Jamie Ross, Fund Manager for Henderson EuroTrust, investigate how some companies have used disruptive situations to emerge stronger and explore the lollapalooza of forces that often lead to an outcome that is much larger than the sum of the parts.

• The 2002 SARS pandemic was a driving force in launching Alibaba to great heights through the adoption of broadband and e-commerce among many Chinese households. A similar trend is emerging in today’s post-COVID world, with a huge uptake in online grocery shopping and increasingly digitalised real estate markets.
• The team believes that companies that consistently think long-term tend to thrive and see their business accelerate in the face of new competitive challenges or economic uncertainty.
• A focus on customer loyalty and a consistently long-term focus are key traits that the team believes can make a company increasingly robust over time.

As the global economy recovers from the COVID-19 crisis, we are confident that the internet companies in our portfolios can improve their market positions even further in the coming years. This event is causing consumers to adapt to a new way of life, turning to online businesses for needs previously fulfilled by brick and mortar peers. Some of these trends were already underway pre-COVID, but adoption has been accelerated by the widespread ‘forced’ need to consume in this new manner.

During every crisis, there will always be companies that manage to emerge as stronger businesses. It was during the 2008-09 crisis that Shopify first proved that its business model was sustainable, allowing it to grow into what it is today. In an interview with ‘How I Built This’ in May, the visionary founder and CEO of Shopify, Tobias Lutke, detailed how, going into the 2008 Global Financial Crisis, he had originally expected subscribers to “fall off a cliff”. But instead, subscribers and usage started climbing at an accelerated pace. Those who had been laid-off determined that there was no better time to take a risk and search for a new source of income and potential financial independence by opening online stores. By providing the tools for these budding entrepreneurs, Shopify went from being barely able to meet payroll, to breaking even for the first time in its history. Even after the economy recovered, these entrepreneurs had bedded into their new careers and online stores continued to thrive, being built on the solutions Shopify provided. In this case, the habits that formed during a period of crisis proved to be a permanent shift.

When China’s SARS outbreak started in November 2002, Alibaba was just on the cusp of launching its consumer-focused Taobao website. Having sent all employees to work from home, Alibaba co-founder Jack Ma and a core group of developers worked around the clock and launched Taobao from his apartment in May 2003. In the book Alibaba: The House That Jack Ma Built, author Duncan Clark explained that the outbreak came to represent a turning point, when the Internet emerged as a truly mass medium in China. This event coincided with the arrival of broadband connections and, for the first time, people experienced what they could do when they were stuck at home. Millions of people, confined to their homes or dormitories for days or weeks on end, looked to the internet for information or entertainment. Crucially for Alibaba, SARS convinced millions of people who were too afraid to go outside to try shopping online instead. This event forced a population, who had previously not seen the need to try e-commerce, to suddenly adopt a new method of shopping out of sheer necessity.

These habits stuck, and you could argue that without SARS, Taobao, with its several hundred-billion-US dollar valuation, might not exist today. The event drove a large influx of new users to e-commerce and created the white space that Alibaba needed to fight the incumbent EachNet (later bought by eBay), quickly gaining critical mass and reaching the network tipping point that is so crucial in a marketplace business. Alibaba had created a superior model. They just needed a large group of new e-commerce users – which SARS provided. By 2006, Alibaba had won and became the dominant marketplace in China.

So, if history is any guide, there will be companies that adapt and emerge stronger during this crisis too. Once again, it is the e-commerce industry that is a shining example, given the tremendous growth we have seen globally in the past few months.

But starting in March 2020, online grocery orders began to surge overnight. Orders went up 100 – 200% year-on-year, and most importantly, 42% of those customers had never bought groceries online before.³ This is favourable for the industry, since customers proactively seeking out the service means that companies may need to spend less on acquiring customers.

Chart 1 is a powerful indication of the increase in e-commerce as a percentage of retail sales in the UK and the picture is very similar in the other countries too. The eight-week period at the start of lockdown saw e-commerce penetration increase by the same amount as had been achieved over the prior decade (although we note that it is very likely that some meaningful portion of this e-commerce market share increase will reverse as physical stores reopen).

We believe e-commerce will catalyse large shifts in many industries. For instance, with virtual tours having fully replaced open houses during lockdown and digital notarisations becoming legally binding for real estate sales in some countries, it may be that the real estate purchasing experience becomes much more of an online transaction.

Scout 24, owner of Germany’s ImmoScout, is a leading digital real estate platform in our portfolio. In March 2020, Scout 24 announced a fee deferral option for estate agents in order to help them during tough times. In their first-quarter earnings call this year, the Scout 24 CEO said that the company had continued its payment deferral solution for agents in May but that only around 10% of their agents had asked for the payment holiday. This could be due to the current good health of the industry or because the payment for Scout’s services is still a small part of their own turnover. Today, the return on investment of an online ImmoScout advert is multiple times that of any other form of traditional advertisement, such as print newspapers, for estate agents. Companies that have flourished in the crisis may be more likely to come out much stronger once the crisis abates.

The global internet investment group Prosus, another of our portfolio holdings, was an early investor across most e-commerce segments. Prosus sees a huge long-term opportunity in internet consumerism and aims to help both sellers and buyers to keep both parties engaged, and has been very active in recent months, with three very value accretive merger and acquisition deals. Prosus has a very strong balance sheet with approximately US$5.4bn net cash⁶ meaning that they have the means to invest and potentially take advantage of the crisis.

We believe that a long-term focused company is more likely to make value-creating investments. Companies that successfully think long term and are prepared to evolve are better positioned to thrive in the face of new competitive challenges or economic uncertainty. A perfect illustration for this statement is iFood, the Prosus-owned food delivery platform in Brazil. According to Forbes, iFood was the absolute market leader with an 86% market share (17x bigger than the second competitor) through their marketplace-only model. However, they were not content with this. They saw an immense opportunity to expand their total addressable market by exploring the ‘own delivery’ model whilst, in the short term, disrupting their profitable marketplace business model. We consider this to be a good indicator of long-term thinking and adaptability. We are continuously looking for management teams that go beyond optimising for the near term; we feel reassured to be aligned with these companies in times of crisis and disruption.

Delivery Hero, another core internet holding, has also weathered this period extremely well, enjoying a strong year-on-year gross merchandise volume increase of 58% in the first quarter, to €2.4bn as at 31 March 2020.⁷ Despite strong demand, the management team did not want to let the potential benefits of the COVID crisis escape them. They used the lockdown period to increase their presence in the convenience store delivery space (q-commerce). The company has so far opened 104 D-mart stores in nine markets across the Middle East and North Africa, Asia, and the Americas with a target for 400 by year end, as illustrated in the Q1 2020 Delivery Hero presentation. In doing so, Delivery Hero is untapping a large and underpenetrated total addressable market opportunity.

We believe that this crisis will help to accelerate the user adoption for companies like these and, in some cases, provide the jump start needed to achieve their tipping point ­- in other words, a sustainable business model. We are already seeing hard data on how consumers are behaving and how it is impacting companies’ financials.

Studies have shown that it takes around 66 days to form a new habit – coincidentally the length of the social distancing period in many countries (so far). Even if we go back to normal tomorrow, it is safe to bet that some of the habits and loyalty gained during this period will be maintained and extended as we move forward. Loyalty and scale are amongst the most important metrics for us as they are the most sustainable   and measurable   competitive advantages. They are much more important online than offline, which is why the internet economy has such a pronounced “winner takes most” dynamic relative to the offline economy. The investments that our portfolio companies are undergoing now to make the steps towards increasing scale and loyalty will be crucial in improving their long-term margins.

The statement ‘CAC is the new rent’ from Daniel Gulati of Comcast Ventures, is a perfect one-line summary to explain the transition of the online economy. It refers to the fact that advertising spend, i.e. Customer Acquisition Cost, is generally the largest expense for most consumer-oriented internet companies. While in the offline world it is impossible to be a retailer without paying rent, it is impossible to be a retailer in the online world without paying CAC.

We believe that CAC is subject to a bigger economy of scale benefit than any comparable offline metric. For example, it is not the case that a retailer or restaurant’s rent per location decreases significantly every time they double in size. This is one of the factors driving much higher returns on invested capital for dominant online companies versus comparably dominant offline companies.

Scale is almost always correlated with customer loyalty and customer experience; both online and offline. However, customer loyalty is even more important online given the significance of the advertising quality score for costs and the fact that a loyal customer base lets an internet company avoid paying “rent” to Google, Facebook or similar aggregators. Essentially it is almost impossible to be a large internet company if you don’t have a loyal customer base that raises your ad quality score and thereby lowers your CAC. Customer loyalty generally means more repeat customers and more organic traffic, which means that larger companies effectively are not paying “rent”. For example, according to website ranking site similarweb.com, immobilienscout24.de ranks as the 26^th most clicked website amongst the general category in Germany, competing with the likes of YouTube, Google and Facebook. Such a high ranking for a specialist website reduces CAC costs.

Repeat customers and organic traffic are effectively “rent avoidance,” which magnifies the importance of frequency and retention. The cream really rises to the top in the internet, and once it is at the top it is hard to displace. There is an initial period where market share is up for grabs, but if it is not secured during the initial stages of development it can become much harder to do so at a later stage.

Beyond this, scale matters because so much of internet economics revolves around making accurate predictions; the more data one has, the more accurate one’s predictions are in an artificial intelligence (AI) and machine learning (ML) environment. Internet companies need to be able to make accurate predictions around customer lifetime value, payback periods and recommendations (both for building customer baskets online and increasing engagement). We believe that one of the most fundamental principles to understand a world dominated by AI/ML is that scale matters more than almost any other variable for AI quality. From discussions with the management teams of Prosus and Delivery Hero, we understand that a considerable part of their investment goes into developing proprietary AI technology to better understand customer behaviour and delivery logistics and these efforts are starting to show through in their results; the latest quarterly presentation by Delivery Hero showed an increasing proportion of profitability from the new ‘own delivery’ versus their traditional marketplace-only model.

To summarise, we are very encouraged by the way our portfolio companies are behaving in this crisis. However, we should also admit that we are all still grappling with how society and global business will change. Coronavirus may be the catalyst that accelerates important mega trends. That said, we are not trying to make exact narrow-range predictions. Our aim is to side with companies that take advantage of the volatility leading to emergent behaviour that improves the robustness of the system over time. Imagine a river; sharp bends and narrow straights vary the flow of water and carve out depths to support various ecosystems. This variety, or ‘volatility’ supports a level of diversity that would not be matched if a river ran in a straight line with a constant flow and at a constant depth. Likewise, throughout our careers we have learned to embrace and celebrate the twists and turns that lead to volatility in the marketplace.

¹ Deutsche Bank cited by e-fulfillment technology provider Fabric, as at 11 February 2020

² Coresight Research US Online Grocery Survey 2019, as at 14 May 2019

³ Business Insider Intelligence survey of 1,199 adults in the US aged over 18, as at 12 April 2020

⁴ Nexi Q1 2020 investor presentation

⁵ Conversation with Nexi CFO, at beginning June 2020

⁶ Prosus investor day presentation, as at September 2019

⁷ Delivery Hero quarterly report, as at 31 March 2020

The lollapalooza effect: the phenomenon wherein different biases layer and interlock with one another