How well do you know luxury goods?

LVMH is one of the biggest luxury brand in the world. Under its stable, you’ll find the likes of Louis Vuitton, Rimowa, Loro Piana, DFS and Sephora. In 2016, it had annual sales of €37.6bn and as I write this its market cap stood at €122bn.

Today, I came across its 3Q results and it was interesting.

To see if you know luxury as well as you thought, take the following quiz. The answers are posted after the various photos. Don’t peak.

1. Which region contributes the most to LVMH’s revenues through the first nine months of 2017?

  • A) Asia,
  • B) Europe,
  • C) US,
  • D) Others

2. Which region had the strongest revenue growth rate in 3Q 2017?

  • A) Asia ex Japan,
  • B) Japan,
  • C) Europe and
  • D) US

3. Rank the revenue contribution by product segment from largest to smallest?

  • A) Wine and Spirits,
  • B) Fashion and Leather Goods,
  • C) Perfume and Cosmetics,
  • D) Watches and Jewellery and
  • E) Selective Retailing (i.e. DFS and Sephora)

4. Among the various product segments, which one recorded the strongest revenue growth in 9M 2017?

  • A) Wine and Spirits,
  • B) Fashion and Leather Goods,
  • C) Perfume and Cosmetics,
  • D) Watches and Jewellery and
  • E) Selective Retailing (i.e. DFS and Sephora)
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Which region contributes the most to LVMH’s revenues through the first nine months of 2017?

  • The answer is Asia. Combining Asia ex-Japan (29%) and Japan (7%), Asia contributed 36% to LVMH’s overall revenues in 9M 2017. Europe was the second largest region with 27% of sales (9% France and 18% Europe ex-France). The US was the third largest region at 25%.

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Which region had the strongest revenue growth rate in 3Q 2017?

  • The surprising answer was Japan and Asia ex-Japan. Both regions saw top line sales growth of 21% in 3Q 2017. For the year-to-date, Asia ex-Japan was still stronger at 19% while Japan is only at 11%. However, given all the talk about Japan still struggling with its lost decades, a 21% YoY growth was most unexpected.

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Rank the revenue contribution by product segment from largest to smallest?

  • This question should be the easiest one. I’m pretty sure that 90% of you knew that Fashion and Leather Goods would be the biggest category (at 35.5%) but how many knew that Selective Retailing (i.e. DFS and Sephora, etc) would be the second largest category at 30.6%. Perfume and Cosmetics was third at 13.3% while the Moet-Hennessy part of LVMH was only fourth largest at 11.5% of revenues. Watches and Jewellery was the smallest segment at 9.1%.

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Among the various product segments, which one recorded the strongest revenue growth in 9M 2017?

For the first nine months of 2017, LVMH’s largest segment was also its fastest growing. The Fashion and Leather Goods segment (35.5% of sales) grew 14% YoY in 9M 2017. AS Perfume and Cosmetics also grew 14% (with 17% YoY growth in 3Q 2017), this suggest that luxury branding is very strong. On the flip side, although wine and spirits grew 8% YoY, 3Q growth of 4% YoY made it the slowest growing segment in the group.

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Key Takeaways – Japan and Asia might be getting its Mojo back

As a generalist data point gatherer, the most interesting takeaways were:

1) The very strong performance out of Japan and Asia ex-Japan. Japan was supposed to be struggling to show inflation while Asia was supposed to be still dealing with the anti-corruption curbs. For both regions to show 21% YoY growth in 3Q and 11% and 19% YoY growth in 9M 2017 suggest that Asian consumers seems to have found their mojo and are back to their happy spending ways.

2) Branding remains effective. Usually with the law of the large numbers, as sales reach a certain critical mass, growth would inevitably slow. However, in the case of LVMH, although Fashion and Leather Goods is its largest segment at 35.5%, it growth has remained the strongest among the categories. Further, as many perfumes and cosmetics are branded along the same lines, the strong growth in those two categories suggest that consumers still love the luxury brands.

On point 1), if Japanese and Asian consumers have indeed gotten their mojo back, then the recent catch up of Japanese equities might have more room to go.

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Source: Yahoo Finance

 

 

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Mass Consumption Part 6B – How do you build the FedEx of China?

Last week, we discussed the economics of China’s express delivery industry. This week, we review their balance sheet to gauge who is likely to become the next UPS/FedEx of China.

Last week we discussed China’s rising express delivery market and how it has grown together with China’s massive online retailers. As a quick recap, in 2016, online retail sales made up 14.30% of China’s overall retail sales and for the express delivery industry, it delivered 27.9bn parcels and generated overall revenues of US$59.8bn.  chart (29)

With China’s express delivery market expected to double in the next five years, everyone is vying to become the UPS or FedEx of China.

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When we reviewed the economics of China’s top express delivery companies and compared their margins and profitability to the top US operators like UPS and FedEx, we came away with mixed feelings (see full discussion here). While we were very positive about the express delivery market’s overall growth, we are concerned that competition from new operators vying for market share would compress margins.

Crunching the balance sheet

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After having some time to digest our initial thoughts, we are still scratching our heads. Something is missing. Why is there such a big divergence in valuation?

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One could argue that the high PE ratio of SF Express and Best (net loss) was because of companies sacrificing near-term earnings for long-term market share. But in order to emerge from this fight, you need to either have (1) strong underlying cash flow or (2) a strong balance sheet to sustain you for the long haul.

A look at another conventional valuation metric, price-to-book, shows an even greater divergence. To me, the 3.1x-7.0x price-to-book ratio that ZTO, FedEx, STO and YTO are trading at would be within my range of expectations. But what about UPS at 81.6x and SF Express at 11.3x PB?

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Although labour costs is a major component of the express business but there are also a lot of hard assets as well. What about the trucks, the planes, the computer systems, the conveyor belts, not to mention the drones?

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PPE make up 50% of US express company assets and only 13-28% for China

This is where we see one of the big differences between the US and China express companies. For UPS and FedEx, property, plant and equipment (PPE) was the largest component of their assets. Even after accumulated deprecation, PPE still made up around 50% of UPS and FedEx’s total assets. For the Chinese express companies, SF, ZTO and YTO have PPE around 26-28%. Best and STO’s PPE are only 13-15% of assets.

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Since some companies sometimes classify their software as intangible assets, we further consider intangible assets and goodwill. Again, we see that UPS and FedEx are fairly close with intangible and goodwill making up around 14% of assets. Grouping PPE and intangibles together, we see that these make up around 65% of the US express companies’ asset base.

Need to buy more trucks and build more sorting facilities

For the China express companies, SF, ZTO and YTO are hovering around 39-45% but STO and Best are only around 20-22%. This suggest to me that if these companies want to institutionalize their business and expand their market share, more investments and capex is needed. They must buy more trucks, more planes, build more sorting facilities and build out their logistics network.

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On this basis, it is no surprise that SF Express and YTO have higher PPE and intangible assets. Their revenues have already started to scale.

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Capital structures reflect the early stages of investment

For the China express sector, one silver lining is that they appear to have anticipated this need and have already tapped the capital markets. As of June 2017, four of the five China express companies are sitting on net cash. Although SF Express had US$73mn net debt, its 2% net-debt-to-equity ratio suggest there is lots of scope for it to borrow.chart (42)

In comparison, given the relative maturity of FedEx and UPS business, their capital structure is optimised to boost ROEs.

Incumbents best positioned to become China’s UPS/FedEx

If we apply the filter of (1) normalised margins and (2) high PPE-intangibles, this would suggest that the two largest incumbent operators, SF Express and YTO, best resemble FedEx and UPS. That said, one would still have to decide whether the current PE ratios of 52.8x and 37.2x is too high a price to pay for that potential future.

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Mass Consumption Part 6 – Getting your online purchases from Point A to Point B

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Online shopping. This is the trend behind massive internet companies like Alibaba and Amazon. The picture above is from last year’s “Singles’ Day” sales event where Alibaba pulled in Rmb120.7bn of online sales just within 24 hours on November 11, 2016.

But behind the glamour of online shopping, there is a less glamorous but equally important service that drives this mega trend – express delivery. I have often wondered how the heck do they manage to ship goods so quickly. Didn’t I just click confirm payment yesterday and bam the goods are already at my home.

Here is a picture of how it happens.

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China’s e-commerce expected to rise from US$2.8trn in 2016 to US$5.9trn in 2021

According to iResearch, the gross merchandise value (GMV) of China’s e-commerce market has increased 3x from US$988bn in 2011 to US$2,825bn in 2016. In the next five years, it expects the GMV of China’s e-commerce market to double to US$5,785bn by 2021.

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Source: iResearch.

In terms of online penetration, online retail sales now account for 14.3% of China’s overall retail sales, a higher penetration rate than the 11.7% in the US.

chart (27)

Logistics and shipping are the new landlords

Intuitively, we know the draw of online shopping, namely, cheaper goods and greater convenience. But why are goods cheaper? One big reason is the removal of rental costs from the retail equation.

A while back, I came across an interesting illustration in the WSJ. Using a pair of US$150 jeans as example, the offline “bricks-and-mortar” retail sales would net US$24 after the various operating expenses, a net margin of 16%. By comparison, through the online sales channel, the residual profit is almost double that at US$45, or a 30% margin

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What was interesting in the illustration was where the two channels differ. As you can see from the above, there is no difference in Cost of Goods Sold and there is also no difference in Marketing expenses. Although there is no “Store Payroll” in the online sales channel, one could argue that the software maintenance operating costs is almost the same. Similarly, freight to retail store has been replaced by warehouse/fulfilment.

The key difference is Rent and other retail operating costs being replaced by free standards shipping and return. In the traditional model, rent accounted for 15% of sales and other retail operating costs made up 8%. In the online model, free shipping and return make up 7%.

What this cost comparison suggest to me is that in the new online environment, the shipping and logistics companies are the new landlords in the virtual distribution channel.

China Express Delivery Market – 27.9bn parcels and US$59.8bn

While China’s e-commerce has tripled in size over the past five years, its express delivery market has grown even faster. The number of parcels delivered has increased 7.5x from 3.7bn in 2011 to 27.9bn in 2016.chart (29)

In dollar value, China’s express delivery market has quintupled from US$12bn to US$59.8bn in 2016. According to iResearch, in the next five years, the number of parcels are expected to double, reaching 60bn parcels and US$124.5bn by 2020. Although these numbers may seem big, they are actually quite conservative if one were to consider that FedEx and UPS each generated revenues in excess of US$60bn last year.

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Business model – Network Partner Vs. Direct Model

Unlike the US where express delivery is dominated by two players (FedEx and UPS), China’s express delivery market is more fragmented.

China’s express delivery companies tend to follow one of two business models, namely the network partner model or the direct model.

  • Under the direct model, the likes of SF Express and EMS (related to China post) manage the entire delivery channel from parcel collection to sorting to transportation to delivery.
  • Under the network partner model, companies like ZTO, YTO, STO and Yuanda only manage the centralise sorting and transportation. The last mile pick-up and delivery is left to smaller local network partners to handle.

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Growing pie but profitability being squeezed by rising competition

Looking at the financials released by five express delivery operators, the pie is clearly growing. Among the likes of SF Express, YTO, ZTO, STO and Best, their collective revenue increased by 29.7% in 2016 to Rmb103bn and in the 1H of 2017, their revenues has grown another 30.6% to Rmb60bn.

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Among these five operators, SF Express is the clear leader. In 1H 2017, SF Express earned Rmb32.2bn revenue, giving it a 54% market share among these five operators. YTO Express was the second largest revenue earner at Rmb8.2bn with Best Inc a close number three at Rmb8.1bn.

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As with most things in China, if there is money to be made, competition will sniff it out. When we compare 1H 2017 revenue growth with 2016, only SF Express and Best Inc were able to accelerate sales growth. It is clear that Best Inc’s market share gain is coming at the expense of the other operators.

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More worrying is the manner by which Best Inc is going after market share. In 2016, Best Inc’s gross margin was -6%, some 25pp lower than SF Express’s 19% gross margin.

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With competition aggressively going after top line growth, profitability has suffered with four of the five operators showing a decline in 1H 2017 gross and net profit margins.

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The other key notable from the above gross and net margin chart is the dispersion among operators. Gross margins range from ZTO’s 33% to Best’s -0.6%.

Comparison to FedEx and UPS

In order to gauge what longer term sustainable margins may be like, we turn to the US operators. As we alluded to earlier, FedEx and UPS generated revenues of US$60.3bn and US$60.9bn in their last financial year. This is roughly 7x larger than SF Express’ US$8.6bn 2016 revenues. From a market capitalisation perspective, UPS is nearly 72% larger than FedEx and 2.86x the size of SF Express.  chart (37)

From a profitability perspective, in their last financial year, UPS and FedEx recorded operating margin around 8.3%-9.0% and net margin around 5.0-5.6%. Among the Chinese operators, SF Express and YTO Express’ margins most resemble the US operators. SF Express had operating margin of 6.8% and net margin of 7.2% (it had some non-operating gains) while YTO Express generated operating and net margin of 10% and 8.1% respectively.

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China express sector – Strong sales growth but margins likely to compress further

Based on the, we would come away with the following initial impressions:

  • (1) Strong top line growth for China’s express operator – China’s top express delivery operator, SF Express, currently only generate sales that is one-seventh that of UPS and FedEx. Given the expected rise of China’s overall economy and e-commerce, there should be ample runaway before China’s express delivery sector’s growth peaks.
  • (2) Margins likely to come down – Normally, in a fragmented market, one would expect strong competition and low margins to be the norm. However, in this case, China’s express delivery sector margins are much higher than the US duopoly. As new operators vie for a piece of the express action, margins are likely to come down. Among China’s express operators, only the two larger operators of SF Express and YTO Express have margins that resemble those of the mature US operators.

 

 

Happy Anniversary – Make time to celebrate your success

Over the weekend, I was at my son’s basketball lesson. It’s just something to help the kids learn about the game, work on some drills and have some fun. At the end of each class, the coaches give out a medal for the game’s MVP. Sometimes, this recognises the most skilful player but more often than not, it recognises the child that has worked the hardest and demonstrated the best attitude.

Well, this past weekend, my son got the MVP. I was super excited for him and I couldn’t wait to give him a high five but I noticed that he looked a bit odd. I think he wasn’t used to the attention. We talked afterwards and discussed that it is important to celebrate our success. When you or your teammate score a basket, give each other a high five or a pat on the back, you guys deserve it.

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As I thought about this scene over the weekend, it occurred to me that in our daily lives, we don’t celebrate our successes often enough.

While we frequently conduct post-mortem reviews of things that have gone wrong in order to guard against future mistakes, we don’t celebrate enough. We worry that complacency may set in and we move on too quickly from our successes.

With that in mind, I am giving myself a quite pat on the back.

Happy Six Month Anniversary

Six months ago, I wrote my first blog here. It was a short piece entitled “For better or for worse“. Here are some key stats since that first post.

  • Published 33 articles in total
  • By category, I have written the most on the “Postcard” and “Mass consumption” topics, both with five notes each
  • The most popular post so far has been our “Postcard from London” followed by “Going once, going twice, SOLD“.
  • Our readership is mostly from Hong Kong but I also appreciate the one page view from Madagascar.

Thank you to all those who have Like’d the various articles. Looking ahead, I will try to schedule posts at more regular times, say every Thursday or Friday.

Until the next random idea. Here are two quotes that I like on celebrating successes

Celebrate your success, find some humour in your failures – Sam Walton

The more you praise and celebrate your life, the more there is in life to celebrate – Oprah Winfrey

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Postcards from the car dealer – how the middleman makes money in the internet age

We are selling our seven-seater. With the internet and the various online marketplace, selling your used car should be a cinch, right? While the internet has greatly boosted transparency in the used car market, is there still a role for the middleman? The answer is Yes. From talking with the middleman, I reckon the internet has reduced his margin from 22% to only 4%-10%.

I’m selling my car. We have been debating for some time whether we still needed our seven-seater. That’s the back story but what I really wanted to share about was the selling process. Specifically, how the economics for the middle man has changed as everything now goes online.

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Everything’s online, is there still a role for the middle man?

I am not an expert on cars but even I know that trading in your car to the dealer gets you worst price when you are trying to sell your car.

With the proliferation of online marketplaces, there are now many car trading sites. Positively, these have really increased the transparency of the used car market. Once you key in the make and model year, the search results will give you a pretty good idea how much your car should go for.

In my case, my 7-seater should go for something between HK$198,000 to HK$258,000. Armed with that information, I posted my ad near the top of the range. Our car was well maintained, the mileage was a bit on the high side but I also expected a bit of bargaining.

And so I waited. A few days passed. There were no bites except for one joker who wanted to barter and exchange his RAV4 for my car. Nope.

“Are you a private seller or a car dealer?”

I guessed that my price was too high and lowered the price to the middle of the advertised range. This seems to do the trick. My phone started ringing and people called to get more details. One question that always came up was whether I was a private seller or a car dealer. Most people seemed to be wary of car dealers, fearing that they would mess around with rolling back the mileage or other funny business.

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After much back and forth, a serious buyer emerged. As it turned out, the caller works for a garage and is reaching out on behalf of a prospective buyer. In other words, he was a middle-man. To make a long story short, I brought my car to his garage, he checked it out, done deal.

The Economics of the Middleman

But during the process, he was kind enough to share with me his economics.

Here are the headline numbers.

  • I sold my car to the middleman for HK$218,000 ($10,000 lower than my list price).
  • The prospective buyer is going to pay him HK$250,000.
  • At the headline level, the middleman’s take is HK$32,000 or 12.8%.

However, as they need to redo the leather seats and put on some new tires, this costs of HK$13,200 is part of the HK$250,000 that the prospective buyer is paying for. Taking a 50% haircut on this number, I reckon the middleman’s margin is actually closer to HK$25,400 (HK$32,000 less HK$6,600) or 10.2%.

There’s more. Since the prospective buyer is trading in his 2007 sedan, the middleman is offering him a trade-in value of HK$40,000. According to the middleman, if the prospective buyer did not agree to buy my 7-seater, the price would have been HK$20,000. The middleman expects to sell the 2007 sedan for HK$25,000-35,000.

So, if you factor in middle man’s effective HK$5,000-15,000 loss on the 2007 sedan, the middleman’s real margin would have been reduced from HK$25,400 to something around HK$10,400 to HK$19,400 (a margin of only 4.2% or 7.8%).

At this point, we want to ask a couple of questions:

  • Did I sell my car for too cheap?
  • Why didn’t the prospective buyer approach me directly?

Did I sell my car for too cheap?

On the surface, it would seem that way since the prospective buyer was willing to pay HK$243,400 (HK$250,000 price less HK$6,600 for leather seats/tires). However, in the old days before the internet, the dealers would probably have lifted my car for HK$190,000.

Takeaway #1 – The internet has reduced the middleman’s margin reduced from 22% to 10.4%

So the first takeaway here is that the increased transparency of the internet has reduced the bid-ask spread. Whereas, before the middleman’s margin would have been HK$53,400 (HK$243,400 – HK$190,000), this has now been reduced to HK$25,400 (HK$243,400 – HK$218,000). In margin terms, the online market place has brought down the middleman’s margin from 22% to 10.4%.

Why didn’t the prospective buyer approach me directly?

But why does the middleman still exist? Shouldn’t the online marketplace had connected buyers and sellers directly? If the prospective buyer had approached me directly, we could have split the bid-ask spread and we would both be better off.

I think it has to do with information asymmetry. As the seller, I know that my 7-seater is in perfectly good condition. But from the buyer’s perspective, he cannot tell whether my car is pristine or has suffered serious water damage.

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To guard against being cheated, the buyer needs professional help from someone who he can trust. This is where the middle man comes in. Not only does the middle man help to vet the car’s condition, he also provides the prospective buyer with some recourse. If things go badly, there is a least a store front (in this case a garage) that he can go to protest.

Takeaway #2 – Information asymmetry and recourse sustains the middleman – for now

But what about me, the seller? I suppose if I have more time and more patience to deal with the various callers, I could have waited until the right price came along. However, for the service of matching me up against the buyer, the middleman’s fair wages is now 4-10%.

I suppose it is possible for someone to AirBnB or Uber this type of service but given that most people only change cars every five to seven years, there probably isn’t the volume to scale this business.

As a side note, the middleman also explained why a professional dealer would low ball at HK$190,000. The answer is rent. At the used car exhibition centres, dealers are required to rent at least six spaces and each space costs several thousand dollars.  Given the significant rental costs, it takes the used car dealer three cars to breakeven and he only makes money on the fourth car.

Man Vs. Food – Insights on planning, preparation and patience

Have you seen the show “Man Vs. Food” on the Travel Channel. It was a fun show where the hosts takes on these food challenges like hot wings, giant steaks and massive burgers. Well, last night I watched some interviews that the host Adam Richman did some years back and I was amazed by the planning, preparation and discipline that he put in around the show. Some key takeaways that I got from the interviews were (1) the importance of establishing a baseline, (2) balancing the in’s and out’s and (3) being patient in sticking to a plan. While these were discussed in the context of food and weight loss, I think these could easily also apply to investments and spending as well.

In keeping with recent posts, we are going to keep things light for Friday. Today we are going to talk about weight loss, being patient and the hard work that goes on behind the scenes.

Man Vs. Food – What goes on before and after the show

I used to love this show called “Man Vs. Food” on the Travel Channel. The premise of the show was straight forward, the host goes around America, visit some well-known eateries and take on these food challenge. These included things like the hot wing challenge, a 7.5lb hamburger challenge, a 4.5lb steak challenge to name a few.

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But what I did not realise was the amount of work and preparation that occurred behind the scenes until a saw a series of interviews on YouTube where the host Adam Richman explained some of the preparation and sacrifices that he did before and after the show.

Establishing a baseline – The first point was that he knew that he would have to eat a lot on the show. So, before he even started the series, he made an effort to see all of the medical specialists in order to establish what his health baseline is. This way, in case his health started to take a toll from the “huge” meals that he was eating, he would at least know where he needed to work back towards.

Balancing the in’s and out’s – The second notable from the interview was what he ate before and after filming. Much of weight management is about ensuring that your input and output are not out of balance. Given how many calories he was taking in during the challenges, this meant very light meals when he was not on camera. For breakfast, it was just oatmeal. And for dinner, it would just be a salad with chicken breast. Furthermore, during the show, he also did a minimum of 45 mins of cardio every day. And from a planning perspective, he had it written into his contract that the hotels he stays at must have a gym.

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So while, we only see the fun side of the food challenges, behind the scenes, there was a lot of planning and discipline to make sure that long-term health is not comprised. I think outside of the food and nutritional aspect, this also applies to other things like our investments and spending.

Four weeks, Eight weeks and Twelve weeks

The second interesting thing was the story behind his weight loss. After the show was concluded, the host actually went on to lose 70lbs. The weight loss itself was impressive but what I found far more interesting was what triggered it.

He mentioned in the interview that his decision to lose weight was triggered by a quote that for meaningful weight loss, it would take four weeks for you to notice it, eight weeks for friends and family to see a difference and twelve weeks for everyone else. So he thought, if it was only going to take three months, he might as well give it try.

As anyone who has dieted before, losing weight is easy, the harder part is actually keeping it off which requires a complete lifestyle change. But that is besides the point. The message that resonated with me was that you have to be patient to see results and often times it would take even longer for those results to be validated by others.

About five months ago, I started a new venture (not dieting related, that was actually many years ago where I lost 26% of my body weight with a 5% rebound since). While my new venture has yielded some initial green shoots, it has been slow at times and occasionally I wonder whether I should stay the course. However, I am reminded that my initial plan was to give this new thing 12-24 months to see where it takes me. So hearing the four, eight, twelve week quote above reminded me to stay the course. Hopefully, at the five, ten, 15 month timeframe, the impact would be bigger.

So to sum up, the lessons learnt from this episode of Man Vs. Food.

(1) Beyond the fun highlights, there is always a massive amount of planning and preparation. More specifically, (a) it is important to establish a baseline for performance and (b) be disciplined in balancing the in’s and out’s whether it is with investment and spending or caloric intake.

(2) Be patient with your plan. Given the proximity effect, you will probably see the difference first while others may not. But as time progresses, the impact becomes more pronounced and it could become a virtuous cycle where positive feedback reinforces the right behaviour.

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How to boost your memory?

Ten years ago, the first iPhone was launched. It had 16GB of storage and 128MB of Ram. Last year, when the iPhone 7 Plus was released, it offered 256GB of storage and 3GB of Ram. In the past 10 years, storage has increased by 16x while memory has risen 23x. In this post, we look into the memory trends from the perspective of one of the top 3 operators. Here’s a quick takeaway: (1) Volumes up 53-64% p.a., (2) prices down 23-29% p.a., and (3) manufacturing costs down 22-23% p.a. While the long term demand trend is up, with current margins more than double the long-run average, jumping in now is like buying the iPhone 7 just before the iPhone 8 is launched. You’ll get some enjoyment out of it but you may regret paying full price later on.

Ten years ago, Apple release the first iPhone and completely revolutionised the smartphone industry. But did you remember that when the first iPhone was released it only came with either 4GB, 8GB or 16GB of storage and its memory was only 128MB.

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Fast forward to the present day. I don’t know what the spec of the iPhone 8 is but if you consider the iPhone 7 Plus, that had up to 256GB of storage and its memory was 3 GB. Its storage increased by 16x while its memory increased by 23x.

Here’s a safe bet, demand for memory and storage will rise

I’m not a tech expert but I think a pretty safe bet is that the demand for memory will only increase as our various gadgets become increasingly connected. Furthermore, as more and more computing and applications gets stored in the cloud, although the memory in your computer or smartphone may not rise, the storage in the cloud is being added.

According to the DRAMeXchange, the top three players in DRAM are Samsung (61.5% market share), SK Hynix (21.7%) and Micron (14.9%). In terms of NAND Flash, Samsung is also the leader with 35.6% market share, followed by Toshiba and Western Digital at 17.5% each. Micron holds a 12.9% market share in NAND Flash.

Although Samsung is the leader in both DRAM and NAND Flash, since its business also encompass mobile devices, consumer electronics and a bunch of other stuff, it is hard to dig out details on how the memory market has evolved over the past years.

For that, we turn to the #3 operator. Digging through the past 10 years annual reports, we learned a couple of interesting bits.

Volumes have risen by 53%-64% p.a over the past five years

The good news is that demand for memory has been strong. Over the past five years, the sales volume for DRAM and NAND memory have risen an average of 53% and 64% p.a.

chart (19)

Prices have fallen 23-29% p.a.

The bad news for memory makers (but good news for consumers) is that the average selling price for memory has been declining steadily. Over the past 10 years, the ASP per gigabit of DRAM and NAND have fallen by 23% and 29% p.a.

Put another way, if 1 gigabit of DRAM costs $100 in 2006, it now cost only $4.3 in 2016. Similarly, for 1 gigabit of NAND that costs $100 in 2006, it would now only costs $1.5. This is a cumulative decline of 96% and 98.5% for DRAM and NAND respectively.

chart (20)

Given how quickly prices have fallen, it’s good that demand/volumes have risen so fast, otherwise, it would have been hard for top line revenues to increase.

Costs to manufacture have also fallen steadily, down 22-23% p.a.

The good news for memory makers is that the cost to manufacture have also come down gradually. Going back the last seven years (as far as the data goes), we can see that the cost to manufacture one gigabit of memory has fallen an average of 23% and 22% for DRAM and NAND respectively.

That said, although costs have gradually fallen, prices have dropped faster. Over the past six years, if one were to compare the change in ASP versus the change in costs, there have only been two years when the change in ASP-change in costs have been favourable. chart (24)

So is it a good business? Average gross margins at 18%

Let’s weigh the pros and cons.

On the plus side, demand is strong. Demand has risen by more than 50% p.a. over the past 10 years. However, this demand does seem to be partly price elastic. As price falls, demand rise to mitigate the effect of the price fall. From an overall top down basis, we can see that net sales have grown 13% p.a. over the past 12 years. chart (22)

The key does seem to be gross margin levels. Given the volatile pricing environment, gross margins have oscillated from +33% to -9%. With an average gross margin of 18% over the past 12 years, one could make a case for reversion to the mean over time.

chart (21)

However, given the market is forward-looking, this would mean that perhaps the best time to look into the sector is when reported margins are below trend (18%) and the worst time to look into the sector is when reported margins are above trend. At the moment, margins are at historical highs with gross margins around 48% in 3Q 2017. Although it is always tempting to argue that “this time it’s different” and there are structural changes to the margins, those four words have historically proven to be very costly.

chart (26)

That said, if we consider that  over the past 12 years, the difference between year highs and year lows are 132%, and for 2017 to date, this memory maker has only increased by 43%, perhaps there is room for the current enthusiasm to run a bit hotter. I just hope it doesn’t melt the floppy disk.

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Note: Source for all charts: Company data