Growth Underwriter: Marcelo Lima on valuing SaaS businesses


How did the internet fundamentally change business? It's all about zero marginal costs, and playing a different game: blanket the world, capture customers, and only then, monetize them.


Note: This interview originally aired on The Acquirers Podcast on November 15, 2019. Tobias and I discuss a number of topics: Zoom, Slack, Atlassian; Ben Graham's investment in GEICO, in 1948; how GEICO was a disruptive innovator in the Clay Christensen sense; what factors made it so, and how can we identify similar companies today, and much more.


I'm particularly pleased with how it turned out, because a lot of our discussion remains relevant today.


Tobias Carlisle:

So just before we get started, tell me a little bit about Heller House.


Marcelo P. Lima:

We started in 2010. I left college and started out as a software developer for several years. And then I worked in real estate finance and worked at a hedge fund and started the fund in 2010, really, because I wanted to pursue some very specific ideas that I had. Back then it was the aftermath of the great crisis. There were a lot of these Ben Graham-type situations that were very attractive and a lot of them traded in foreign markets. Specifically for us, we found a lot of things in London. And the reason for this is London has a lot of these closed-end funds.


What happened is that on the lead-up to the crisis a lot of promoter hedge funds and investors were raising these closed-end funds to go and buy European real estate or go buy some other type of hard assets. There was even a fund that we invested in that had carbon credits for pollution offset. Some of these were pretty complicated.


The overall theme though, is that after the crisis, after 2008 and 2009, the asset values dramatically collapsed. A lot of these things had leverage, in the case of real estate. You had this double whammy effect: imagine that you have a closed-end fund trading close to NAV, but then all of a sudden the NAV gets destroyed. There's leverage on it. And then the spread widens.


Now it's trading at a 30% discount to a much discounted NAV. And then you lose liquidity. The stock doesn't trade as frequently. There's no sell side coverage because now the sell side can't really make a lot of money promoting these things. And so that created a lot of opportunities in London. We exploited that for several years. When it works out, it works out fantastically.


There's a very strong intellectual appeal to this Ben Graham type of investing. It's very intellectually stimulating because when you can mathematically prove that something is below liquidation value, maybe this building isn't worth what they're say it's worth, maybe it's worth 50% less, but even then it's impossible for me to lose money. I know what the rents are, I know what the market is like, et cetera. On top of that, there were a lot of these situations where these little closed-end funds had their board of directors taken over by a hedge fund and they had put in place a process to liquidate the investments and return cash to investors.


It was in fact liquidating and there was a hard catalyst in place. So that worked out really well. But as the years went by, the drawbacks of this strategy started appearing. These things are obviously pretty illiquid once you get in, but then as they liquidated, they become smaller and smaller and they become even more illiquid. So it's counterintuitive, but as the thesis plays out and becomes sometimes more de-risked, it becomes harder to participate in the opportunity.


Tobias Carlisle:

Just before you get too much further. So your background was software and then real estate financing, did you say?


Marcelo P. Lima:

Yeah.


Tobias Carlisle:

So how do you make the leap to value investment from there?


Marcelo P. Lima:

When I was in the real estate finance job I was trying to raise money for a consumer products company that I had started on the side with a friend. I came across this real estate investor who was doing tremendously well. And he said, hey, come work with us. It's a great opportunity. And that's when I jumped into real estate finance. Well, the first month on the job, I read Warren Buffett's biography.


Tobias Carlisle:

The Lowenstein one?


Marcelo P. Lima:

Exactly. And I completely fell in love with this idea that you could invest in different businesses. You didn't have to be tied to software or consumer products or real estate. You could analyze things and pull the trigger when it made the most sense to do so. I just became a huge Buffett fanatic and learned everything I could first about Ben Graham, and then Buffett. I read all of his letters and started going to Omaha and attending the Value Investing Congress.


In a way that was a very positive experience, obviously because you learn a lot. In another way, if you invert it, it also, I think, crystallizes in your brain a way of thinking that sometimes is hard to break. I'll give you an example. I saw, and this is something we'll get into later, perhaps, but I saw more than one short pitch on Salesforce at the Value Investing Congress. Famous investor goes on stage and says, this company is dramatically overvalued, look, they're losing money. This makes no sense. It's a short.


Of course, now we know that was incredibly wrong. But all of us were nodding and saying, wow, yeah, of course this thesis is right, this guy is so smart. This thesis is airtight and makes a lot of sense.


But we were fundamentally misunderstanding the change that came about with the rise of the internet and the delivery of software as a service. So that is all to say that being in this crowd of value investors and going to Omaha and listening to Buffett is a great education, but it can also perhaps prevent you from having a more open mind and embracing something that's new.


Tobias Carlisle:

Buffett's own style though, has always been more towards finding something that compounds and finding something that's at a very high return on invested capital sustainably. And then you look at the growth of that over an extended period of time and try and buy that at a meaningful discount that you get a margin of safety. So what has software as a service changed to what Buffett had traditionally done?


Marcelo P. Lima:

Well, I wouldn't say that it's software as a service. I would say it's the internet. The internet has created a world where all of a sudden you have something that never existed pre-internet, which is zero marginal costs. I can create a product. Let's say in the pre-internet world, I am Procter & Gamble, and I create a new type of detergent. Because I'm Procter & Gamble, I have my distributors, I have the slots in the supermarkets and I own some shelf space. I own perhaps the end caps, and I can place that new detergent. I can advertise it on television.



And just for the purposes of this discussion, let's be very extreme to make a point. Let's go back to the 1950s. There's like three TV channels, call it. I can advertise that. I have prime time advertising spots. I control all of them because there's only three channels. And I also advertise on radio. I advertise in print and the customer will go to the shop, go to the supermarket, buy the product, have that brand recognition and go home and rinse and repeat. And so the cycle continues.


Now, imagine all of a sudden the internet happens. And we have an explosion in the number of channels available. In fact, the whole concept of channels disappears when you have YouTube and Facebook and Instagram and Twitter, et cetera. The barriers to advertising are no longer there. The concept of primetime advertising to a large extent disappears. A lot of it is programmatic on Facebook and Instagram, et cetera.


Now you have, of course, this theme of software taking over more and more of the goods and services that we consume. Software is eating the world, as Marc Andreessen says. And software can be delivered at zero marginal cost.


Procter & Gamble is a great business. I'm just contrasting it with this new world. The skills that Proctor & Gamble has in terms of controlling distribution and the slots at the supermarket are less and less relevant or valuable perhaps in this new world.


In ecommerce you have infinite shelf space or practically infinite shelf space. And so the winner isn't necessarily the incumbent. Business dramatically changed with the advent of the internet. It's created a lot of dislocation and disruption is a very overused term, but it created a lot of disruption of incumbent businesses. And so I think that's what really changed. It's not something that Buffett was really onto until, until very recently.


Tobias Carlisle:

So how would you characterize something like Microsoft, which existed pre-internet and sold an operating system that locked you in? And they sold that on floppy disks that were virtually costless to them. They had some distribution and they had some minimal cost of producing them. But as any business school student will tell you that the first disc that comes out costs whatever $1 million. And then every disc that comes out after that costs 30 cents or something like that. And that was selling them for hundreds of dollars?


Marcelo P. Lima:

Yeah. That's a great point. And so that was a software as a service pre-internet, if you will. And it's funny that you bring this up in the context of our conversation about Buffett because there's this famous email that I'm a big fan of. I think it's just fascinating. Jeff Raikes, an executive at Microsoft, he also read the Lowenstein biography. This is back in the late nineties. And he wrote Buffett an email and said, hey, Mr. Buffett I just read your biography, and this is how Microsoft is similar to See's Candies. This is how we're similar to Nebraska Furniture Mart. He’s making all of the analogies that Buffett would understand. And he says, “I know you like Coca-Cola, but we at Microsoft have this money printing machine.”



We have all these PCs that have a Microsoft license just coming out of the factory. And he says, look, I'll concede that as far as the long-term moat, it's a little bit cloudier. It's hard to tell whether Microsoft we'll have such a strong moat 10, 20 years from now as Coke will. And Buffett replies to the email and says, look you guessed it, that's exactly how I feel as well as far as the moat. I can predict Coke a lot better than I can predict Microsoft. And what I find very interesting is that right around that time, the volumes for carbonated soft drinks were really starting to fall in the United States and around the world. So consumer tastes were changing dramatically.


Tobias Carlisle:

What were they shifting to?


Marcelo P. Lima:

I think there was this explosion of drink-


Tobias Carlisle:

Bottled water.


Marcelo P. Lima:

Sort of... Yeah, not only that it's funny, I think it was... I forgot his name. It's escaping me now, but the founder of Boston Beer [Editor’s note: Jim Koch]. He was talking recently on a call and he said, look, when I was a kid you had water and Coke and that was it. Now you have kombucha and ice tea and Starbucks. So there's huge variety of drinks that you could go out and purchase. The only thing that we knew is that carbonated soft drink volumes were going down and customers were really seeking alternatives, whether it was water or La Croix or coffee or who knows what else. That traditional advantage that Coca-Cola had was becoming less and less relevant.


It was fascinating because Coca-Cola the company in 2000 was trading at something like 40x earnings which is a very high multiple given the subsequent very low growth that it experienced. Microsoft was also trading at a very high multiple and that stock underperformed for a very long period of time after 2000. But it turns out now with the benefit of hindsight, twenty years later, that Microsoft was indeed a much more prosperous business than either Jeff Raikes from Microsoft or Buffett believed because perhaps they were in very high margin software. They were able to take those cash flows and invest in adjacent businesses like gaming and search. And they're not huge in search, but they do have, I think, 7 billion of revenue from Bing, which is kind of unbelievable, but gaming is a big business for them; all their entire office suite, Microsoft Azure, their cloud offering, of course is growing dramatically now.


It turned out to be a much better bet than Buffett believed. And I find that kind of fascinating. So to answer your question, the internet accelerated that process of delivering software at very low marginal costs. Whereas the marginal cost was a floppy disk back then, all of a sudden it was just the cost of transmitting the bits over the internet.


Tobias Carlisle:

So one of the companies that we were discussing before we came on air: Zoom. So would you like to just tell us a little bit about Zoom and then I just want to use that as a way that we can discuss software as a service?


Marcelo P. Lima:

Yeah. So what's fascinating is... And this ties into a broader discussion of disruption and what it is, but a company like Zoom, I think it helps if we talk a little bit about disruption, but the traditional theory of disruption envisioned by Clay Christensen is a theory that involves a new startup company attacking an incumbent at the very low-end. It's typically a low-end offering; it's a lower margin offering. It's attacking customers that the incumbent doesn't necessarily care about because they are so low margin.


Tobias Carlisle:

What would be an example of that?


Marcelo P. Lima:

The classical example that Clay Christensen uses in his book, back then he talks about hard disk drive makers and backhoe excavators. A more recent example, I think, is Netflix, which everyone in the audience will be familiar with. Netflix, when it started out mailing DVDs, it was in many ways an inferior experience. You didn't have that instant gratification of going to the Blockbuster store and getting the tape that you wanted. In some ways it was superior because you could have this long tail of the catalog available to you but –


Tobias Carlisle:

And also you didn't have time to go to the store.


Marcelo P. Lima:

You also didn't have to go to the store. You did have to wait though. You’d have to wait for the thing to arrive in the mail. I remember clearly when Netflix started offering streaming, it was horrible. It was low resolution. It was choppy because the bandwidth wasn't really there. It was clearly an inferior experience, but for a certain cohort of customers, it was good enough. And Netflix moved up market, so to speak and started improving their offering and then eventually started creating their own original shows and bypassing completely the existing value chain of the movie industry, which means not showing movies in movie theaters, going direct to consumer, et cetera.


By virtue of being effectively a software as a service offering, not in the traditional enterprise sense, but software delivered over the internet, they could then expand globally at a very rapid clip. So that's an interesting example of that. Now, there are other examples that do not fit the Clay Christensen definition, like Uber. And so Clay Christensen came out and said, look, Uber is not disruptive. And the reason it's not disruptive is they didn’t come in and offer an inferior service at a cheaper price and then moved up market. In fact, Uber started at the high-end. It was a replacement for black cars in San Francisco, the very expensive high-end.


Tobias Carlisle:

That was the original pitch for Uber, that it would be a way to call a limousine ride. There's that very famous deck that floats around. But most people probably became aware of Uber when it was in fact, that's probably not a bad description of it, it was a low-end, you got into somebody else's car, you didn't get into a taxi and it costs less. And that was kind of the idea.


Marcelo P. Lima:

Exactly. So, so even though Clay Christensen claims that Uber is not disruptive because of the way it began, the aftermath looks very much like disruption because to your point, they use the same technology that they developed for the high-end, meaning, the app, the routing technology, and this idea of matching riders and drivers. They were able to segment that across the low-end as well. Now they have a number of offerings; all sorts of things between low-end and high-end. And that's the difference. Now, when you have the internet, you're actually able to serve everyone because your marginal cost is essentially zero.


And so bringing the discussion back to Zoom. Let's think of a pre-internet business, if I'm delivering a conferencing service without the internet, hard to imagine what that looks like, but and I'm offering it to enterprise customers. They're paying a lot of money for me to offer these services. I'm leaving the low-end open for a worse offering at a lower price. I'm leaving myself open to disruption there by a low-end provider.


What Zoom can do is they can just make it free for customers who don't want to pay. As we were discussing prior to this call, anybody can go on zoom.com, sign up and start using their conferencing services for free. There's a time limit and there's obviously a lot of features that you don't get, but it's good enough. That prevents them, in theory, from being disrupted by a low low-end attacker. Then what they can do is they can build all the features necessary and requested by their most demanding customers as well. So they can serve everyone. And in fact, that's what they're doing. Of course, Zoom is just a toy model that we're using here. This applies to a lot of these enterprise SaaS companies.


Tobias Carlisle:

There are existing conference lines, though, for example, we're using Skype, which is a competitor to Zoom. And if you search free conference calling on the internet, you can find any number of free alternatives. So why would somebody shift from Skype or from a free alternative to Zoom?


Marcelo P. Lima:

Yeah, that's a great question. It's funny because a lot of these companies have a lot of competition. It's also the case for Salesforce. The space for a customer relationship management software is incredibly crowded and yet the company continues to do very well. What I think is the case, the companies that are very well managed, they have this tremendous focus on customer pain points. What is it that our customers are looking to do? What is it that's difficult for them to do with these other offerings and how can we make it easy for them? How can we remove friction and just make the experience better and better all the time, and build additional features that promote lock-in?


Zoom has this network effect, which of course Skype does as well. But if I am a large enterprise and I have now developed all these Zoom rooms so with all the hardware there, and I have my transcription, that's built in, and I've got Zoom, if I have multiple people on the call, Zoom will automatically focus on whoever's speaking. So if you're constantly focused on building these features it becomes harder and harder for somebody to switch out. And conversely, if you're, let's say, a Skype customer you're not going to have all that functionality. So as you become a larger enterprise, you might have HIPAA compliance or whatever type of capability that you need as an enterprise customer, that you might not be suited any longer to stay with a Skype offering.


Tobias Carlisle:

Zoom does have that potential to get those network effects. And I think that that's probably been Skyped saving grace, even though the product probably hasn't advanced much. And it is reasonably difficult to use still, almost everybody has a Skype number, and you can contact almost everybody on Skype, but what about something like Netflix? Where do you see Netflix as a competitive advantage?


Marcelo P. Lima:

Netflix has this incredible focus. I think part of the competitive advantage of these companies is the fact that they are a founder-led and they have earned the right to make these very tough decisions and steer the company in certain directions. And we see that very clearly today with Facebook, for example.


By the way, for the folks who are listening to this who are familiar with Tom Russo: Tom Russo likes to talk about... Tom Russo is a famous value investor. He's been running a very successful value portfolio for, I don't know, 30 years. And he likes to talk about the capacity to suffer and how family-owned businesses have this ability to burden the income statement today in order to reap the rewards tomorrow.


When you look at SaaS or something like Netflix, it very much looks like that. Netflix is famously losing money, however you cut it from a cash flow perspective or an earnings perspective, but they're playing a different game: they're playing this game of conquering the world and garnering those customers all around the world and having the largest audience because once they have the largest audience, they can then spend more money on content.


If I spend 15 billion, which I think is what they're spending this year in content, I can spread it across many more subscribers: 140 million subscribers. Whereas my competitors who are starting now, a lot of them are starting from zero. How can you stomach that type of content spend, if you have effectively zero customers to spread that content over?


Reed Hastings saw this very early on and he played out the chess in his mind and said, look, if that's the end game, then I just have to be as aggressive as possible in acquiring customers. That was the game that they were able to play in a nutshell. Their competitive advantage I think is really their strategy and their ability to pursue that strategy, which a lot of competitors don't have.


Tobias Carlisle:

How would you contrast them to something like a Disney offering?


Marcelo P. Lima:

Now, that's a question a lot of people's minds is what's going to happen to Netflix when Disney+ starts, I think next month in November. And I tend to believe that this is going to be complimentary and not really a substitution. I think there might be some substitution, let's say a family is subscribing to Netflix and might churn out and just subscribe to Disney+. But I feel that in the overwhelming case it'll be complimentary. In other words, people will add Disney+ to their Netflix subscription and not really substitute because Netflix still has an extremely large catalog. It's got completely different types of offerings in terms of the titles that they are willing to fund. Disney's going to be more likely a more family-oriented offering.


I think it's brilliant for Disney. It's about time that they did something like this. I've already signed up. I got the deal where you can pay a huge discount for three years. So I'm very excited for that, but personally, I won’t be canceling my Netflix subscription because I feel that it's something that I'll need to have as well.


Tobias Carlisle:

In order to compete in this new world, it sounds like you need to be a content producer, and it's not quite like being a cable company, which had to punch into your house and had the connection there. And If you're in various parts of the states, you have one cable company in your area and they basically charge you whatever they want. And there's nothing you can do about it. Whereas for Netflix, it's just a tile on your Apple TV. And if you look through the tiles that are available there are a lot there. And basically, I think that what people tend to do is they have a show that they like. So Game of Thrones, for example, means that you need an HBO subscription. Once Game of Thrones goes away, HBO’s offering looks a lot weaker, and I'm sure that there are a lot of people thinking about churning off. Netflix needs to have that killer show, doesn't it? Or is it always going to be the bargain bin of you just going to scroll for 45 minutes? Maybe you find something you like, maybe you don't, what do you think?


Marcelo P. Lima:

Yeah, look, and I want to be clear. We do own Netflix. It's a quite small position for us. So it's not something that I am pounding the table on, et cetera. I'm a big believer in the company long-term. And if you do the math I believe that the company can be extremely profitable in the future. Having said that, there are challenges, which you just outlined, what I think is the case is that Netflix has to have two things. One, it has to have filler content, which is the content that you described as just flipping through the catalog and being on a couch and vegging out and watching Friends or Seinfeld or whatever the case may be. But then it also needs to have that big attraction.


Stranger Things, or Game of Thrones in the case of HBO, something that will give people that must-watch content, which is the strategy that HBO or Showtime have been very successful with. We'll see how that plays out. I think that Netflix is doing a very good job with its local content. Things in India and in Brazil and Germany have been extremely successful in other countries.