Managing Partner and Chief Investment Officer, Atreides Management, LP
Gavin Baker on Investing in Omnichannel Retailers at Sohn Hearts and Minds Australia November 2020
Gavin Baker gave a presentation focused on investing in Omnichannel Retail in November 2020 to help raise money for the Sohn Hearts and Minds Foundation in Australia.
This presentation builds on Gavin Baker's Medium article, "Why Category Leading Brick and Mortar Retailers are the Biggest Long Term Covid Beneficiaries."
Please note that this is not an investment recommendation or advice in any way, shape or form. The presentation was given more than a month ago and the content is therefore dated. However, the thought process and analysis in the presentation may be of interest to some.
About Gavin Baker
Gavin Baker, Managing Partner and Chief Investment Officer at Atreides Management, has appeared frequently in media over the past two months to discuss the SpaceX IPO, the AI infrastructure buildout, and market dynamics. Following the SpaceX IPO, Baker praised the execution by Goldman Sachs and Morgan Stanley, calling it "perfect execution from start to finish." He described SpaceX as a potential "must buy, must own" for institutional investors, stating he does not know "another entrepreneur or another business that's a better bet on the future." Baker also interviewed SpaceX CFO Bret Johnsen, discussing Starship's rapid reusability, the company's AI compute business, and the potential for orbital data centers. Baker has been a prominent commentator on the AI sector, describing the recent growth of companies like Anthropic as "the most extraordinary moment in the history of capitalism." He noted that Anthropic added $11 billion of ARR in one month, a pace he said exceeds the combined 10-year build of Palantir, Snowflake, and Databricks. Baker has argued that the market has a greater tolerance for investment and a longer time horizon than many in venture capital assume. He has also discussed supply chain constraints, the role of retail investors (stating "stupid is stupid does"), and the importance of "watts and wafers" as physical constraints on AI growth. Baker expressed skepticism about China's domestic chip capabilities, saying "they have this crazy belief that, oh, you know, our own internal chips are good enough. They're not."
Transcript (25 segments)
✨ AI-enhanced transcript with speaker attribution
G
Gavin Baker0:13
Hey, so my name is Gavin Baker. I'm the Chief Investment Officer at Atreides Management. I would like to thank the Zone Hearts of Mind Foundation in Australia for having me here. Atreides is a 1.2 billion crossover fund that invests in both public equities and venture and growth equity opportunities across consumer and tech. I've been investing in e-commerce for nearly 20 years. I've looked at probably nearly 100 different e-commerce and DTC startups from a venture perspective, and what I'm going to do today is look at one of the world's most dominant e-commerce franchises, which is a public equity, through the lens of a venture capitalist.
So here are some disclosures that you can read at your leisure. The company I have in a pitch is among the fastest-growing e-commerce companies in North America. Forget Amazon, you know, growing 70% in North America. In the second quarter, this company grew faster than Etsy, that's 137%. It grew faster than Peloton's 172%. This company grew 194% year-over-year in their July quarter, and they did it at significant scale. Second quarter, July 2020, annualized earnings were 15.6 billion dollars.
If we map this company on an S-curve against Amazon, they are following almost exactly that same trajectory that Amazon followed from roughly 350 million dollars in quarterly revenue to roughly 4 billion. That's a great S-curve to be on. Amazon went on to 24x total revenue from that point. We're not forecasting that, but the great thing is you're not paying for that either, because this company is profitable and currently trades at 15 times their FY23 earnings.
The company that I am pitching is Target, and I'm pitching it through the lens of a venture capitalist. Target is in an incredible position today. It was really two decisions that they made. The first was to not build a separate distribution system for e-commerce, but to really leverage their stores, and that is looking like a brilliant decision. Second, they've been investing in IT and delivery technologies for years to really bring the e-commerce and store experiences together, and actually just finalized a lot of those IT projects right before COVID hit, which was good timing.
You can see here, Target has one app that you can use to shop in-store, pick up in-store, drive up, have it delivered to you—whatever you want as a consumer, you can choose. And we believe that consensus forward estimates are materially too low. Target's digital revenue should grow much faster and much more profitably than consensus expects over the next three, four, five years.
Target just beat in their July FY21, which is calendar 2020. They beat the consensus earnings estimate by more than 100%. That's that blue bar. They earned roughly three dollars and forty cents. Consensus does not believe that this level of earnings power is anywhere near sustainable. Consensus believes that actually the July 2020 quarter is going to be Target's best quarter ever. I think this is highly unlikely.
These are the gray bars for forward consensus estimates. This strongly embeds a belief that Target is not going to be able to retain all of the customers they acquired during the first half of calendar 2020, which is their fiscal 21. I can just tell you, having looked at customer cohort data for nearly 100 e-commerce companies and DTC startups over the last 20 years, that I think this is extremely unlikely.
20 years of e-commerce history tells us really one thing authoritatively: once you get someone's name, their email address, their mailing address, a credit card, they store an account, you know, that account name and password in Chrome or Safari, or better yet in an app that they can unlock with Face ID, and they make two or more purchases, the odds that they continue to repeat are overwhelming. So consensus embeds a belief that is completely at odds with 20 years of e-commerce history. And let's see if it's right so far.
So we use credit card data to look at Target's monthly cohorts and see how the newly acquired 2020 cohorts are performing. Target told us on the second quarter earnings call that there was an extremely high repeat rate amongst their newly acquired customers, and credit card data tells us this is continuing. Cohort analysis is absolute ground truth for e-commerce due diligence and investing from the venture side. We have very precise cohort data working with third-party credit card data. It's not as precise, but you can still see that their new customer cohorts in 2020 are landing larger and expanding faster consistently, and this has continued through September 2020.
So far, the expectations embedded in consensus are wrong. There's also been a very significant change in their top-of-funnel momentum. This is traffic to Target.com compared to Amazon.com. Target is the blue bars. You can see in January and February, traffic to Target.com was actually declining in January, growing slower than Amazon in February, and it really changed March, April, May, and even here in September. They're growing more than twice as fast as Amazon from a top-of-funnel perspective. That's powerful.
There is a strange belief in the world that stores are not valuable and the future is going to be e-commerce only. I find this deeply strange because the world's largest and most sophisticated e-commerce companies do not share this belief. JD, Alibaba, and Amazon are all opening stores—lots of stores in lots of different formats. The reason they are doing this is they all believe, maybe they're wrong, but they all believe that the future is omnichannel and that they need stores for a variety of reasons. I think that they are right.
The actual single largest day of dollar turnover in my career, in a prior life, was the day that Amazon bought Whole Foods. I had begun hearing from probably as early as 2014, you know, Warby Parker opened stores in 2012, that stores were incredibly valuable for e-commerce companies. Seeing Amazon make their largest acquisition ever, buy Whole Foods, to me was a tremendous validation of the value of physical real estate. And yet, your average physical retailer in America was down 5 to 15% that day on what to me was the deeply silly idea that this was going to make Amazon more competitive with, you know, companies like Home Depot. It's not like Amazon bought Whole Foods to put power tools in Whole Foods or clothing in Whole Foods.
So after being structurally underweight physical retail for many years because I believe the future is e-commerce, I bought an immense amount of physical retailers that day. Stores are valuable. They create better unit economics not just across all channels, they create better online-only unit economics. The most important ratio to look at for an e-commerce company is LTV to CAC—lifetime value of a customer to customer acquisition costs. The higher that ratio, the better.
Lots of e-commerce companies have found the best way to lower their CAC, to increase their online marketing efficiency, is to have stores. Consumers trust brands that they have seen in the physical world more than brands they have not. Stores are also ideally located to serve as low-cost same-day delivery hubs, and they enable new omnichannel experiences. At the end of the day, the cheapest same-day delivery option will actually be click-and-collect, where the consumer places an order online, drives to a store, and either picks it up via drive-up experience or picks it up by walking into the store. That is even cheaper than having a drone deliver a package.
And omnichannel—we can see it in the Target numbers—giving consumers choice leads to more spending. Target's omnichannel customers spend four times as much as a store-only guest and 10 times as much as a digital-only guest. And what's actually fascinating about this chart on the right is that in many ways, younger consumers value stores more. So the light blue on the left is speed, then purple is convenience, black is the in-store experience, and then the gray is price. Gen Z values the low prices at stores more than baby boomers, which makes sense because baby boomers have more disposable income. But I just think it's interesting that the younger generations value the speed, convenience, experience, and prices associated with in-store shopping more than baby boomers. So demographics are not at all working against stores.
Importantly, they also increase the lifetime value of customers by improving delivery economics in the cheapest same-day experience. As a consumer shopping online, creating a basket, and then driving themselves to pick up their basket at the store—and you can see this—these are Target's indexed delivery costs per unit. When they ship it from a distribution center, index is to 100. When they ship it from a store, it's 40% cheaper than shipping from a distribution center. When a customer effectively pays for the delivery themselves via click-and-collect experience, like pick up in store or drive up, it is 90% cheaper.
And Target's network of nearly 1,900 stores are ideally located for these omnichannel click-and-collect experiences. It takes 18 to 240 days to form a new habit, there's a lot of research, and I think that these experiences have become a habit for many of Target's consumers. What really blew my mind in the second quarter was seeing their drive-up revenue. This is when somebody shops online, creates a basket, checks out, they drive to the store, they pull up to a designated parking spot that has this big red 'Drive Up' sign that you see in the picture. A Target associate confirms their identity and then puts the order in their trunk. Those drive-up revenues grew 734% year-over-year. And what was shocking to me, the NPS score for a relatively new, fairly unoptimized experience was over 80. Consumers love this. Amazon is a world-class company; their NPS score is 62.
After a customer tries drive-up for the first time, they spend 30% more at Target roughly. And because of this shift away from shipping from distribution centers towards shipping from stores and click-and-collect experiences, Target's unit costs for digital fulfillment declined 30% year-over-year in the second quarter, even as their digital revenues nearly tripled. That is incredibly powerful math.
Target's nearly 1,900 stores are ideally located for same-day delivery. If you're going to have a network of same-day delivery small little mini warehouses, why not make them stores? Target is already where Amazon and the rest of e-commerce wants to be from a last-mile delivery network. It is a dense network that is ideally located.
Almost as importantly, Target's nearly 1,900 stores make them an ideal partner for a lot of digitally native brands. There are a lot of digitally native brands, and I've looked at many of them on the venture side, who do not want to sell through Amazon because they don't want to give up their data, and they can't afford stores of their own. But they understand that if they can have a physical real-world presence, it will lower their online customer acquisition cost, improve their marketing efficiency, thereby improve their unit economics and that all-important LTV-to-CAC ratio. A lot of those brands have come to Target and said, 'We would like to sell through your stores.' Target says, 'Sure, but you can only sell through us.' This gives Target exclusive supply, and I think it's going to be the foundation, and they're just going to follow the Amazon playbook. They're going to develop a curated 3P marketplace where other brands sell through Target. That's the highest-margin form of e-commerce, and I think these brands are going to be the foundation of Target's own 3P marketplace, which is going to work powerfully in concert with the stores.
They're also, you know, it's funny, we're looking at Target's digital business. They do have this retail business where somebody just walks into the store and buys stuff, and that's, you know, over 80% of their revenue. And their nearly 1,900 stores are ideally located to take share from weaker retailers who haven't invested to enable these omnichannel experiences, and in many ways and in many cases have gone bankrupt. A lot of brick-and-mortar competitors in very high-margin categories have gone bankrupt. Target took 25% of the sales up for grabs from Toys 'R' Us when it went bankrupt, and I think that they could do something similar with the wave of bankruptcies that we've seen so far this year. That would be a big tailwind to their core business.
So putting this all together, there's kind of two ways to look at Target. The first is kind of a traditional PE framework. If we take a really conservative $11 earnings per share number for FY23, which is by the way 25% above consensus estimates, it is still 19% below the annualized number they just printed in the second quarter of FY21. 24 times that $11 gets you roughly 70% upside. 24 times is a reasonable multiple; that's where kind of perceived retail winners trade in America, you know, the Home Depots of the world.
Or we can use a sum-of-the-parts digital-only framework, and if we take a reasonable group of e-commerce comps, that solves for Target should be trading at five times digital revenue, which means you're getting 80% of their revenues—the 80% that is pure physical retail—for free. But I think both of those frameworks are conservative. I think there is a world where Target really leans into omnichannel and e-commerce. I think they can earn over $20 a share in five to seven years. Putting 24 times on that number makes Target a triple, and it's a pretty low-risk story in my mind. They have a dividend yield, it's at a reasonable multiple on consensus estimates.
But to get there, to get to that $20, they have to lean in operationally, strategically, and culturally to omnichannel and e-commerce. And this is critical: the reason a lot of retailers were slow to embrace e-commerce was cultural. The most powerful people at most retailers were merchants and the real estate department that decided where to put stores. Because in the world of physical retail, if you have well-located stores that are stocked with the right goods at the right prices, you're going to do well. So that's why the merchants and real estate were the most important functions. Online, algorithms do the merchandising and you have endless shelf space. And while these stores are super important for omnichannel, your online presence is a URL or an app. So for the first time ever, because of COVID, because of this tremendous success they've had, I think the analytics team at Target and a lot of other retailers is becoming as important as the merchants, as the real estate teams. And at the end of the day, I believe nothing accelerates change like success. Target's having a lot of success, and I think that they are going to lean into this.
So that's it. I hope you enjoyed it. I'd like to thank the Zone Hearts of Mind Foundation again. I really enjoyed this. Thank you.