This past month was notable in that it marked the two-year anniversary of the global spread of COVID-19, an external shock that generated one of the steepest drawdowns and recoveries in stock market history. It’s quite extraordinary that an unprecedented 1-in-100 year pandemic resulted in the S&P 500 losing a third of its market value in 32 days, only then to rally 100%-plus over the ensuing two years. For the team at Lakehouse, this sequence of events served as a timely reminder that basing investment decisions on largely unpredictable macro developments can be fraught with danger.
For the most part, our strength lies in analysing businesses, not predicting economic gyrations, and thus we stick to seeking companies that have the ability to thrive regardless of whether the global economy races or stumbles forward. Our investment process focuses on identifying companies with superior economic models based around loyalty, network effects and IP, that also stand to benefit from long-term industry tailwinds that are secular in nature. At the end of the day, we’re of the view that these superior economic models are a key driver of sustainable long-term growth and ultimately value creation.
In this piece, I’ll touch on Lakehouses’ investing fascination of loyalty and discuss why we believe it’s an attribute investors should be thinking about.
What is loyalty and why does it matter?
We are always on the lookout for companies that provide products and services that are tightly integrated within a customer’s life or business workflow. Think enterprise software, payment processors, subscriptions, or any other form of business with an intense focus on customer loyalty and retention. The more mission critical the product is, the greater the ‘lock-in’ as there are significant costs in terms of time, money and operational risk, to switch to a competitor. Importantly though, we view loyalty as not just switching costs, but also the delivery of value and delight to customers that makes them want to stay.
A prime example of a company that has prided itself on executing a customer centric approach for over two decades now is Amazon. In Jeff Bezos’ own words “We see our customers as invited guests to a party, and we are the hosts. It’s our job every day to make every important aspect of the customer experience a little bit better.” This mentality has been a key force behind Amazon’s success over the years and when it comes to their e-commerce business, they have done an amazing job at fostering customer loyalty. Just consider the fact that Amazon Prime now counts roughly 60% of the US adult population as customers and boasts a retention rate of nearly 98% for customers that have been members for at least two years.
Businesses with extremely loyal customers are often underestimated by the market because of their staying power, pricing power and ability to cross- and up-sell. At their core, these businesses generate valuable recurring revenue streams which aid predictability and durability. For example, a company with $1 billion in revenue and a 95% retention rate can count on $950 million coming in the following year from existing customers. That figure is stable and predictable. Management can plan and invest accordingly.
The same cannot be said of a business doing $1 billion in revenue where nothing is recurring as they will effectively have to start next year at zero. Not an ideal situation when one considers it costs roughly 5 times more to acquire a new customer than to retain and enrich existing customers. In our experience, many investors underestimate the inherent value within recurring revenue business-models, which often creates an opportunity for discerning buyers to separate the wheat from the chaff.
A super sticky compounder with plenty of runway
The recent correction in high growth names provided us with an opportunity to increase our position in what we believe is a high-quality, industry leading business that exhibits intense customer loyalty.
Avalara is the leading provider of cloud-based solutions that automate the calculation and filing of sales and use tax, primarily for small- to medium-sized businesses (SMBs) in the United States. At the outset, it’s important to understand just how complicated and burdensome this process has become for any business to handle manually, especially for online or multi-location retailers. In the United States alone, there are currently over 13,000 tax jurisdictions, set at the state, city, county, and municipal level, each with their own unique rules and regulations that continue to evolve overtime. If you are an e-commerce company selling multiple products, across multiple platforms, into multiple jurisdictions, then it becomes an absolute nightmare to track your sales tax liability in real time.
To this end, Avalara’s value proposition is fairly straightforward — their cloud-based platform eliminates considerable time, cost, and risk inherent with the manual approach to complying with sales tax — solving an incredibly complex problem for their customers where demand is compliance driven. This is a setup that we love to see as Avalara’s platform becomes deeply embedded in its customers day-to-day workflow and systems, providing them with an automated solution central to their ability to transact. This typically leads to an incredibly sticky customer base and Avalara’s retention metrics bear this out. Customer retention is north of 90% — implying an average customer life of 10-plus years — and net revenue retention is 115%, indicating the company is currently growing revenue 15% year-on-year before the addition of a single new customer.
When it comes to the competitive landscape, Avalara is the clear industry leader with 50% market share. In our view, the company is likely to retain its dominant position as they have spent 16 years building and maintaining a library of tax content, and have developed an ecosystem of over 1,000 partners that refer a significant portion of their business. They also have a long runway for growth given that the US market is still only 8% penetrated and ultimately, we believe the sales tax compliance market will end up going in a very similar direction to payroll — that is, 100% outsourced and 100% automated. At the end of the day, we believe Avalara is in the perfect position to capitalize on what will be a very long tail growth opportunity for many, many years to come.
Loyalty is a trait valued by all but for companies it can add significant economic value over time. Companies who are able to attract and maintain loyal customers can minimise acquisition costs, create value through cross- and up-selling, build referrals and become long term partners. The ability to identify true loyalty can therefore provide investors a fascinating insight to those companies that are built to last and deliver durable long-term growth.
Disclaimer: Equity Trustees Limited (‘Equity Trustees’) ABN 46 004 031 298 | AFSL 240975, is the Responsible Entity for the Lakehouse Global Growth Fund and the Lakehouse Small Companies Fund (‘the Funds’). Equity Trustees is a subsidiary of EQT Holdings Limited ABN 22 607 797 615, a publicly listed company on the Australian Securities Exchange (ASX: EQT). The Investment Manager for the Funds is Lakehouse Capital Pty Ltd (‘Lakehouse’) ABN 30 614 957 603 | AFSL 526842. This publication has been prepared by Lakehouse to provide you with general information only. In preparing this publication, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Lakehouse, Equity Trustees nor any of their related parties, their employees or directors, provide any warranty of accuracy or reliability in relation to such information or accept any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statements before making a decision about whether to invest in these products. The Target Market Determination for both funds is available at www.lakehousecapital.com.au It describes who each financial product is likely to be appropriate for (i.e. the target market), and any conditions around how the products can be distributed to investors. It also describes the events or circumstances where the Target Market Determination for the financial product may need to be reviewed. Lakehouse, its directors, clients, employees, and affiliates, may, and likely do, hold units or securities in entities that are discussed in this presentation and ensuing question and answer sessions.