Dreamy Business
There was a time I thought Amazon (AMZN) was a bubble stock, but over time, I started to realize the true value in this business and how smart its CEO Jeff Bezos is.
In his 2014 annual letter to shareholders, he gave out his criteria for a "dreamy business":
A dreamy business offering has at least four characteristics. Customers love it, it can grow to very large size, it has strong returns on capital, and it's durable in time - with the potential to endure for decades. When you find one of these, don't just swipe right, get married.
As someone who cares about growth very much, I certainly agree with him on these 4 traits. So, what about Ubiquiti Networks (UBNT)? Can we call it a dreamy business?
I think UBNT certainly satisfies the first 3 criteria:
- Customers love its products; you just need to read their product reviews to tell this.
- Most of their products have much bigger potential markets, but more importantly, this business is not limited to one market or one industry, and the recent success in the enterprise segment should already prove this point.
- Finally, the ROE is very good, even if we consider the R&D spending as capex, which is not reflected in the "official" capex or book value (because this expense is not capitalized), the ROE/ROIC should still be well above 50%.
However, it is the 4th criteria that becomes questionable: is it durable in decades? After all, we are talking about some fast moving industries with short product cycles. The technology behind these products are changing relatively fast over time, and given its capital-light nature, the barrier of entry tends to be small as well. Beyond that, hardware sales are non-recurring revenues. To maintain the sales, the business has to provide upgrades or new products on an ongoing basis - relying on "replacement" sales is usually not enough.
I believe this is where many value investors had stopped and looked away, and this is why I have called it a relatively risky investment in the past (only relative to those traditional high quality stable businesses though).
However, one thing investors tend to forget or underestimate is the "human factor." More accurately, it is the ability of the management and its talented employees, as well as its corporate culture.
Indeed, the industry is fast moving, but the CEO is very smart and has been constantly adapting to the changes as well. One example is the "Unifi refresh" that happened in 2015. Not only the hardware has become better, the price also dropped 50% (I guess no one worries about deflation in high-tech products). This actually confused many customers, as they couldn't believe something better could be so much cheaper. It certainly surprised many investors as well, me included.
The corporate culture also stands out. By many standards, Ubiquiti's corporate culture is very unique. The CEO seems to be a strong leader, but weak on management. Or maybe I should say he seems to prefer almost "zero management." Personally, I have worked in many IT companies in the past. I know the traditional management in an IT company is constantly using daily stand-up meetings, daily/weekly review meetings, and bug triages to push people forward. While this style certainly worked to some degree, I don't think it is the best method to encourage people to have a sense of ownership and become fully innovative.
In contrast, the CEO Robert Pera has a completely hands-off style in terms of managing each employee. That doesn't mean he doesn't care what people he hires or their performance. It is just that he probably doesn't like to baby-sit each one of them. If these are elite professionals who care about their own careers (not just a paycheck or a "job"), shouldn't they act for themselves or behave by themselves? While "slavery" certainly worked in some degree, couldn't we invent a better system that can better motivate these workers and unleash more energy and potential from them?
I believe many elites would agree with me and prefer Pera's hands-off style. However, that doesn't mean a strong management-style has no value. Sometimes, a strong management can get things done in time and ensure a minimum level of quality in the work. Despite all the ideals we could have, we have to realize that many people tend to get lazy over time, and a bad culture can spread like virus.
I think this would pose a dilemma to the management: they can take a strong "leadership style," completely hands off, and let the elites have a lot of freedom and become fully creative, but also risk on seeing the other less passionate workers getting sloppy over time, or even worse, seeing this bad culture spread to the other team members or other teams.
Or perhaps they can take a strong "management style" instead, actively taking care of each little detail, and pushing people forward with meetings, deadlines and schedules. This will maintain a basic order, and ensure a project getting done by the deadline with a minimum level of quality, but also potentially suppress innovation, passion and upset the elites.
Or perhaps they can take a "combined style," treating each employee in a different way. Those with passion will be set free, and those who need babysitting will be rightfully policed and pushed. Frankly, I used to think this is the right way to go. However, I am not so sure any more. For example, will the elites with full passion and momentum like to work with the other passive forced workers? Maybe not. Also, can the managers really treat people differently? Can they require only some of their team members to join daily stand-up meeting, but not some others?
Here enters the CEO Robert Pera's method: he hires selectively (he interviews everyone himself and only targeting for elites), but fires those who turned out to be under-performers later. In fact, he laid off about 50% of his employees last year as the development progress in some teams virtually stopped.
As astounding as it is, it may be a viable last resort to fix the corporate culture and keep a strong leadership style to allow elites only work with other elites. In general, I believe it is very hard to fix a corporate culture that has gone bad, so every effort has to be taken to prevent it from happening in the first place. However, if it is truly beyond repair, then using Pera's word, it might be necessary to hit the "reset button." (Unifi has a reset button to reset the device to factory settings.)
Luckily, because the company has a very distributed structure (many R&D offices around the globe), the deteriorating corporate culture was likely only limited in some teams, but not the others, as we have seen that the other product lines still had high quality and steady progress.
One of my friends once questioned this method: is this too cruel? Undoubtedly, some good employees might be mislabeled and be treated unfairly. But more importantly, shouldn't the employer give a sense of security to its employees?
While I certainly think this is debatable, I also think people should choose the type of company they work for. If you care about efficiency, career, and freedom, Ubiquiti can be a good choice, where you can be set free, work on your own, and work with others who also have full passion in their work. It is a place you can find other elites, build something you can take pride of, and potentially create wealth for yourselves as well. However, for those who mostly care about job security, this might be a place to avoid.
Regarding to what is "cruel," here is my answer: perhaps the cruelest thing in our world is this rule set by our mother nature: "every living thing has to die with no exceptions."
But there is a good reason behind this: it is often much easier to restart from scratch than repair something that is beyond repair.
This is not necessarily always a sad story though. While we are all yearning for the kind of power seen in the sci-fi movie "Edge of Tomorrow," where we can retry the same thing over and over, with accumulated experience from the past failures, but hasn't the human race already been set up with the same kind of power? Here we have each new generation accessing the history/experience of the past generations and possessing all the hard assets left by the past generations, restarting over and over again with a forever-elevating starting point.
For the same reason, like individual creatures, businesses or even countries have to die if needed. If a business is no longer fit for survival, the people who will lose their jobs would be 100%, instead of 50%. In fact, many other big high tech firms are constantly refreshing their blood too, but in a less noticeable pace: perhaps 10% every 1-2 years.
Why do I spend so much time talking about the corporate culture and management style? This is because I believe this can be critical to a company's success. It is also because I believe every one of us has so much potential that is similar to "nuclear energy," but normally only a smart part of it is unleashed which is more like "chemical energy." Unleashing every member's full potential not only requires the right incentives (money, pride and sense of achievement), but also requires allowing them to choose their passions and give them enough freedom in order to encourage innovations and creativity.
In summary, I believe that with the CEO constantly monitoring the industry trend, and a good corporate culture that encourages innovation and maximizes efficiency, it is possible that the company can be adaptive enough and make their advantage endurable. Beyond that, an industry that is constantly on the rise will also be helpful (it is reasonable to expect internet traffic to grow like what computing power and storage did in the past decades).
That said, if a business has to rely on human factors to be endurable, and not by its own business characteristics, maybe it shouldn't be called as a "dreamy business." However, in that sense, I am not sure we should call Amazon's AWS as a "dreamy business" either, even though Jeff Bezos clearly thinks so.
Industry Tags
One method that Wall Street favors is to tag each business with an industry and compare its valuation with the sector's averages. Therefore, it is considered justified to value a software business much higher than a hardware business.
Certainly, there is some valid reasoning behind this method. Different industries have different characteristics, and should be valued accordingly. On the other hand, many of those taggings could be superficial as well.
For example, Ubiquiti sells hardware, and would certainly be tagged as a hardware company. However, as Pera said, Ubiquiti is actually a software company, but monetizes through hardware sales. This is because its hardware is not much different from other vendors. For example, the Airmax line uses the same standard indoor Wi-Fi chips, and virtually any vendor could do the same. It is mainly the software that made the difference and gives its advantage over the other vendors. I believe the same thing could be said for Edgemax and Unifi. (Airfiber is an exception since it has a customized chip designed ground-up).
This is one of the reasons why Ubiquiti has a ROE similar to those software companies.
Beyond the industry tags, investors also like to use business model tags. For example, "Franchise" model is one of those hot models investors tend to go after. Don't we like the economics of Franchises? It is capital-light, with high ROE and low risk even in cyclical industries. Moreover, it captures both scale advantages and efficiencies of distributed business models. In other words, the Franchisors can pool all resource to do marketing, design, manufacturing and distribution, enjoying the advantage of large scale, and yet the Franchisees are usually small-scale businesses, with full operational efficiency due to their small sizes.
However, many people often stop at those tags, not going one more step and discover the driving forces behind the business model. Take Ubiquiti as an example, some people called its business model "weird," others called it "lean," but in essence, isn't it very similar to a Franchise model?
Here, we have Ubiquiti responsible for the centralized design, R&D, manufacturing, and branding, and each individual 3rd party service providers responsible for sales, marketing, and tech support. Essentially, it enjoys both the scale advantage at the company level and the operating efficiency at the servicer level. If we can tag Ubiquiti's business model as a Franchise model, shouldn't the market give it a much higher valuation?
Five Sources of Growth
Some people asked me where I expect Ubiquiti's growth to come from. I think there are 5 areas we can see growth, some of them will need capital, some not:
1. New products in existing business lines.
For example, Airmax AC, Unifi AC, Unifi Switch Lite models, EdgeSwitch Fiber, Airfiber 11x, and the 3rd generation Unifi Video cameras all belong to this category.
2. New products in new business lines.
Sunmax and AmpliFi all belong to this category, and we may see other products coming later this year. Some of these new products share the same user base with the other existing products, and some don't. Naturally, those that do are expected to have an easier ramp up. But those that don't could potentially open up a completely new user base, and therefore are very valuable if they do become successful later on.
3. Growth from enriched features and improved quality.
This is most obvious in the EdgeMax line. The hardware didn't improve much, and most improvement came from the software features. Unifi Video Camera is also gaining traction due to the bug fixes in its controller software.
4. Growth from viral marketing and penetration into a new territory.
Some of this growth is autonomous, but some requires setting up new offices and initiating new sales/marketing efforts in a new territory. This may also include contracting with major new distributors.
5. Growth from 3rd party service providers' growth.
If we consider this as a pseudo-franchise model, the growth of the franchisees (service providers) will also bring capital-free growth on Ubiquiti itself, fully demonstrating the power of the franchise model. In fact, Ubiquiti World Network was an attempt to stimulate this type of growth. However, for some reason, this attempt didn't prove to be very effective and therefore is currently suspended.
Conclusion
The attraction of fundamental investing comes from the fact that it is a combination of both business skills/insights and capital allocation skills. Although many investors like to stay with what have worked, I believe there is still a lot of room for new investment theories. Since investment itself is a competitive business, mastering a new investment theory is much like adopting a new business model: its value is unquestionable.
As Pera said, his success mainly came from his ability to think independently. In other words, his innovation isn't just limited to technology, but also in business models and how he manages the R&D teams. He is willing to challenge everything others have long accepted as "common sense."
In this path, however, he is determined to make some mistakes by being different from others. As one saying goes, "it is usually 'safer' to fail conventionally than succeed unconventionally." When he suffers from those mistakes, he will be attacked and even laughed at. But I believe those who are willing to think independently can understand the true value in his methods.
