2023-08-18 16:15:33 ET
Summary
- Nextdoor is a social network for neighborhoods operating in 11 countries.
- Potential user universe is limited by the number of households in the operating markets.
- Under-monetized user base provides substantial upside potential, when compared to competition.
- At current price of $2.2, there is 64% upside potential, under the base-case scenario, with a 95% chance for undervaluation.
Introduction
Nextdoor Holdings, Inc. ( KIND ), in simple terms, is a social network for neighborhoods that operates in 11 countries, including, most notably, the US. This report will look into the growth drivers of the company, what sets the company apart from its nearest competitors, the possible risks related to that, and the valuation.
Growth Opportunities
Similar to my article on Snap Inc. ( SNAP ), we can identify three main growth drivers for KIND:
- Innovation – being a communication platform, though for neighbors, KIND is somewhat similar to Facebook of Meta Platforms ( META ), Pinterest ( PINS ), and Snapchat ((SNAP)). It is, therefore, not surprising that the company generates its revenues from digital advertising. In order to promote customer engagement on the platform, as well as provide the advertisers with the necessary tools to serve the ads to the target audience, the company has prioritized three main areas of investment and development:
- Core product development – to improve the platform and bring functionalities and interaction solutions. This has led to the creation of several tools of communication, which can be found below.
Company's Investor Presentation
- Ads solutions – development of the company’s Ads Platform to deliver advertiser value and reduce advertising effort, all of which is delivered through such products as newsfeeds, In-app Digest and Email Digest, and “For Sale & Free”.
- Cloud infrastructure – further optimization of the platform to make it scalable and flexible.
- Internationalization – as of Q2’2023, KIND operated in 11 countries and had 41.6mln weekly average users (WAU), of which 33mln (or about 80%) came from the US. These figures encompass more than 305,000 neighborhoods around the world, with 78mln verified neighbors (discussed in more detail below). Still, the growth trajectory has not been a great one – as can be seen from the Figure 1 below, growth, though positive at 2-year cumulative growth of 42.5%, or 19.4% CAGR, has been slowing down. Interestingly, while International markets have posted higher cumulative rate of growth of 68.6% (Table 1), relative to only 36.9% for the US, the latter’s contribution to total WAU growth, given its scale, was higher, at 30.5 percentage points (pps).
Figure 1
Company's 10Ks/Qs, Author's calculations
Table 1
Company's 10Ks/Qs, Author's calculations
- Monetization – Since KIND breaks down its revenues into US and International segments, the former contributes almost 96% to the total (Table 2). As of TTM Q2’2022, total revenue stood at $213.9mln, which is a 1.7% YoY decline, driven exclusively by lower US revenue.
Table 2
Company's 10Ks/Qs, Author's calculations
On ARPWAU basis (average revenue per WAU), the company was at a relatively low level of $1.37, over the Q2’2023 (or about $5.3 on annual basis), which has declined both sequentially and YoY (Figure 2). This puts the company significantly below its direct competitors, with PINS over the same fiscal quarter standing at around $6 (assuming WAU/MAU of 25%) and SNAP at $5.4 (assuming WAU/DAU of 50%), or $25.5 and $23.7, respectively, on annual basis.
Figure 2
Company's 10Ks/Qs, Author's calculations
Switching to ARPWAU by geography (Table 3), despite low monetization level of the non-US markets, the 10 international markets contributed a positive, though negligible, 0.5 percentage points (pps) to the overall 7.5% decline in total ARPU, while most of the growth drag came from the US, which contributed -8pps. Also notable is that, even though the US market is the main revenue driver for KIND, with Q2’2023 US ARPWAU of only $1.3, there is plenty of room for growth, given the ARPWAU of $23.7 for PINS (again, with WAU/MAU of 25%) and $13.6 for SNAP (WAU/DAU of 50%) over the same period.
Table 3
Company's 10Ks/Qs, Author's calculations
Notwithstanding the above, it is worth mentioning there are several other factors that separate KIND apart from its competitors, which may have both positive and negative impact on platform’s development and its potential.
First, each neighbor’s account is verified using several methods to ensure they actually live in the designated neighborhood. With 78mln verified neighbors, KIND offers a potentially unique value proposition to advertisers, who may launch their ads campaigns around specific neighborhoods/neighbors with focused interests.
Second, the “user” definition of the company is quite unique. Given its focus on neighborhoods, the typical user is actually not an individual. This implies that when we talk about the current and, more importantly, the potential user count, we should actually be referring to the number of households. More specifically, based on some estimates , there are 131.2mln households in the US in 2022 and approximately 317mln across the 11 markets the company operates in (using the latest WAU figures, this implies a 25% penetration rate for the US and 13% overall across 11 markets). Meanwhile, SNAP had 397mln DAUs (or almost 200mln WAUs, based on 50% WAU/DAU) and PINS had 465mln MAUs (or 116mln WAUs, assuming 25% WAU/MAU). As a result, households, as platform users, substantially compress KIND’s user universe and, in order to achieve WAU levels of some of its direct competitors, the company will have to attain significantly high penetration rates.
Third, we should also look at the typical household profile of the KIND platform. According to Q4’2022 investor presentation, the company noted that 73% of people visiting its platform in any given month had not visited Snapchat (which caters mostly for younger audience of 13-24, or almost 60% of its user base). This may imply that KIND's typical user’s age is likely to be more than 25 years. This is somewhat supported by yet another data point, indicating that only 18% of the respondents did not visit Facebook (which is more popular with higher-aged groups of 25+, or 73.7% of its user base). This is all not surprising, as a household on the platform will likely be represented by a single user (spouse or partner), who, on average, is aged 30+ .
Fourth, there are some longs who indicate that KIND has been able to generate much better ARPU in 2022 than other social media platforms back when they were of similar size – like SNAP in 2017, despite the latter then having five times as many DAUs. While I do expect KIND’s ARPU to increase over the years and will show later on in the valuation section that there is a substantial upside potential for the company, I tend to disagree with the analysis above for one particular reason – digital advertising is a fast-growing industry, which is rapidly evolving each year, and comparing these two periods, though separated by some six years apart, is not accurate. To add some context, back in 2017, US digital ad market size was around $88bln (or 43% of US total media ad spending, according to eMarketer ), while in 2022 that number sky-rocketed to almost $250bln (or 72% of the US total media ad spending). Clearly, both the size and the relative proportion of the digital ad market has increased over the years, which must have played a significant role in KIND’s higher ARPU figures in 2022, relative to what SNAP generated in 2017.
Fifth, KIND's "For Sale & Free" platform feature is a local marketplace for neighbors that is currently not being monetized (despite already having about $1.2bln in monthly GMV, as per the CEO during this year's Morgan Stanley Technology, Media & Telecom [MS TMT] conference), but which does present an upside optionality kicker.
Sixth, and to show why ARPU should grow, which is an assumption I make in the valuation section below, Nextdoor currently under-utilizes its platform's ads potential, because it still relies on Google ad manager. But as the company works on building its own, proprietary ad server, it will be able to provide more flexibility and focus to advertisers and drastically improve platform monetization.
Valuation
To start with, the value drivers that we shall discuss below will center around my views on Nextdoor – a niche digital ads company, with neighborhoods being its target audience. As a result, unlike its direct competitors, KIND's target market size will be limited by household, rather than user, count, which is only ~317mln based on 11 operating markets. This factor will also dampen positive operating leverage effects and limit and defer operating margin expansion.
- Revenue growth – I will make the revenue growth assumption, based on my projection of the revenue level KIND will achieve in year 10, derived from household and monetization growth. Specifically, I will assume the penetration rate will reach 50% in the US and about 30% overall. Assuming roughly 0.75% annual household growth rate, that would translate into slightly more than 71mln WAUs in the US and 101mln WAUs overall. Assuming further that the total ARPWAU level will reach around $24 (roughly the mid-point of what both PINS and SNAP deliver today, as per earlier analysis), this will result in a year 10 revenue of $2.4bln.
As such, the base-case revenue growth will be based on four stages:
- 5% growth in Year 1, based on the management's guidance of 'mid-single-digit' growth rate for the year;
- 25% growth in Year 2 that will gradually increase to 52% in Year 5;
- 52% to 4.3% ( 10-Year US Treasury Note ) gradual decline from Year 6 to Year 10 (which will allow to achieve $2.4bln revenue in Year 10);
- 4.3% in the terminal period (Year 10 onwards).
- Profitability – KIND is still an unprofitable company. While the management does provide the adjusted EBITDA calculation, similar to its competitors, such as PINS and SNAP, the company still remains increasingly unprofitable. As per the company, the adjustments (relative to GAAP EBITDA) include non-cash and non-recurring items – the most frequent one being the stock-based compensation (SBC) expense. As I have mentioned in my previous articles, the SBC is not only an actual cost for the company, but also a recurring one and, therefore, by adding this item back, we run the risk of understating future expenses. To see the extent of the issue, we can look at the percent contribution of SBC to the EBITDA adjustment over the available two TTM periods:
Table 4
TTM Q2'2022 | TTM Q2'2023 | |
EBITDA | -$115.1 | -$147.1 |
SBC | $60.8 | $72.1 |
Adj EBITDA | -$55.5 | -$75.8 |
SBC contribution | 102% | 101% |
Source: 10Ks/Qs and author’s calculations.
We can clearly see that the SBC expense plays a significant role in the improved adjusted EBITDA figure. In fact, the SBC expense takes up an ever-increasing portion of total expenses (COGS plus SG&A), reaching almost 20% in TTM Q2’2023, up from 18% in TTM Q2’2022.
Separately, KIND spends considerably on R&D – in fact, over the last two TTM periods, the company has spent, on aggregate, 58% of its revenue, which is much higher than 34% for PINS or 43% for SNAP, over the same period. As is usually the case, I will capitalize R&D expenses.
Looking forward, I will assume that KIND will be able to reach 20% in operating margins (similar to late-period Twitter), though with a little delay, given user (aka household) headwinds, as discussed above – only year 7 in the base-case scenario.
- Reinvestment – this is a composite term that usually includes three important items: capital expenditures (including acquisitions and divestments), depreciation and amortization expenses, and working capital investments. As mentioned above, it will also include capitalized R&D expenses. For the purposes of valuation, the sales to reinvestment ratio will be used to project future reinvestment activity of the company. For KIND, I will use the ratio of 1.0, which is around the level the company has shown over the last two available TTM periods.
As usual, to calculate the reinvestment rate in the terminal period, we shall use the re-arranged sustainable growth formula at the stakeholder level:
Reinvestment rate = Sustainable growth / ROIC,
whereby the sustainable growth will equal the 10-year Treasury Note rate of 4.3% and an ROIC of 8.8% (equal to terminal period WACC):
Reinvestment rate = 4.3% / 8.8% = 48.9% (to be multiplied by the after-tax adjusted EBIT to arrive at an absolute value).
- Risk – using market values of equity and debt (including leases), we have the following:
Equity | After-Tax Debt | Capital | |
Weight in Cost of Capital | 95.8% | 4.2% | 100% |
Component cost | 10.81% | 3.46% | 10.51% |
The equity component was calculated using the risk-free rate of 4.3%, ERP (geographically weighted by sales) of 5.37% and a levered bottom-up beta of 1.21.
Even though KIND does not have any interest-bearing debt, it does have some leases, which, as per the latest 10K report, had weighted average discount rate of 4.5% (pre-tax debt component):
Cost of equity = 4.3% + 1.21*5.37% = 10.81%
Cost of debt = 4.5% * (1-23%) = 3.46%
This 5-year WACC of 10.51% will be linearly adjusted downwards during the remaining five years (from Year 6 to 10) to a terminal rate of 4.3%.
Apart from these major assumptions, the following has been applied in the model as well:
- Share count of 415.1mln (comprising Class A and B stock, but also including RSUs);
- Marginal tax rate of 23%
- Value of leases of $69mln (the company has no interest-bearing debt);
- Value of options of $102mln, based on 53.4mln options outstanding; average strike price of $2.7; average maturity of 7.1 years, and standard deviation of 66% (10Q filing);
- Loss carryforwards of $617mln, which will reduce the taxable base once the company becomes profitable.
The table below presents the model results:
At the current price per share of around $2.2 and the base-case value of $3.6, there is almost a 64% upside potential. To account for the uncertainty factor in the main assumptions discussed above, the Monte Carlo simulation of 10K trials has been conducted by applying probability distributions to base-case assumptions of revenue growth, operating margin, target margin adjustment period (year 7 in the base-case), reinvestment ratio, and the WACC. The results are provided below:
Figure 3
Figure 3 shows the median value per share of around $4 (vertical green line) and the area (colored red) above the $2.2 of value per share. As a result of these simulations, given the distribution assumptions, it appears there is almost a 95% chance the stock is undervalued at the current price.
Potential Risks
- Limited ads dollars allocation from advertisers – due to its niche position and limited, household-based, user count;
- Under-monetization of the markets KIND operates in, especially non-U.S. ones (i.e., failure to consistently and efficiently grow its ARPWAU);
- Failure to reach and maintain households in the markets KIND operates in, resulting in slow DAU growth;
- Slow operating leverage effects – deferring operating margin expansion (e.g., special concern is on high SBC expense);
- High holdings from original backers (PE/VC firms) that have almost 30% of shares outstanding (Seeking Alpha);
- A buyback program implemented by the company, as these funds should better be directed for growth rather than stock repurchases, even if they are being traded at levels below the perceived fair value.
- Dual-class share structure, with publicly traded Class A stock having 1 vote per share and Class B (privately held) 10 votes per share. As a result, even though Class B stock itself has 53% by count, by voting power it rises to 92%, implying an exceedingly high concentration of power within the current directors of the company.
While I have tried to capture risks 1-4 when running simulations, it is still important to draw attention on what can go wrong, since there are scenarios under which the stock can go even lower from its current level.
For further details see:
Nextdoor: An Enticing Upside Opportunity