The purpose of this weekly is to sharpen my thinking by sharing thoughts about industries and companies that fit into powerful long-term investment themes. It is also a place to share insights into decision making, takeaways from the past week, and random thoughts that arise. Thank you for reading this piece! Feedback is welcomed.
This week:
➢ Proven Business Models and the Tie to LT Value Creation; A Case Study of Hubspot and Wayfair
➢ The AI Hype Cycle and Infrastructure
The Importance of a Proven Business Model; A Case Study of Hubspot and Wayfair
Just because a company is considered innovative, it does not ensure that it will compound market beating returns for its investors. In my more than 30 years of experience, a company needs to be both innovative and have a proven business model to be a great performer.
When I saw the large layoffs at Boston based Wayfair, it triggered memories of when the company went public in 2014. I was introduced to the idea around the same time as another local company here, Hubspot, went public. Both companies were touted as innovative small cap companies at the time of their IPOs, but they have had very different market outcomes.
As an investor, the challenge is to have a process that is consistent and repeatable. This means knowing what kind of company is attractive, and conversely, knowing which companies are not attractive. This is a good case of comparing two companies and how I evaluate them as potential investments.
First, a bit of background on the two companies.
Industry and Core Business:
Wayfair is an e-commerce company specializing in home goods and furniture. It operates primarily in the online retail space, offering a vast array of home products.
HubSpot is a software company that provides cloud-based marketing, sales, and customer service platforms. Its primary focus is on inbound marketing and sales strategies, offering tools to enhance customer relationship management, social media marketing, content management, lead generation, and more.
Business Model and Revenue Streams:
Wayfair generates revenue through direct sales of home goods on its platform. It relies on a vast inventory, a network of suppliers, and efficient logistics to deliver a wide range of home products to its customers.
HubSpot operates on a SaaS (Software as a Service) model. Its revenue is primarily subscription-based, generated from businesses subscribing to its software solutions for marketing, sales, and customer service needs.
Market Position and Growth Strategy:
Wayfair focuses on expanding its online presence in the home goods market, continuously broadening its product range, and improving user experience on its platform. Its growth strategy includes leveraging advanced data analytics to optimize pricing, logistics, and customer targeting.
HubSpot aims to expand its suite of inbound marketing and sales tools, constantly innovating and adding new features to its software. Its growth strategy involves increasing its user base globally, enhancing its platform’s capabilities, and focusing on customer retention through excellent service.
Technological Focus and Innovation:
Wayfair uses technology primarily to optimize its e-commerce platform, improving customer experience through AI-driven recommendations, AR tools for visualizing products in a home setting, and efficient supply chain management.
HubSpot is deeply integrated with technology at its core, constantly evolving its software offerings to align with the latest digital marketing trends and tools. It invests heavily in AI, analytics, and integrations to stay ahead in the competitive CRM and inbound marketing space.
I look for conditions that allow for long-term value creation. This means the company needs to have a business model that has a margin structure that can generate cash at scale and have avenues to reinvest back into the business at high rates of return.
As an online retailer, Wayfair has a structurally low gross margin and as outlined above, needs to offer a lot of options for its customers and handle logistics, including physical inventory. Wayfair’s gross margin has been around 25% since its IPO.
Hubspot, on the other hand, as a SaaS company, has built its business in the cloud, so its gross margin is very high, close to 81%.
Both companies must market and sell their products and services, as well as continue to innovate their technology. Thus, they need to spend a lot to obtain and keep a high growth rate. It is often the case that smaller companies with aspirations to be much larger will operate their company close to break even or a slight loss to grow faster and get ahead of the competition. Both companies have been undertaking this strategy, and they have had divergent results nine years later.
First, I would say that gathering more revenue is not helpful to building long-term value if it is not at margin levels that can generate cash flow. I often see people confuse growth with what is quality growth.
Hubspot, since the IPO, has had a revenue compounded growth rate (CAGR) of close to 40%. Wayfair has had a CAGR of close to 30% over that same period. Both have high rates of growth, but they translate very differently to adding economic value. See, Hubspot, starting with a much higher gross margin, has a much easier path to generating cash flow in the future than the much lower margin scenario at Wayfair.
The market recognizes the differences in the business models, and values them accordingly. Hubspot, with the higher margin structure and higher probability of generating cash flow, had a market cap to sales multiple of 14x at the time of the IPO. Wayfair, with the lower margin structure, had a multiple of 1.3x revenue. From these levels, both companies need to execute on growing revenue and eventually show investors they can generate cash and reinvest it, otherwise, these multiples will not hold.
Fast forward to today, and this is how things have played out:
| Hubspot | Wayfair | ||||||
| Revenue at IPO | $ 116,000,000 | $ 1,319,000,000 | |||||
| Revenue 2023 est | $ 2,147,000,000 | $ 12,017,000,000 | |||||
| Revenue CAGR | 38% | 28% | |||||
| Market value IPO year | $ 1,614,000,000 | $ 1,709,000,000 | |||||
| Market value today | $ 29,708,000,000 | $ 5,178,000,000 | * excludes shares | ||||
| from convertible debt | |||||||
| Stock Price IPO year | $ 47 | $ 38 | |||||
| Stock Price today | $ 590 | $ 56 | |||||
| CAGR | 32% | 4% | |||||
| Market value to revenue IPO year | 13.9 | 1.3 | |||||
| Market value to revenue today | 13.8 | 0.4 | |||||
| Source: Factset | |||||||
Hubspot has been the much better investment even though both companies have delivered on getting larger as measured by revenue.
A few concluding remarks from me:
With innovative companies, not all revenue is created equal.
- Not all innovative companies are the same. Growth in revenue needs to be accompanied by a proven business model at scale to translate into value creation for investors. In this case, software business models are already proven to be great at scale and can generate lots of cash. Their margin structure allows for it.
- Hubspot has been a tremendous value creator despite having what many would consider to be a high valuation at the time of their IPO. How can that be? As I mentioned earlier, the market is good at setting valuations for what the company’s model is today and what its forward prospects are.
Initial Valuations were very different:
- Hubspot is a Saas company, with high recurring revenue and high margins. Investors assign higher valuations to these types of companies.
- Wayfair is an ecommerce retailer with lower levels of recurring revenue and lower margins. Investors do not pay high multiples for these models given their margins and high fixed costs.
Hubspot held its valuation and compounded value for stakeholders, Wayfair did not:
- Hubspot has delivered, as you can see, with revenue growth strong, building a bigger base. Even though they are not showing a lot of profit today, the market is still enthusiastic about their forward prospects for growth and the understanding that the model allows for a lot of cash generation at scale.
- Wayfair has seen a slowdown and a recent decline in revenue year over year. They have a lower level of recurring revenue and lower margins. This recent slowdown has caused the valuation to shrink, as investors are rightly concerned about the company’s expense base, and their high debt load that has been built up over a number of years.
This comparison is to illustrate the choices that investors have every day. It shows that value creation needs to have both elements and that revenue for the sake of revenue does not necessarily mean that a company’s economic value will grow.
There are thousands of public companies, but only a few compound as much value for investors as Hubspot has. The way that they have done it is not new, and it will continue to be the case for decades to come. One thing that is newer is the way that
the market recognizes the way that Hubspot has built its value and that it can be lucrative to investors over the long term. They are reinvesting heavily right now to grow revenue, but this is the kind of revenue that can produce a lot of cash if they decide to reinvest less. They have done a fabulous job of reinvesting at high rates of return, which has allowed the stock to appreciate alongside the growth of the company.
The AI Hype Cycle and Infrastructure
The market has started to get excited about the potential for increased spending on infrastructure that is needed to power more AI models and serve the millions of requests (inferences) over the coming years. This past week, Mark Zuckerberg said in an interview with The Verge that Meta is on pace to acquire around 600,000 GPUs, which is a staggering number. Taiwan Semiconductor (TSMC), the large
Taiwanese semiconductor fab company, expressed optimism for semiconductor orders, issuing guidance for increases each quarter in 2024 after an inventory reset in 2023. Investor enthusiasm is building as evidenced by the Semiconductor index (SOX) is up 40% since late October and is up 35% for one year.
When there is transformative change, there is an early hype cycle. Part of the hype cycle is the proliferation of articles and predictions, which for AI we have already gotten. There is also a boost in valuations for companies that are believed to be beneficiaries. To me, it feels like we are in that phase right now. For many investors, there is still scar tissue from the dot com collapse, and as such, there can be wide skepticism about any hype cycle.
The AI hype cycle has a different feel to it. The base layer of technology is in place for AI to begin to get its best use. I would argue that the hardware infrastructure is not sufficient yet, but there is a line of sight to get there. Also, there isn’t a major behavioral change that is needed for the models to be used. That in hindsight was a major deficiency of the internet hype cycle, where the valuations skyrocketed but for the revenue and profitability to translate, it required people to make changes to the way they do things (shopping, etc). It happened, but not quickly enough to justify the lofty valuations that were pervasive in 1999-2000.
I am keeping an open mind on this, but right now, this hype cycle could be followed up with more immediate increases in revenue and profits. The results that Nvidia has shown already are evidence that there is urgency on the part of end customers. The Meta example also supports that. This does not mean that increases in valuations will not get extended, they likely will. It will be important to keep a clear view of where valuations compare with historical multiples. With higher than historical valuations come great expectations. There will have to be follow through of actual AI associated demand or else we should expect mean reversion.
Disclosure to readers: Arrowside Capital maintains positions in Hubspot, Taiwan Semiconductor, and Nvidia.
My story
I am an investor and entrepreneur, having started two investment companies. I am the Founder and CIO of Arrowside Capital (http://www.arrowside.com), based in Boston, MA. I have more than 30 years of experience in the investment business, investing in companies geared toward innovation and growth. The blog is named The Zen Innovation Investor because I believe it is so important to remain calm
and focused during the rapid pace of change in the world today. I am keeping a view of the long term while also keeping abreast of developments in the world of innovative companies. I view this as a place to sharpen my thinking and provide some insights that are thought provoking.
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