Motley Fool Hidden Gems Investing - Leaders Gonna Lead

Episode Date: April 4, 2022

One thing we like to focus on is the people running the businesses we own shares of. (00:20) Jim Gillies discusses: - Howard Schultz suspending Starbucks' stock buyback plan on his 1st day as interim CEO - The likelihood of Schultz remaining CEO beyond his "interim" period - Elon Musk taking a 9% "passive stake" in Twitter, according to the SEC - The subtle-yet-important difference between a 13D filing and a 13G filing - Whether Tesla shareholders are bothered by Musk paying attention to another company (18:30) Asit Sharma and Brian Stoffel examine cloud infrastructure company DigitalOcean through the lens of competitors like Amazon Web Services and Microsoft Azure. Stocks: SBUX, TWTR, TSLA, DOCN, SHOP, MSFT, AMZN, ORCL Host: Chris Hill Guests: Jim Gillies, Asit Sharma, Brian Stoffel Producer: Ricky Mulvey Engineer: Rick Engdahl, Tim Sparks Learn more about your ad choices. Visit megaphone.fm/adchoices

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Because we have your number. One cloud business is ready for its close-up and two CEOs are in the spotlight. It's a busy Monday, so let's get to work. Motley Fool Money starts now. I'm Chris Hill, joining me today from Motley Fool Canada, it's Jim Gillies. Good to see you. Good to be seen, Chris. Here at The Motley Fool, we focus on businesses, but we also pay attention to the people who are leading the businesses that we are shareholders of. We have two long-time business leaders that we need to talk about today. We're going to start with Howard Schultz,

because today is his first day on the job as interim CEO of Starbucks. If you're scoring at home, this is his third time in the corner office. He's not waiting. Unlike most interim CEOs, his first act of business is to suspend the share buyback plan that Starbucks had announced, I believe it was last year, to the tune of $20 billion that they had allocated. And Schultz and the executive team saying, we're going to suspend this buyback plan, this frees up money to invest in future growth of the business. You and I were chatting earlier today. I get the sense you think this is a good move. I do. I'm going to commend you on being able to say interim CEO of Starbucks with a straight face. I am someone who remembers the

last time Howard came back as interim CEO of Starbucks and lasted for nearly a decade, I believe. I thought as interim CEO, his job is to find the next leader of the business. I suspect he finds that leader of the business every time he looks in the mirror. So, just putting it out there, I think Howard's around for a while. But I also happen to think that's a good thing if he is, and I kind of hope he's around for a while, because Howard Schultz has demonstrated in two tenures, a multi-year, if not decade, tenures with Starbucks, that this man knows how to grow this business. If Howard Schultz says, we are going to cut the buyback, and I'm going to point out that that $20 billion buyback on the table is about 20% of Starbucks market cap. It was a

potentially seriously large buyback. Now, I note that if you have been, and I know, Chris, you are a shareholder, as am I. I know you were a shareholder three years ago, as am I, or as was I, I suppose. I know that all we have made from our Starbucks over these past three years is basically the 2% dividend yield. This is in spite of Starbucks spending about $8 billion in share buybacks over that time. I understand we had the pandemic through that. But they've not done a lot of buybacks. They've only done about $8 billion over the past three years, roughly, since the end of June 2019, so almost three years. That's maybe money that was wasted a little bit, but I have to quote a couple of our colleagues, because it was purchased at higher valuations.

I am a fan of Starbucks investing in themselves, investing in their stores, not necessarily new store growth, but in systems and their existing stores as well. updating and improving their stores, improving benefits for their service providers, their members, the team members, the staff, the people who work there. I've always thought of Starbucks as a fairly good employer. I'd like to see better for the employees there because then it leads to happier members, happier customers, happier shareholders eventually. While I'm giving Howard a bit of a hard time, like he cares what I think. While I give Howard a bit of a hard time, I don't think buybacks here were a large enough amount to really worry about. I mean, they've

spent just slightly more on buybacks than they have on dividends, and we know they like to raise their dividend every year. I suspect they're going to keep on doing that, that's a return. I also note that over the past three years, the buybacks have only taken out about 4.5% of the the stock count, which, you know, is a meaningful buyback. And that's a good thing. Like, we talk about companies as cannibals that eat themselves over time. So, Apple's one, Home Depot's another one, eBay's another one. Companies that buy back meaningful and shrink their share counts. And so, if you still hold the shares, you are a comparatively larger percentage owner. And I think Starbucks will eventually come back to buybacks. But for now, if Howard thinks this

is the best course of action. I feel like I'm just a Howard Homer here. If Howard thinks this is the best course of action, and to me that suggests more that he is going to be sticking around for a while to guide his baby, I am fine with taking my dividend, seeing what he does, because they're making lots of cash, that's not the issue. The issue is, yeah, let's get this thing righted, and we'll come back to buybacks in a few years. I appreciate you pointing out, because it's true, there are companies that do a very effective job of buybacks, that it is a meaningful way to reward shareholders. This is, and I say this as someone who has owned shares of Starbucks for more than 20 years, this is my least favorite way the company allocates money historically.

And I wouldn't bet against them doing it effectively in the future, but I saw this news this morning. By the way, the stock is down 5% on this news. I'm not entirely sure that move is warranted. In a few minutes, we'll get to another stock moving in the opposite direction that I also wonder if it's really warranted. But when you look at the stock down 5%, I know it's not a huge drop, but I looked at that and I thought, boy, for people who wanted to get shares of Starbucks at a 5% discount, congratulations, today's your day. Yes. It's funny you say that about buybacks, you impugn buybacks in that fashion. Wait a minute. You impugn. I don't think I impugn it. You impugn chastised.

I impugn Starbucks track record with this. With the exception of the investments they've made in food over the year, every other way Starbucks has spent money has been better spent money than the money on buybacks. The food they never get right. Exactly. Look, I quite like buybacks. They are, in some aspects, a more tax-efficient means of returning capital to shareholders, presuming the share count goes down. I can give you a long list of companies where they're blowing every penny of free cash flow, the share count is going up, that's suboptimal. But I note that if you throw out the couple of months in the March of 2020, really the end of

February 2020 to, say, going into May 2020. So, there was something happening in the world at that point, the depths of the COVID initial pandemic panic. You're buying Starbucks at its lowest valuation on an enterprise-valued EBITDA in the past decade. It was about 13 times EV EBITDA heading into today. As you say, it's down 5% already. That's the low over the past decade aside from that chunk of time when the pandemic was spooling up and no one knew what was going on. The other aspect, of course, is that, as I said, I believe the dividends, since they have a history, a track record of raising them annually. They're currently paying $0.49 a quarter. They paid three-quarters of $0.49, so they'll probably pay one more.

Then I would not be surprised by a hike, because they've pretty much, I think they brought out the dividend in 2010 and have pretty much raised every year since. I still think investors will get their take. Like you, I think today's valuation is interesting. It's been a while as I've added to my Starbucks holdings, but I'm on board with this one. An SEC filing shows that Tesla CEO Elon Musk has taken a 9% passive stake in Twitter. This news has sent shares of Twitter up more than 25% today. Before we dig into this, because you did this for me earlier today, for the dozens of listeners, the difference between an SEC filing a passive stake versus an active stake?

It's funny, because I actually recommended a company last week in the service that I run, Hidden Gems Canada, where I had to literally go through this exact differential. So, I'm going to pretty much read from what I wrote. There are two primary types of Form 13s that we will see filed with the SEC. Both denote that the filing party has accumulated at least a 5% stake in the underlying company. That is a level of ownership that is deemed significant enough that it must be disclosed to the public. However, the suffix, the letter suffix is what differentiates. A 13G, as in gold, a 13G, don't impugn it, there's something with gold there. 13G is one that denotes a passive stance. The filing entity is simply

bought and is holding shares that amount to 5% of the total outstanding, but has no designs on control of the company. So, when you see, and I apologize for my dog making noise, when you see, say, like an ETF kingpin-type company like Vanguard or BlackRock, and practically every February they file a 13G or a 13G-A, which is an amendment to a 13G, on practically every large company in America, when you see that it's because they run trillions of dollars in index funds, passive index, the index says thou shalt hold 3% of Starbucks, so they buy 3% of Starbucks. That's what a passive listing is. So, they have no designs on controlling the company. A 13D also signals a 5%-plus position, but comes with added requirements

of disclosure primarily concerning the purpose of the transaction. So, when you see a 13D, as in dog, it's generally an activist or some other interested party looking to force some change, influence the business itself. So, Musk filed a 13-G. So, Musk files this document, says, I've got 9% of Twitter, but it's a passive stake. So, why are all of these other people piling into shares of Twitter? Because I could see it if they thought he's going to write this ship, he's going to push for a subscription business model, this is going to change the business of Twitter. But if it's a passive stake, why is everyone reading into this seemingly that he's going to change the business?

Isn't that the question? Yes. And the problem with that is, did Musk file the wrong filing? Is this a stunt? Is he trying to, like, longtime Fools know I'm not the biggest Elon Musk fan, so I'm going to try to not let that trip over here. But, you know, I think he's going to have to be very careful, because if he is seen, well, he has to be very careful if you believe the SEC will have any teeth to it, which might be another topic. But if he is seen to be engaging in practices that are perceived to be looking to exert control over the business, over the course of the company, then he's filed an incorrect filing and he's going to get slapped for that. He should have

put in the 13-D. I'm a little shocked that his lawyers didn't tell him to put in a 13-D anyway, but then that would send a whole other message. Here's Elon Musk, who is, regardless of my personal feelings about the man. I think he is an absolute master user of Twitter. He is an absolute master of seizing and controlling, creating a narrative. I note with some sarcasm, some sardonic viewpoint, I note that this past weekend, Tesla, Elon Musk's primary vehicle, no pun intended, to talk with the public on, Tesla released their car deliveries for the first quarter, they released those numbers, they were mildly disappointing, and as well as they changed the definition of what they call a delivery. So, are these delivery numbers directly comparable

to a year ago or the prior quarter? We don't know, they changed the verbiage of what defines delivery. I noticed that both of those news stories, which I thought were reasonably things we should be talking about or that people should be looking at, they're both gone, because all people can talk about is Musk buys 9.2% of Twitter. A couple of weeks ago, he was publicly speculating on whether Twitter was a force for good in terms of free speech. He publicly speculated on Twitter about starting his own competing offering, which sure, whatever. As I said, I think Musk is an absolute master at seizing the narrative and defining where the narrative is going to go. And this would be a good example of that. Last thing, and then I'll let you go.

With this move, with shares of Twitter up 27% today, that means that in the past 12 months, shares of Twitter are now down only 22%. Yeah. But I want to go back to Tesla. We can end here. That was another one of my thoughts this morning, that if you're a Twitter shareholder, great, you're having a wonderful day. I'm not a Tesla shareholder. Do you think the average Tesla shareholder is happy about this? Wouldn't they rather he'd be spending more time on Tesla? Yes. The concept of scorecarding, that stock price is the only thing that matters, I think is probably what's driving the average Tesla shareholder right now, because the stock price over the past few years is up substantially. It's not really gone anywhere for much of the last

year, but I think it's an eight or 10 bagger over the past three or four. I am someone who has been both long and short Tesla in the past. I am currently longer today via index funds and look through exposure to Tesla than I've ever been. I suppose I have a vested interest in saying, hey, Tesla, go. I think the average Tesla shareholder looks at the share price and says, yeah, go get them, Elon. I don't think the nuance between a 13G and a 13D filing is entering anybody's thought process aside from poor folks like us who do this for a living. I think it'll be interesting to see what, if Tesla's share price were to, I don't know, drop 50%, I'll just pull a number out of thin air, if Tesla's share price were to drop 50%

over the next quarter, I think that's when you'd see people complaining, oh, he's distracted by Twitter. Until then, I don't think it matters. But I do think this is, we know that he got sanctioned in 2018 for the 420 funding secured thing, which, you know, some folks would consider to be securities fraud. We know he paid a fine, $20 million fine for both himself and on behalf of Twitter for that. He was supposed to have a so-called Twitter sitter, sorry, on behalf of Tesla. He's supposed to have a so-called Twitter sitter to oversee his tweets, which I don't think is the most lenient Twitter sitter in history. We know right now he is currently engaged with the SEC on that prior settlement. I know he's trying to maybe loosen

some of the strings there. And with the scrutiny that he is attracted to himself, I think it's in his best interest to be real careful about his filings and about real careful what he does. So, hopefully, he says nothing about his stake in Twitter, just he has it, okay, it's there. And he says nothing and we hear nothing. And then at that point, you know, got the money. I mean, how about it, man? There's nothing to say, but I hope for the sake of Tesla shareholders that he does that, that he does in good faith, keep it passive, because there's nothing that says he can't do this, that he keeps it passive and Twitter just goes on its merry way and hopefully Twitter then, under the new CEO, starts to make some real progress in monetizing

the business. Because as you say, Chris, until today, you were basically buying Twitter at the IPO price on Friday. Since the IPO was in 2013, I believe, that's not a compliment. Jim Gillies, always great talking to you. Thanks for being here. Thank you. One question investors have had for years about Twitter, Tesla, and Starbucks has to do with just how big their market opportunities are. Social media, electric vehicles, and coffee are about as different a set of businesses as you can find, but the underlying question is both common and important. Take cloud storage, for example. It's a huge market

opportunity, but it can be difficult to figure out how competing businesses are unique from one another. Today, Asit Sharma and Brian Stoffel take a closer look at cloud infrastructure company DigitalOcean through the lens of its competition and how DigitalOcean is serving its customers differently than Amazon Web Services and Microsoft Azure. Okay, Brian. Investors have been hearing for years how competitive the cloud computing and storage market is. But outside of very familiar cloud titans, which seem to completely dominate this industry like Amazon Web Services, Microsoft Azure, Google Cloud, IBM Cloud, Oracle Cloud Infrastructure, you get the picture. Are there any other companies that can even

compete in this space? Well, Asit, I think it depends on what we mean when we say, can they compete in the space? Because there is this market that you don't hear about that often unless you're directly involved in this business. And that is meeting the cloud needs, the cloud infrastructure needs for small and medium-sized businesses. And that's where the company we're talking about today, DigitalOcean, comes in. Now, it's hardly the only player in its field, but what makes this company unique is that they're really geared towards your small and your small companies that need some type of cloud presence, but working with Amazon or Azure just doesn't make sense. And I was a little bit surprised to find out myself. Now I'm a former teacher,

so I've been a teacher and I've worked for the Motley Fool. You don't want me touching your cloud anything. Okay. But when I researched it, what was interesting to me was just how difficult it can be to use AWS and Azure and how it really requires a company to have a team of IT professionals to make it work. Now, obviously your big companies like Netflix uses these guys, they've got the people to do that. So that's not a concern. But if you have like a small startup, say architecture firm, you can't hire five people just to handle your cloud infrastructure because you might be a two or three person organization. And there's a lot more of these two or three person organizations out there than we might think. Add all that together, and that's what

DigitalOcean is after. Yeah, Brian, what's really interesting to me is how DigitalOcean has positioned itself to this extremely crucial segment of cloud purchasers. CEO Yancey Spruill of DigitalOcean was recently talking about the sheer numbers associated with this market in both a recent earnings call and an investors conference. He said that by the end of this decade, there are going to be some 100 million small and medium-sized businesses around the world. And there are, in addition, 50 million individual software developers that are associated with these businesses that will be working on projects by the end of this decade. So, when you take this big group together, what do you think the spend is? It's big. So, the estimates are,

according to Yancey Sproul, that there will be $100 billion spent annually over the next several years just for cloud infrastructure that relates to small and medium-sized businesses. To me, this is almost a niche space, but it's really hard to gain traction. The way that DigitalOcean has gone about this is to just cast a wide net. They've got some 600,000 customers. They got a very wide marketing funnel. You can start with free tutorials on the site and the company will follow you along for years potentially before you maybe join a startup firm and spend the first penny. But having this sort of niche focus and concentration on small startups growing customers is great because it's a space that Amazon Web Services and Microsoft, Azure, Oracle,

et cetera, it's not really profitable for them to touch because it doesn't really move the needle for their huge operations. One last thing I'll say on this point is, Yancey Spruill had a really nice case study example he's been citing. There was a company in Tel Aviv, a startup, just the type you're talking about, Brian. They had eight people. When the company started, they were spending 20 bucks a month. Fast forward eight years, they're spending $170,000 a month. Now, not every customer is going to grow like this, but the idea is to scale with these customers,

even if that spend goes from $10 to $20 a month to the hundreds. You have a nice business here. Yeah, and you know, I like that story, Asit, and the one thing I just want to say with that is it kind of reminds me of Shopify, and here's what I mean by that. I always argued that there's a lot of detractors who said, Shopify has 2 million merchants. Like most of those are just garbage.

And the fact of the matter is that's probably true. But the point is, is they just need to catch the black swan. And what I mean by that is it's almost impossible to know what's the small startup today that's going to be a big, important company organization tomorrow. We might think that we can predict that looking back, but we can't. Because if you could, like you'd be a genius. And so instead, I said, you know, Shopify just needs to cast a wide net, get a whole bunch of potential customers, and then grow alongside them. And in fact, there are three different companies, I know Oatly is one of them, that started their business on Shopify and are now publicly traded companies.

It's the same dynamics with DigitalOcean. And one of the things, Asit, you and I talked about is the company needs to make sure that as those customers get bigger and bigger, that they continue spending on DigitalOcean and don't leave wholesale for Amazon Web Services or Microsoft Azure. Very true. Brian, I wanted to ask you, you know, we've talked about the whales in this industry. Some call them cloud titans. Some call them hyper cloud providers. But DigitalOcean, if it's swimming below those, does it have to worry about any smaller competitors?

Does it have this space all to itself? So, no, it doesn't have this space all to itself, but it still has a unique position. So, for instance, there's one provider, Heroku, that was bought out and is now a subsidiary of Salesforce. And they are more of a high-end service. When you look at the stats for DigitalOcean, they tell you about customer spending, or you can just go on their webpage and look at their

prices. And it's like $5 for this product per month, $10. Like it truly is cheap. And your average revenue per user is below a hundred dollars. So we're talking about some very simple things that people are buying. Um, whereas Heroku, they started about like $250 if you go on their website. So they're, they're tailoring to altogether different ones. The two that stick out to me. One is Linode, which is a subsidiary of Akamai. And then there's another one, Vulture, that's privately owned, that just released that it has about $125 million in annual recurring revenue. To put that in perspective, that puts it at about a quarter the size of Digital Ocean. So Digital Ocean is much bigger. And Linode, we can't really get a beat on how big their

business is because they're a subsidiary of a much larger company and doesn't need to be broken out like that um that being said i still think that we can follow the numbers to see how it's doing and this is not a one winner take all category if it was then microsoft azure and google cloud wouldn't exist because amazon web services had a seven year head start and they still understandably not a knock against them don't have a hundred percent of the market for those enterprise customers you mentioned numbers let's talk about a few numbers and then i've got a couple of big picture questions for both of us. These numbers look pretty decent to me. DigitalOcean is a company that's growing between 30% and 40% on an annualized basis. In the last

quarter that they reported, this was in February, their fourth quarter of 2021, their top line increased about 37% to roughly $120 million. They have, as you mentioned, what they call an annual run rate revenue. It's pretty similar to annualized recurring revenue. of almost half a billion dollars. They are running at a loss, but this company is getting closer and closer to breakeven, negative operating margin of about 8%. Turned cash flow positive this year, and in fact, gross profit has been growing in some quarters at a rate that's faster than the sales acceleration. Improving gross margin profitability. I think this is a company that looks interesting simply because it's not a hyper-growth company that's loss-making.

It's established its niche. It's got some pretty decent metrics when you compare them to other software-as-a-service or platform-as-a-service type companies. The leadership team I should mention, which is not only made up of Yancey Sproul, but Carly Brantz, who's Chief Marketing Officer, came from a company called SendGrid, which this team scaled up and sold to another public company, Twilio. So a lot of elements here of a successful company. But given that, Brian, I wanted to ask you, is this a company that you'd invest in? Why or why not? So right now I don't own shares. I don't plan on owning them anytime soon either, but it's not because there aren't a lot of compelling things going on here. Part of it just has to do with the fact that it's much harder for me to gauge

how wide the moat is around DigitalOcean's business. And that's because I'm not involved in cloud infrastructure. Personally, I don't work on that. It's easier for me to understand the net dollar retention rate of some other tools because I can see why switching would be so hard. But I said, I don't think it's uncommon for us

to hear about a large company switching from, for instance, Azure to AWS. Like that happens. And so I don't know, how big are these switching costs? Is it a real moat or is it not? I will say that their dollar-based net retention has gone up significantly. It used to hover at about 100%, and a lot of people might think 100% for a SaaS company, that's not very good.

But you need to look at this in the same way that we look at a HubSpot. By that, what I mean is HubSpot focuses on companies that have between 2 and 200 or 2 and 2,000 employees, small companies. And if you focus on those, most small companies are going to go out of business. And that's okay. That's no fault of HubSpot, no fault of DigitalOcean. So that keeps that dollar-based net retention much lower.

But it's up over 115% now. That is a really important increase. That's more impressive than what HubSpot's been able to do. And I'll just throw another number that you really want to watch is the average revenue per user. And it's gone up from mid-40s to mid-60s over just the last year. And that, again, is a really impressive increase.

So those are some of the things that I think you need to watch. But again, I'm sitting on the sidelines, not because I don't like the company, but because as an investor, you get to be super picky. There's 4,000 stocks for you to pick from and a portfolio of 20 to 30 is good.

So it's one of those things where you shouldn't knock a company for not being included. Just focus on what is included. Brian, you just sold me on investing in this company, the last couple of minutes talking about their great customer retention metrics, despite the fact that they probably see a lot of churn in that base because of the nature of having small customers. Our investing styles are different in that your portfolio is much more concentrated than mine.

I'm not really ashamed to say this, but I say I have 65 different companies that I invest in. I could see myself taking a small position in DigitalOcean to follow it along, maybe invest some more as they keep growing and the strength of that moat becomes more apparent. This is a company I can definitely consider putting some money behind, maybe not bet the farm here, but I love the fact that it has a solid financial profile. This has been so much fun as always to chat with you and look forward to the next time. Thanks, Asit. That's all for today, but coming up tomorrow, conversation about kids and money. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may

have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow. Thank you.