Twitter: Can It Fly Again? 🐦

A breakdown of the social media ugly duckling

It’s earnings season again, so we’re getting a lot of fresh operating & financial data from various companies, and that tends to drive big moves in individual stock prices. One of the more striking moves so far this earnings season was Twitter’s ~25% decline on the back of much weaker than expected earnings:

Oof. Losing nearly a quarter of a company’s market cap in a handful of trading sessions is pretty awful to say the least. Even worse, since Twitter’s IPO nearly six year ago, the stock is only up 15% from the IPO price and is actually DOWN about 30% from where it closed on that first trading day. That is a terrible result for long time public shareholders to say the least.

Contrast that lack of value creation to that of Facebook, another large social media company that went public 7.5 years ago, which has grown its share price about 400% since its IPO:

No wonder Mark Zuckerberg once took a dig at Twitter by calling it a “clown car that fell into a goldmine”! 🤡🤡🤡

However, it’s worth noting that in terms of platform importance and user base, Twitter has likely never been stronger. And the company is increasingly making decisions that diverge from the behavior of other social platforms like Facebook. Just last week, the company’s founder CEO Jack Dorsey announced that Twitter will no longer be accepting political advertising on a global basis:

Political advertising is a meaningful source of revenue for social media platforms, including Twitter, so this will NOT be a good short term move for the company financially. It may however be a great move in terms of user retention and platform health for Twitter given how political advertising has increasingly led to the spread of misinformation, hate, and division among the general populace.

For investors though, the question now is can Twitter ($TWTR) turn things around from a business standpoint? At what level might the stock be a good long term value? Can the company get on the right track and eventually deliver strong returns? This is what I aim to tackle here today.

Twitter: A Brief History Lesson 📚

Why has Facebook done so well for its investors and Twitter done so poorly? The simple and obvious answer is that Facebook’s financial performance has been much better. Facebook has shown tremendous revenue and profit growth, with both growing even faster than the user base. In the past five years, despite growing from a much larger starting base, Facebook has grown annual revenue by nearly 500% compared to 188% five year revenue growth at Twitter. Now Twitter has grown operating profit (“EBIT”) at a faster rate than Facebook in the past five years, but that’s mainly because Twitter was growing off a very small base of profit five years ago. Absolute operating profit at Facebook dwarfs that of Twitter by an astonishing 35X! In addition, EBIT margins at Facebook are nearly double that of Twitter’s.

*Note: EBIT adjustments by Sentieo; figures in USD millions; TTM = trailing twelve months

Facebook also had a more reasonable starting valuation five years ago relative to its future profit generation compared with Twitter. In other words, Twitter’s starting valuation multiple did not do it any favors over this five-year time frame. Adding fuel to the outperformance, Facebook’s share count has grown at less than half the rate of Twitter’s share count over the past five years. That means less of the pie is being taken from shareholders to pay management & employees at Facebook.

What are the underlying drivers of the financial outperformance by Facebook, and the underperformance at Twitter? A number of factors, but a few of them stand out:

  • Facebook has been MUCH better at acquisitions (Ex: 📸Instagram vs 🌱Vine)

  • Facebook’s product teams have developed features MUCH faster (Stories etc)

  • Facebook developed a SIGNIFICANTLY better advertising platform (ad formats, targeting options, reporting, etc)

  • Facebook’s larger user base naturally attracts more advertisers (scale advantage)

  • Twitter’s CEO splits his time between two companies ($SQ and $TWTR) while Facebook’s CEO has been laser focused

Facebook’s acquisition of Instagram is particularly notable, with that user base growing over 20X to more than 1 Billion users under Facebook’s stewardship, and an estimated standalone valuation over $100 Billion. It’s been called one of the top corporate acquisitions in recent history. Relative to Twitter, one thing that Facebook has done dramatically better is integration and MONETIZATION of their largest social media acquisitions. Twitter has made promising acquisitions like Vine, TellApart, Periscope, and Magic Pony and then repeatedly failed at doing anything meaningful with them. ByteDance’s TikTok is essentially a more modern version of Vine, and was reportedly last valued around $75 BILLION (3X the current market cap of $TWTR)

Message to Twitter’s highly paid management team 👇👇👇

Swinging and missing on M&A is one thing, because it’s notoriously hard for most companies to succeed with game-changing acquisitions. Failing at product development and advertising platform development however is just inexcusable.

If there’s a slower product team in consumer tech than Twitter’s, I’d be shocked. This is the product team that:

  • Took YEARS to roll out the basic expansion to 280 character tweets

  • Took YEARS to double down on the super useful functionality of Lists

  • Took YEARS to implement features that enhance users’ ability to follow topics (still in testing / limited availability)

  • Took YEARS to truly address harassment, doxing, and bots on the platform

  • Still hasn’t added 5-second Tweet editing functionality despite it being a top user request for YEARS

  • Has not improved the richness or length of user profiles in YEARS

  • Can’t seem to figure out how to order comment threads in intuitive ways, despite the blueprints they can copy from Facebook

  • Has made it increasingly difficult to build applications on top of Twitter, despite the company failing to add valuable features themselves

  • Has strange & arbitrary verification procedures

  • Has not pioneered the development of any features competitors find compelling enough to copy since the hashtag symbol in 2007

  • etcetera…

Now that all being said, Twitter remains THE BEST place for people to tap into trending and real-time news. It’s become the de facto global news network, a place where people turn to for breaking news, live sporting events, hot takes, and viral content. Celebrities, politicians, & influencers are increasingly using the platform to amplify their messages and build their followings. Regular people can often engage back with celebs & brands, and even build their professional networks. Journalists use Twitter to source breaking stories and crowdsourced media. And where else could a cult CEO publicly commit blatant securities fraud or a head of state threaten war with just a few keyboard taps? 😳

An argument can be made that the primary responsibility of Twitter’s product organization is to merely not screw all that up. Furthermore, to 💩 on Twitter too hard would be to ignore the strides the company has made in recent years. User, revenue, and profit growth trends have generally been moving in the right direction over the past two years. User base growth has actually accelerated of late:

Twitter stock doubled from January 2017 to January 2019, and kept rising through the middle of this year to over $45 per share ($35 Billion market cap). TWTR’s earnings reports in Q1 and Q2 looked healthy, with year-over-year revenue growth of ~18%, adjusted EBITDA margins in the mid-30% range, and strong free cash flow generation. The company had even shown some discipline on CapEx & expense growth!

The stock went up after both Q1 and Q2 earnings releases, and it looked like Twitter might have finally gained some business momentum. Solid execution, financial discipline, and free cash flow generation leading to stock price appreciation?! Imagine that! 😏

A Disastrous 3rd Quarter 📉

So what the hell happened in Q3 and why has the stock dropped 25% to a market cap in the low $20 Billion range? In short, the numbers were UGLY. Revenue growth suddenly decelerated to just 8% while costs and CapEx spending ballooned, leading to a double digit DECLINE in adjusted EBITDA as well as a ~50% drop in free cash flow compared to the prior year. Making matters worse, management’s excuses for this poor performance were weak and guidance for Q4 suggested continued headwinds. Investor confidence was once again lost.

Classic Twitter.

One of the major headwinds cited by management for the poor results in Q3 was a hit to $TWTR’s mobile app install advertising revenue due to software “bugs” which affected advertisers willingness to spend on mobile app install ads. Management claimed that the company is working on addressing these “bugs”:

However, this was misleading, as these are not truly “bugs” that can be fixed but actually flaws that allowed advertisers to target users incorrectly in the past. That means that this revenue is permanently lost. (See more context here, here, and here)

That was a headwind that apparently cost Twitter three percentage points of revenue growth, but the broader issue is that Twitter is still struggling to improve monetization. Their primary revenue driver is advertising, and they just aren’t attracting advertisers & advertising dollars at a high enough rate. My guess is that many advertisers still aren’t confident enough in the return they can get when advertising on the Twitter platform.

This is an area I know very well, having run the Growth team at a B2C consumer tech startup for four years. My team spent millions of dollars a year on advertising across platforms such as Google, Bing, Facebook/Instagram, Snapchat, Twitter, Spotify, Nextdoor, and others. Performance marketing / user acquisition is all about finding the largest source of users in the target demographic and acquiring those users for as cheaply as possible. Google and Facebook/Instagram attract the majority share of digital ad spending because they have the reach (billions of users) and historically they’ve provided positive return on ad spend for many advertisers. These giants drive the ability for advertisers to obtain positive returns through a combination of factors including:

  1. Very specific intent targeting (Google) or very specific demographic targeting (Facebook/Instagram)

  2. Lots of different ad formats that blend naturally into their products

  3. Clear attribution & reporting so marketers can tie the users who click ads to the conversions that later happen in their apps, websites, or stores

But here’s the thing: these platforms have become increasingly expensive as more and more advertisers spend and compete to acquire the same users. Average cost to reach 1,000 users in developed markets tops $10 on Facebook & Instagram, with a cost per single ad click pushing over $1.00. That may not sound like a lot, but that means a company selling a $100 product needs at least one out of every 100 ad clicks to turn into a sale just to breakeven. On Google, cost per click can easily top $5 or $10 depending on the industry. In competitive industries, digital marketers have driven the cost per acquisition of a user on Google to a level very close to average user LTV (lifetime value), which is the logical long run upper limit an advertiser can tolerate.

Meanwhile, Twitter appears to be less expensive when it comes to cost per thousand impressions (CPM) or cost per click (CPC):

Granted, these are proxy metrics that only mildly correlate with cost per acquisition (CPA), cost per conversion, or cost per action which are the metrics that drive advertiser spend in the long run. But assuming conversion rates on Twitter are in the ballpark of those on Facebook/Instagram, it appears that Twitter could be a cheaper advertising option for many advertisers.

Here’s another way to look at it: Twitter’s Revenue per Daily Active User is less than HALF of Facebook’s currently despite Twitter having a higher proportion of highly monetizable US based users (note: the companies don’t report DAU metrics the same way, thus the comparisons aren’t totally apples-to-apples; However, Facebook’s Revenue-per-DAU metric may actually be understated due to the inclusion of Messenger users in DAUs).

So in this environment with increasing digital ad spending and increasing costs for advertisers, Twitter should be an alternative platform that can attract more advertising spend quarter after quarter. This is especially true now that Twitter has a large engaged user base that is actually GROWING at an accelerating rate, which means increasing reach potential for advertisers! It just doesn’t seem like Twitter is executing very soundly on this opportunity right now.

Meanwhile, as revenue growth languishes the company continues to increase headcount and spending, which leads to a decrease in profit and makes the stock look more expensive from a valuation perspective. The selloff is thus not surprising at all.

The Opportunity 💸

It’s easy to be bearish on Twitter. But you don’t drive a car by looking solely in your rear-view mirror. Similarly, great investors don’t make money focusing solely on the past.

How big can Twitter be? What might the shares be worth in a couple of years?

If Twitter could double its Revenue-per-DAU metric, that would translate into more than $3 Billion of incremental annual revenue at presumably very high incremental profit margins. In that scenario Twitter might be able to generate a billion dollars of incremental free cash flow, and that’s before even factoring in a growing Daily Active User count. That might lead to the stock doubling in value or better. The question is, how likely is this to happen and over what time frame?

Management acknowledged the need to improve Twitter’s advertising products on the Q3 earnings conference call. In my opinion, the focus should be on improving the ad formats and courting advertisers by offering better service. Ad load is actually pretty high on Twitter already. Targeting options are reasonably specific with Twitter offering targeting by gender, age, location, keyword, behaviors, followers of specific accounts, as well as re-targeting and custom (“tailored”) audiences. But Twitter still lags behind Facebook and Instagram when it comes to the richness of ad formats.

Facebook and Instagram’s ad formats have more call-to-action (“CTA”) options, allow for richer interactions such as horizontal swiping through image & product card carousels, can roll in the middle of videos, often take up entire screen real estate, and can even be triggered and interacted with through chat messages. You can even book movie tickets from within some of the ads on Facebook & Instagram!

Some example rich ad formats on Facebook & Instagram:

Basic image carousels were tested at Twitter as far back as 2016 but apparently may only soon become a reality here in 2019 or 2020. Ads on Twitter still look pretty basic these days, and the CTAs don’t “pop”, making them less likely to draw clicks for further action. Many ads on Twitter are also odd because the content within the ad is not related at all to the brand running the ad!

There’s no booking movie tickets here…and what do most of these ads even want me to do?

There’s a ton of low hanging fruit just in improving ad formats and calls to action. Twitter’s Explore/Moments section is an ideal place for full screen mobile experiences, along with rich full screen ads, similar to those found on Snapchat and Instagram Stories. A good friend of mine suggested this more than two years ago.

Advertising on Facebook, Instagram, and Google can be extremely frustrating for small advertisers, most of whom are not assigned an account rep or human liaison. Furthermore, Facebook’s advertising platform has become noticeably less stable for advertisers of all sizes in the past two years. As the company has grown more successful they’ve stopped executing like they once did, and this leaves a huge opening for Twitter. If Twitter could figure out how to provide better service to advertisers, that might go a long way in acquiring new clients. Twitter is also under-penetrated in small accounts (“SMBs”), which they’ve admitted as recently as the Q3 2019 shareholder letter:

“By sales channel, large to mid-tier customers continue to represent a sizable majority of our advertising revenue, while our self-serve channel continues to deliver growth off a smaller base”

With its recent ban on political ads and focus on platform health, Twitter is already positioning itself as the good actor within the social media industry. They should use that as a leverage point to gain influence and partners. Partnering with a platform like Shopify, Squarespace, or even Jack Dorsey’s other company Square might be a quick way to accelerate SMB penetration.

In addition, Twitter could reap a lot of benefit by enabling seamless 3rd party transactions from within Twitter. Similar to what I was saying about improving ad formats, Twitter could enable new monetization pathways with “cards” or feed widgets that enable one-click or one-screen Kickstarter/GoFundMe donations, Patreon/Substack subscriptions, Eventbrite/Evite RSVPs, OpenTable reservations, Amazon purchases, Venmo/Paypal transfers, etc. Many of these often already originate on Twitter when users tweet suggestions or requests to their followers. Think this is a crazy idea? This is exactly what Google has done over the past decade with its push to enable flight & hotel bookings, restaurant listings, knowledge panels, maps, and EVEN embedded tweets right there on the Google search page!

Free Call Options? 💰

Meanwhile, with US-China tensions still flaring and TikTok under review by a US Government agency, might there be an opening for Twitter to relaunch Vine🌱? I’m not convinced Twitter has the ability to pull off a sustained comeback here, but it’s worth considering.

What other revenue upside opportunities exist that the stock might not be reflecting today?

Facebook Groups has quietly become a blockbuster product within Facebook, even occupying one of the coveted bottom tray icons in the core mobile app. Many groups number in the 10’s or 100’s of thousands of users, and Facebook is not only serving ads on these pages but also enabling subscription commerce. Reddit is thriving because of its large network of user communities. Paid Slack & Discord groups are also a thing (ex: TrafficThinkTank, NomadList, etc). Similarly, Twitter users are already forming informal communities on the platform (FinTwit is a prime example).

Twitter should figure out how to encourage users to find their tribe and engage in conversation, while enabling creators to make money. Adding the ability to follow interests/topics is part of that, and it’s good to see Twitter finally moving in this direction. The same can be said of Twitter Lists. Perhaps Twitter could acquire Launchpass, Discord, or Substack to move into subscriptions. Like I said before though, Twitter hasn’t been very good at M&A in the past, but there’s $4 Billion of net cash sitting on the company’s balance sheet earning less than 3% annually.

While we’re on the topic of subscriptions: is there a world where Twitter could charge individuals for premium features? Many consumers are increasingly showing an affinity for subscriptions to services like Spotify, Netflix, Amazon Prime, Tinder, YouTube Premium, Stitch Fix, Dollar Shave Club, Dropbox, etc. Even old media companies like the Wall Street Journal and the New York Times are seeing positive subscriber growth. Consumers have finally realized that “if you’re not paying for the product, you ARE the product”. I don’t see why Twitter couldn’t develop and charge for premium features like zero ads, tweet scheduling, one-click tweet promotion, trend monitoring, advanced search & analytics, multiple account management, security enhancements, bio verification, bio videos, etc. They already do much of this through their Premium & Enterprise APIs but perhaps extending it to individual users would be compelling. Companies like Hootsuite and Sprout Social, which may go public soon, have built meaningful businesses providing some of those very services.

There might be other options too, something akin to micro-transactions. When tweets go viral, you’ll often see the author follow up with a link to their Soundcloud or GoFundMe page. As Eugene Wei said, this is a “vulgar monetization hack”. Why doesn’t Twitter try to capitalize on this? Twitch is a great example of a business that built micro-transactions into its product, benefiting both creators and the company.

Twitch users can purchase subscriptions and virtual goods that enhance stream & chat experiences

Tweets are inherently ephemeral, and Twitter prides itself on being the place where real time conversations take place. But there’s also a lot of really cool / valuable things that have been posted on Twitter throughout the years. Why hasn’t Twitter built something that resurfaces the most popular or important Tweets? Or something that allows a user to search for the most bookmarked or pinned content relating to a topic? This might even lead Twitter down the path of becoming a valuable search engine of sorts, which is VERY monetizable given searches typically have high intent (searchers aren’t just mindlessly scrolling a feed).

I don’t particularly like investment theses that depend on some acquirer coming in to scoop up a company at a premium. But as far as free call options go, it’s worth noting that Twitter is a unique asset enjoying improving network effects that has seen potential acquirers surface in the past. Disney, Google, Salesforce, Microsoft, and Verizon have been linked to acquisition rumors previously. It’s also not clear how long investors will tolerate Jack Dorsey remaining at the helm of TWO large companies. Might there be pressure on him to sell Twitter? In my opinion it may be equally likely that Square gets sold, but the dynamic with Dorsey is worth keeping an eye on IMO.

What’s It Worth? 📊

Given the optionality and potential growth levers at Twitter, how should an investor think about the current valuation relative to the company’s future potential?

Let’s start with two bullish assumptions about $TWTR: over the next five years the company will 1) increase daily active users (DAUs) and 2) improve Revenue-per-DAU. If one disagrees with these assumptions, it’s very unlikely the stock would look compelling. Here’s what $TWTR’s annual revenue would look like in 5 years under various growth rate assumptions for both DAUs and Revenue-per-DAU:

Even under the most aggressive assumptions here, $TWTR’s revenue-per-DAU metric in five years would be below that of Facebook’s today. The DAU growth assumptions are all below the current growth rate as well. But I’ll stick to the more conservative sets of assumptions and assume Twitter can grow annual revenue to about $7 Billion in five years. That’s a roughly 15% compound annual growth rate (“CAGR”) in revenue, and more in line with Q1 and Q2 of this year than Q3.

Twitter’s Free Cash Flow (FCF) can swing dramatically in a short time span due to the high incremental margins inherent in the business, as well as the pace of capital investment which has historically varied a lot. Twitter appears to be in a heavy investment period, investing both in higher operating expenses as well as CapEx. In fact, CapEx as a % of Revenue doubled in the past two years. Management comments and financial filings suggest heavy data center investments, though it is not clear how much of that is recurring. If I assume 1) Twitter can get CapEx back down to something like 10-12% of revenue and 2) operating expense growth stops outpacing revenue growth, then Twitter’s adjusted EBIT margins could once again reach 30%. That would be in line with management’s target of 40-45% adjusted EBITDA margins:

“there's no change to our thinking that, over time, Twitter can be a 40% to 45% adjusted EBITDA margin business” - Twitter CFO Ned Segal @ Citi Global 2018

With $7 Billion of revenue, 40% adjusted EBITDA margins, and a normalized cash tax rate of ~20%, Twitter might generate close to $1.7 Billion of Free Cash Flow in five years. That’s about a 16% CAGR in FCF from today’s levels. It would be even higher except for the fact that current FCF is inflated since Twitter pays very little in cash taxes at the moment. Due to a history of accounting losses before Twitter became GAAP profitable in 2018, Twitter has a large balance of Net Operating Losses (NOLs) it can use to reduce taxes over the next several years. I typically choose to value NOLs separate from the long-run operating business. There’s about $800 million of present value in Twitter’s tax assets, or roughly $1 per share.

Twitter has about 790 million diluted shares outstanding, though the share count has grown at roughly 4% a year on average over the past three years. Fortunately, the dilution has slowed from egregious to borderline tolerable this year, at roughly 2%. For now, if I assume 2% annual dilution, the share count will be around 870 million in five years.

So that means that $TWTR might be able to generate ~$1.95 in annual FCF per share in five years. Today the average S&P 500 company trades at roughly 20X FCF. Applying that multiple to $TWTR would mean roughly a $40 share price in five years, though that does not include the $5 per share of net cash on Twitter’s balance sheet today or the excess cash $TWTR will generate in the five year period. In fact, it’s likely that Twitter will generate close to $5 per share in additional FCF during the next five years. So Twitter might be worth ~$50 per share in five years. From today’s price of ~$29.50, that would deliver an annualized return of roughly 11% per year over a five year holding period (ignoring unknown impacts from dividends & share repurchases). If you believe the right discount rate for Twitter is 10% then you might conclude that $TWTR stock is slightly undervalued today.

Now it’s also possible that Twitter would deserve a higher FCF multiple than the average S&P 500 company in five years. As any savvy analyst knows, growing companies which sport a Return on Invested Capital (ROIC) greater than their Cost of Capital typically warrant a premium valuation multiple.

If I normalize Twitter’s abnormally low cash tax rate, here’s what I come up with for Twitter’s ROIC over the past five years:

$TWTR has achieved ROIC in the mid-20% range, which is quite good. As of Q3 2019 however, Twitter’s ROIC is trending down, at least in the near term. Under the five year assumptions I assumed previously, $TWTR’s ROIC would likely rise to >30%. If Twitter still has significant growth opportunities in five years, that level of ROIC would arguably justify an above average valuation multiple, providing further upside to what I mentioned previously.

Valuation is always a tough exercise given the predictions we have to make about the future. As you saw, a proper valuation of Twitter depends on a number of things, including:

  • Revenue growth drivers such as DAUs and Revenue-per-DAU (monetization)

  • Incremental profit margins & mature profit margins

  • Capital Allocation (level/return on CapEx, acquisitions, dividends, buybacks, etc)

  • Deferred Tax Asset and tax rate assumptions

  • Value given to excess cash on balance sheet

  • Share count & dilution

  • Discount Rate / Valuation Multiple / Valuation Methodology

Final Word on the Bird 🦢

People once questioned Facebook’s ability to monetize mobile, but then the company fixed its product, made successful acquisitions, and became one of the most valuable businesses in the world. Can Twitter prove the critics wrong and do something similar? So many of us see the value & future potential in the product. There were signs in 2018 & 2019 that Twitter was beginning to move faster and produce increasingly exciting features AND financial results. Q3 results were a departure from that, and it seems likely to me that the stock will be volatile in coming months.

Personally, I hope that $TWTR gets it momentum back. I’m also going to be keeping a sharp eye on the stock, because it won’t take that much more of a selloff to bring the stock to levels that I find interesting as an active investor! 🤑

disclaimer: I may own securities mentioned in this publication. I am not a financial advisor and none of this should be construed as financial advice. There’s always risk of loss when investing in stocks. Your investments are your responsibility.

Can GoPro 📸 Be A Hero?

Breaking down the challenges & opportunities with $GPRO stock

Happy Trade War Talks week! Maybe this is finally the week where the US and China get an actual agreement in place (I doubt it). But since there’s plenty of ink already spilled on that, I want to talk about something else that’s arguably more actionable.

People often ask me, “where can I find good stock ideas?”. There’s a TON of places to find potentially interesting stock ideas, from running qualitative & quantitative screens, monitoring SEC filings, following the positions & filings of certain investment funds, picking up on legal insider transactions, reading websites like SeekingAlpha or the Wall Street Journal, looking at new & recent IPOs, searching through news or transcripts for specific keywords, watching price % losers/gainers and 52 week high/low lists, doing competitor or industry research, following certain accounts on Twitter, and even just picking up on major consumer trends in one’s daily life (the old Peter Lynch method!). [Quick shameless plug: I cover many of these areas / tactics in depth in my courses and in weekly videos over at the subscription-based Skill Incubator Wealth Building Community]

To me the two MOST important keys 🔑🔑 to consistently having a healthy funnel full of potential stock ideas are 1) READ A LOT and 2) BE CURIOUS as hell all the time. Great stock pickers typically love the process of hunting for needles in the haystack. We are information junkies who scour lots of sources but who also develop a good filter for what’s noise and what’s signal, similar to great investigative journalists or detectives. Personally I’m constantly adding to ➕ and subtracting from ➖ some very long watchlists of stocks while waiting for the right catalysts / prices to strike on the most compelling of the bunch. It’s like Warren Buffett famously said, “there are no called strikes in the business”. Investors can wait and wait and choose to act only on the truly best opportunities. And I keep working hard in the meantime to find them.

A Tweetstorm Gets The Wheels Turning 💡

So that said, I came across an interesting Twitter thread and blog post this past weekend that got me re-engaged with a stock that has crossed my watchlist a few times but never made the cut as an investment. The stock is GoPro ($GPRO) and the Tweetstorm is from a guy I’ve never met. But this dude, Adam Keesling, seems pretty smart and likes to analyze consumer companies’ business models which is candy to a stock geek like me. Adam’s Tweetstorm (see below) walks through the recent past of GoPro, the action sports camera company which IPO’d at a $3 Billion dollar valuation back in June 2014:

Now as Adam mentioned, $GPRO has been an abysmal stock, losing over 90% of its value from its post-IPO peak nearly five years ago 😳:

Adam talks about some of the reasons behind the poor performance, including:

  • A very high post-IPO valuation that depended on mass market adoption

  • A shift to marketing to a mainstream audience in an attempt to meet those aggressive growth expectations (alienating some core action-sports customers)

  • The hiring of expensive high-profile media executives to build a content business

  • Poor execution with the Karma Drone product (now abandoned)

  • Camera hardware = infrequent purchase for most consumers

Adam’s points are pretty much spot-on, though he misses a few notable things. His prescription for GoPro is for the company to use their camera sales as a wedge to sell more high margin software. He briefly acknowledged that GoPro has already been heading in this direction since 2016 when they bought two video editing apps, but thinks they can do more with services & software to become a platform to help influencers manage & scale their fanbases.

The last point is an interesting one, and I happen to agree that software & services is an area that GoPro might be able to derive value from. More on this a little later!

The timing of Adam’s post was serendipitous as it coincided with another dramatic sell-off in $GPRO last week, after the company announced about a 1.5 month delay in shipping its new HERO8 cameras along with a small cut to its full year financial guidance. The stock was down 20% on the announcement:

Now GoPro will still have its new cameras on shelves for the crucial holiday selling season, so the slight delay doesn’t seem like THAT big of a deal in the grand scheme. However, the company has a history of disappointing investors so it gets punished heavily for any small infraction.

I noticed that $GPRO now sports a market cap of about $550 million and trades for a roughly 10X Price-to-Earnings multiple using their updated 2019 earnings guidance. That’s not terribly expensive but it might not be cheap either, depending on future growth and cash flow generation. I like to take a look at stocks that the market has become ultra-pessimistic about to see if there’s possible hidden value above-and-beyond just a low valuation. Is there hidden potential value in $GPRO?

First, The Bear Case 🐻

Adam touched on some reasons for GoPro’s stock bloodbath over the past few years, but here’s some additional things he skipped over:

  • Smartphone cameras have gotten insanely good over the past few years which has limited GoPro’s appeal to the broad mass market consumer

  • Even in action sport cameras, GoPro faces fierce competition from DJI

  • GoPro’s annual revenue peaked in 2015 then declined in 2016, 2017, & 2018

  • GoPro’s gross margins have steadily declined due to discounting & lower selling prices. GPRO’s 2018 gross profit is down roughly 46% since 2015

  • GoPro over-hired in many areas of its business (not just media) and its cost structure was too bloated, leading to net losses in 2016, 2017, & 2018 (see below)

  • GoPro has about $50 million of net debt on its balance sheet, and burns cash in most quarters (typically those lacking a new product launch). Cash burn isn’t sustainable long term, especially with a large debt repayment looming in 2022

  • GoPro’s CEO Nicholas Woodman seems to have a poor reputation with investors, many of whom blame him for the company’s product delays & missteps and criticize him for his frequent stock sales to fund his lavish lifestyle which includes owning yachts and private aircraft

  • Shareholder governance at GoPro is problematic. Nicholas Woodman has super-voting shares and the company is also a prolific issuer of stock options & RSUs, which dilutes existing shareholder stakes over time. The company has 31 MILLION shares available for future grants (20% of the company) and that number grows each calendar year due to an AWFUL evergreen grant program similar to the one I wrote about last week with Stitch Fix

So What’s To Like? 🤔

Here’s where the eternal optimist in me gets to shine!

If you were paying attention to the charts above, you might have noticed that GPRO’s annual losses have been improving each year for the past three years. The company has been cutting headcount and overhead costs, and actually expects to grow revenue AND turn a profit this year. Current earnings per share guidance for 2019 is in the $0.33-$0.39 range, which is how we get that ~10X P/E multiple I mentioned previously. Management also expects positive cash flow and for the company to be in a slight net cash position by the end of the year (cash > debt).

That’s all fine, but doesn’t get me super excited. There are plenty of cheap stocks in this market, many trading at single digit earnings multiples, with proven management teams and better track records of shareholder value creation. It’s a start though, and more importantly it may give GoPro time & runway for a comeback.

That POTENTIAL comeback story I see with GoPro lies in 3 KEY 🔑 AREAS:

  • Software (Video Editing etc)

  • Subscriptions (GoPro PLUS)

  • HERO8 opening up large adjacent hardware market (Vloggers, Influencers, etc)

The Opportunity in Software 💾

Woodman & Co actually deserve some credit for seeing the software opportunity a couple years ago when they acquired a pair of video editing apps in early 2016. At a cost of $105 million, I think they probably overpaid for those assets, but perhaps it will work out longer term. Video creation & consumption continue to explode globally, and will continue to for the foreseeable future as smartphone cameras and 5G wireless availability keep improving.

While Instagram, Bytedance (TikTok), Twitter, Facebook, and Snapchat soak up a lot of short-form video where minimal edits can be made in-app, the number of longer videos requiring more advanced editing continues to grow as well. From YouTube to online courses to company marketing and beyond, editing outside the walled garden apps requires good software and expertise.

This is one of the primary reasons that Adobe ($ADBE) boasts a market cap of around $134 BILLION and has seen its stock rise over 300% in the past five years:

That’s a nice looking chart if you’ve been an $ADBE shareholder! Creative Cloud, which is the suite of photo and video editing software (cloud-based) produced by Adobe, currently produces about $6.6 billion of annual revenue with gross margins of over 95%! 😮

That product alone makes up almost 60% of Adobe’s annual revenue and an even higher percentage of gross profit. It’s probably safe to say that Creative Cloud accounts for at least $70 Billion of Adobe’s market cap, and if it were a standalone business it would have a Price-to-Revenue multiple greater than 10X.

Now imagine for a second that GoPro could capture and monetize some of that growing video editing market in the near future. For every 1% of Adobe’s current revenue that GoPro captures, assuming 80% gross margins, that would add about $50 million of annual gross profit to GoPro’s financial results. Most of that would likely translate to incremental net profit, so it’s not crazy to think that GoPro could see an uplift of $.30-.35 in per share earnings ($50 million / 155 million shares outstanding today) for every 1% of market share capture. That’s the size of 2019 EPS today! If GoPro captured just 3% of the market it might increase EPS to more than $1.30 per share, or 4X current levels. Today Adobe trades at a 30X forward P/E multiple. If $GPRO were to achieve EPS of just $1.00 per share and garner a P/E multiple that is just HALF of $ADBE’s, then $GPRO stock would trade for ~$15 per share or over 4X today’s price!

To $GPRO’s credit, management understands the opportunity. Here’s some of their recent comments that I found searching through conference call transcripts:

Now how likely is it that $GPRO pulls it off? Today the market puts a VERY low probability (essentially zero) on GoPro getting market share. That feels right today. Adobe’s software is very robust and widely recognized as the industry leader. They have large teams of developers pumping out improvements and new versions all the time. But the video editing software market is large and still growing nicely (26% YoY growth for Adobe last quarter). Competitors such as Final Cut Pro (Apple), iMovie (Apple), Windows Movie Maker, Camtasia, Vegas Pro (MAGIX), Avid Media Composer, and others generate meaningful revenue in this market.

Today GoPro is not a major player in that market BUT there’s a case to be made that they have a shot to carve out some market share on mobile devices. On iOS, the GoPro app’s download ranking in the US Photo & Video category has recently fluctuated between 75 and 100, and maintains a solid 4.8 star rating:

In the free app category, I counted at least 20 video editing apps that outrank GoPro’s app. So that’s not great. Despite a good review score, GoPro needs to climb the ranks.

In the Google Play Store, the opposite is true. GoPro appears to have a relatively poor user review score (2.7), but ranks higher in its category (mid 40’s ranking):

None of that looks super compelling. HOWEVER, GoPro does outrank Adobe’s Premier Rush app, which is their fresh product aimed at simplifying and making video editing more accessible. Rush is slightly behind on iOS and far behind on Google Play. Might an aggressive competitor of Adobe be interested in acquiring GoPro as a beachhead for a competitive assault? Or Adobe itself to play defense? Perhaps 🤷‍♂️

More realistically, if GoPro can successfully get cameras into the hands of more consumers, that could drive higher uptake of GoPro’s editing software as well. The new HERO8 product is actually another shot at expanding the addressable market for GoPro cameras which I’ll cover shortly.

As Adam mentioned, perhaps there are other software niches GoPro can tackle as well, though I don’t see evidence of those efforts currently.

The Opportunity In Subscriptions 💸

Three years ago (in mid 2016) GoPro launched their monthly subscription service called GoPro PLUS. That service now costs ~$5 per month and gives subscribers:

  • unlimited cloud storage for GoPro footage

  • free or discounted replacement of damaged GoPro cameras

  • discounts on GoPro gear & accessories

It’s like Dropbox + AppleCare + membership rewards for GoPro camera owners. And it’s very high margin recurring revenue for GoPro that has the potential to drive significant earnings if the company can attract enough subscribers:

So $GPRO’s CFO is on record saying one million GoPro PLUS subscribers would mean $0.30+ in additional earnings per share (doubling of current EPS). Today $GPRO has roughly 250,000 GoPro PLUS subscribers, with that base growing at roughly 50% year-over-year in the most recent quarter. Given that growth rate, half a million subs seems achievable within 3 years, even if the growth rate decelerates modestly. One million subscribers might take anywhere from 3-10 years (or never) depending on the growth rate acceleration/deceleration as well as churn rate.

GoPro expects to sell more than 4.3 million camera units this year, and has cumulatively sold over 30 million cameras in the last decade. There’s likely 10-15 million active camera owners and growing, so 1 million subscribers would be somewhere in the neighborhood of 5% take rate. I’ve seen anecdotal data suggesting that’s roughly at the level of AppleCare uptake, and Dropbox has about 3% paying users (as a % of total active users) despite a price point that’s more than double GoPro PLUS. Other premium subscription benchmarks roughly align with these figures and suggest 5% take rate is potentially achievable.

The Opportunity With New Hardware (HERO8) 🎥

For now, the #1 thing GoPro can do to drive success in software & subscriptions is continue to produce and sell great cameras. The more consumers that join GoPro’s ecosystem, the better. GoPro’s new HERO8 camera looks like it might be a step in the right direction, because it stays true to its action sports roots while offering new features & attachments aimed at attracting a broader audience.

People who get serious about recording video eventually go down the rabbit hole of buying expensive gear to improve audio quality, lighting, and details like resolution/focus/transitions/etc. High end smartphones have good capture resolution but really fall short when it comes to lighting and sound in particular.

GoPro’s HERO8 introduces new hardware add-ons specifically aimed at improving lighting and audio, along with a display aimed at vloggers who shoot selfie style:

This isn’t going to cause professional videographers to ditch their DSLRs, lenses, tripods, box lights, hot shoes, and wireless mics. But it’s possible that it could attract some new influencers and video creators who are just getting into the game. It’s a much simpler and cheaper (~$600 for camera + all mods) solution for those starting out. And it comes with all the other bells & whistles GoPro is known for, like mounting, 4K, 1080p, waterproofing, image stabilization, voice control, timers, etc.

A friend of mine with 200K+ YouTube subscribers even texted me:

“this looks like a game changer…likely to crush dslr’s with the vlogging crowd”

It’s certainly a strong effort to expand GoPro’s appeal, which it desperately needs. Shooting and editing high quality video are truly daunting and time-consuming tasks, so if GoPro can simplify these tasks with hardware and software solutions then it’s a win for everyone involved.

Anything Else? 😴

If you aren’t yet asleep, bless you. There’s just a couple other things worth noting before I finish.

GoPro is a widely recognized brand with a relatively high Net Promoter Score. It failed at creating an entertainment & media business a few years back, but it has succeeded greatly in attracting followers on social media:

  • 📺 YouTube: ~8 million followers and 40+ million monthly views

  • 📷 Instagram: ~16 million followers

  • 📘 Facebook: ~11 million followers

GoPro and its users produce some unbelievably epic video footage. GoPro even has a partnership with Adobe to provide videos for Adobe Stock. Might this content & community be worth something to one of the big media conglomerates or streaming companies that are currently buying up content rights left and right? Or perhaps a social media company like Snapchat that’s fighting to stay relevant? Maybe an action sports associated brand like RedBull? Or even an iconic consumer hardware & software company that dabbles in GoPro’s markets, has boatloads of excess cash, and has made acquisitions of consumer hardware brands before? It isn’t a crazy thought.

When it comes to management, I’ll leave it to you to decide your opinion on the founder CEO Nicholas Woodman. He’s done some questionable things but he’s done some decent things too. In 2018 the Board cut his salary to $1 and he was not eligible for a bonus. Sadly, as of 2019, he’s back to an $800K base salary and 100% potential bonus despite the stock being down from where it started 2018! Although Woodman started selling a bunch of his stock in early 2019, it appears he may have paused after June. He still owns around 27 million shares (~17% of the company). There’s a lot of confusing signals here when attempting to figure out his alignment with shareholders.

One thing that really bothers me is the share dilution and ever-increasing amount of shares available for grants to GoPro employees. Woodman and his Board simply cannot allow that to continue. Employees and execs should not be rewarded year after year while the stock sinks. No more issuing shares and options with lower strike prices, enough is enough. It’s time for management to step up and deliver returns to shareholders. It’s in management’s own interest from a financial and reputational standpoint anyway.

TL;DR (THE END) 👋

GoPro’s stock price is currently at it’s all-time low. The company has had numerous missteps over the past four years, and it may even face extinction if it fails to generate better financial performance. However, there’s also a LOT of optionality and potential catalysts lurking within GoPro. The company is trending in the right direction with improving financial results. If it can gain momentum in its hardware, software, and subscriptions, it has the potential to be a multibagger stock.

For me it will be almost as interesting watching what happens 🍿 as watching this:

The Manufacturing Recession

Plus some stocks I'm watching this week

Hey there, it’s nice to be back home after some time away in Asia. I’ve been getting back into the groove of the US & European markets so expect A LOT more stock related content coming your way 😎

Last night I recorded a quick video discussing the ugly manufacturing data we got earlier this week in the US, as well as some stocks that are catching my attention this week that may deserve some further study:

Now one thing that didn’t make the video, which I noticed AFTER recording it, was a new SEC filing from Stitch Fix ($SFIX) indicating that their Board just approved a massive new stock grant to company insiders. For the 2ND year in a row, the company is allocating 5% of total outstanding shares for future stock grants to execs & employees. In my opinion, this is TOTALLY EGREGIOUS 😡.

Further, there’s no end in sight to this behavior since Stitch Fix’s 2017 comp plan has this batshit INSANE evergreen provision which allows a 5% stock grant allocation EACH YEAR through 2027.

That level of stock grants year after year brings insane and unnecessary dilution to public shareholders of this company. If they continue this behavior each year, existing shareholders may end up with 50% LESS ownership of the company by 2027. Mathematically, this makes it very difficult for $SFIX to deliver consistent robust shareholder returns with that kind of headwind from share creep. Even if the stock price stays flat, market cap grows and grows because of the addition of all these new shares.

I had to call out Bill Gurley, a VC who I otherwise admire, on Twitter because lately he’s been on a crusade calling out bankers who under-price tech IPOs, which causes a little more dilution to existing shareholders than necessary. YET here Bill sits on the Stitch Fix Board of Directors, allowing these unconscionable MASSIVE dilutive share grants. Talk about hypocrisy!

I also make the point here that there’s already a TON of existing options and shares (over 20 million on an existing share count of about 101 million, worth $300+ million at today’s prices) available to incentivize employees and executives at this company. The Board and management team CANNOT argue that they need these excessive ongoing grants to keep employees engaged in their jobs.

This is the kind of thing that you NEVER see from companies that compound value for their shareholders year in and year out. The 10-baggers and 100-baggers that create massive wealth over time, the companies with owner-managers who become legends in the market. But this is certainly the kind of thing that keeps me from buying a stock that I otherwise might be buying.

Anyway, for now I’ll end my rant on excessive stock grants 😂 Luckily for all of us there’s a lot more companies out there in the market who don’t exhibit this behavior!

Cheers,

T

The HUGE Rotation In the Market

And can a tech stock be a value stock?

In my post last week I talked about how bifurcated the market had become between tech/growth stocks and the rest of the market, with tech trading at stratospheric valuations and many other sectors including retail, energy, and financials trading at cheap levels. I had no idea that was about to suddenly shift in a matter of a couple days!

Over the past several trading days we’ve witnessed massive rallies in the formerly beaten up areas of the market while tech stocks have experienced a broad correction. On my watch lists and in my own portfolio I’ve seen some spectacular upward moves in levered companies (those with lots of debt), turnarounds, small caps, retail, energy, and value stocks. This has been very broad based, as evidenced by a chart of the Russell 2000 (small caps) vs the S&P 500 and NASDAQ indices (mid/large caps):

Or a chart plotting the performance of value stocks versus growth stocks over the past several days:

Or a chart of the tech sector versus other sectors such as energy, financials, and materials:

I actually think this is very healthy, especially for tech which seemed overextended & over-owned. Most of the large, popular hedge funds that I follow own the same 20 to 30 stocks, with heavy concentration in tech, SaaS, and payments. This herd behavior increasingly creates latent risk for holders of those stocks if something goes wrong (recall my $ULTA example from last week).

Here you can see the five day performance of some of the high valuation stocks I mentioned last week…it’s not good! 📉

On the flip side, here’s a chart of a handful of stocks that I identified as being interesting risk-reward scenarios in the past few weeks:

The difference in performance is stark!

Some of these companies I’ve tweeted or written about publicly ($DBX, $MCFT, and $ANF for example) and others I’ve talked about privately in my subscription investor community. I identified these well before the market turned. And to be honest, it wasn’t rocket science. It’s just a matter of separating from the herd and making rational & independent judgments, with a very specific focus on identifying asymmetric reward to risk setups.

Where Do We Go From Here?

Now the question is, what happens next? Do I expect this market rotation to continue?

Personally I don’t think the love affair with tech/growth/SaaS is completely over. We’ll likely see some rallies in some of these stocks. But I also think there’s still juice to be squeezed from a lot of the beaten up value plays. I’ve taken some profits on some of my big winners over the past week. However I’m also planning to hold a few of them for long-term multiyear plays.

There’s still a LOT of opportunity in stocks generally right now. Q2 earnings reporting season is mostly over, which means the macro & political environment will dominate market direction until early November. Recession signals and fears probably won’t disappear either, even if the economic data improves a bit with easier comparisons going into late fall. I imagine this could lead to more market-wide whipsaws like we saw in August.

My personal plan is to maintain a solid amount of cash in my active investing portfolio (currently around 35%) both as a hedge against corrections and as dry powder for future opportunities. For me it’s all about finding the irrationality in whatever corner of the market it’s being served up.

Opportunity at the Intersection of Tech & Value?

On to a specific stock that caught my attention today. Lately it’s been hard to find tech stocks that are also reasonably priced, BUT there is such a thing as a value stock within the tech sector once in awhile. Cloudera ($CLDR) might be an example of that, which is a big data software company whose stock was down over 70% from October 2018 through July 2019. Carl Icahn, the famous activist hedge fund manager, filed a 13D indicating he took a new stake in the company around August 1, 2019. Since then, the stock has risen over 50% in just over a month:

Now Cloudera isn’t the subject here (I have no position or opinion on it currently), but I’ve been following another software company stock for the past year that has also had a roller-coaster ride. The company is Domo ($DOMO), which makes BI and data visualization software. Check out the one year chart on this bad boy:

Wowzers. The stock went from $16/share last fall to over $40/share in the spring, but has since sold off all the way back down to mid teen’s levels here in September. It’s in a hot space that has seen two major acquisitions, with Google acquiring Looker for $2.6 Billion and Salesforce acquiring Tableau for a whopping 15.7 Billion. Meanwhile today Domo’s market cap is less than $500 million, and it trades for less than 3X Enterprise Value-to-Revenue while most of its software peers trade north of 8-10X in most cases.

The problem with Domo is that it’s not profitable yet, it’s burning cash, and it’s year-over-year revenue growth rate has decelerated to just 21% in the most recent quarter. It has $133 million of cash on its balance sheet, but also $99 million of debt and it’s burning down its cash pile at a rate of roughly $20 million per quarter currently. The cash burn has been improving a little quarter by quarter and the company keeps saying they will make it to profitability before the current cash runs out, but some analysts aren’t so sure.

I actually put together a very rudimentary forecast model to see if Domo will produce enough cash flow to skirt past any problems in the next couple of years:

Unless revenue growth stops decelerating and/or profit margins rapidly improve, it looks to me like there’s going to be a solvency problem with Domo sometime around the middle of 2021. Now a lot can change before then, and my estimates may certainly be off the mark. Nonetheless, I think it’s important to understand that Domo needs to sustainably generate AT LEAST $50 million of quarterly gross profit to dig itself out of the funding hole (assuming no additional capital gets raised), which is about 75% higher than its gross profit levels today. That means year-over-year revenue growth needs to be above 25% with gross margins at 70%, inconsistent with what we see currently (21% rev growth and 66% gross margin this past quarter).

However, an astute investor & friend of mine pointed out to me that the CEO of Domo, Josh James, spent $1 million of his own money to buy DOMO stock recently. Those kind of large insider buys always get me interested in digging deeper.

🤔 So this one is certainly very puzzling indeed! I clearly need to do a bit more work to understand what the CEO sees that the market and myself do not see. The rewards to getting an edge here could be pretty significant given the volatility and relative valuation discount of this stock.

I’m going to keep hunting through the corrections in tech stocks to see if there’s finally some value emerging somewhere in there. I’d love to find the next $ROKU for 2020! 😎📈

This Market Is Weeeeeird

Plus some thoughts on retail stock carnage

From January through the end of April this year, US stock markets had a clear and robust direction: UP. The rapid 20% market correction that we saw in late 2018 gave way to optimism that the economic environment wasn’t as bad as previously feared. The S&P 500 rallied +18% through the first four months of the year. 📈

But since then, the market has essentially gone nowhere. It’s chopped around, with a particularly choppy August. The old cliche saying “sell in May and go away” would have definitely served passive investors well:

The whipsaws from day to day haven’t gone unnoticed by others:

Now some of this volatility can certainly be pinned on Trump’s seemingly hot-and-cold approach to trade talks with China. But there are other, deeper forces at work.

It’s no secret that we are ~10 years into the current bull market, bond yields have been collapsing, yield curves are inverting, corporate profit growth is generally weak, and global macroeconomic data has been increasingly weak. Just this past Monday, the US manufacturing PMI (a widely followed gauge of manufacturing sector health produced by the Institute for Supply Management) signaled contraction for the first time in over three years. The Atlanta Fed reduced its estimate for Q3 GDP in the US as well. Major countries like Germany and the UK are already seeing declines in GDP. So it makes sense that some investors are getting worried and even getting out of the market. It also makes sense that other investors are hanging on to hopes of trade war breakthroughs, lower interest rates, and fiscal spending that could support markets in a critical upcoming election year. With these two opposing forces it doesn’t surprise me that the market has struggled to find a clear direction.

Where It Gets Weird

Now it gets more perplexing when I look at the divergences between various stocks and sectors underlying the stock market. There are entire sectors which appear to be pricing in recession with high probability: autos, retail, energy, steel, chemicals, materials, financials, casinos, and foreign stocks just to name a handful. Additionally, most companies with high net debt on their balance sheet have gotten whacked in the past couple of months. So what’s keeping this market afloat near all time highs?

Investors as a whole are still enamored with high growth stocks, many of which are unprofitable, particularly in tech & software. Valuations in software stocks still hover near decade highs, with many trading at double digit multiples of sales. Stocks like $SNAP, $VEEV, $OKTA, $SMAR, $MDB, $PLAN, $NOW, $TWLO, $TEAM, $ZEN, $ESTC, $DOCU, $PD, and many others. I won’t even discuss $BYND which is outright silly and not a high margin tech business at all.

There hasn’t really been a risk-off mentality with regard to these particular stocks, and it’s as if investors in these companies believe the good times will keep rolling. Now I get that these businesses are very good ones generally, with years of potential revenue growth ahead. But the aggressive expansion of valuation multiples this year means that the margin for error is TINY. And IF a recession hits, the unprofitable ones will find themselves in a hole where growth slows or turns negative, costs will need to be adjusted downward rapidly, and new funding might be needed just to escape bankruptcy. When the tech bubble burst quickly in 2000, many high flying tech stocks did not survive the next two years. Most lost more than 90% of their value. THAT is the risk that isn’t being priced into these high-flyer stocks today.

So it’s an oddly bifurcated stock market where the probabilities of recession seem very high on one side and very low on the other. Growth stocks have significantly outperformed value for the past few years. Investors have flocked to tech & momentum stocks which SEEM to have low volatility and steady gains.

The Contrarian View

My current view is, as it often is, somewhat contrarian.

While I don’t usually like to go sifting for stock ideas among cyclical sectors, capital intensive businesses, and businesses with high operating or financial leverage, these are places where I suspect high returns might be found in the years ahead.

Of course, I’m not going to buy stocks that have a high probability of getting wiped out in a mild or medium sized recession. I’m certainly going to prioritize companies that have good management teams, good capital allocation, profitability, competitive strengths, and low net debt. Surprisingly, companies like this do exist, even in hated sectors that are susceptible to downturns. And they often get sold off to silly valuation levels when their entire sector gets hit with waves of selling pressure.

Being a contrarian is hard and it takes guts. You question yourself every day. And if you are wrong, you might pass up gains elsewhere and/or end up with steep losses. But the rewards to being a contrarian and being right are ENORMOUS.

Hardly anyone wanted to buy $ROKU during the heart of a deep market correction in late December 2018. I did, because I could see the pessimism had extended much too far. The stock seemed like a good long term bargain around $27/share ($2.1B market cap at that time, <3.5X revenue and growing 40%+ annually with a huge growing addressable market). Just nine months later, every momentum trader wants a piece of $ROKU at a price that is over 6X (600%) higher than where I bought it less than a year ago. Funny how that works.

[Note 1: rarely does it work out that well that quickly! Note 2: I sold my position on the way up, much too early to capture all the gains, but that’s a story for another time 🤣 ]

Retailpocalypse 👔

That brings me to the retail sector, which is one of the aforementioned hated sectors. This sector has the unfortunate distinction of being vulnerable to a recession AND being subject to changing consumer behaviors that threaten the long term viability of many businesses within the sector (Amazon + the Internet threats). Naturally, I believe it might be fertile hunting ground for finding some very undervalued stocks.

This sector is bruised & battered. Out of 41 retail stocks that I’ve started tracking, only 5 have positive stock performance in the past year. The median return in the past year within this group of stocks is -40.6% and the median return year-to-date is -25.6%. Terrible!

Many of these retailers are being forced to close scores of their brick-and-mortar stores, and many are seeing declining year-over-year comparable store sales. Some even have a lot of debt on their balance sheet, in addition to being locked into long term store leases that hamper their ability to restructure / downsize.

However, 24 of the 41 companies are actually experiencing flat or positive comparable sales growth in the most recent quarter. 34 have repurchased shares in the open market in the past year, 17 have net cash (cash > debt) on their balance sheet, 26 pay a dividend, and 15 have insider buying in the past year. Even more interesting, the median valuation multiples are significantly lower than the market average: the median EV/EBITDA multiple is 4.7X and the median forward Price-to-Earnings (P/E) ratio is 9.0X. For context, the average P/E multiple in the US stock market is around 16.5X right now.

Where I think it gets particularly interesting is with a few of these stocks like Abercrombie & Fitch ($ANF). What?! Abercrombie & Fitch was a hot brand in the early 2000’s but didn’t it become irrelevant after people got sick of their overpriced moose laden t-shirts, ripped denim, awful brand image, and heavily cologne infused stores? Not quite. You see, A&F has undergone a turnaround in the past few years. They’ve revamped their image & clothing lines, closed some under-performing stores, attempted to improve their culture, expanded further internationally, and beefed up their online presence & e-commerce. They also own Hollister, which has performed well (positive sales growth) in the past few years.

It’s not the greatest business out there, but it’s a business that can currently generate about $200 million of annual free cash flow for shareholders (closer to $150 million this year due to elevated e-comm investment). Comparable store sales were positive in Q1 and flat in Q2, which isn’t bad in this weakish economic environment. Meanwhile the market cap has shrunk to about $950 million, and they have $250 million of net cash on the balance sheet. So effectively today the business is selling for just 3.5X cash flow (4.75X if you don’t back out the net cash). That is an absurdly pessimistic valuation. Even if a recession hits and free cash flow gets cut in half, the stock would STILL trade for a single digit free cash flow multiple. That feels like a decent value assuming you don’t believe ANF is about to head into rapid terminal decline, which I don’t see signs of at this moment in time. Management agrees and the company repurchased 3.5 million shares this past quarter, about 5% of the total outstanding in just one quarter. I love to see opportunistic stock buybacks that take advantage of low valuations, Outsiders style! Did I mention investors get a 5%+ dividend yield at today’s prices while they wait for a stock recovery? Not too shabby.

Now you might be asking, what about the better performing companies in this sector? Why go dumpster diving for value when you can buy faster growth, albeit at higher valuation multiples? Well there’s plenty of ways to make money in the market, so if that’s your approach I won’t knock it! But here’s a cautionary tale from just this week: $ULTA. Ulta Beauty is a fast growing cosmetics & fragrance retailer whose stock doubled in the past five years. Ulta has been putting up impressive comparable stores growth numbers for the past several years. But investors had bid up Ulta’s stock way above average retail sector & market wide valuation levels, assuming the company would keep delivering growth above their rising expectations. When Ulta announced a slightly disappointing, but still nicely positive Q2 earnings report (sales growth of 12% & comparable sales growth of 6.2%) the stock lost 30% in one day! It just shows the risk inherent in buying high valuation stocks that carry very high expectations.

At some point $ULTA could be a compelling stock idea itself…

Wrapping Up (For Now)

Now there’s a few other stocks in the battered retail sector that look interesting to me right now. There’s also a retail REIT that I find quite intriguing (not in the list above). And that’s just in retail, I haven’t even gotten to the other beaten up sectors! But this post is already quite long so I’ll save all of those for another day 😎

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