now buy homes at a far higher rate than in the past with 65% of single women now saying they would rather not wait until they were married to buy a home. The home ownership rate for women increased 10.3%, from 50.9% in 1990 to 61.2% in 2019, and single women now own more homes than single men in every one of the top 50 MSAs3.

An additional key driver of demand over the next few years could be the large cohort of young people who have been living at home with their parents moving out. After hovering around 15% from the late 80s to early 2000s, the percent of 25 – 29-year-olds living at home started to rise during the 2008 financial crisis and has now settled around 24%, or ~5.5 million people. On top of this, another 11% of men (~2.5 million) and 15% of women (~3.4 million) in this age range live with a relative that is not a parent. Many of these people have been working and saving money or going to college and have good earnings prospects and a source of new household formation should they decide to get their own apartment or house.

Like the marriage rate, there is a significant change in behavior as people age into their 30s and the percent of people aged 30 – 34 living with parents drops from 24% to under 14%4. While it’s tough to predict with any confidence, any reversal in this trend of people living with their parents to a level more in-line with what we saw from the 1980s – 2007 would result in millions of new household formations.

While we’ve mostly looked at the 25 – 34 age range as a pivotal point in people’s lives, the 34 – 44-year-old range is often referred to as the “peak household formation” years. This is when the marriage rate increases from 50% to 60% and home ownership increased from 67% to 77%. The chart below shows a projection for this age group out to 2030. To us, this shows two things: 1) there should be a strong demographic demand floor under housing for years to come and 2) comparisons to the housing bust in 2007 are misguided. In the early 2000s we were building a high number of homes into declines for this key demographic. Today, we are just getting back to a historically average level of home construction as this age cohort is expected to grow for years to come.

Absent a brutal recessionary environment with millions in job losses (there are currently a record 11.3 million job openings) where an even larger percentage of 20- and 30-year-olds move in with relatives, the most likely path to housing market inventory normalization is to accelerate the pace of building or, at the very least, sustain the current level of new construction for many years to come.

Investors

There are roughly 17 million single family rental homes in the US. While institutional buyers like Blackstone get a lot of the media headlines, institutional landlords only own ~2% of the single-family rental homes in the country.5 One sign of the explosion in the number of small landlords is the growth in subscribers to Reddit’s r/RealEstateInvesting message board, up 8x since January 2021 to 1.3 million subscribers.

This infatuation with being a real estate investor and “passive income” has also soaked up available homes for the coming wave of owner-occupied demand described above. According to John Burns consulting, in January 2022, small investors (own < 10 homes) accounted for 27% of all homes bought during the month.

As John Burns also points out, this interest in owning a rental property seems to be particularly popular among young adults.

Second Homes

One additional small but underappreciated ongoing demand driver will be people buying second homes. While cooling from a breakneck pace (reaching +87% in early 2021 vs 2019), second-home demand remains 13% above pre-pandemic levels according to Redfin6. More importantly, the surge over the past two years contributed to the depletion in available home supply for people moving cities and first time home buyers.

Less than 1% of homeowners in the 22-30 age cohort own more than one home compared to >7% in the 66 – 75-year-old age cohort. As wealthy Boomers age into this key range, but are not yet old enough to “age out” of their existing home (the primary home ownership rate climbs from 66 to the late 70s), we expect secondary home purchases to provide sustained incremental demand for several hundred thousand homes per year.

Additionally, >50% of recent vacation home purchases have been paid for in all cash7, so these buyers are much less mortgage rate sensitive than entry level/first time homebuyers. This level of demand may have shifted even higher recently given work-from-home flexibility and the strongest consumer balance sheets in modern history.

Conclusion

In our view, the current housing market is a textbook example of supply and demand imbalances driving up prices. The demand that has resulted in bidding wars and rapid home price appreciation isn’t coming from euphoric real estate speculation. The ongoing wave of demographic driven demand is crashing into a structural housing supply shortage after we spent over a decade underbuilding following the financial crisis. While we don’t want to try to predict housing prices, we think the calls for a housing price crash on par with or even worse than 2007/2008 are sensationalistic as we believe there is a strong demand floor for the foreseeable future.

Pulling it all together, we attempt to quantify just how many new homes we need to build to fulfill demand over the next few years.

We believe most of assumptions that went into this estimate are conservative which include:

• Current home ownership trends by age cohort and marital status carry forward

• No tear downs (historical average of ~250,000 – 350,000 per year)

• No demand contribution from immigration

• Steady vacancy rate for homes of ~8% compared to 7.7% - 9.3% from 2015 – 2021

• Ignores demand for the under 30 age group

Our current estimate is that we will need to build 5.6 million homes from 2022 – 2025 or an average of 1.4 million new single-family homes built per year.

Next in this series of articles we will assess housing affordability in the context of a historic surge in mortgage rates, home prices, and apartment rents. We will also give an outlook for repair and remodeling spending.

Let’s start with a look at the supply side and breakdown how we got to this point of record low homes for sale.

The US Underbuilt for a Decade

Since 1960 we have built 1.01 million single-family homes on average in any 12-month period. Following the peak of the housing bubble in 2007 we then spent 13 years building below that level, even as the population grew and the number of households increased by 14 million over that time frame. In theory, we could build at the current rate of just over 1 million starts for the next two years without a single new unit being occupied and we would only return to an average level of available inventory and the 20-year average home vacancy rate. In other words, we’re just getting back to normal.

How did we get by building at such a low level with millions of households being formed?

We believe a big part of it was due to excess inventory from the 2006-2008 time period that took several years to chew through and absorb. For example, with ~38 million rental units across single family and apartments as of 2009, starting from an 11% vacancy rate in Q3 2009 and slowly grinding down 5.6% means an incremental ~2.05 million units became occupied (~160k units/year).1

Furthermore, the proportion of people aged 25-34 living at home with parents went from 14% to 19.7% for men, and 8% to 12.3% for women from 2005-2021.2 This means an incremental ~1.34 million young men and 973k young women who might have otherwise formed a new household and occupied an additional housing unit instead lived with parents (ignores the number living with other relatives) most likely due to the weak economy coming out of the GFC. This cohort, along with Gen-Z, has likely been saving lots of money by living at home and in our view are now a major source of pent-up demand for new household formation, something we will examine in much more detail in a later post within this housing series.

Additional factors besides just a decade of underbuilding contributing to the current lack of available homes include:

• People buying new homes but renting out their old home instead of selling because they’re locked into a low mortgage rate, i.e., taking a home off the market without putting one on to replace it.

• Investors buying homes for short-term and long-term rentals – estimated to be 33% of home sales.

• Secondary home purchases by wealthy people. 33% of respondents in a recent Knight Frank survey saying the pandemic made them more likely to purchase a second home and 13% of buyers saying their next purchase will be a vacation home.

• People deciding to remodel their homes instead of venturing out into the competitive housing market, i.e., “trading up in place.”

One other often overlooked factor to consider in the supply/demand equation is that it is estimated that approximately 0.25% of the existing home stock is demolished or obsoleted each year. This equates to ~350,000 homes which need to be replaced just to keep existing housing stock flat.

Inventory Levels

All these factors taken together has resulted in a severe shortage of available homes for sale. Across the US currently there are only 338,738 active home listings as of February 2022. This is down 25% y/y from the already low February 2021 figure and down 71% from the pre-covid average (2016 – 2019).

The shortage is particularly pronounced in some of the states which saw an influx of migration over the past two years. In Florida there are only 27,139 homes currently for sale across the top MSAs, down 49% y/y and down 75% from the pre-covid average.

It is a similar story in the Carolinas with less than 11,000 homes for sale across the top MSAs, down 40% y/y and down 80% from the pre-covid average.

The housing shortages are widespread without a single MSA in the top 75 having less than a 40% reduction in available inventory compared its 2016 – 2019 average.

Within the top 25 MSAs, the largest reductions in inventories have come across Florida, Texas, the Carolinas and Arizona. The top 25 MSAs have 22% less homes for sale on average versus a year ago, and 67% less than 2019. Prior to COVID the average MSA had 3.1 available homes per 1,000 people while there is now only 1 available home per 1,000 people.

A similar story exists in the top 26 – 50 MSAs southern/southeastern states seeing the largest drops in inventory. The average MSA in this group has 22% less available homes versus a year ago and 70% less than 2019. Available homes per 1,000 people have gone from 2.9 in 2019 to 0.8.

The smaller MSAs (51st – 75th in terms of population ranking) have seen the largest declines in available homes with 29% less homes vs a year ago on average and 75% less than 2019. These smaller cities came into 2020 with a lot more available homes per 1,000 people than the larger MSAs with 4.1 homes/1,000 people, but now have less than the top 25 MSAs with only 0.9 homes/1,000 people.

So single family home supply is incredibly constrained but what about other living options? If someone isn’t living in a single-family home, then the most likely other option is a multifamily building. Multifamily vacancy rates are currently just 2.4%, their lowest ever. In other words, they’re filled to the brim. Because of this, the median rent for an apartment in the U.S. is up 19.8% y/y, and much higher in cities like Miami (+52%), Tampa (+38%) and Austin (+31%).3

One way to contextualize this vacancy rate is that we could build at the current pace of 500k multi-family unit starts over the next 3.6 years, not have a single person move into any of the new units, and we would just get back to the 30-year average vacancy rate.

Demand

We’ll get more into the demand side of the equation in a future article, but we’ll leave you with this. The chart below shows the change in the number of employed persons in the top 40 MSAs now versus pre-covid relative to the change in available homes now versus pre-covid. With an r-squared of 0.47, the growth in an MSA’s employment level explains nearly half of the reduction in available homes. This makes intuitive sense--more employed people in an area means more need for housing and more people with the means to buy instead of rent.

The level of employment change can be a result of a multitude of factors, but we believe they are mostly explained though population growth due to an influx of people (with jobs) and/or a stronger recovery from the job losses during the depths of the forced government lockdowns.

Interesting to note is that four of the top five MSAs with the best employment growth since 2019 (and thus the most home buying demand) are in Texas or Florida, both red states who had less severe and less lengthy covid restrictions and shutdowns, while the bottom five states are all large cities in blue states which had the most restrictive and lengthy shutdowns.

Conclusion

The long period of under investment in single family homes, combined with the strongest consumer balance sheets in modern history, has created an extreme shortage of housing inventory on a nationwide basis. We will continue to explore this topic with articles on demographics and demand, housing affordability and interest rates, our outlook for repair and remodel spending, and lastly a look at some individual stock picks to express our views.

The common perception here is that the so called "high-flier" stocks which were trading at obscene 30x+ sales multiples a few months ago were in their own little bubble that is bursting and thus have borne the brunt of the severe deratings.  The thinking goes that these high-fliers are primarily high growth and currently low margin companies, with most of their value deriving from cash flow several years out.  As interest rates rise and investors put a higher discount rate on cash flows in out years then that value should get disproportionately hit relative to the lower growth, lower multiple names that are generating FCF right now.

We wanted to look at the history of software multiples as well as go under the covers of the software decline to answer the following questions:

1) Has anything outside of interest rate expectations changed at a fundamental level to justify the massive sell off?

2) Are the highest multiple names really bearing the brunt of the deratings and has "value" software mean reverted?

3) Have the low growth, higher margin names started to outperform high growth, lower margin names?

RingCentral

Not to pick on any one name, but we'll start by using an example to illustrate the severity of derating despite seemingly intact fundamentals.  If we look at RingCentral (RNG), we can see that at the beginning of 2021 it was trading at 27x NTM revenue, with expected growth for the year around 25%. Fast forward to today, and the company’s expected revenue growth has rarely been higher (~26%), but the multiple has de-rated a full 80% from peak.  One can certainly say this is an extreme case and there are likely other idiosyncratic factors (large growth funds concentrating into it and concerns about Microsoft/Zoom disruption), but we thought it would be prudent to at least show a representative illustration for what is a decided trend in the industry.

The Relationship Between Revenue Growth and Revenue Multiple

As you can see below, the median EV/Revenue for software companies is reasonably correlated with the median expected revenue growth (NTM/LTM). The derating has been intense, from 8.8x to 4.7x, but expected revenue growth continues to accelerate, now at 21%, a 20-year high.

Additionally, you can see gross margins remain remarkably steady over time within a range of 69%-75% so this is unlikely to have cause the de-rating.

However, EBITDA margins have steadily declined over time.

If we look at the “Rule of 40” over time (EBITDA margin + revenue growth), the metric is in a decidedly normal range.

For years, investors had been signaling that revenue growth was more important than EBITDA margin in the Rule of 40 equation. However, the current market environment suggests a reversal of this trend. Given that the EV/Revenue multiples have collapsed while the expected growth rate is the highest ever and the Rule of 40 is flat, it implies that investors have begun to exhibit more of a preference for profitability.

Will sustained, elevated interest rates make this shift in preference permanent?  Or is the market perhaps signaling that the projected revenue growth and/or long-term margin targets are unrealistic?

Of additional interest is how various management companies react to this signal.  Will they pull back on the cash burning/growth at any cost strategy (similar to how the E&P space has shifted to capital return over production growth)?  Will there be a more balanced approach to growth and profitability? 

At Voss we generally prefer a more balanced approach for our software stocks.  If a stock is trading at 15x sales and burning a lot of cash to drive growth, it is hard as an analyst to estimate true unit economics and to underwrite a downside case. In situations like that, if you get the ultimate margin projections wrong the downside can be severe.

Are High Multiple Names Driving the Decline?

The short answer is yes, but with a caveat that ALL software is getting hammered from unusually high multiples.

"High-fliers" were historically valued at 4.5-7.0x sales until a massive breakout beginning around 2017. During this spectacular euphoria phase peaking in mid-2021, the group more than quadrupled their multiple to over 30x sales.

The cheapest software names also doubled their own historical multiple in 2020 and 2021 to over 2.0x sales.

Looking at the table below, the most expensive names have indeed led the derating, averaging a 58% decline from peak, while the cheapest have de-rated by 37%. So, while it is true that the higher fliers have led the decline, the tech stock crash has hardly spared the cheaper equities.

Another observation from the table below is that the most expensive names now have the *least* downside to their historical average revenue multiple, although there is still 24% downside as of mid-March. Remaining downside to historical averages is still 24-40% across the quintiles, so it is hard to say with any conviction that the software selloff is over.

From our point of view, the key to assessing whether there is further downside for software stocks is whether investors now believe potential margins could be higher than current/historical margins, thus these stocks will not necessarily revert back to historical average valuations. Or, equally plausible, the market is seeing that extraordinary capital inflows/competition are likely to cap terminal margins significantly below what some of the mature software giants enjoy today (e.g., Oracle/Microsoft).  Perhaps it’s a little of both, and frankly it's an exciting time to be a stock picker as many companies may start to show their true colors, for better or worse.

Is Profitability Mattering More Now?

Finally, we wanted to see whether the profitability part of the Rule of 40 score was currently dominating, performance-wise.  To test this, we divided the software space into two groups, one being high growth and low margin and the second being the opposite, low growth and high margin.

Looking at rolling relative 12-month performance, we see the following:

We can see that there was indeed a huge spike in 2020/2021 towards "growth at all costs."  At its peak, while still not obtaining the even more ludicrous spread of >200% during the tech bubble, high growth/low margin software stocks outperformed low growth/high margin ones by 91% over a 12-month period.

Over the last 12 months this has materially reversed, as seems to be a pattern during corrections in the markets.  To zoom in, here are the last 12 monthly spread returns:

Although there were some early rumblings early last year in March and May, the real hit to high growth/low margin came in November 2021 – January 2022.  In those three months alone, higher margins/lower growth names outperformed their lower margin/higher growth peers by a cumulative 33%.

Conclusion

In our view, software as a maturing industry has proven it is stickier and less “disruptible” than perhaps previously thought.  With the shift towards recurring revenue/subscription models, it's our belief that fundamentally higher multiples relative to the 1990s and 2000s are generally justified, as there is greater visibility and less volatility in financial results.

We suspect the massive relative outperformance by higher margin/lower growth software stocks is nearing an end and the returns will be more equal going forward, hopefully favoring names with a more balanced approach to profitability and growth, which has always been our preference.

It is possible that despite expected growth being at a 20-year and valuations having witnessed their biggest collapse since the tech bubble, there is still room for 20%+ downside.  We can't rule that out. Many of the largest hedge funds have been concentrated in the same few software names so there could still be more de-grossing.

As we stuck to our valuation discipline, we had taken our software exposure from a peak of ~40% to start 2021 down to high single digit % and sidestepped most of the carnage. We now view software multiples as more fairly valued. If some high-quality software stocks decline another 20%, we might significantly increase our industry exposure once again as we would view it as an overcorrection for an otherwise healthy industry.

In two previous articles we explored the basics around inflation (what it is composed of, what drives it, etc.) and then examined whether the United States might ultimately parallel the low inflation environment Japan has experienced for the last thirty years.  We concluded that there are significant policy and cultural differences between the US and Japan and thus it is unlikely the US will follow in the deflationary footsteps of Japan.

Given this, is it possible the US way overshoots on its inflation targets? Could policy makers lose control and could sheer indifference allow for “higher for longer” inflation, or even hyperinflation as seen during Germany’s Weimar Republic regime?

While Weimar Germany after World War I is hardly the only instance of hyperinflation in history, we are focusing on it because some prominent financial minds like Michael Bury have directly compared the current United States to Weimar Germany.  In theory, it is a logical example to point to given Weimar Germany was one of the only recent, modernized economies to go through hyperinflation, as opposed to more common cases in emerging economies.  Bury’s argument is that Germany from 1914-1923 is similar to the United States from the financial crisis up until now:

“Throughout these years the structure itself was quietly building itself up for the blow…Germany’s #inflationcycle ran not for a year but for nine years, representing eight years of gestation and only one year of collapse.”

While lacking any specific empirical evidence, (at least any shared via Twitter) Bury points to several parallels, noting that:

“One was the great wealth, at least of those favored by the boom…business and stock market were booming…side by side with the wealth were the pockets of poverty.  Greater numbers of people remained on the outside of the easy money, looking in but unable to enter.  The crime rate soared…demoralization…crept over the common people…from watching their own precarious positions slip while others grew so conspicuously rich…almost any kind of business could make money…the boom suspended the normal processes of natural selection…speculation alone, while adding nothing to Germany’s wealth, became one of its largest activities…everyone from the elevator [operator] up was playing the market.”

To paraphrase as best we can, Bury is arguing that 9-10 years of easy money policies has been the “gestation” period of the US economy, where waves of speculation have been building, weird types of businesses and investments are occurring (see here and here for corollaries), and wealth disparity/crime is increasing.  The ultimate upshot is that there will be an eventual crisis of confidence in our currency, which tends to be the driving force behind all hyperinflation, and that policy makers will lose control of their purported tools to manage inflation.

Germany’s Hyperinflation

From 1922 -1923, Germany went through one of the worst periods of inflation that a modern, industrialized nation has ever seen.  By November of 1923 one US dollar was worth 4.21 trillion German marks.1  

The roots of this inflation started with the Great War itself, which demanded incredible fundraising from all countries participating, France, Germany, and Britain most notably.  Countries had various strategies for this fundraising, but most centered on aggressively borrowing and raising taxes with the thinking being that the war would not last very long and these would be temporary measures.  John Maynard Keynes, in one of his fallacious predictions, noted he was “quite certain the war could not last more than a year.”2   

On the contrary, the War lasted for more than four years, from 1914 to November 1918, with the Treaty of Versailles being signed in June of 1919.  During that time, Britain is estimated to have spent $43 billion, France $30 billion, and Germany $47 billion (multiply this by ~13x for figures in today’s values), while their total currency in circulation rose 2x, 3x, and 4x, respectively.3  While one can draw parallels here with large increases in the money supply to the United States, it should be noted that unlike the United States now, inflation in Germany during the War exceeded 40% a year.4  To this point, we find Bury’s argument that there was a 9-year benign gestation period followed by massive hyperinflation to be misleading.  In fact, there was extraordinary volatility in prices throughout the war and thereafter, ultimately resulting in the crescendo of hyperinflation. 

Intentional Hyperinflation Due to Reparations?

When thinking about differences between the US now and Germany in 1922, one can immediately point to the draconian reparation payments Germany was sentenced to pay.   Indeed, as Adam Ferguson, the author of “Dying of Money” notes, the “ask” from the Allies was quite stupendous:

“The allies first firm bill for reparations, presented in May of 1921, amounted to the fantastic sum of 132 billion gold marks.  This was about four times Germany’s maximum annual national product and greater even than Germany’s entire national wealth; it was like asking the United States in 1973 to pay more than four trillion dollars in gold over a period of years.”

Looking at this, one could logically conclude that the Germans knew they were basically screwed and went down the intentional path of hyperinflation to clear their debts.  However, the differences between the demands (132 billion gold marks) and what ended up being paid between the end of the War and hyperinflation period (2.4 billion gold marks) was gigantic. This 2.4 billion marks amounted to about five percent of a year’s national product.

Ferguson comes to the same conclusion:

“That Germany inflated deliberately in order to avoid the costs of reparations is not a proposition that bears examination.  The evidence is wholly against it.  First, the rate of inflation was enormous long before reparations was an issue.  Second, industrial pressure to inflate, largely self-interested, had nothing directly to do with the war debt.  Third, it was correctly recognized that…reparations had to be paid either in kind or in gold equivalents…fourth, at no time did Germany’s financial authorities so much as hint, privately or publicly, that their policies derived from cynicism rather than incomprehension and incapacity.”

To summarize, inflation in Germany existed before the reparations bill, many people liked the inflation, reparation receiving countries demanded non-inflated payments, and the German authorities appeared more inept than Machiavellian. 

Reparations as an Indirect Cause of Hyperinflation

If reparations did not directly create hyperinflation could they have indirectly contributed?  The evidence here is far greater and convincing and the crisis of confidence in the mark can be at least partly attributed to the reparational Sword of Damocles hanging over Germany. 

We would argue that the reparation demands were but the opening of a series of catalysts that ultimately led to hyperinflation. A vicious cycle occurred in Germany following the reparations bill whereby Germany implemented a series of higher taxes to pay the debt which in turn created the ever present threat of even more/higher taxes coming at any moment. This rise in taxes and anticipation of more was followed by widespread demand for higher wages, with the only realistic option of raising wages being done through inflationary mechanisms. This aggressive taxing and “medicine taking” may have actually worked to pay off a good chunk of the reparations if there existed the political will to resist the unions and industrialists who argued that both higher wages and inflation were not just necessary, but a good thing:

“The mighty Stinnes Group, for one, was still working on gold capital.  The fall in the value of the paper mark, however, had written off 98 percent of the gold debt…Hugo Stinnes himself, the richest and most powerful industrialist in Germany, whose empire of over one-sixth of the country’s industry had been largely built on the advantageous foundation of an inflationary economy, paraded a social conscience shamelessly.  He justified inflation as a means of guaranteeing full employment, not as something desirable but simply the only course open to a benevolent government.”

In addition to inflating away paper mark debt, those industries primarily involved in exporting also now had a strategic advantage with a severely devalued local currency.

A major psychological blow was later dealt with regard to the Minister of Finance, Matthias Erzberger. Erzberger was the one who signed the armistice on behalf of Germany in 1918. While this caused many Germans to view him as a traitor, internationally Erzberger was viewed as the responsible one who would take the reparations payments seriously. The series of taxes and reforms proposed by Erzberger to help pay for the reparations caused his political opponents to hurl a brushback pitch at him by linking him publicly to a corruption scandal. Public pressure led to his subsequent resignation which “may be taken as Germany’s turning point, from this day her crusader for financial probity was gone.”5 and after one unsuccessful attempt in 1920, Erzberger was assassinated in August 1921.   

With Erzberger gone and industrialists like Stinnes and Fritz Thyssen heavily influencing policy under the new Minister of Finance and “chief architect of Germany’s economic disaster”, Karl Helfferich, there was no longer a perceived will for the Germans to act responsibly. 

Indeed, because unemployment remained low and industry was booming, it was hard to find the political will to curb the rising inflation:

“Stopping the inflation would have killed the boom, and that seemed excessively unpleasant.  In this respect, peacetime inflation was far more insidious than wartime inflation, which produced only war goods to be expended and no boom for the people to become addicted to…every day that passed, appeasing the inflationary dragon with more inflation, increased the assured severity of the inevitable medicine.  So long as the Siren-like lure of the easy wealth continued, it was impossible to persuade enough of the nation that titanic measures of austerity…were necessary.”

It should be noted that basically all countries except Germany went through lengthy recessions after World War I, and it certainly could be argued that the longer the “boom” went on the greater the repercussions ultimately were. 

A final but important point was the apparent naivety of Germany’s monetary policy makers to basic economic concepts. As Ferguson notes, “they staunchly denied that higher discount rates would moderate the inflation and on the contrary, opined that they would merely raise the costs of production and push up prices further.”

US as the Next Weimar?

It is now clear to us that no one factor led to hyperinflation in Germany, but rather the causal nexus was a series of factors in concert that self-reinforced each other, with the largest ones being:

1. Psychological crisis in confidence of the mark because of the draconian reparations demands

2. Erzberger assassination

3. Lack of will to curb inflation by influential political parties

4. Poor understanding and implementation of monetary policy

If we take all this together, we can certainly see some similarities between the US and Weimar and if pressed we could craft a narrative around very high inflation in the future.

One could argue that the United States is becoming more and more numb to responsible spending and that we are mortgaging our future by running up extravagant deficits in concert with ongoing quantitative easing. The monetary bases have expanded significantly, like Germany, with a Federal Reserve openly stating they are willing to “run hot”, and there is evidence of rising wealth disparity and rising crime in 2H 2020/1H 2021.

Furthermore, many of the current proposals from the US government, if actually implemented, could cause a surge of inflation.  For instance, getting more aggressive on curbing carbon emissions is likely inflationary, as not only will there be government stimulus spending on renewable programs but actively shutting down cheaper energies sources will likely result in higher energy prices.  The concept of a Universal Basic Income (a preview of which was seen during COVID, now potentially leading to a major worker shortage and wage inflation), could be quite inflationary, especially if it’s funded through debt. Another proposal being advanced by US Representative Maxine Waters is for a $25,000 down payment assistance program for homebuyers. With residential real estate price appreciation setting records in 2021, more down payment assistance and subsidies will only exacerbate housing affordability issues and not treat the root cause of lack of available supply. A lack of supply which also usually comes about due to local government regulations on issues such as minimum lot sizes and restrictive zoning.

Basically, there seems to be a lot of discussion around spending a lot of money, and not a lot of discussion around balancing a budget.

Our conclusion on this, however, is that unless you buy into the paranoid idea that the United States government wants hyperinflation as some kind of “reset” to their debt levels, it’s very unlikely that anything near hyperinflation would occur in the United States at the present or in the near future.  We think there would be significant pushback from the Boomer generation whose savings would be destroyed. This is what occurred in Germany as the lower class who had no savings fared better than the middle class whose savings were wiped out.

Also the psychology today is largely different. For one thing, the United States does not have other countries pointing a gun to their head asking for reparations.  While the United States does owe a lot of money to China and other countries, most of our federal debt is actually held by the Federal Reserve. And while many may hate to admit it, comparing the Federal Reserve’s understanding and skillset to Germany’s leaders in the 1920s is stark and quite favorable to the Fed. 

In summary, while there are some similarities to post-WWI Germany in the current backdrop, we would argue there are critical differences that make hyperinflation very unlikely.

That does not mean we will not see sustained, elevated inflation though due to the ongoing money printing, along with some risks of stagnant growth due to supply constraints and the threat of higher taxes. At some point, the United States will have to face up to the fact that we have run up huge debt levels and vastly increased the monetary supply to “keep things going” for political expediency. But we are likely nowhere near that point, as Japan has demonstrated that debt/GDP levels can theoretically increase and be sustained well beyond where the US is today.

To set the stage for the basis of this comparison, it is important to understand that Japan had a massive asset bubble in the 1980s which we wrote about here. The historic bubble was characterized by low interest rates, an increased marketability of assets, excessive money printing, and a nationwide speculative euphoria. (Sound familiar?)

The easy credit provided by both banks and shadow banks during the 1980s resulted in an overly leveraged corporate and consumer sector (similar to the US in 2008-2009). During that time, everything from contemporary paintings to country club memberships could be used as collateral to fund real estate and stock speculation. This self-perpetuating relationship drove the bubble on the way up and made the unwind equally severe on the way down:

“When the bubble burst, commercial real estate prices fell 87% nationally, touching levels last seen in 1973…since real estate was always used as collateral for borrowing money in Japan, the collapse of land prices devastated private-sector balance sheets."1 

That’s right, commercial real estate prices dropped 87%! For reference, the US housing market fell about 33% during the Great Recession in 2008.

By 1991, 38% of 12 trillion yen in loans (~$110 billion USD today) from "shadow banks" were non-performing and by 1995 a full 75% of these loans were non-performing. The government stepped in with bailouts equivalent to ~11% of Japan's GDP at the time to cover bad debts.

Lost Decades(s): 1990 - Present

Since the bubble popped in 1990, Japan has been mired in 30 years of stagnant growth characterized by low inflation (at times deflation), high savings rates, and low loan growth. The original “lost decade” from 1990 – 2000 has now turned into three lost decades.

Since that time, the United States has routinely had around 2% a year higher inflation than Japan:

The stagnancy has remained despite aggressive quantitative easing by the Bank of Japan who has expanded the money supply by over 16x since 1990. As can be seen below, there seems to be a severe diminishing return for what expanding the monetary base can do in terms of stimulating lending (and in turn GDP/inflation). There are those like Ken Fisher who believe that QE can actually be deflationary because it inevitability results in a flattened yield curve, which disincentivizes banks to lend.

There has been debate about whether the general economic sluggishness in Japan is 1) primarily psychological, 2) a function of changing demographics, or 3) a rational, mechanical response to repair balance sheets that has never fully been completed.

We believe the work of Richard Koo, Chief Economist at the Nomura Research Institute, who has studied Japan as well as other recessions/depressions, has merit as a potential analytical framework.

Koo has made his career arguing that traditional macroeconomic analysis has a major blind spot. The traditional view is that monetary policy can impact inflation in all circumstances. The argument goes that because the central bank can effectively manipulate interest rates, there will always be demand for loans if rates go low enough, with loan generation leading to growth, improving money velocity, and ultimately inflation. The key underpinning of this theory is that companies and people are rational economic actors who will always try to maximize profits.

Koo, however, believes this is only true when an economy is not in what he calls a "balance sheet recession." During a period like this people and corporations will go into a mode of "debt minimization" rather than profit maximization, under which no level of interest rates will convince them to take on more debt. When countries are in this state of debt minimization, quantitative easing as a monetary policy becomes ineffective.

"‘Inflation is everywhere and always a monetary phenomenon' may be valid when there is strong private-sector demand for funds but is basically irrelevant when the private sector refuses to borrow despite zero or even negative interest rates." – Richard Koo, “The Other Side of Macroeconomics”2

Koo’s Prescription

Koo argues that to break out of a “balance sheet recession” countries need to engage in sustained, aggressive fiscal stimulus, meaning the government needs to be the borrower of last resort with the government then spending that money. To this point, he recommends stimulus comes in the forms of infrastructure projects as opposed to tax cuts because while tax cuts do help repair balance sheets, they don’t directly encourage spending. Also, in order to generate reasonable inflation and get out of a potential deflationary spiral, this policy needs to be sustained and cannot be curtailed at the first sign of recovery.

"Experience shows that when private-sector borrowers disappear, fiscal stimulus is absolutely essential in keeping the economy going. Every time fiscal stimulus was implemented, the economy improved, and every time it was removed, the economy collapsed."3

In his book the “The Other Side of Macroeconomics”, Koo is quite critical of Japanese and European policy where he believes “fiscal hawks” rein in stimulus at the first sign of recovery. This leads to a relapse into low growth before balance sheets has been fully repaired.

He notes that Japan “did the right thing” from 1990-1997 and the situation would have been measurably worse without the large stimulative fiscal policies that amounted to 11% of Japan’s GDP at the time. While the bursting of the bubble in 1990 caused wealth losses that exceeded losses during the Great Depression, nominal GDP in Japan never dropped below bubble highs and unemployment never went above 5.5%. In other words, the stimulus worked as intended and the government initially avoided a painful recession.

However, in 1997 fiscal austerity measures were put into place too early which Koo estimates set the country back a full decade. In 1998 GDP dropped 1.1% while the national deficit expanded by 72%...not a great combination.

The US Today

To the point of this article, Koo believes the US generally “gets it”, with high praise in particular for Ben Bernanke:

"He understood that when the private sector is not borrowing money, the effectiveness of monetary policy is dependent on the last borrower standing, i.e., the government. Even though the US came close to falling off the fiscal cliff on several occasions, it is doing better now because, after eight years of fiscal support, private-sector balance sheets are growing healthier, and some households are actually starting to borrow again."- ‘The Other Side of Macroeconomics’

We would argue that based on Koo’s theory, the US is in a much better place to potentially generate inflation than Japan was, particularly given recent fiscal action and proposed future fiscal action. 

At Voss we have continuously noted that the US consumer balance sheet is about as good as it has ever been. Debt service payments as a percentage of disposable income has been in a downward trend since 2000.

Similarly, while US corporations have more elevated debt, extremely low interest rates means their coverage ratios are quite high. For example, the US manufacturing sector is currently at 11.8x interest coverage.

Now, because of COVID, there has also been strong fiscal stimulus with the potential for much, much more if Biden’s multi-trillion infrastructure bill passes. While the bill appears to raise taxes as well, we believe Koo would conclude the net effect would still be stimulative, although the devil will be in the details as to how stimulative. 

Following Koo’s logic, we conclude that with strong direct fiscal stimulus, a healthy consumer balance sheet, and a Fed willing to let inflation run above target, the United States is in a position to finally see real, sustained inflation.

The argument of why the US is “not Japan” is strengthened by a few more theoretical factors, notably that American psyche is likely nowhere near as damaged as Japan’s was following the 1990 collapse. The financial and psychological damage back then was significant and more like the Great Depression whereby an entire generation could hardly fathom the idea of taking out debt again. In fact, as we have discussed in Part I and in our quarterly levels, there are signs that Americans are starting to spend even more aggressively. For instance, there is a home buying boom underway in the US with real estate prices rocketing upwards amid an unprecedented housing supply shortage, even as builders aggressively complete housing projects. As Zillow noted in late January:

“Currently, there are fewer than three months of supply of homes on the market, the lowest on record since the turn of the century.”

Some also argue that Japan is simply financially more conservative culturally, with longer term trends of holding more cash than the United States, and that Japan may have fewer domestic investment opportunities given its highly contained geography.

Still, there is uncertainty and data points to monitor. For instance, it is hard to know if the American psyche towards taking on additional leverage could change, especially with the disruptive (potentially deflationary) effects of COVID not fully playing out economically. So far, growing deposits at banks over the past year has yet to result in any loan growth to speak of.

Second, we don’t really know how the US consumer will react to even moderate inflation. Will they begin cutting back on spending at even the slightest hint of interest rates rising? This has been an issue in Japan where any time prices begin to rise there is a quick and severe reaction to curtail spending, as this article notes:

“When prices start to rise, Mrs. Watanabe cuts spending. So firms don’t raise prices, and because they don’t want to squeeze their slim profit margins, they don’t raise wages either. Mrs. Watanabe’s income remains stagnant, so she remains hyper-sensitive to price rises. It’s a demand-deficient feedback loop that traps inflation on the floor.”

Finally, an aging population in the US may be a headwind as the older crowd becomes more conservative and wants to save more. While the US is not nearly as old as Japan, who has the oldest population in the world with 29% of the population 65 or older (compared to the world average of 9% and 16% in the United States), we are moving into the part of the curve where Japan became very sensitive to modest inflation and where savings rates remained elevated.

Takeaway

At Voss we agree that if fiscal stimulus remains aggressive, we will likely see higher, for longer inflation. There are clear differences between the US and Japan (and Western Europe for that matter) in culture, policy, and psyche. The questions are “how high” and is there a risk it gets out of control? We believe a key flaw in Koo’s analysis is that he essentially assumes that there is the capacity for unlimited fiscal stimulus. In other words, that the United States government can borrow to infinity if needed. His open scorn towards “fiscal austerity” leaves the possibility, or risk, open for more runaway inflation that might be challenging to stop once it has started. For instance, very smart people have been predicting (unsuccessfully) for years that the Yen would implode from all the QE along with a gigantic ongoing fiscal deficit. It is only several years ago that Europe faced material sovereign debt risk with Italy and Greece. Nobody can really predict when the international markets declare a country is too levered, but when it happens it can happen quickly.

So if not Japan, might the US end up like the Weimar Republic post-World War I with crippling hyperinflation? That will be the discussion in the final article in this three-part inflation series.