Q3 Mohawk

Executives
Fabrice Hamaide – CFO & Director
Ilya Grozovsky
Yaniv Zion Sarig – Co-Founder, President, CEO & Director

Analysts
Allen Robert Klee – National Securities Corporation, Research Division
Brian David Kinstlinger – Alliance Global Partners, Research Division
Maria Ripps – Canaccord Genuity Corp., Research Division
Randy Watkins Slifka – Slifka Asset Management LLC
Scott Wallace Searle – ROTH Capital Partners, LLC, Research Division
Thomas Ferris Forte – D.A. Davidson & Co., Research Division

Presentation

Operator

Good afternoon, ladies and gentlemen, and welcome to the Mohawk Group Holdings, Inc. Third Quarter Earnings conference call. [Operator Instructions]

I would now like to hand the conference over to your host, Director of Investor Relations, Mr. Ilya Grozovsky, the floor is yours.

Ilya Grozovsky

Thank you for joining us today to discuss Mohawk’s third quarter 2020 earnings results. On the call are Yaniv Sarig, Co-Founder and CEO; and Fabrice Hamaide, Chief Financial Officer. A copy of today’s press release is available on the Investor Relations section of Mohawk’s website at mohawkgp.com.

I would like to remind you that certain statements we will make in this presentation are forward-looking statements. And these forward-looking statements reflect Mohawk’s judgment and analysis only as of today, and actual results may differ materially from current expectations based on a number of factors affecting Mohawk’s business.

Accordingly, you should not place undue reliance on these forward-looking statements. For a more thorough discussion of these risks and uncertainties associated with the forward-looking statements to be made on this conference call and webcast, we refer you to the disclaimer regarding forward-looking statements that is included in our third quarter earnings release as well as our filings with the SEC.

We do not undertake any obligation to update or alter any forward-looking statements, whether as a result of new information, future events or otherwise. In addition, the company may refer to certain non-GAAP metrics on this call. Explanation of these metrics can be found in the earnings release filed earlier today.

With that, I will turn the call over to Yaniv.

Yaniv Zion Sarig

Thanks, Ilya, and good afternoon, everyone. It’s exciting to see Mohawk continuing to grow rapidly as we focus on our vision to build the consumer product platform of the future. This quarter’s results reflect the progress and efforts delivered by our team and is highlighted by our net revenue of $58.8 million and adjusted EBITDA of $5.1 million.

I always thank everyone at Mohawk for continuing to operate at the highest level despite the challenges the world is facing on work and our personal lives due to the COVID-19 pandemic. I’m very proud to be working alongside a team that is determined and focused as ours.

For those who are joining us for the first time, I thought it would make sense to take a minute to talk about our company’s mission and purpose. We started the Mohawk Group 6 years ago because we believe that the online retail model, pioneered by tech companies like Amazon and Alibaba, would permanently and significantly disrupt the traditional consumer product model.

We set on a mission to build the world’s most efficient consumer product platform for CPG brands. We believe that just like technology has reinvented retail, it will also play a major role for CPG companies who will seek to predict market trends, drive efficiency through supply chain and automate the marketing efforts.

In the last 6 years, we’ve invested in building a proprietary software platform called AIMEE, which analyzes a terabyte of shopping trends data every day for our team to efficiently automate various tasks such as product selection, forecasting, pricing and media-buying decisions in real time.

We’ve launched through our platform 7 different brands and over 250 consumer products across various categories. We sell those products and brands predominantly through online retail marketplaces in the U.S., such as Amazon and Walmart. We believe that agile and data-driven online brands will eventually replace the traditional brands that we grew accustomed to seeing on the shelves of every brick-and-mortar retailer.

The third quarter of 2020 was an important stepping stone on the path towards this vision. On our last earnings call, I mentioned that Mohawk had achieved profitability at the adjusted EBITDA level a quarter earlier than expected. While the acceleration of e-commerce adoption due to COVID-19 played a role in this earlier-than-anticipated success, our Q3 results illustrate to us that we’ve matured as a company and our underlying unit economics metrics are strong.

This last quarter also included a very important step to our strategy going forward. With the acquisition of Truweo, a wellness brand. Following the completion of the transaction, we were able to efficiently integrate Truweo’s business in ours in less than 48 hours. In addition, we’re already in production for several products designed to further develop the Truweo brand in the wellness and ergonomics category. We expect those products to launch in Q1 2021.

The strategy of acquiring and consolidating third-party Amazon brands is continuing to attract significant private investments. In the last 6 months, 3 private equity VC-backed companies have reportedly raised over $400 million collectively to execute on an M&A strategy similar to ours. We believe that Mohawk is better positioned to consolidate and operate small and digital native brands than any competing company today, thanks to a scalable platform, and we intend to aggressively pursue this path.

Based on our last round of financing in August, we also believe that investors not only understand this part of our strategy, but we also see significant value in it, just as we do. Looking at Mohawk’s position at the macro level, we continue to be very excited with the rapid adoption of e-commerce and the evolution of the trends we identified 6 years ago.

In an interesting report that was published by McKinsey on July 30, earlier this year, digital ubiquity, value price sensitivity, the explosion of small brands and the meteoric rise of marketplaces were mentioned as one of the most disruptive trends for traditional CPG. Those trends are at the core of Mohawk’s strategy, and we believe they will continue to benefit us while forcing traditional brands to reinvent themselves or be left behind.

The report also mentioned the importance of managing data, proprietary insights, in particular, it mentions that CPG manufacturers and brands must become experts in retail marketplaces data trends in order to keep up their seat at the table. They must demonstrate expertise in big data analytics, inside generation, ROI tracking of investment and other functions.

We couldn’t agree more and believe that the gap between tech-enabled consumer product companies and those who fail to build such capabilities will become more accentuated as the move to e-commerce accelerates.

To give a concrete example, a McKinsey analyst points out the complexity and time-consuming effort brand owners face when managing online marketplace products. The analyst mentioned that brand owners are required to manage over 700 different attributes for each SKU in their portfolio. The article states that it takes a team of 3 to 5 people per channel approximately 4 weeks to aggregate and analyze the data for each SKU.

At Mohawk, again, we anticipated those issues many years ago and realized that our ambition to manage effectively thousands of products across dozens of channels cannot scale without adopting the latest automation and machine learning technologies. Today, our incredible team is supported by algorithms that create forecast daily for all our products, aggregate data from all our SKUs and across channels in real time and adjust our marketing strategies every minute of an hour.

We still have much more to accomplish, but I’m very proud of the strong foundation we’ve created and the results of Q3 2020 which reflects our progress.

With that, I’ll turn it over to Fabrice for more details on the third quarter.

Fabrice Hamaide

Thanks, Yaniv, and good afternoon, everyone. Here are the operational performance details of our third quarter. For the third quarter of 2020, net revenue increased 45% to $58.8 million from $40.6 million in the year ago period.

The strong gain was primarily attributable to increased direct sales volume of new products launched since the second half of 2019, net of vertical expansions, where we launched competing products to our own sustained products. This contributed $7.5 million in net revenues. Historical products, of course, keep on growing and wholesale revenue of PPE products, which contributed $8.9 million.

We did suffer from inventory shorts in the quarter, as previously indicated in our Q2 call, which we estimate to be an impact of approximately $7 million to $8 million in the quarter.

Gross margin for the third quarter increased to 47.8%, up from 43.2% in the year ago quarter and 46.2% in the second quarter of 2020. The solid sequential and year-over-year improvement in gross margin was due to both favorable product mix and higher product pricing while being partially offset by wholesale PPE sales which carry much lower gross margin.

Our overall Q3 contribution — Q3 2020 contribution margin was 19.1% as a result of the previously mentioned factors, which improved compared to the prior year 8% and second quarter 2020’s 16.8%. This year-over-year sequential improvement was driven significantly by improved product unit economics coming from mix and pricing related to inventory shorts of our sustain products, which had a CM of 23.7%.

Fixed costs, which we continue to focus on, were down 7.5% at $6.2 million in Q3 2020 compared to $6.7 million in the second quarter of 2020. As a percentage of net revenue, fixed operating costs, excluding stock-based comp, decreased to 7 — to 10.5% from 14.6% in the year ago period.

Adjusted EBITDA, which excludes stock-based compensation for the seasonally strong third quarter of 2020, improved to a record $5.1 million from a loss of $2.7 million in the third quarter of 2019 and also saw sequential improvement from $3.4 million in the second quarter of 2020.

I would highlight that our adjusted EBITDA profitability is a result of the growth in our business from both our existing and new product launches, combined with our fixed operating expense leverage, which benefits from the automation in our business model and continued improvements in our unit economics.

During the quarter, Mohawk purchased the assets of Truweo, a leading e-commerce brand in the health and personal wellness category, for approximately $16.4 million, approximately $13.9 million in cash at closing and approximately $2.5 million in the form of an unsecured promissory note. This transaction reflects an approximately 2.5 multiple on Truweo’s trailing 12 months operating income measured as of July 31, 2020. Truweo’s trailing 12-month revenue and operating income ending as of July 31, 2020, were approximately $14 million and $6.5 million, respectively.

Turning to the balance sheet. At September 30, 2020, we had cash of $37.4 million compared with $17.2 million at the end of June 2020. This sequential increase in cash stems primarily from $5.1 million from adjusted EBITDA, $12.9 million from working capital and approximately $10 million of net proceeds from the Truweo — after the Truweo acquisitions, and approximately $7.5 million in debt repayments and cash interest payments.

The cash provided from working capital comes from a mix of seasonality as well as inventory turns above ForEx. In terms of our outlook for new products in the fourth quarter 2020, we expect to launch approximately 7 to 10 new products.

To conclude, the key takeaways of the quarter are: revenues are growing; profitability continues to improve, both from unit economics and the operating leverage; and generating cash.

For full year 2020, the company continues to expect net revenue to be in the range of $175 million to $185 million, driven primarily by continued growth of its existing product portfolio, new products launched in 2020 and the positive contribution from wholesale personal protective equipment. The company continues to expect to generate positive adjusted EBITDA in the fourth quarter of 2020 and for the full year 2020.

With that, I will turn it back to the operator to open the call for your questions.

Question and Answer

Operator

[Operator Instructions] Presenters, your first question will come from the line of Thomas Forte from D.A. Davidson.

Thomas Ferris Forte

Great. So Yaniv, I was hoping that as a student of e-commerce and an understanding of marketplaces, that with today’s news of a potential vaccine that may be effective, I wanted to know what your thoughts are on what may be the short-term benefits to e-commerce from COVID and what you see as the long-term structural ones that would not go away even with an effective vaccine?

Yaniv Zion Sarig

Thanks, Tom. Well, just like everyone else, I think we’re really happy to hear this great news about the advances Pfizer has been making on the vaccine and, I think, other companies behind it. I don’t — I’m not an expert at all, and I’ve not had the chance to study today what is the expected time line on actually productizing and getting to market the vaccine. I hope it’s obviously as quickly as possible so that everyone can benefit from it.

I think that when it comes to what that means for e-commerce, we’ve spent a lot of time looking at data ourselves and what I think other experts in the field say. And although everyone believes that, of course, the acceleration that happened through COVID-19 is fundamentally driven by the lack of access to traditional retail, right, there’s a very strong, I think, belief overall that, as Fabrice mentioned I think earlier, once the — unless the toothpaste is out of the tube, it’s not easy to put it back in, right?

So we believe that, in general, we’ll see a strong adoption of e-commerce continuing to be around for at least as long as it takes to deploy the vaccine in a meaningful way but also way beyond that, right? I think that what happened here with COVID has been incredible for e-commerce in general and has brought a lot of people who were probably on the sidelines in terms of their shopping behavior to adopt e-commerce.

What the exact number is, it’s hard to tell, right? But we definitely believe that, that acceleration is here to stay. I think it’s everyone’s guess as to what percentage of e-commerce is going to be now sort of retail is going to be down online, right? We’ll have to wait and see. But we believe very strongly that it will — that acceleration is not going backwards in a significant way.

Thomas Ferris Forte

Great. And as a quick follow-up, now that you’ve made the acquisition of Truweo, how do you think about your ability for future acquisitions? And has it changed your decision tree as far as building or buying new products?

Yaniv Zion Sarig

Yes. So I think, first of all, we’re — as we mentioned, we’re very pleased overall with the acquisition of Truweo, specifically with our ability to integrate the business very rapidly and without taking additional fixed costs.

At a kind of macro level view, I think that anyone who understands this business well, anyone who understands the intricacies of actually acquiring these type of companies will, in my opinion, tell you that there’s — it’s a very unique situation that I’m not aware of any other business or industry where there is so much revenue to consolidate that can happen in a way that is, overall, not too complex compared to other M&A transactions that might be out there, right?

And I think for us, specifically, with all the efforts and the infrastructure we’ve built in the last 5, 6 years, we believe that we are extremely well positioned operationally to go and execute on these deals, right? And then when you look at the multiples, I think there’s no doubt that this is a very important part of our strategy.

At the same time, everything starts and ends with data, right, where we look at the markets on our — obsessively, right, and constantly look at opportunities and priorities of build versus make — sorry, make versus buy, depending on many different factors, trends. And so it’s not like there is particularly a strategy that stays in the upper hand. I think these 2 will continue to go — going forward and they’ll depend extremely on the changes in the market, on the changes in the data, on how do we think in terms of priorities of deploying the capital in a most effective way.

But the exciting thing is that there are a lot of opportunities out there. Again, there is over 2.5 active — 2.5 million active sellers on Amazon, and Amazon is adding north of 3,000 a day. And so we expect that pipeline of deals to continue to be strong and allow us to kind of pick and choose what is the next best way to deploy capital across these 2 strategies with, again, a very unique situation around our ability to integrate and efficiently manage going forward these acquisitions as asset deals, where we don’t take on any additional fixed costs, any additional personnel. Very, very unique, I think, situation in any business industry that we know of now. So we’re excited about both.

Operator

Your next question will come from the line of Maria Ripps from Canaccord.

Maria Ripps

You had a very strong profitability flow through this quarter. I just wanted to ask you, what drove that cost leverage and this year-over-year decline in fixed expenses? And I guess how sustainable is that going forward?

Yaniv Zion Sarig

Fabrice, do you want to take that one?

Fabrice Hamaide

Sure, sure. Yes. It comes from — we had indicated that we’re rationalizing or operating a COO organization where we had a [ successful ] organization with the COO based in the U.S. and a number of folks based in the U.S., as well as a strong general manager on the China side. We ended up actually deciding back in early Q2 — late Q1, early Q2 to actually consolidate that organization in Asia, it makes it much more efficient.

So that was one of the key drivers of that operating fixed cost reduction as well as G&A reductions, in particular when it comes to D&O insurance, for example, your — 1 year after IPO. So you can actually start actually now realizing some savings on that front. And those are permanent and will stay going forward.

Maria Ripps

That’s very helpful. And can you maybe update us on how the timing of your product funnel is working as your platform becomes more mature and more effective? How big is the funnel of potential product ideas that you’re generating? What percentage of those are making it to launch or sustain? And what does the time line look like now? Are you getting faster in there?

Yaniv Zion Sarig

Maybe I’ll start, Fabrice, and then you probably want to add some things, right? So thanks a lot for the question, Maria. In general, obviously, what’s interesting is the market keeps changing all the time and we adapt the technology, and that obviously opens up new opportunities. And the most important thing for us is culturally and technologically always to be with a finger on the pulse as to what is happening in the market and how can we best transform the data that we’re seeing into opportunities that we can capitalize on very quickly, right?

In general, our pipeline is always way ahead of our ability to operationally launch products. I mean there’s always a lot more opportunities that we can actually perform in terms of bringing the products to market. Typically — and I think we mentioned that overall, our goal next year is to reach 10 new products a month, which we think is exciting and ambitious, and very much looking forward to it.

We feel that from a pipeline perspective, the challenge is not going to be in the data or in the identification of the product, it’s going to be more in the agile scaling of the sourcing, doing the quality control, maintaining that high-quality product ratio and high rate of success going forward is what’s key. And again, as Fabrice mentioned, we’re really proud of our new COO out power of Shenzhen, Pramod, who’s building up that team in preparation for this task. And overall, feeling very excited about our ability to go after that scale that we’re looking for operationally.

So in short, I think the challenge on the data is obviously there, but the bottlenecks is probably always going to be, even as we scale further above 10 products a month and as we scale internationally, right? But the challenge is always going to be more operational than on the data. The data is always going to be about prioritization of opportunities versus what the market shows us.

Fabrice, I don’t know if you want to add anything.

Fabrice Hamaide

I was just going to add one piece of data since Maria was asking about our success ratio. We’re still at 80% plus trailing 12 months on the success ratio of our launch to launch to sustain, right? And there’s no reason for that to change. I mean it can fluctuate, of course, every quarter, but year-to-date, including Q3, we’re still at above 80% success ratio.

Operator

Presenters, your next question will come from the line of Brian Kinstlinger from Alliance Global Partners.

Brian David Kinstlinger

First, one numbers question, and maybe I missed it. It’s only a short period of time, but what was Truweo’s contribution to revenue?

Fabrice Hamaide

So as you know, we don’t provide Truweo as one product and we don’t provide numbers on a per product basis, right? So — but remember, we concluded the acquisition late August, so the contribution to revenue in Q3 was minimal, right, obviously, right, especially in this strong quarter where the seasonality of our core environmental appliances is so key.

Brian David Kinstlinger

Okay. And then recently, in recent calls, you’ve talked about the difficulty in this environment for AIMEE to forecast demand of new products, I mean more specifically, even focus — sorry, predict the uncertainty of purchasing patterns. So has that changed at all? And does that give you more confidence in your ability to introduce SKUs?

Yaniv Zion Sarig

Brian, I think it’s more just — and thanks for the question. I think what is challenging is not necessarily identifying new trends or identifying new opportunities, but quantifying the size of the market can be very challenging. And therefore, what we’ve done, as we mentioned, right? We took — we slowed down a little bit the products for this year and have planned really to ramp our capabilities next year in quite a dramatic way.

We believe that what it is today gives us really good visibility. And with also some changes that we’ve made on the operations’ inventory levels, we feel very strongly that we are armed with the right data and the right visibility into what the market is going to look like next year to make the right calls on products, and that’s why we’re accelerating the number of launches.

Again, we’re always taking a very agile approach, right? We’re always taking an approach where because of the nature of our business and because we can adapt pricing in real time and marketing in real time, we can swaddle sales if we need to. That is an incredible advantage when it comes to managing sort of unknown volumes next year because as we deploy inventory on a monthly basis, right, if there are some changes that we didn’t anticipate, we can always, again, adjust our marketing and pricing in real time to be as close as possible to the forecast.

Which is something that, again, a traditional consumer product company that doesn’t have the level of automation and the level of real-time reactivity that we have is going to be — is going to have a lot more challenges than us in doing so, right? So overall, to kind of like summarize, to your question, we feel that where the data is today and where we’re looking at already products for next year, we feel quite confident that we are well on to make the right decisions.

Brian David Kinstlinger

And as a follow-up to that, Yaniv, I think you mentioned to one of the other questions you’d hope to get to 10 per month next year. Is that achievable in the first half of the year? Or is that more likely in the second half of the year that you get to that goal?

Yaniv Zion Sarig

So again, not — putting aside any kind of like unknowns, we’re still in COVID world, right? We’re not — a vaccine was announced today, but still unknown. But putting those unknowns aside, right, any kind of black swan event that we can’t foresee, which we don’t see why we would have one, but you’ll never know. If you put those aside, we believe it’s very feasible, yes.

Brian David Kinstlinger

Great. And last question I have. As you complete more acquisitions, does deploying capital to acquire a company at all impact the number of products you can release through the direct model for the manufacturers?

Yaniv Zion Sarig

Sorry, can you repeat the question? I didn’t get it. Yes.

Brian David Kinstlinger

Yes. I’m just wondering, if you do 2 or 3 acquisitions per se in a given year, which requires capital, does that impact the number of new SKUs you can introduce throughout the acquisition?

Yaniv Zion Sarig

Fabrice, you want to take that?

Fabrice Hamaide

Sure. Sure. So in principle, no, I mean remember that we’re profitable and cash flow positive today already with — and launching 8 products in the quarter. And as we add and increase our profitability, that actually allows us to actually self-fund all of that growth of new products that we would launch organically. And all acquisitions would — at the multiples that we can buy, the new cash flow that actually brings up actually can pay for a very significant portion of the financing that we would actually contract in order to do those acquisitions.

So at this stage, as Yaniv said, it’s not — in answering Tom’s question, it’s not like we are — it’s not a trade-off of — from a capital lending perspective of launching more products versus doing more acquisitions because the limiting factor is less capital than it is operationally — QA, QC, sourcing, those elements that are actually more of a limiting factor, and those take — are step functions and take a little bit more time to actually implement anyway, right? So in principle, the answer is no.

Operator

Presenters, your next question will come from the line of Matt Koranda from ROTH Capital Partners.

Scott Wallace Searle

It’s Scott stepping on for Matt. Just want to talk about the implied revenue guide for 4Q, and it’s set between $31 million and $41 million. Can you kind of help us understand what would swing you to $41 million versus that $31 million? And I mean we have 6, 7 weeks left in the quarter, why not just give us a bit of a tighter range there?

Fabrice Hamaide

I’m sorry. It was very difficult to hear you, Matt. So I’m not exactly sure of the nature of the question, maybe Ilya or Yaniv, if you heard it correctly. Did you?

Yaniv Zion Sarig

No, I had a hard time too, Matt. can you can try again, please? Sorry.

Ilya Grozovsky

Yes. It’s okay. I got it just in case [ it’s hard ] to hear.

Scott Wallace Searle

Sorry about that. You guys hear me better now?

Yaniv Zion Sarig

Yes, yes. It’s better, Matt, yes.

Scott Wallace Searle

Sorry about that. It’s Scott stepping on for Matt. I just want to talk about that 4Q guide, the implied guide. I think it’s set between $31 million and $41 million. Just wanted to understand what swings us down to $31 million versus the $41 million with your — I mean, we have 6, 7 weeks left in the quarter. Just wanted to get a little more color on that.

Fabrice Hamaide

Yes, sure. So I mean it’s obviously, in this particular case, there are substantial macroeconomic uncertainties, right, in the near term and we’re being conservative as a result. Many economists are predicting growth concerns as there are high levels of employment, elevated savings rates, the resurgence of COVID cases which, thanks to the news on the — from Pfizer this morning, hopefully, will be the last elevation of or wave that we see, right? But whatever wave we have over now and for the short term, and for sure between now and the end of the quarter, the vaccine will not change anything to that. And so all of those elements are actually playing into creating a significant level of uncertainty into overall in overall spending patterns from consumers. So that’s one.

And the second, of course, is Q4 is, by definition, heavily back-end loaded, right? It’s not with the October numbers that you know how your Q4 is actually going to do because of it, most of your Q4 is going to start mid-November through December 21, 22, 23, depending on shipping constraints, right? So that’s the reason why we’re not changing the guidance at this stage, and we’ll see how all of those factors pan out.

Scott Wallace Searle

Super helpful. And just, I guess, on that note. I know with the inventory positioning, you guys burned through a healthy figure this quarter. How are you feeling going into ’21?

Fabrice Hamaide

On inventory levels or on inventory shorts?

Scott Wallace Searle

Yes. On the inventory shorts, sorry.

Fabrice Hamaide

Well, I mean the manufacturing is still tight on the inventory side, on the manufacturing side, and it’s going to stay there until Chinese New Year. So we probably will suffer from a little bit — still a little bit of inventory shorts in Q4. Obviously, can’t quantify it until the demand has actually showed versus the level of inventory that we have. But for sure, it’s going to still be a little bit part of our numbers in Q4, right?

Scott Wallace Searle

Okay. Helpful. And I guess lastly, on the other and PP&E, I mean solid, it was at $8.9 million. What is sustainability — not sustainability, but going forward, once we move past COVID, how do you guys view that like revenue stream? Does it go away? Do we keep leaning into it? Just more color on that.

Yaniv Zion Sarig

Yes, it’s a great question. We’re not counting on it, right, like we’re basically happy to be able to help and do the right thing. And obviously, at the same time, generate business for us, right? But it’s not something we’re necessarily counting on. We’ve built a — I think, overall, I would say that it looks like we’ve built a good reputation, and we’re getting interest and additional opportunities so far, right, or there, right? But again, it’s hard to quantify. It’s not something that is as predictable, of course, as our core business, right? So we are basically going to continue to benefit from it as it arrives, but we’re not counting on it specifically, if that makes sense.

Operator

Presenters, your next question will come from the line of Allen Klee from National Securities.

Allen Robert Klee

Your launch segment was up 81% year-over-year. Can you talk about — I mean was that due to PPE? Or was there something else going on there?

Yaniv Zion Sarig

Sorry, you mean our success rate on launches? Is that what you want?

Allen Robert Klee

No. Just the dollar amount of revenue from the launch segment.

Fabrice Hamaide

Which is that $5 million plus in the quarter?

Allen Robert Klee

Yes, yes, yes.

Fabrice Hamaide

And so what is the question on that? I mean it’s reasonably low in many ways, right, I would say. But the reason it’s low is because we — remember, we slowed down product launches since Q1. So you actually, therefore, have less launch revenue in the Q3 period, right? In Q1 and Q2, we launched a lower number of products. And in Q3 as well and that means — that’s the reason why you have lower launch revenue in the Q3 period, right? You can expect the same in some ways in Q4. And then as Yaniv mentioned, next year, when we start accelerating again on a number of new products, the launch portion of your revenue will climb again.

Allen Robert Klee

Okay. My other 2 questions are: one is, are you going to have to pay holiday surcharges to your third-party logistics network in the fourth quarter? And second, what’s been your experience with competition from Amazon private label?

Fabrice Hamaide

I’ll take the first question, Yaniv, maybe, and you can take the second one.

Yaniv Zion Sarig

Perfect. Yes. Sounds good. Yes.

Fabrice Hamaide

Okay. So well, our third-party logistics partners, first, I mean there’s a volume question because everybody is anticipating or there’s been lots of talk of massive volumes of e-commerce and ship to home in Q4. So — and first, the key for us is that, of course, our third-party logistics providers are set up well to handle any significant increase in shipping in December, at least on our FBM products, or the fulfill by merchant, where we use our own fulfillment network. But it’s likely going to come at a slightly higher costs, the surcharges that you’re actually mentioning, right?

On the FBA side of things, we’re obviously subject to Amazon’s ability to cope with the volume, the prices there will not change because they actually would have announced that earlier on. And the pricing that we have, of course, is higher, but we’re already factored in, in particular on warehousing cost. There’s a seasonal surcharge always on FBA every year, and it’s going to stay the same this quarter.

Yaniv Zion Sarig

Yes. And then — well, Allen, when it comes to Amazon competition, right? Again, I think it’s something that we’re tracking very closely, right? But in general, I think throughout the year that Mohawk’s been around, right, once we — if we do our job well and get a product to sustain, really, I would say our biggest enemy is not Amazon or for that matter on any brand, it’s us, right?

I think what has been proven to me, looking at our product time over time, is if we’ve done a job well and if we take a certain amount of market share and if we manage correctly the inventory levels that we don’t run out, so we don’t have to get into a position where we open up the door for someone else to catch up to us, right? Typically, it doesn’t really matter if it’s Amazon or any other brand for that matter, right, as long as we execute well on our strategy, the way the marketplaces and the way consumers shop — and the way the marketplaces operate and the consumer shop work, right, it’s really a meritocracy.

And everything we do is all about identifying what the opportunity is. Time it very well, right, coming in into the market with a good product that differentiates, that takes market share. And then we aim to maintain our market share for as long as possible. And again, I’d say that the places where we’ve lost market share here or there, right, it’s always been more because of us than because of anyone coming in and disrupting us in a way that we didn’t expect, right?

So specifically, going back to what you said on Amazon, right, there’s no — I mean again, we follow everything Amazon does very closely, but we’re not alarmed by them entering categories we’re in as long as we execute well on what we set to do. And so far, that’s been the case, so.

Operator

[Operator Instructions] Presenters, your next question will come from the line of Randy Slifka from Slifka Asset Management.

Randy Watkins Slifka

Congratulations on a good quarter. I was wondering if you could talk a little bit about — in your prepared remarks, you talked about being happy with your unit economics. I was wondering if you could sort of drill into that a little bit and also address some vision regarding the categories that new products might be coming into?

Yaniv Zion Sarig

Fabrice, do you want to take the first part, and I’ll do the second one?

Fabrice Hamaide

Yes. It sounds like a regular practice. Yes, I was saying that — mentioning, when you look at our unit economics, I mean our contribution margin overall is at almost 19% for the quarter. So that’s, net av, it’s before any fixed costs, but it’s including absolutely every cost from warehousing to shipping to marketing spend and so on, and of course, cost of goods sold and the international shipping as well.

So it’s a testament of a couple of things. I mean the first one, of course, is we do have a little bit of pricing effect in the quarter. When you have inventory shorts, you actually slow down demand a little bit by increasing price. That’s one of the way or slowing down your marketing spend, but that was also the case in Q2, and you still see a sequential increase.

And the reason why you see a sequential increase, it’s because of the strength of our fulfillment platform, where we actually had done significant efforts at the — late last year and early this year, increasing our footprint of partner warehouses, getting our products closer to the closer to demand. When you do that, your zone — average zone goes down, therefore, your shipping costs, your last mile fulfillment cost was down. And we’re now, on average, at zone 3, over 65% of all the orders that we ship are actually shipped in 1 day.

And those not only provides better quality of services or consumers, but they also actually drive the cost of performance down, right? And that’s what you see in Q3 because in Q3, because of the seasonality and the product mix, a very vast majority of our sales are fulfilled through our fulfillment network and not through FBM, where we get the more benefit of the cost savings and the footprint that we have implemented. That’s the key driver on that.

That will stay for next year and so on. And of course, we benefit a little less of that in Q4 and Q1, because people buy less humidifiers or products that are fulfilled or categorized that’s oversized and fulfilled through our own network and not through Amazon, right? So that’s the reason why we’re mentioning the strong unit economics and the improvements there.

Yaniv Zion Sarig

Thanks, Fabrice. And just to add to this, right. I mean just in general, when it comes to unit economics, and if you take at a macro level about what we’re doing, right, it’s all about continuous efficiency, right? I mean at the end of the day, the consumer product space is competitive and dramatically changed by e-commerce. And we just strongly believe that efficiency, the ability to automate your supply chain to keep your fixed cost as effective as possible versus the strong unit economics of your product is where it’s all about. That’s what it’s all about, right?

I mean for us, there’s going to be some winners of massive scale here in the consumer product space, and they’re going to be the companies that can best identify what it is the consumers are looking for, react to it pretty quickly with an agile supply chain that brings the right products to market, that is focusing on best quality-based price, right?

And then as Fabrice mentioned, last mile shipping and the efficiency that happens there as well as the efficiency of the marketing, the ability to price the product correctly in real time, these are the factors that we believe are going to really give the market some winners at a big scale. And that’s why we’re investing so much in technology to manage all these aspects because we believe that that’s the only way to be able to build a big company operating with this model, right?

When it comes to the categories we’re going after — again, what’s fascinating is the data is fluid and changes, and the more — the better we get at absorbing it and are learning from it, the more it’s interesting to see how the ability to pick specific products without necessarily focusing on one particular category is extremely efficient, right? A lot of companies are really kind of focused on being experts in a particular category, if that makes sense. But in reality, we believe that there’s — that’s really limiting, right?

When you have kind of like an overview of the market data and trends and you discover that in certain categories that you might have not really operated in before, there’s an opportunity, you wouldn’t want to be limited. You want to be able to again leverage the conveyor belt that we’ve built and enter that category precisely based on what the data showed you and going after whatever is the biggest opportunity, right?

We’re not going to continue to make more air appliances just because we are doing well on that. If there is another interesting category that is showing up on our radar as right for disruption, that we’ve not been into, right? That’s really the whole point here is to be very precise and pick and choose literally at the product level as opposed to a particular category level, if that makes sense.

Randy Watkins Slifka

So just a couple of follow-ups. From what I understand, there are now 28 different FBA roll-ups out there between Thrasio and Perch and Boosted and Dragonfly, Heroes, I mean, blah, blah, blah. You guys clearly have a competitive advantage in AIMEE, on the one hand. On the other hand, you’re planning on licensing, I believe, that technology out. Can you talk a little bit about, if you’d be so kind, the competitive advantage you have today and whether you are going to be fully licensing out AIMEE or whether there are pieces of it that are proprietary algorithms or other, should we say, competitive advantages that will allow you to provide that as a service or provide to third parties but also maintain your competitive advantage?

Yaniv Zion Sarig

Sure. So it’s a great question. And the way to think about it is, again, if you take a step back and you think about what the purpose and the mission of the company is, is we — going back to what I mentioned earlier, we just believe that as retail moves to online, the complexity of managing consumer products on what the retail channels of the future is going to look like is exponential for brands.

And a lot of traditional brands that have been used to brick-and-mortar retail are just not going to be able to keep up with it, right? And that’s why we’ve been building and investing so much in technology is because we think that, that’s where the advantage is going to come from. And we’ve proven it already in the last few years as we continue to scale and become EBITDA profitable despite a pretty interesting growth, right, on the other end.

And then when it comes to licensing the software, we are predominantly focused on those companies that are going to need to change, right? Those companies that are going to need to move from a B2B business to a D2C business. Those are not that I hope companies that are in that list you mentioned out there acquiring B2C brands, right? Those companies are still the large majority of CPG and are facing a lot of challenges operationally, technologically, culturally to adapt, right? And that’s also part of the reason why we’re not just going all-in on this, right, because it’s still unclear what percentage of them are going to actually adopt.

And so what we’re doing is we’re building a platform and we’re leveraging it by building our own brands, servicing probably older type of brands that — or focusing on trying to service all the type of brands that want to move into this model through the same platform that we use. And then lastly, buying — just like these other companies you mentioned, acquiring and adding to our portfolio accretive acquisitions that are a good fit for us, right?

And so when it comes to offering the platform as a service, it’s not like it’s like competitors who are rolling up other brands are going to go out there and use it. We are selective in offering our platform where we think it’s a good fit. But — so in terms of competitive advantage versus the other roll-up strategies, I think that, definitely, Thrasio has paved the way here, right, to this, we believe, really great opportunity.

I think the challenges that a lot of these companies are going to have is to manage so much revenue, to manage all these acquisitions as you add them into your portfolio becomes extremely complex and should and typically, without the platform that we have, will result in an increase in fixed cost, right? And so I think that a lot of these players are trying to build a platform. They’re, I think, investing. And I think that we have many years of advantage ahead of them on top of — on the entire supply chain, logistics, the ability to launch new products to augment the existing brands.

I believe that operationally, technologically and culturally, we’re way ahead of them. There’s no doubt that a lot of them have benefited from this new trend and have raised a lot of capital. But I think at the end of the day, we’ve seen a lot of companies who raise a lot of capital, it doesn’t necessarily mean they’re successful, right? We’re going to continue to do what we do best. And I think, again, that we’re well positioned to capitalize on this trend in a very meaningful way. So we’re excited about it.

Randy Watkins Slifka

Sure. So just one last follow-up. Yes, you mentioned Thrasio specifically, obviously, they’ve made something like 80 acquisitions in the last 2 years. And the most recent rumor mill is that their valuation is approaching $3 billion. I was wondering — 2 questions.

One, what do you think — what are you guys going to do to get the story out? Obviously, the company is ramping up and is facing a fair amount of success recently. Can you talk a little bit about that? And secondarily, can you talk a little bit about pipeline in terms of are there other acquisitions that you guys think are likely in the next quarter or 2 and…

Yaniv Zion Sarig

Yes. Yes, sure. So first of all, when it comes to valuation, right, obviously, private public markets, right? But more than anything, I think that Mohawk, obviously, for anyone who knows the full story, had a challenging start in the public market. I think that there was a lot of questions around our ability to be profitable at the EBITDA level and things that we’ve proven very recently, right, as of just a quarter ago. Pair that with the fact that, yes, we need to invest more into getting our story out there.

Those are 2 things that are on the top of our mind and high priority for us, right, to go out there and continue to talk about what we’re doing about the strategy, about the size of the opportunity. And also, obviously, the fact that our results now, I think should take away a lot of the doubts, right, hopefully, off the table. But those are things that are very recent. So we haven’t really capitalized on them yet, but it’s absolutely top of mind for us and for me personally to go out there in a more meaningful way and convey that story, right? So definitely on that, you’re absolutely right.

And when it comes to the pipeline, again, there are millions of sellers out there. There’s a lot of exciting opportunities out there. We’re always keeping an eye on it. And we’re evaluating deals very carefully all the time, as we mentioned in previous earnings calls. And that’s all I can probably say right now, right? But we’re constantly evaluating opportunities and deals. That’s a very significant part of our strategy, and we’re out there looking at things all the time, if that makes sense.

Fabrice, I don’t know if you want to add anything to that or…

Fabrice Hamaide

No, I think you addressed the question, right? I mean as you said, I think the ability to be cash flow positive and have raised, at the same time, enough cash during IPO was — the market took a definite wait-and-see approach, right? And as we delivered now after the last quarter and now this quarter, the cash balance, obviously, is extremely strong.

And I think that — and when you take a look at the evolution of our stock price over the last few months, I think that the market is essentially turning the corner and saying, okay, those guys actually delivered and the team actually delivered on what they said that they would deliver in terms of profitability, cash positions and so on and so on. And therefore, we’ll get a little bit more credit going forward. That’s actually our belief.

Operator

Thank you, presenters. And I am showing no further questions at this time. I would like to turn the conference back to Mr. Grozovsky for any closing remarks.

Ilya Grozovsky

Thank you, Laura. In terms of the upcoming calendar, Mohawk management will be participating in the ROTH Virtual Technology Conference on November 11 and 12, the ROTH Virtual Consumer Conference on December 9 to 11, the Needham Growth Conference on January 11 to 15 and the ICR Conference on January 11 to 13.

Thank you for joining us on the call today. We look forward to speaking with you on future calls. This ends our third quarter results call.

Operator

Thank you, sir, and thank you very much presenters. And again, thank you, everyone, for participating. This concludes today’s conference. You may now disconnect. Stay safe and have a lovely day.

Relation of Oil price to USD

Short thoughts:
1) ECB & BoJ focus on headline inflation including energy and food. Lower oil prices leads to lower headline inflation -> expand QE -> Weaker JPY and EUR vs USD.

2) FED focuses on inflation ex energy. Hence lower oil prices leads to stronger USD vs EUR and JPY.

3 Lower oil price -> smaller current account deficit for the US (ie import/export increases) ->  less petrodollars recycling -> strengthen the US dollar.

Amazon

Amazon
Stock price: $1500
Market Capitalisation: $726bn

Amazon has large amount of positive catalysts coming up: Echo Look sales numbers, official announcements with regards to push in groceries, furniture, entry into Australia, advertising revenues split out, prime subscriber numbers, breakout of India segment from international (revealing profitability of international ex Indian segment).

Valuation wise:
Business IT spend is estimated to reach $4trillion by 2021 by Gartner. Roughly half on software/hosting/services. Other half is hardware, which will likely decrease over time as load is shifted towards cloud, but conservatively assume that does not happen.
AWS currently has 40% marketshare, assume this does not increase.
0.4*2trillion=$800bn.
Assume 20% margins (currently 24-26% and stable in last few quarters)= $160bn in EBIT.
Oracle represents the lower end multiples of software companies at roughly 5x sales, but they generate 34% EBIT margins, hence use conservative 2,5x sales => $2trn mcap. Assuming this takes ten years and discounting at 10% for ten years yields NPV of $770bn for only the AWS division. Reality is innovation follows S curve and takes off after penetration reaches ~20% which might be much faster than 10 years. Startups are already deployed fully on cloud.

Variant view is AWS margins. AWS is the lowest cost operator due to massive scale. In the long run, only a few players will remain due to large cost differential and continuous introduction of newest functions (AWS lambda was introduced 2 years before Google introduced Functions. 2 years in IT is ages).
Hence blue sky scenario is that AWS reaches margins closer to the likes of Intel = 70% gross margin. Since OPEX in software companies is much lower, 40% EBIT margins are very much a possibility, doubling AWS NPV to $1.5trn.

AWS alone provides enough upside to warrant the AMZN stock price.

Additional upside from: new offerings from AWS with higher margins and increasing marketshare as the market increasingly becomes a winner takes most market (AWS, Azure, Google), opening and monetizing internal businesses (see note below).
A note on AMZN’s moat: It’s not pricing;

AMZN stays competitive by opening up their internal systems for 3rd parties. All AMZN services are developed from the bottom up so that one day they can be offered to 3rd parties with a click of a button. By allowing 3rd party to use fulfilled by AMZN and AWS, AMZN can effectively determine whether their offering is still competitive in terms of pricing and technology. Where other companies simply “believe” they are, AMZN can test this. If AWS for example grows slower than the market, AMZN knows that either their pricing is not competitive enough or their offering is inferior in terms of service/technology. AMZN is applying this through their whole company, hence all their “internal” services are at least as good as competitors offerings or they would be losing clients. Source: a Google software developer that used to work at AMZN.

Netflix

Share price: $315
Market cap: $136bn

Founder, CEO and Chairman Reed Hastings owns 2.7% of stock and management is paid 800k-1m salary+ multiples of that in stock options. Reed received $20m in stock options in 2017 and these are tied to revenue goals, not subs.

Investment case comes down to:
1) NFLX can monetize content the best given largest subscriber base (ie lowest cost/sub)
2) NFLX has strong pricing power with limited churn as shown before. Its currently priced barely above Spotify which 1) streams commodity (vs Apple music, Amazon)
3) NFLX international position is far stronger than market appreciates. While there is some competition in Western content, it is insignificant in countries including Japan (49m households) and South Korea (16m households).

Downside:
1) Pricing power is weaker than expected and competing services ramp very very quickly. Unlikely as shown by the likes of Hulu (1/10 subscriber base).
2) Cash flow negative due to investment in content that take 1-3 years before monetization. If debt markets freeze, Netflix will have to fund its operations in a different way ie equity raises, but if NFLX falls enough it will likely be taken out.

Why buy now in 2018 after run up? Bear case was Netflix has no pricing power and will experience high churn once they raise prices. Q4 17 was first quarter with price increases and still showed large subscriber growth (that beat estimates), ie disproving the NFLX has no pricing power case.

Rough valuation sanity check:
7.6bn world population
1.4bn China
6.2bn World excluding China

Average is 3.5 persons per household:
1.8bn households in the world ex China

NFLX 2017 subs: 117.6m or 6.6% world penetration.

US Households: 126m
55m US subs currently or penetration of 44%
NFLX targets 60-90m, yielding penetration of 48-71%.

If we assume Netflix doubles sub base in 10 years (conservative), they must add 120m subs. Assume 20m from US and 100m international, conservative again considering US trend.
NFLX must increase their world EX US and China penetration from 2.6% to 8.7% in 10 years.

Valuation:
240m subs
Assume $30/month per sub on average in 10 years:
1) cable bill runs at $90-100, assume $40 is broadband, leaves $60 in entertainment bill;
2) alternatively, Spotify & Apple music are at $10 a month offering no original content.
240m subs x 12 x $30 yields $8.6bn in sales
x 30% EBIT margin = $2.6bn in EBIT

At 20x EV/EBIT multiple: $520bn EV or $200bn now using 10% WACC.
With currently $6bn in debt = $194 bn or 42% upside.

Notes:
US is at 37% contribution margin
international at 4.5%, management has stated LT margins differ per country, but likely to trend considerably higher.
Company EBIT margin is at 7% or 18% excluding marketing which decreases over time as % of sales.
2018 outlook: 10% EBIT margin despite ramping up marketing spend.

Additional upside:
1) Licensing fees to IQIYI in China
2) Licensing fees to Hasbro for toys, theme parks, games
3) 10% WACC
4) Subscribers only double in 10 years
5) 20x EV/EBIT multiple is conservative for business with a) long runway for revenue growth b) subscription based revenues c) very high contribution margins