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Blue skies for consumers, caution for investors

"Blue skies, Smiling at me

Nothing but blue skies, Do I see."

- Composed by Irving Berlin in 1926

The equities bull market is excited by the potential for technology to continue to change the world. Among many examples, Waymo, Zoox and Uber are developing self-driving cars, Amazon is employing AI rather than human cashiers in automated grocery stores, Facebook is mining your behaviour and predicting your next move for advertisers, Titomic and CSIRO have built the world’s largest 3D titanium printer, another 3D printer manufactured a human kidney, and just about every auto manufacturer is racing towards electric vehicles. Meanwhile, global spending on AI and machine learning is forecast to grow from $12 billion last year to $58 billion by 2021.

It’s almost impossible not to be caught up in the wave, but investors need to remember that the rapid advances in technology have been funded by a record supply of money at the lowest interest rates in history. When technology has changed the world in the past, investors didn’t always win.

Often, the consumer reaps the benefits. From Moore’s Law accurately predicting the doubling of transistors per chip every two years, to Koomey’s Law observing that the energy of computation is halved every 18 months, or Kryder’s Law showing the number of bits that can fit onto shrinking hard drives doubles every 18 months, and Swanson’s Law that states the cost of the photovoltaic cells needed to generate solar power falls by 20% with each doubling of manufacturing capacity, we find a lot of evidence that companies need to run faster and faster just to stand still.

As the sales volume rises, supplier returns decline because the technology becomes commoditized and cheaper. This is great for customers and the planet, not so good for shareholders who are swept up in the excitement of the new, new thing - as investors may yet discover.

Is Australia different?

Australia is not immune from the exuberance gripping parts of the equity market, such as the valuations of emerging disrupters such as Kogan, Pushpay, Getswift, and Afterpay.

One of the best performing industrial stocks over nearly two years has been Kogan (ASX:KGN), established in 2006. Despite the threat from Amazon, its share price has rocketed from around $1.50 a year ago to around $9.00 today. According to its Wikipedia entry, it has a “portfolio of retail and services businesses including Kogan Retail (the and retail websites), Kogan Marketplace, Kogan Mobile, Kogan Internet, Kogan Insurance, Kogan Health, Kogan Pet Insurance, Kogan Life Insurance and Kogan Travel.”

Despite the spread of interests, Kogan derives over 90% of its gross profit from its core e-commerce retail business selling private label and third-party products.

Based on most recent numbers, the founder Ruslan Kogan appears to be a solid operator of the core business. Through “sourcing, analytics and automation”, Kogan’s gross profit margin was 17.9% at the end of FY17, compared to 15.5% the year prior.

The company has also strongly improved various metrics recently. As at June 30, 2017, the company claimed to have 955,000 active customers, representing a 36% increase from FY16. For the six months to December 2017, revenue at the online retailer jumped 45.7% to $209.62 million and reported profit was 470% higher at $8.33 million. Keep in mind, however, that in the prior period there was $3 million of costs associated with the IPO. Add back those costs into the prior period and the jump in profit isn’t as high.

On 23 April 2018, the company provided its Appendix 4C Cash Flow Statement for the quarter ended 31 March 2018 (3QFY18) and reported revenue growth of 46.1% and active customers of 1,288,000 or 5% of the Australian population.

But while Kogan displays growth, sound management, and popularity amongst shoppers, investment returns are determined by a company’s future prospects. We must ask whether the determinants of the company’s future are beyond management’s control.

Perhaps this is the reason new ‘verticals’ such as mobile and pet insurance are being explored by Kogan. Kogan has, for example, entered the mobile phone services space and has grown gross sales from a standing start in 2016 to $3.6 million in FY17, and has also launched an internet service offering unlimited NBN data plans for as little as $58.90 per month.

While they are currently small divisions, they leverage the Kogan’s database, and bring to the company a stream of recurring revenues, something retailing lacks. But these new verticals are already populated by larger and more established rivals. And in the case of internet service providers, margins are also generally under pressure.

Competition from the global giants

When the much larger and deeper-pocketed Amazon announced its entry into Australia, Kogan’s response was to welcome additional competition, citing ‘online retail’ accounting for about 7.5% of the total Australian retail market, compared to 20% for economies with a large marketplace player such as an Amazon or an Alibaba.

A similar response was offered by A2 Milk, upon news the global food giant Nestle had entered the Chinese market with its own A2 protein baby-milk formula. A2M told that it is “uniquely positioned to benefit from expansion of the category over time”.

Perhaps Kogan and A2 Milk should ask Woolies and Myer how they felt after the arrival of Aldi and Zara respectively.

Amazon recently announced that a fulfilment centre would be operational in the second half of 2018 in Moorebank, south west of Sydney. The location sits in the middle of one of Australia’s biggest retail markets, ensuring fast delivery to a significant proportion of its customers, many of whom may have previously shopped with Kogan. Amazon’s move may also increase product selection and support more third-party sellers using Amazon’s marketplace and fulfilment services.

Research results from US tech giant Pitney Bowes showed widespread dissatisfaction among Australian shoppers with local merchants, with 88% choosing to shop through overseas retailers in the past year. Almost nine out of 10 Australians shop through offshore e-merchants.

With Amazon Australia now offering goods from more than 5,000 sellers — making it the fastest-growing Amazon marketplace in the world, ahead even of India – it could be more challenging for domestic e-commerce providers to continue to claim a unique selling proposition.

Australia is a small country with few global winners. However, investors are betting that all of the latest batch of upstarts are going to win despite much larger global rivals and low barriers to entry. In the short run, popularity determines returns, but ultimately share prices cannot help but follow business performance.

Australia’s crop of disrupters need to be watched closely, especially when share prices are implying uninterrupted double-digit growth.


Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is in the nature of general information and does not consider the circumstances of any individual.


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