Dropshipping Business Notes

  • Are Dropship Businesses Amazon's Achilles Heel?

    This changed briefly last month, when a consortium of private-equity firms announced an acquisition of CommerceHub Inc. for $1.1B. Commercehub gives businesses a core [dropship malaysia](https://www.chinabrands.com) solution that allows the outsourcing of the burden of shipping and warehousing. Commercehub achieves infrastructural economies of scale not feasible for smaller retailers, and passes these cost savings onto its customers. \n\nThe oft-mentioned decline of retail has served as a tailwind for the dropship business, as struggling retailers realize they must achieve at scale shipping and handling cost savings that are not achievable independently. Commercehub not only benefits from the decline of traditional brick and mortar sales, but also from the dovetail of the paired rise of ecommerce.\n\nMark Walker of Seven Pillars Capital presciently submitted a long on the stock to SumZero March 5th, the day before the acquisition.\n\nLuke Schiefelbein, SumZero: What about CommerceHub initially caught your eye as a value investor? What catalyzed your entrance into the position?\n\nMark Walker, Seven Pillars Capital: We are attracted to companies that enjoy genuinely interactive network effects. As the number of network participants on a platform increases arithmetically, the number of interactions between them increases geometrically, creating switching costs through the higher per-user utility of the platform. This can lead to winner-take-most outcomes, creating assets which are extremely difficult to replicate and, with appropriate managerial nurturing, can lead to tremendous economic value creation.\n\nIn our view CommerceHub’s software as a service ecommerce solution has these attributes. CommerceHub enables retailers to sell a broad selection of products without the cost of buying, storing and shipping inventory by leveraging a network of 10 thousand ‘dropship’-capable suppliers. The platform is mature enough to provide assurance as to the clear benefits to retailers and suppliers, but there is still clearly significant scope for growing the platform with minimal capital requirements, widening the moat with each new customer win. Retailers and their end customers benefit from dropshipping in two ways: (1) wider product assortment and (2) lower inventory warehousing and distribution costs and faster delivery times. This potentially helps ecommerce businesses to compete more effectively with Amazon. Legacy software that dealt with point-to-point connections between retailers and suppliers is not well suited for a dropshipping model, as access to real time supplier inventory is required. CommerceHub onboards suppliers in a few weeks, vs. months spent by retailers manually onboarding suppliers under a legacy supply chain model.\n\nCommerceHub’s network is a hub model that replaces the requirement for multiple point-to-point connections between retailers and suppliers. Customer acquisition cost requirements are far lower than typical SaaS business models; CommerceHub acquires the retailers, who then bring their suppliers onto the platform. CommerceHub does not acquire suppliers, but it generates revenue from them.\n\nThe business seems to have a fairly reliable low cost growth opportunity. The total addressable market should expand as ecommerce penetration grows from a low base. US ecommerce has grown from $5bn to $400bn over the last 20 years, yet ecommerce remains less than 10% of total retail sales. Faced with the prospect of expanding SKUs from 100 thousand per store to one million via a website, dropshipping may entice retailers to accelerate the transition online and accelerate the pace of ecommerce penetration growth.\n\nWe initially looked at the business in September 2017. Our conclusion at that time was that this was a very high quality business with a compelling emerging moat, especially the core [dropship clothing](https://www.chinabrands.com/category/dropship-women-s-clothing-c-1.html) solution, which enjoys strong and growing network effects, likely long runway for growth and negligible capital requirements given CommerceHub’s low customer acquisition costs. However, despite poor sellside coverage, at $22.5 the valuation seemed to incorporate these qualities.\n\nAdjusted EBITDA margin as reported by the company was 38%. Removing $11mn of stock based compensation lowered this to 26%, a level we felt underestimated the normal profitability of the business as the CommerceHub for Brands initiative was loss making but generated 10-12% of revenues. The magnitude of losses were not disclosed but core dropship incremental margins are likely to be high given the platform business model and low customer acquisition costs. On an estimated steady state EBITDA of c.$30mn the stock traded at 30x EV/EBITDA. We estimated that the market cap of c.$900mn at that time was c.35x FCF.\n\nCommerceHub didn’t strike us as a business whose normal steady state or maintenance FCF was depressed due to material capital redeployment, as growth is inexpensive by virtue of the network effects. So as great a business as it was, we felt at that time that very high business quality and growth prospects were broadly reflected in a market price that implied an enterprise value 9x revenues and a <3% FCF yield. We seek investments in companies which can earn sustainably high economic returns on capital investments, can reinvest substantially all of these profits into positive NPV projects, and which are trading at a modest multiple of current intrinsic value. An entry point of closer c.25x FCF would provide a downside scenario in which we would have a good chance of making positive annual return; this was one third lower than the quoted market cap at that time.\n\nGiven the nature of CommerceHub’s retailer customers we also felt that it might be worth waiting for some customer loss, retail slump or other road bump that might create an opportunity to invest at a more modest multiple of current intrinsic value. Fast forward to March 2018 and the market offered just such an opportunity. CommerceHub reported impressive FY17 results; customer and revenue growth had increased in the mid-teens and FCF generation had materially positively inflected. But the stock was down as much as 15% because of an undisclosed customer loss in the fourth quarter and exposure to the Toys R Us store closures. The depth of our research on the name six months prior allowed us to do a quick back of the envelope calculation: trailing 12 month FCF was $36mn. Adjusting for our post-tax stock based compensation estimate of $7mn, this was $29mn. Post the sell off the quoted market cap of $730mn was 25x this number, creating the entry point at which we felt the odds of achieving a satisfactory investment result were weighted in our favour.\n\n

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