As I stated in my introduction, a good investment needs to be rooted in a compelling narrative and numbers to back it. A strategy helps keep focus, and my strategy is enterprise software companies that are essential to a business. These companies have great business models, are hard (and expensive) to replace, and won't be cut out when things turn south. A star in this segment is WIX (WIX). As you can see below, they've been on fire; I want to try to explain why that is, and why there could still be room to grow.spS
Full disclosure, most of what I'm going to say is extrapolated from their Investor Presentation over here:
The WIX narrative is pretty simple but very important. They supply businesses with websites. I use the word supply intentionally since it tells us a lot about WIX's positioning. A company's competitive environment can be described with Porter's 5 Forces:
- Strength of suppliers
- Strength of customers
- Threat of substitutes
- Threat of New Entrants
Typically, if a company has a small concentration of customers, that puts the business at a disadvantage since the customers are in a position of power to determine the terms of the relationship (i.e. Apple with a chip provider).
If you have a lot of scattered customers, and they have few options of replacing you, you have a tremendous advantage. This is especially true if you provide something essential to a business- it's one thing to replace your toilet paper supplier, it's another to change your website supplier.
WIX is in this position. There are few direct competitors and a huge untapped market of potential customers.
What makes WIX even more special is that their narrative is growing. They started as a platform for designing websites but expanded that to a full solution. Their offering now includes WIX Stores and Payments for eCommerce, WIX Restaurants and Bookings for entertainment, SEO Wiz for advertising, WIX LogoMaker for branding, and so much more. They also have a WIX academy. People have side jobs designing WIX sites.
Bottom line, they grew from a product, to a solution, to an ecosystem. This expansion entrenches them deeper into their customer's business, making them more and more essential.
WIX has a compelling story that talks the talk; but do the number walk the walk? Let's have a look
|Gross Profit Margin||79%||84%||84%||83%||82%|
On the surface, things seem normal. Revenue has healthy growth:
The fact that they can sustain a growth rate of over 40% should not be taken lightly.
There does seem to be a hicup in Gross Profit:
You can see on the graph that the Gross Profit Margin took a nosedive this past year. This is a representation of the expanding gap between Revenue and Gross Profit.
The cause of this is the dramatic acceleration in Cost of Revenues (COGS) as you can see here:
It could be easy to dismiss this as a one-off phenomenon. I was inclined to do so, espeicially since COGS are very sporatic while their revneues are growing consitently (revenue growth has a standard deviation of 1.8 while COGS growth has a standard deviation of 21), indicating that revenues will continue to grow steadily while COGS will come back to Earth just as quickly as they shot up.
But the company descirbed this increase in their annual report and said as follows:
"Cost of revenues consists primarily of costs directly associated with the provision of services, namely, bandwidth and hosting costs for our platform, customer support software solutions and related call center costs along with domain name registration costs. Cost of revenues also consists of personnel and the related overhead costs, including share-based compensation. We expect our cost of revenues to increase with the increase in the number of registered users and due to our sale of Google’s G-Suite application, which will consequently increase our cost of revenue as a percentage of revenues."
Notice how they state that they expect COGS to increase as a percentage of revnues as they continue to grow. This means that the drop in Gross Profit is not a one off event, but is expected to be a growing trend in the company's financials.
But I wouldn't be too concerned about this for 2 reasons:
- This is the cost of doing business. WIX is still a growing company and growth has costs. Indeed, if increaseing costs means providing a great product line and recurring revneues, then keep at it. As they mature, these costs will need to be managed better. But for now, it is something I would be willing to tollerate as an investor.
- While they are still not profitable, the company has been decreasing their losses despite the thinning of their Gross Margins.
Their loss has been declining as they get closer to breaking even. Moreover, their loss as a percentage of their revnue is in a freefall. Unlike other high growth companies that are a cash bonfire, quickly spending whatever revnues they bring in, WIX can manage their costs more efficiently and prime themselves for growth.
This means they can manage the impact of their growing costs.
Rule of 40
As a side point, the decline in WIX's Loss over Revenue marks a major milestone- crossing the Rule of 40. The Rule of 40 is a metric for gauging the sustainability of software companies. The rule is that the companies growth rate plus their profit margin (or minus their Loss over Revenue) should equal at least 40. Meeting this rule reflects a healthy balance between growth and efficiancy which is a strong signal of a sustainable business. Indeed, WIX attained this goal in 2018, and the trends in their growth and EBITDA margin indicate that they will continue to reach that year after year.
Sign of Strength
Perhaps the most promising part of WIX's growth is the easiest to overlook. Their strategy is to become a full ecosystem for SME websites, which means constantly expanding their offering. Therefore it is important to be able to increase your prices as your offereing expands. In the past year, WIX was able to do exactly that. For the first time, they increased their revenues from their existing clients:
Be careful. Most points that I've made are just things I echoed from them company, so don't take them as law. As you saw in the first chart, the stock has been on fire and could very well be overvalued- I just wrote about my opinions on their story and very rough topline numbers and trends to back it up.
Please do further research and please let me know your thoughts in the comments!