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General Commentary
June 19, 2016

Finding The Next Starbucks

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Market Snapshot

Indices Week YTD
GSV 300 1.80% 42.10%
S&P 500 0.70% 9.10%
Dow 0.60% 10.40%
NASDAQ 0.80% 16.40%
Russell 2000 1.40% 1.50%
MSCI P/E Fwd P/E/G
Valuations 25.8x 0.7x
GSV 300 17.6x 2.3x
S&P 500 Now YTD
I-Rates 2.17% -11.40%
10-Year Note 1.03% 102.00%
3-Month Bill - Current
Sentiment - 28.1-38.3
Bull-Bear - 0.97
Put-Call - 11.28
Vix Now YTD
Inflation $1 12.50%
Gold $47.86 -11.10%
Oil - Week
Mutual Funds - -$3.40
Fund Flows (bil) 00-09 09-Now
Growth-Value -34% 218%
Growth 87% 133%
Value

I was fortunate to be one of the first research analysts to identify Starbucks as a huge opportunity following its IPO in 1992, when its market cap was $200 million. Today its market cap is over $80 billion.

Lucky? Maybe a little. Art or science? Both. Let me tell you a story.

It was a Thursday afternoon after a long week on the road visiting companies. I was in Seattle with one meeting to go before I flew home. My friends told me about this coffee company — named after a Moby Dick character — that had a cult following. I almost cancelled my meeting on the way to the airport because I just wanted to get home and the company sounded ridiculous.

Maybe people in Seattle would embrace a coffee house as a great business, but I couldn’t imagine this concept traveling beyond the Puget Sound. But, Starbucks headquarters was just off Interstate 5 on the way to the airport and I figured, “Why not, I’ll make it quick.”

The minute I walked into the reception area, I knew something was going on there. The level of energy in the air was electric. When I sat down with CEO, Howard Shultz, he crystallized how Starbucks was going to become the most important coffee company in the World.

He talked about the importance of his employees and how he was creating a partnership with them. He was passionate about the quality of the product and the customer experience. He had a roadmap to become a universally respected consumer brand.


Starbucks CEO Howard Schultz

Source: ABC News

I was convinced. I left believing I had just met the next Ray Kroc — the man who turned McDonald’s into a billion-dollar hamburger business.

Today, a new wave of innovation is beginning to crest led by culinary and cultural upstarts seeking a piece of the $100 billion global coffee market. Businesses like Blue Bottle and Philz have raised $116 million and $30 million respectively by creating a highly curated consumer experience focused on carefully sourced and brewed coffee — combined with a rigorous emphasis on the aesthetic of their stores and take-home products.

The rise of Greek yogurt is instructive when considering the market opportunity for coffee newcomers.

Greek yogurt was an obscure 1% of U.S. yogurt sales in 2007. Then Chobani entered the scene, luring consumers away from sugary stalwarts like Dannon and Yoplait. Now Greek yogurt accounts for 40% of the $7.4 billion U.S. yogurt market, while the heavyweights are racing to catch up.

STATE OF PLAY

More American adults drink coffee on a given day than any other beverage — including soda, juice, tea, tap water, and bottled water.

$52 Billion U.S. Coffee Market

Source: Specialty Coffee Association of America, GSV Asset Management

According to the National Coffee Association, Americans drank two cups of coffee per day in 2015, the continuation of a steady rebound in coffee consumption from historical lows in the 1990s. Two key drivers are behind this trend. First, young people are drinking more coffee than ever before.

Young People Are Drinking More Coffee
Percentage of Americans Who Are Daily Coffee Drinkers By Age Group, 2000-2015*

Source: National Coffee Association, GSV Asset Management
*Trailing Five-Year Average

A second key driver for increasing coffee consumption is a growing appetite for “specialty coffee”. According to the Specialty Coffee Association of America, one of every two cups of coffee consumed in the U.S. is considered specialty, and according to the National Coffee Association, specialty coffee consumption rose threefold between 2000 and 2015. Over 34% of adult coffee drinkers report drinking specialty coffee daily, up from 24% in 2010.

The estimated $28 billion U.S. speciality coffee market represents a broad spectrum of coffee varieties sourced from a range of regions. The common threads are high quality beans, nuanced flavor profiles, and greater attention to sustainable, eco-friendly supply chains. Served primarily in coffee houses, the rise of the speciality market is at the core of what Pulitzer Prize winning food critic Jonathan Gold described in 2008 as the emerging “Third Wave” of American coffee.

Three Waves: The Evolution of the U.S. Coffee Market

Source: GSV Asset Management

FIRST WAVE

In the “First Wave”, coffee consumption accelerated as brands like Folgers and Maxwell House made coffee a household good with a variety of “instant” and easy-to-brew products. Capitalizing on improving vacuum packaging technology, First Wave companies were able to prolong the shelf-life of coffee, allowing them to source, store, and ship products in mass quantities.

The launch of the Mr. Coffee drip coffeemaker in 1972 accelerated this trend, enabling high-quality and user-friendly home brewing. Prior to this machine, coffee was primarily made in a percolator, which often gave it a bitter and burned flavor. Baseball legend Joe DiMaggio became a spokesman in 1973, and by 1974, Mr. Coffee had sold over one million units.

SECOND WAVE

Howard Schultz grew up as an immigrant’s son in the projects of Brooklyn, New

York, where his father was an oft-unemployed janitor. Schultz went to college only because he secured a football scholarship to Northern Michigan University. After college, he moved out to Seattle, where he was a household appliance salesperson.

Howard came up with the idea for what Starbucks would become on a trip to Europe,

where he witnessed the connective power of the local coffee bar. Today, Starbucks has taken the power of “local” and made it global, with over 23,000 stores in 63 countries and a market value of over $80 billion.

Starbucks VS. Keurig Green Mountain Coffee: 10-Year Performance
Market Capitalization ($ Billions), 2006-2016 (YTD)*

Source: Capital IQ, GSV Asset Management

*Keurig Green Mountain was acquired in March 2016 for $13.9 billion by a group of investors led by JAB Holding Company

Starbucks is the poster child for coffee’s Second Wave because it created a scalable retail experience based on consistently serving high-quality coffee in a magnetic setting.

What Starbucks tapped into was the “affordable luxury” trend. Whether your were a CEO or a secretary, for $3 you could enjoy the best latte in the World. Starbucks also became the “Third Place” — You had your home, you had your office and Starbucks was the place where you could hang out to unwind, read the newspaper or mingle with people in the community.

Howard Schultz got that he was selling so much more than a gourmet cup of coffee — he was selling an experience and a brand that people wanted to belong to. Carrying around your white and green Starbucks cup with the Siren on it signaled to the World that you cared about quality, you cared about community, and you cared about being part of a hip culture.

Starbucks Coffee Culture: It’s More than a Cup of Coffee

Source: Business Insider

Starbucks brought customers its own music label. In 2002, It offered Wi-Fi in cafés before most people knew what Wi-Fi was. No surprise, the average Starbucks customer began showing up 20x a month, which effectively created a recurring revenue model for a restaurant — unheard of.

Perhaps more importantly, Starbucks demonstrated how to build a powerful relationship with employees in the service economy. It was the first “fast food” restaurant to provide health care benefits to even part time workers. It offered stock options. Starbucks showed that it was not only the right thing to do but the smart thing to do, as employee turnover dropped by 70% and the program paid for itself… with incredibly happy and loyal workers.

Starbucks figured out that if they treated their employee “partners” great, they would in turn treat the customers great and everybody would be happier and better off. Starbucks aspired to a higher mission than selling coffee and truly had a goal to make the World a better place. But it could only get there by earning a great return on investment.

The recent college education program it launched in conjunction with Arizona State University is just the next smart initiative focused on creating a better relationship with its people… and the program is already proving that it will pay for itself.

Key Companies: Second Wave

Source: Company Disclosures, New York Times, Yahoo Finance, GSV Asset Management

Single Serve

Another key development appearing later in the Second Wave was the rise of single-serve brewing systems, which began appearing in kitchens and offices in the 1990s. In the United States, the trend took off when Green Mountain purchased Keurig, launching the market leading “K-Cup” coffee pod in 1998.

Over the past decade, the $8 billion single-serve industry has grown from 2% to almost 10% of the global coffee market. In 2015 U.S. consumers bought $3.1 billion worth of coffee pods — versus $132 million in 2008. In comparison, last year Americans bought $6 billion worth of traditional roasted coffee, and about $2.5 billion in instant coffee.

The success of single-serve owes in part to the rise of retail chains like Starbucks, which accustomed consumers to the idea of ordering a single cup of coffee, chosen from a wide variety of beans. Incidentally, Starbucks, which is in the midst of a five-year partnership with Green Mountain, has emerged as a major player in the field, claiming about 15% of the single-serve market with its branded K-Cups.

Keurig Green Mountain has faltered over the past two years as it has failed to innovate beyond its initially popular K-Cup machines. Consumers have met recent product releases with a collective shrug. Despite this, the company was purchased by Joh. A. Benckiser GmbH (JAB) in late 2015 for $13.9 billion.

At the same time, Nestlé’s Nespresso, which accounts for 6% of the company’s $100 billion in revenue, is surging. The leader in the global coffee pod market with 26% market share, Nespresso has developed a line of wildly popular single serve espresso machines, positioning itself as a premiere, high-end coffee brand. It has taken aim at the U.S. market with the launch of VertuoLine, which brews traditional coffee and competes directly with Keurig Green Mountain.

Nespresso: High Octane U.S. Advertising Push

Source: Nespresso

THIRD WAVE

The next generation artisanal coffee shops such as Blue Bottle Coffee and Philz have been enabled by the coffee culture Starbucks established around the World. Coffee needs to be great, but it also needs to tell an authentic story.

The 18- to 34-year-olds who are driving coffee’s Third Wave are picking products and brands based on their origins, processes, methods, and design. Coffee is a lifestyle. Not surprisingly, the coffee shop has replaced the garage as the place where businesses are created and started. In fact, you’re beginning to see artisanal coffee shops adjacent to or embedded in start-up spaces.

Artisanal Brands Lead Coffee’s Third Wave
Store Aesthetic = Competitive Advantage

Source: GSV Asset Management

Philz Coffee has been a pioneer of the Third Wave, becoming synonymous with carefully crafted cups of coffee served in an environment people love.

Philz founder Faisal “Phil” Jaber opened San Francisco’s Gateway Liquor & Deli on the corner of 24th Street and Folsom in the city’s Mission District in 1976. With a signature fedora and thick mustache, he quickly became a neighborhood fixture, selling everything from cigarettes, to whiskey, and eggs.

The Cult Spreads
Philz Coffee Featured in HBO’s Silicon Valley

Source: HBO

But Phil’s passion was coffee. In his spare time, he experimented with beans and created his own speciality blends.

Before converting his store into the now iconic coffee shop, however, Phil studied the market. As he recalled in a 2014 interview, “I visited over 1,100 coffee shops and five-star restaurants to figure out why people went there, what they were looking for, how the employees interacted with the patrons. It wasn’t to see how they made coffee. I wanted to know how they were building a culture around it.”

Today, Philz has opened 34 locations in the Bay Area, Los Angeles, and Washington DC. The business is led by Phil’s son, Jacob Jabber, who is committed to scaling the business without sacrificing its core asset — an authentic experience based on a cup of coffee made with love.

The recent rise of SoulCycle is instructive for the brand and experience Philz is creating. SoulCycle transcends fitness — it’s about being part of a community where you strengthen your mind, body, and soul. The casual observer might mistake it for a “spinning class.” But when you study SoulCycle, you realize that its monster success derives from doing a hundred little things better than anybody else.

The bikes are specially designed for SoulCycle to develop your “core.” The program emphasizes every muscle in your body, so that after 45 minutes, you’re wiped. The instructors are trained to be both inspirational and aspirational. The music is perfectly choreographed. Despite the heavy sweat, SoulCycle studios sparkle and smell fresh. And there is plenty of cool SoulCycle swag, so you can proudly display that you’re a member of the tribe.

We’re betting that brands like Philz can become to Starbucks what SoulCycle is to the fitness industry. Starbucks is a $80 billion company. Capturing just 2% of that market is a multi-billion dollar opportunity.

Key Companies: Third Wave

Source: Wired, Fast Company, Crunchbase, GSV Asset Management

WHAT TO WATCH

As entrepreneurs continue to pour into coffee, expect the Third Wave to gain more momentum. Already, a variety of new models are beginning to emerge, offering products and services targeting the home, offices, and cafes.

Riding the Third Wave
Pushing the Boundaries of Coffee Innovation

Source: Fast Company, GSV Asset Management

Subscription

As Third Wave coffee purveyors increasingly address demand for high quality coffee at home, expect a continued proliferation of subscription services. In 2014, Blue Bottle announced the acquisition of Tonx to pave the way for the launch of its service, Blue Bottle at Home. The company is delivering its expertly sourced, single origin beans to doorsteps just 24 hours after roasting.

Blue Bottle at Home costs roughly $20 a month, while other boutique coffee roasters, including Chicago’s Intelligentsia and Portland’s Stumptown, offer tiered plans that can be adjusted to ship weekly or monthly.

Caffeinated M&A

According to Dealogic, since the beginning of 2015, there have been 50 coffee or coffee-related mergers and acquisitions worth an aggregate $3 billion worldwide. Strategic buyers have represented 97% of the dollar value of the deals in 2015, with an emphasis on adding scale to the higher margins associated with specialty coffee.

Dollar Value of Annual Global Coffee M&A

Source: Dealogic, National Coffee Association, Brown Brothers Harriman

Joh. A. Benckiser GmbH (JAB), particularly, has been on a buying spree. The company purchased California-based Peet’s Coffee & Tea and Minnesota-based Caribou Coffee in 2012, and D.E. Master Blenders 1753, which had been spun off from Sara Lee Corp., in 2013. In July 2015, JAB acquired Danish retail coffee shop chain Baresso Coffee, later capping the year with the purchase of Keurig Green Mountain for $13.9 billion.

JAB Buying Spree
Recent Coffee M&A Activity Joh. A. Benckiser GmbH (JAB)

Source: Brown Brothers Harriman, Forbes, Wall Street Journal, GSV Asset Management

Blue Bottle has acquired three coffee startups over the past two years, including Tonx (Monthly Personalized Coffee Subscription Service), Handsome Coffee Roasters (Coffee Roaster + Retail Store), and Perfect Coffee (Subscription Service for Freshly-Ground Coffee). Look for Third Wave M&A to accelerate as the battle for the future of coffee heats up.

Bubblin'

by Luben Pampoulov

A New Sheriff in Town

Snapchat’s surging popularity is beginning to re-define modern media. While Facebook has grown to over 1 billion daily active users, it is increasingly becoming a utility — a news aggregation platform — rather than a personal social network. Users are sharing increasingly less of their own picture and videos, and instead are reposting, commenting and liking what’s trending on the web. When I look at my own Facebook feed, maybe 1 out of 3 posts is something personal from a friend. Five years ago, that ratio was the exact opposite… (Disclosure: GSV owns shares in Facebook, Snapchat).

So what happened??

Snapchat!

In just under two years since launching its Story feature, Snapchat has become the go to medium for personal content. With its video-first application, Snapchat is the best and easiest way for users to capture a moment and share it with friends. And the extras like filters and lenses have added magic, making Snapchat fun and highly engaging. In fact, geo-filters are currently viewed ~800 million times a day!

Many from the pre-Millennial generation are still struggling to understand how Snapchat works, but the trend is shifting and already half of the users today are of age 25-years and older. This is also the fastest growing demographic, indicating a very similar expansion path to Facebook during its early years. “It doesn’t matter if you are 60 years old or if you are 20, everybody likes to see their friends’ Stories,” said Imran Khan, Snapchat’s Chief Strategy Officer.

Since launching Stories, Snapchat has began an extremely powerful trend in Social Media, allowing anybody and everybody to broadcast a personal reality show. Users snap videos on the go, post those to their 24 hour rolling story, and friends are watching.

Celebrities love to broadcast themselves, because they control the content. Unlike with paparazzi, celebrities can show and say what they want, when they want it. And fans are shifting towards following and watching their idols on Snapchat, and away from TV shows, Twitter, Instagram, or Facebook. (Disclosure: GSV owns shares in Twitter).

One of the best examples of a celebrity on Snapchat has been DJ Khaled (whether you like him or not). The once little known radio host from Miami, is now one of the hottest and most popular personalities in the World! By “recording” his life and posting it on his Snapchat story all day long, Khaled took Snapchat to a totally new level, and Snapchat made him a superstar…

If someone still does not yet understand Snapchat, my advise is to just follow DJ Khaled for a day! (username: djkhaled305)

Last week, Snapchat announced the launch of its new version of ad formats — Snap Ads. While still early in the monetization cycle, interest from advertisers is rising, and Snapchat is finding new ways to put ads in-front of its users. So far, ads only appeared on the Discover or Live channels, but starting last week, ads are also displaying between friend’s stories. This is kind of cool, because it makes users feel like they are in a TV show. You watch your friend’s story, and suddenly a 10 second ad shows up.

What’s also impressive is that Snapchat’s CPM, cost per thousand clicks, has been way above comparable social media platforms. In some cases, CPM rates that the company charges advertisers has been in the $40-60 level, which is competitive to TV ads, according to Adweek. Facebook for example has CPMs in the $6 range, and most other social media sites have CPMs of around $2.00.

Advertising on Snapchat is also proving quite effective. According to Oracle, Snapchat’s ads are working well. As part of the data partnership that was just announced, the company said that 92% of ads for consumer packaged goods drove higher in-store sales.

Recently, Snapchat also worked with MediaSciences and performed a survey on 552 sessions, with the results showing that Snapchat ads generated 2.0x the visual attention compared to ads on Facebook, 1.5x compared to Instagram, and 1.3x more than on YouTube

On the day of Cinco de Mayo, Taco Bell’s sponsored lens was viewed more than 224 million times, surpassing Gatorade’s Super Bowl lens which was viewed 165 million times a few months earlier. Also, the average user engaged with Taco Bell’s lens for 24 seconds before sharing it with friends. And Taco Bell’s Snapchat engagement has seen 100,000 views per video with an 80% completion rate, on average.

With a fast growing user base, and with users spending between 26 and 30 minutes on Snapchat per day, it already counts as one of the most engaging platforms. Daily video views surpassed the 10 billion mark a few months ago, which was up from 8 billion just two months earlier. 

Pioneer Notes

by Li Jiang

Of Course I Still Love You Apple

The stock market pundits had their pitchforks out. Apple was done. Innovation has stopped at Apple. The next great company has dethroned them.

So the narrative goes.

But those pundits have missed the forest in the trees. While Apple’s individual product innovation has indeed seemed to be slowing, the entire Apple ecosystem has been getting more powerful and useful. Quietly, Apple has been building each product while keeping the larger strategy under wraps.

Until now.

At the 2016 WWDC this week, Apple’s big focuses was continuity across devices. They even renamed the desktop operating system from OS X to macOS to be inline with the other three operating systems — iOS, watchOS, and tvOS.

Soon Apple devices will have Universal Clipboard, a way to allow users to copy text on their phone and paste it onto their desktop or laptop and vis versa. Siri will be accessible on desktop while Apple Pay can be used to make payments online through Safari on your computer if you confirm via your Apple Watch or iPhone.

Siri is now open to developers so you can ask Siri to order you a Lyft, send a message over Slack, play a song on your Spotify list and more.

In addition to the new updates, Apple also released some impressive numbers. There are now two million apps on the app store, 130 billion downloads, $50 billion paid to developers. Siri receives 2 billion requests each week. Apple Music now has 15 million paid subscribers and Apple News has 60 million monthly active users. tvOS now has over 1,300 video channels and close to 6,000 native apps in just six months.

While the individual updates are minor on their own, taken together, it represents a leap forward for the Apple ecosystem and makes it all the more important for customers to use multiple Apple devices. 

Market Update

Week ending June 19, 2016

World Indices

America Index 9/20/2017 YTD Week
U.S. GSV 300 107.4 42.1% 1.8%
NYSE 11812.0 6.8% 1.0%
Dow 21813.7 10.4% 0.6%
NASDAQ 6265.6 16.4% 0.8%
NASDAQ-100 5822.5 19.7% 0.5%
Russell 2000 1377.5 1.5% 1.4%
S&P 500 2443.1 9.1% 0.7%
Brazil Bovespa 71073.7 18.0% 3.4%
Mexico IPC 51373.2 12.6% 0.6%
Canada S&P TSX 15056.0 (1.5%) 0.7%
Euro-Asia Index 9/20/2017 YTD Week
China SSE 3331.5 7.3% 1.9%
Heng Seng 27848.2 26.6% 3.0%
Singapore Straits Times 3259.6 13.1% 0.2%
Indonesia JKSE 5915.4 11.7% 0.4%
Japan Nikkei 225 19452.6 1.8% (0.1%)
India Sensex 31596.1 18.7% 0.2%
Russia RTS 1979.1 (11.4%) 2.5%
France CAC 40 5104.3 5.0% (0.2%)
Germany DAX 12167.9 6.0% 0.0%
U.K. FTSE 100 7401.5 3.6% 1.1%



U.S. Indices Snapshot

Valuation P/E Est. P/E/G Price/Sales
LTM NTM Growth LTM NTM LTM NTM
S&P 500 24.2x 17.6x 7.60% 3.2x 2.3x 2.4x 2.1x
NASDAQ 25.2x 17.5x 7.90% 3.2x 2.2x 2.6x 2.2x
Russell 2000 24.7x 17.6x 6.30% 3.9x 2.8x 1.9x 1.6x
GSV 300 50.6x 25.8x 38.40% 1.3x 0.7x 5.5x 4.0x

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