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Emma Rapaport: Hello, and welcome to Morningstar. I'm Emma Rapaport. We're here today to explore some ideas on our Morningstar best ideas list. We're here with Dr. Roy Van Keulen.

Roy, thank you very much for joining us today.

Dr. Roy Van Keulen: Thanks for having me.

Rapaport: Roy, we're here to talk about Kogan, and I think a lot of our viewers will know Kogan mainly because of the massive share price increase that happened in 2020, but then also, the subsequent massive share price drop last year, and it's back to where it was pre-pandemic. So, can you walk us through what has happened with this company, why there's been so much movement and why now the market has essentially turned against this stock?

Van Keulen: Yeah, sure. It's been quite a rollercoaster. You can kind of answer that question in two ways. One is, what was originally a very positive sentiment, just turned around. So, when the sentiment is positive, you're only focusing on pluses of a company, and when it turns negative, suddenly all of the negatives become more emphasized. So, that is one part. It's the sentiment part. The other part we think is that there has been a bit of a setback in the last half year, which – there's two main reasons for it. One is, there's been a bit of an excess in inventory build-up. So, we think that probably in anticipation of supply chain shortages around the shopping season Kogan really build up its inventory. But it turned out a lot of people had the same idea, so it actually shopped for the shopping season, the Christmas season a little bit earlier. So, there's been a bit of a hangover there.

And then, the second part is the increasing marketing spend. So, that one is interesting. It's not very much discussed. But when you think about it, when COVID came, there was all of this movement of shopping to online. And as part of that, both pureplay as well as omnichannel retailers had to basically increase their spending to try to capture this demand shift. And what happens when there's a lot of demand for something? You get a bit of a supply shortage, and we think that's been the case in not just microchips, but also in online keywords and just online advertising. So, we see that that's kind of blown up everywhere, and when you can get a return on that marketing spend, there's a bit of a negative overhang from that.

Rapaport: So, you've put Kogan on the – well, yourself and the rest of the equity analyst team has put Kogan on the Morningstar best ideas list, which implies to me that you think that the market has gotten this wrong and that there is an opportunity in buying Kogan today or buying Kogan with some additional research around it. So, can you walk me through your thesis as to why you think everyone else has gotten this wrong and why you think the company will be able to have a bit of a turnaround in the long term?

Van Keulen: Yeah. So, some of the things that we think are not well understood by the market is that this marketing spend is discretionary. So, they've really upped that marketing spent, but they can also dial it down because it's just buying ad words, buying keywords and that kind of stuff. So. that's the first thing.

The second thing is, this is a market that part of this transition to online is sticky, right? We probably all know people who didn't buy things online a lot before, but they've now gotten used to doing it a couple of times, and once you've kind of gotten through that friction a couple of times, the next time when you're thinking of buying something, you're more likely to go to the online channel than the traditional bricks and mortar. So, that's one thing. It's probably just a stickiness and a higher base.

In addition, there's the – online is still a really big growth area. We think it grows by, like, closest to double digits. And if you look at it over the next decade, there's a real big increase in market size for Kogan. And then, the next part is, we think that they will actually maintain their market share. Maybe we'll talk about Amazon a bit more. But…

Rapaport: Yeah. So, when I look at this online retail space, and I understand, yes, you've had all these people coming from the pandemic and have a learned experience of what shopping online is, and that's great. But when you go online, there are lots of people competing for attention, for shoppers' attention. So, are you at all worried about places like Amazon humming and competing with Kogan maybe on price? Or they've got this Amazon Prime service. Is that something you're worried about?

Van Keulen: Well, yes and no. So, Amazon is obviously like the 800-pound gorilla, right? And it's probably the least fun competitor to have. Having said that, if you look at, for example, the U.S., which is their home base, they only have about a third of the online market share, which means that they don't have two-thirds of the market share. And we think that Kogan as well will be able to maintain some sense of market here. It won't be Amazon size, but it's now around 3% of online marketing spend if you exclude food. And we think it's very likely that they will maintain it, and there's a couple of main reasons. One is that they really know their local market. So, I looked this morning at the Amazon website, and it was just the generic online website as it is every day. Then I looked at the Kogan website and it has the humidifiers because there's been (floods), right? So, they really know their local market very well, I think.

And in addition to that, Kogan also has its own, kind of, brand in Australia. They may not offer the cheapest 24-inch Samsung TV, but they have their own Kogan TVs, 24-inch. Maybe probably not a TV, but a computer monitor 24-inch. But, sure. And then, the last one is that Kogan First is seeing really fast adoption…

Rapaport: This is their subscription service?

Van Keulen: This is their subscription service, that's right. So, maybe to double click on that one a bit, they now have around 300,000 subscribers to that. So, it's a monthly or annual fee, and then you get some discounts on delivery costs and just general discounts throughout. And we think that that communicates quite a high buyer intent. So, for comparison, Amazon Prime in Australia has 2.9 million subscribers, so it's quite a bit more. But we think that, one, a lot of people who are taking that have just gotten bored of Netflix and they're taking Amazon Prime Video. And the second is, if you just look at Kogan First, it's all about just delivery discounts. They don't have this this other service on top. So, it does demonstrate buyer intent for the future. So, yeah, we think that that is showing that they have a longer-term relationship with their customers. That's quite encouraging for the future market share.

Rapaport: One of the things that we've been talking about for quite some time and has actually become more and more bigger the topic in the last month with the oil price going up and people being worried about rising inflation and potential for rising rates globally, Australia and in the U.S. We're talking a lot about inflation and the impact it has on individual stocks and sectors, and this is a consumer discretionary stock.

Van Keulen: Yeah.

Rapaport: Are you at all concerned that Australian consumers will start tightening the purse strings if they're worried about all these other costs and this could have either positive or a negative flow-on effect for Kogan?

Van Keulen: Yeah. So, obviously, as you said, it's a discretionary company in a way. So, if everything goes up, the Australian consumer will first pay their groceries and their gas at the pump and only then do they buy the next iPhone. So, that's definitely on a revenue perspective and a possibility.

But there's also another aspect, and that's the inventory level. So, Kogan currently has quite high inventory, kind of by accident, but it may turn out to be a bit of a happy accident because the prices to buy new inventory is quite high. So, they can potentially get some more margin on that inventory. And then, lastly, I would say that – we mentioned Kogan First a bit. Kogan First itself is a more recurring revenue stream. So, you don't really watch it too closely. It's like your Netflix subscription or your Spotify subscription.

Rapaport: It's hard to turn off.

Van Keulen: People don't really turn it off, right? That's what they're seeing as well, and that's what we've seen before in the U.S. with Amazon Prime. So, this Kogan First part kind of feels more, not like buying an iPhone, but buying a Telstra subscription, so more of your monthly recurring revenue. And if you look at the difference in multiples for discretionary companies versus (telcos), those command higher multiples because of higher predictability. So, we actually think that Kogan First may in five years from now be worth more than current enterprise value, just as a standalone business, even though there's this whole business on top of it.

Rapaport: And just finally, one of the things that our viewers always like to know is what's happening with the dividends with the company, and I know there's been some movement here that they had dividends and now it's been turned off. Do you have a dividend outlook, or do you have a perspective on their approach to shareholder dividends?

Van Keulen: Yeah, sure. So generally, dividends are a sign of a healthy company and especially, in Australia, that's something that investors are quite used to. But we don't really think that's a big issue. So, a couple of reasons. The first one is the dividend wasn't substantial before, right? The second part is their balance sheet is actually healthy. So, it's not a sign of a business that's unhealthy. And then, you can say, okay, but are they properly including shareholders in the returns. They're saying we would rather reinvest that into the business, we think that there's a big opportunity at the moment. And we tend to agree with that. If you look over the last five years, for every marginal incremental dollar that they put into marketing spend, they get that dollar plus a percentage which would be above your average share market return back in gross profits. So, in that sense, they have a bit of a compounding machine. So, we actually think that that's a proper allocation of resources. They have growth opportunities. They can invest in that rather than giving it straight back to the shareholders.

Rapaport: Wonderful. Thank you very much for joining us today. I'm sure we can go and read this special report that you've written. So, thank you very much.

Van Keulen: Thanks, Emma.