3 Tech Listener Questions, Answered

You wanted to know about Naspers, tariffs, and the SaaS bubble -- we’ve got answers.

Evan Niu
Evan Niu, CFA
Jul 16, 2019 at 12:00AM
Technology and Telecom

In this pre-recorded episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool analyst Evan Niu answer some listener questions. First, a deep dive into the tangled web that is Naspers -- a little South African media company that got more than it bargained for when its 30% stake in a little Chinese company, Tencent (OTC:TCEHY), got a lot bigger. Should investors be interested in the spin-off Naspers is looking into to offload some of that wealth?

Also, why are Chinese companies like JD.com (NASDAQ:JD) and iQiyi (NASDAQ:IQ) affected by U.S.-China tariffs, when they're selling almost entirely to Chinese consumers?

And, the software-as-a-service bubble -- does it exist? Is it ready to blow? How can investors tell the difference between a quality SaaS business and a weak-consumer goods company that's just trying to siphon up a more SaaSy multiple? Tune in to learn more.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on July 12, 2019.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, July 12, and we're going to the mailbag. I'm your host, Dylan Lewis, and I've got fool.com's Evan Niu on Skype. Evan, what's going on? 

Evan Niu: I have to say, I'm excited to see this Lion King movie remake that's coming out this month. It looks pretty good!

Lewis: Are you a fan of the live action remakes that they've been making?

Niu: Some of them. I mean, we didn't take the kids to see Dumbo or Aladdin. But we took them to see Beauty and the Beast like a year or two ago. It's one of my wife's favorite Disney movies. But, I think some of them turn out really good, some of them looked silly.


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Lewis: I saw The Jungle Book. I'm not a big blockbuster movie person, but I saw The Jungle Book. And it was a little jarring to see a quasi live action type of thing done with something that I'd always pictured as animated from my childhood. It's kind of like seeing someone that you only ever seen a suit wearing gym clothes or something like that.

Niu: I didn't see that one, but I think the technology's come a long way since that one. All the trailers they put out for this one, they look pretty good, in my opinion, for a live action, cartoonish, talking animals... [laughs] 

Lewis: I think, like it or not, we're going to be getting more of them because the studios know that's where some serious money can be made. Maybe we'll do a little follow up, see what you think after you've seen it, Evan. 

Niu: Yeah, I think this one's going to make a ton of money.

Lewis: We have a fun mailbag episode. We have a couple of really awesome questions from listeners on today's show. A quick note before we dive into the discussion, we are pre-taping this episode. I am on vacation in early July, so we're knocking this out. So, if there are any changes to some of these stories, we'll apologize in advance. Things can change a bit. We just wanted to make that note. 

Evan, we love getting listener questions. It shows that listeners are curious, that they're interested, and in my opinion, most importantly, it proves that we actually have listeners.

Niu: [laughs] Yeah, dozens of them, right?

Lewis: [laughs] Dozens of them! So, the first one that we're going to hit comes from Tim. Tim writes in: "Hi, IF Team. I love your show, and especially love it when you dedicate airtime to sharing research or insight on specific companies and IPOs." Evan, you're always in the mix for those. "Your breakdown of a company's fundamentals, SEC filings, business model and potential red flags are invaluable to part-time investors like me." What a sweet note! He asks, "Any chance you can take a look into Naspers spinning off their technology/ internet investments into a separate company? This new company is supposed to unlock hidden market value for its 30% stake in Tencent, which is believed to be trading at a huge discount as compared to how Tencent ADRs trade on their own. Thought you may want to look into some of the other start-ups that are included in this spin-off company. It might be a better way to get exposure to Tencent, as well as some other foreign tech companies."

Before we answer the question, we need to give a lot of background here, Evan, because this is a complicated story, and admittedly one that we weren't super familiar with before we started doing research for today's show.

Niu: Right, I have to admit, I was not familiar with this at all. I probably should be, since I own Tencent directly, at least the ADRs. I hadn't heard this story, and it's a pretty wild one.

Lewis: The background here, Naspers is a hybrid media group and investment firm. They are based in South Africa. You go back to 2001, they paid $32 million for a large stake in a Chinese tech start-up. You may have heard of it -- Tencent. You're a shareholder, I'm a shareholder. It is surprising that we didn't have this awareness, probably a little omission on our part. But, as Tencent has grown, that $32 million stake has grown to be something north of $150 billion, I think at one point it was $175 billion. This investment is widely looked at as one of the most successful VC bets of all time. But with this growth, it has created some pretty serious problems for Naspers and South African investors, Evan.

Niu: Right, because Naspers is a pretty small company, as far as their actual operations go. It's a small little media operation in South Africa. The vast majority of their value is now because of this stake in Tencent. It's almost like Yahoo and Alibaba back when that was a whole thing, very complicated and a tangled mess just like this.

Lewis: Yeah, I think I saw a number, Naspers alone is about a quarter of the Johannesburg stock index. It is the valuable company in Africa. So, it has bloomed into this massive company pretty much on the back of this individual stake, not anything to do with the operational success of Naspers, the underlying business. One of the big problems with that kind of size, it creates problems for people that are fund managers, and because of some of the tangled nature of this ownership and whatnot, the company trades at a pretty sizable discount to their actual Tencent ownership stake just because of all the difficulties that come with being so large. Also, I think there are some issues with people only being able to own so much of a company or have much exposure to a company on the fund management side, so people are a little timid, to buy shares of Naspers.

 Niu: Right. I think the current Naspers total market cap is currently worth less than its stake alone. That in itself is obviously a pretty clear sign of a mispricing or market inefficiency. And I think a lot of these reasons are related to these market mechanics. It's a small stock index, it's a relatively small exchange, and then you have this one position that is worth $150 billion. It's just really hard to have the market operating in a smooth and efficient manner when you have this elephant right there.

Lewis: So, to remedy all this, Naspers wants to list some of the Tencent stake, as well as some of their international properties, in a business called Prosus, and it'll be listed on one of the European exchanges, I believe in the Netherlands. Naspers will retain 75% of this holding company that they are creating. Evan, what do you make of all of this?

Niu: It sounds like it's going to get even more complicated, even messier. If you're an individual investor, what's the point of buying into these shares once they start trading publicly, when it's still basically just dominated by Tencent? Yeah, you get a little bit of exposure to some of these other investments they have that are going to be held in this holding company, but unless those investments interest you, why not go buy Tencent shares?

Lewis: I think one of the concerns that I have when I look at a somewhat tangled holding company structure is, it's tantalizing to get that discount. I totally understand that, especially if it's like 20% or 30% on the underlying asset. But for that, you're giving up some control. You don't own the shares in the way that you would if they were sitting in your brokerage. You're beholden to whatever the management team of the holding company decides to do. And very often, they're thinking about tax efficiency, which can be good for those people, but it's on a case by case basis. You don't have the autonomy that you would if you were just owning the stock.

Niu: Right. It also ties into, are you the kind of investor that really wants to be proactive in making these votes and exercising your voting power? A lot of people really don't. Another aspect to it.

Lewis: I think, also, when you see something trading at a significant discount, in this case, it's very obvious because you have the market value of the holdings, and you have the market cap of Naspers, but if you're a value investor, you're always looking at what you value something at and then what the market values it at -- that can be a very lucrative way to invest; the problem is that at some point, the market needs to realize that they have been undervaluing something, and that doesn't always happen when we have these tangled holding company structures.

Niu: Right. There's a lot that can continue to hold the valuation back. Again, tying back to these market mechanic issues, not anything with Tencent's actual fundamentals.

Lewis: Yeah. I am reminded quite a bit of Altaba and Alibaba, Altaba being the spin-off that was used to house all of Yahoo's stake in Alibaba after they were purchased. This is something that has traded at a massive discount pretty much the entire time that it has existed as a publicly traded option for people, and that's because they've had this huge anticipated tax liability that selling the shares would create. Now, we're at a point where the holding company Altaba is expected to sell at least some of their shares. Again, that's where you run into an issue, where you're not in control of the shares the way you would be if you just owned Alibaba outright.

Niu: And Yahoo will have to get to know all this tax liability stuff, which may not be the most interesting thing to investors compared to studying the fundamentals, which to me is more interesting than tax liability.

Lewis: I am with you there, Evan. For me, it's a matter of keep it simple. Don't wind up in something that is a little too complicated, more complicated than it needs to be. I can see how that discount might be interesting to people. Depending on the international properties that are in there, there might be a way to access stuff that would otherwise be a little bit tougher to get into. But for my money, if you're interested in Tencent, I would rather own the Tencent ADRs than own some stake in this Naspers spin-off.

Niu: Yeah. That's the same boat I'm in. I've never touched Altaba, either, but I do own Tencent.

Lewis: You and me both. Good company to be in there, Evan!

Alright, we have a question from Stojan. I hope I'm saying that name right. Stojan wrote in, "My question is in the context of trade tariffs. I own several Chinese companies for the long-term growth potential in the region. Among my holdings are Alibaba, Autohome, Momo, JD.com, IQ, and Sina. Most of these companies deal either exclusively in China or more broadly the Asia Pacific market, so why are these companies and others like them subject to so much market volatility as a result of the trade deals with the U.S., despite not having any business relationship with the U.S. market?"

This is a great question, Evan, and I think it's one that a lot of people have. You think of these primarily as pure plays on the emerging middle class in China, and the general growth story there. How come they're getting caught up in all this macro stuff?

Niu: It is a pretty far reaching question, because the impacts of these things, it's hard to appreciate them. Even though these tariffs apply to specific goods moving between the U.S. and China, there is a ripple effect that reverberates throughout each economy. For example, the Chinese government has been very surgical with the tariffs that it's been putting in in response to Trump's tariffs, specifically targeting regions that are really politically important to him, such as agricultural products, hitting rural economies, which is where his base is concentrated. The same thing is happening in China. The U.S. tariffs are impacting broad swaths of their economy. Basically, what it does, it hurts everything from consumer confidence to demand for discretionary goods to large ticket purchases like cars. For example, China is the world's largest car market. Sales in May were down something like 16%, which was the worst-ever decline, and like the 11th consecutive month of declines. But other sectors -- real estate, e-commerce, consumer electronics -- they're all getting hit really hard. So, they have really broad macro effects that affect pretty much everything in the economy.

Lewis: Right. Markets hate uncertainty. I think that's one of the truisms of investing, and something that, as you spend more time looking at businesses and looking at big picture economic issues, the market's never going to respond favorably to uncertainty. We want predictability. That's true also for people that are operating businesses. If you are trying to make purchase order decisions based on what you think the next six or 12 months might look like, and that's a very cloudy picture, it'll be a lot harder to do it with a lot of confidence. 

Niu: Right? Imagine if you're a company that's impacted by these. All the sudden, you have this huge new costs introduced into your operations. You don't know how long the tariffs are going to be in place, because these negotiations are ongoing. Things are going back and forth; the talks are very volatile. So, do you absorb the costs? Or do you pass them along to consumers in the form of higher prices? If you eat the costs, you're hurting your bottom line. It might even put you in the red. Raising prices hurts demand. Maybe you set aside some money to pay for them, but that's money that you might otherwise be using to reinvest in the business or hire more workers. If you drill that into it, imagine what these companies are faced with, it adds to this idea of how much uncertainty is being thrown into the mix -- which, as you mentioned, no one likes.

Lewis: And you take the next step there, and you start thinking about, higher prices mean that consumers are paying more for things. That's why we see demand for some of those discretionary items come down. If you have only so much money to work with, and the things that you need to be buying wind up going up a little bit in price, you may not be as willing to shell out some money for entertainment or luxury goods or something like that. So, even though they may not be directly tied to what's going on in terms of tariffs, it winds up having this trickle-down effect.

Niu: Right. Another angle is, imagine your company that's already getting caught and all this stuff, the trade war, but you have the ability to maybe shift some of your operations to other countries that aren't affected. That's what a lot of these companies are going to want to do. And you start to invest in other countries to diversify your supply chain and reduce this geopolitical risk that you're facing. So, foreign investment in the U.S. and China both got hurt, too. As an example, there have been recent reports that Apple's even looking to move some of its production out of China. Apple's always had a huge production footprint in China, and they're now looking at moving to other countries in Southeast Asia. Those jobs are not coming back to the U.S., but they're moving stuff around. That's money that they otherwise would have been investing in China, but now they need to spread out their infrastructure. So, yeah, that's another piece of it. There's a lot of ways that this all gets tied together.

Lewis: Yeah. I think we can wrap up the answer to this one by saying the economy's complicated, but tariffs wind up throwing a fairly large wrench into this machine. Even if you're just a small gear in the upper right corner of the machine, if one of the large gears down in the bottom left isn't spinning, it's probably going to impact you in some way.

Niu: Right. These are the world's two largest economies. I do think that this trade war is very much threatening to put the global economy into a recession. We're already seeing signs; GDP growth is slowing. It's worth noting that's part of how Trump says he thinks that China pays the tariffs, which they do not, by definition. But he thinks that they're going to pay for it in terms of the economic slowdown. And some of the numbers are starting to play that out in terms of GDP growth China's putting up, it's really decelerating.

Lewis: And any deceleration there will generally hurt Chinese companies, period.

Niu: And then us, too. Tim Cook, put it like, the U.S. and China are tied together with their economies. We're hurting ourselves, too.

Lewis: Our last question takes us from a super big picture issue to something very specific to one industry. One of our listeners, Paul, asks, "There seems to be a lot of lofty valuations for SaaS companies right now. Does that seem sustainable, or more like the beginnings of a bubble that might pop? Also, any specific companies that seem more or less vulnerable?" 

I think over the past year and a half, I have done more episodes on SaaS companies than I had in probably the previous three years. This has become such a large part of the investing consciousness, especially in the tech space, because the returns have been so good for so many of these companies. But, I think there are a lot of people starting to wonder with these valuations, is it getting out of hand?

Niu: Software-as-a-service is one of these sectors that has always fished these high multiples and lofty valuations, because, quite simply, a lot of them are really fantastic businesses. They have great visibility because a lot of their revenue is coming from long-term subscriptions that are billed up front, then recognized over time. They have great margins and operating leverage because software-as-a-service can scale extremely well, so the profits are really good. And then, on top of that, a lot of them have made their platforms and services indispensable to large enterprise customers. That's a really powerful trifecta of really strong business.

Lewis: It is. You have recurring revenue, which we love; high margin, which we also love. But the valuations can get a little out of hand. When you look at the SaaS space, is there anything in particular where you say, "This is the hallmark of a bad business"?

Niu: We've done some shows on Domo before, and they had a bunch of red flags. I don't want to get too deep into it again. But I didn't think that they looked like a very promising one. They also had a pretty lofty valuation. But they just didn't seem to fit some of these other criteria when you actually drill down into it. That's just one that came to mind for me.

Lewis: Something I think people should probably have on their radar is, this question is about SaaS, but what we have seen over the last two years as SaaS has become way more popular, and the valuations have been pretty incredible, is that you have a lot of other industries that are not really SaaS that are trying to brand themselves as-a-service. I remember looking at the prospectuses for Lyft and for Uber, and basically saying, these are billing themselves as TaaS companies, transportation-as-a-service. The fundamental issue there, though, is these businesses look very different than a company like salesforce does.

Niu: [laughs] Right. This whole as-a-blank is really contrived to me. For example, Fiverr just went public, and they billed themselves as a, quote, "service-as-a-product platform." What does that even mean? Yes, you pay for a service. Like, really gratuitously trying to turn it into that as-a acronym. So, yeah, another example of what you're talking about, this trend of these companies trying to piggyback on this as-a-something, and as a result, hoping to get a really good valuation.

Lewis: Yeah, I think it is the buzzword of the time, particularly in tech. If you are looking to identify best in breed SaaS companies, for me, it's always a matter of, what does net revenue retention rate look like? That is looking at the existing customer base a year ago, and that customer cohort now. Are we collecting more money? I'd like to see that number somewhere north of 110%. For a lot of these companies, you see some really stellar businesses that'll be 120%, 130%. And you'll have to pay a higher premium for that, but it means that with every customer they're bringing in, they're not only getting growth from adding that customer, but they're rolling in all these extra products, services, functionality that gets them to pay more down the road. That's a sign that they have a pretty compelling offering.

Niu: Right. Just to add on top of that, some of the things I look at when looking at these types of companies. A lot of them report how many prominent customers they have, which is usually defined by, they spent X amount per year. They'll report that number, and it's always good to see how many big customers they have. Billings is also an important metric, because it usually represents revenue with some adjustments related to the change in deferred revenue. It shows how much they're billing to their customers. 

Another thing to keep an eye on with these companies is that a lot of them target enterprise customers, which means, to your point about increasing this net revenue retention rate, the way they do that is they have these human salesforce people with really long sales cycles that tend to be longer and more complex because you're really engaging with these IT managers or leadership in IT organizations. But that also means that your sales and marketing expense is really high. Some of these deals take a really long time to close, so you have to be patient there. Vs. in the consumer space, a lot of the times, you'll see sales are more self-serve or automated. So, it's just another thing to be aware of, one key difference in how a lot of these companies operate.

Lewis: Yeah. I think, if you're trying to figure out, "Where does a company fall? Is it that they are bid up because of expectations? Or is this a company that may take a hit as the market takes a downturn, but will generally weather it OK?" I think it's important to look at what the valuation for the business is built on. Is it a story of total addressable market that they haven't yet realized? Or is it something where they have a huge customer base and there is the promise that for the next foreseeable future, they're going to be enjoying all this high-margin recurring revenue? If it's the latter, that those are the types of businesses that can weather economic downturns and the looming recession a lot better, because they have an indispensable product. I'm thinking specifically about the Adobes and the Salesforces of the world. They will fare far better than some of the high-flying growth stories that we're seeing come public now.

Niu: Right. Salesforce is really the poster child and pioneer of a lot of this current modern breed of SaaS companies. It's interesting, my wife actually is a Salesforce admin. She works very deeply in this platform. It gives me some exposure to understand how these companies rely so heavily on Salesforce. They can't switch away from it because they're so invested in the platform, the switching costs are enormous, you have to retrain so many people, and it just works so well. And it's just an interesting thing, now that we're talking about it.

Lewis: I didn't know that, Evan!

Niu: Yeah, she's been there for a couple of years now. The past two to four years, she's been getting into that world and getting certifications and finding better jobs. There's a lot of demand for those types of jobs, too. That's also a nice thing.

Lewis: I guess, the reason that these companies are so powerful is that they are sticky, as you mentioned. Once you're in as an enterprise client, and people start using you, the utility is there. As long as you serve those customers well, you should do pretty fine because the switching costs are so high. But if the story is, "We are going to dramatically be increasing our customer base over time," and we run into a period where, OK, we hit that economic downturn, and businesses are starting to be a little stricter in what they're spending on, they may not go after those new tools. One business I think that is probably worth putting into the valuation built on TAM type of bucket here is Slack, because so much of the story with this company is, it's early days, they are a killer enterprise product, and they're going to be the must-have corporate communication tool.

Niu: Right. But, also, their valuation is insane. They're trading at over 40X sales. For a sector that has notoriously high multiples, theirs is even on the high end of that. I agree, I love Slack as a user, and I think some of their fundamental metrics that they're putting up are great. But I have a couple of concerns, which is why I'm not investing at this point, because, A, valuation, but also, B, a key part of how these companies expand is by offering a range of stuff to keep these customers immersed in the platform. And Slack hasn't expanded beyond core messaging. And the messaging is great, but customers could potentially switch to something like Microsoft Teams, which Microsoft bundles with like a million other core productivity stuff. So, that's one thing that I would like to see Slack do. Can they expand into other areas in a way that's compelling? For example, Dropbox is another one of these SaaS companies. They've historically always been on cloud storage, but now they're trying to push other types of team collaboration tools in an effort to try to make themselves indispensable.

Lewis: Yeah. That's how you juice that net revenue retention rate number, too. 

Niu: Yeah, that's the key. 

Lewis: Folks, I hope that answers some of the questions that you have. We love doing these mailbag episodes, so please write in with more ideas for shows. Evan, anything else before I let you go?

Niu: Happy Fourth of July!

Lewis: Happy Fourth of July! Yes, we're taping on the second. We are about to enjoy a nice little break. Are you doing anything fun?

Niu: No, I don't think we'll do anything too big. Just take the day off. 

Lewis: Nice! I will be grilling and hanging out on my deck, enjoying a nice D.C. summer day. Producer Austin Morgan, what's the July 4th plan? 

Austin Morgan: Well, I have to do physical therapy every day this week, except for the 4th. So, I think I'm going to drive up to my parents' house in Solomon's Island in Maryland, and then drive back on Friday morning. [laughs] 

Lewis: I bet that's going to be a rough drive home in the morning. 

Morgan: Yeah, I'm going to drive home, go to physical therapy, and then probably drive back up there for the weekend. It'll be lots of road time. Lots of shoulder pain.

Lewis: It's hard to frown when you're out on a body of water. 

Morgan: Can't beat it!

Lewis: Can't beat it!

Niu: There'll probably be a lot of traffic, though.

Lewis: It is easy to frown in traffic.

Morgan: It's very easy to frown in traffic.

Lewis: [laughs] Alright, listeners, that does it for this episode of Industry Focus. I hope that you guys have a great July 4th. If you guys have any questions or you want to reach out and say hey, shoot us an email at industryfocus@fool.com. Or, you can tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes or check out the videos from the podcasts on YouTube. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass! For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!