Is Facebook Stock Approaching Bubble Territory?

Here is a list of the U.S. companies that are worth at least $300 billion today based on stock market value:

  1. Apple $522B
  2. Microsoft $392B
  3. Exxon Mobil $365B
  4. Berkshire Hathaway $357B
  5. Facebook $336B
  6. Amazon.com $318B
  7. Johnson & Johnson $311B

If you are surprised to see Facebook (FB) registering as the 5th most valuable U.S. company you are not alone. Given the company’s high growth rate, many investors do not mind the stock’s valuation. At $117 per share, the stock trades at 33 times this year’s consensus forecast of $3.54 per share of earnings. Given that Wall Street is currently estimating more than 30% earnings growth in 2017, this P/E ratio seems high, but warranted, if you are a true believer in the company’s future.

I am not going to delve into the company’s future growth prospects in this post, as I have been wrong about them so far. My thesis was that Facebook usage would decline over time as early adopters such as myself tired of the service and the network became overloaded with parents, grandparents, aunts, uncles, etc. That has proven to be wrong. Perhaps Facebook has evolved from a cool place to connect with friends to a crucial hub to connect with family. At any rate, the stock’s valuation is what has peaked my interest lately.

Facebook is one of a growing number of growth companies in the technology space that is overstating its profitability by paying its employees with stock and not treating it as an expense when speaking to Wall Street analysts. The official GAAP financial statements do disclose how much stock they dole out to employees (for instance, in 2015 the figure was a stunning $3 billion), but when investors quickly look at earnings estimates, they see the $3.54 figure for 2016 which does not include stock-based compensation.

So what happens to the stock’s valuation if we treat stock compensation as if it were cash? After all, if Facebook decided to stop paying its employees with stock, we can assume they would have to replace it with cash. Below I have compiled the company’s free cash flow generation since 2012 and subtracted the dollar amount of stock they have paid their employees. This simply tells us how much actual free cash flow Facebook would have generated if they compensated solely with good ol’ U.S. dollars and cents.

FB-FCF

As you can see, adjusted for stock-based compensation Facebook had free cash flow of $1.09 per share in 2015, which is about 50% less than their actual reported free cash flow ($2.13). Put another way, Facebook’s employees (not their shareholders) are being paid out half of the company’s profits.

From this perspective, Facebook stock looks a lot more overvalued. If you annualize the company’s first quarter 2016 free cash flow adjusted for stock compensation ($0.38 per share), the company trades at a P/E of 77 ($1.53 of free cash flow). There is certainly an argument to be made that such a price resembles bubble territory. That potential problem could be rectified if the company continues to grow 30% annually for the next five years, resulting in $4.05 of “adjusted” free cash flow in 2020. But buyers of Facebook stock today at paying about 30 times that 2020 estimate right now, which is still a very high price.

Below is a summary of Facebook’s stock market value relative to reported and adjusted free cash flow since 2012, as the stock has nearly quintupled in price:

FB-Pr-FCF

How do situations like these typically play out? One of two ways. The less likely scenario is probably one where Facebook’s growth hits a wall and investors quickly slash the P/E ratio they are willing to pay by 2-3 times. That would be ugly, but does not appear to be the most likely outcome given their momentum right now. The more likely scenario is the one that we usually see with very good companies that have staying power but simply have seen their stock prices get ahead of the fundamentals. In that case, the cash flow multiple comes down slowly over a period of several years, resulting in the stock price lagging the company’s underlying profits.

If I had to guess, I would say the latter seems like a real possibility going forward from here. Regardless, investors should check to see how much of a hit a high-flying tech company’s cash flow would take if stock compensation was factored into the equation. As Warren Buffett likes to say, “if stock-based compensation is not a real expense, I don’t know what it is.”

Full Disclosure: No position in Facebook at the time of writing, but positions may change at any time

Election Cycle + Valeant Collapse = Healthcare Opportunities

If you look around the U.S. market these days you are likely to find the most value from a quantitative perspective in the energy and healthcare sectors. The former area is tricky because the underlying commodity price is so crucial to the profitability of many industry participants. Pipeline owners and large integrated energy plays depend less on the actual commodity price, but because of that you will likely find less value in safer subsets of the industry.

Within the healthcare space, we are seeing a familiar pattern come to the forefront again during the current election cycle. During the 2008 campaign the sector was in focus and saw unjustifiable selling. Back then it was largely centered on the private insurance industry, and this time around bad apples like Valeant have shined a light on drug company practices that sometimes tow a shady line.

Despite many that claim the markets are efficient, history shows us that just because markets go through periods where they shun certain companies, assuming the worst by painting every player with the same brush can be shortsighted. I recall back in 2008 when the health insurance stocks were crushed on fears of what government involvement under President Obama might look like. Many simply assumed that for-profit entities would suffer, without even thinking through what the political goals were and how that would play out in Corporate America.

To address whether the market “always gets it right” during the heat of the battle, let’s briefly revisit the 2008 healthcare scare. The thrust of Obamacare was that Americans would be required to purchase insurance and that said insurance would have a federally mandated minimum level of benefit (no lifetime benefit caps, no exclusions for pre-existing conditions, etc).  For a long time investors were so focused on the government getting involved that they missed the big picture. The law required that Americans buy a private health insurance plan. Only on Wall Street would the resulting market reaction be to conclude that this would be a bad development for companies selling those very insurance plans.

Quite logically, the health insurance stocks have been some of the biggest winners during President Obama’s seven-plus years in office. For instance, the iShares U.S. Healthcare Providers (IHF) exchange-traded fund, whose top holdings include all of the largest health insurance companies, has more than doubled in price since January 2008.

Fast forward to current day and we once again have an assault on the healthcare sector, but this time the selling is focused on pharmaceutical companies and their drug pricing, reimbursement, and distribution policies. Unlike the energy sector, there is not a large outside factor beyond the control of company executives that will determine the fate of their financial results. Sure, bone-headed management decisions like those made at Valeant under CEO Michael Pearson will get you in trouble, but that is true for any company in any industry. The idea that every drug company in the country acts just as Valeant has in recent years is ludicrous.

Sure, the ripple effects will be felt across the sector, but the idea that the business model of selling drugs is broken is silly. The U.S. demographic trends only point to more demand in the future. And with more Americans being covered by insurance, there will be plenty of dollars to be spent on treating an aging population.

So where should investors look for bargains? Below are four names that my firm owns in various quantities. If you strip out the noise and focus on underlying cash flow, I think there are plenty of attractively priced drug companies out there. And a year from now when the election cycle is over and the Valeant situation has been rectified one way or the other (bankruptcy or slow recovery back to health), I suspect market participants will get back to basics.

*Allergan (AGN) $225

*Horizon Pharma (HZNP) $16

*Perrigo (PRGO) $100

*Shire (SHPG) $183

All four of these companies look like Valeant in that they have engaged in a lot of M&A activity. In the case of Allergan, they also competed with Valeant for some of those deals. Horizon is smaller company that has grown by acquisition. Two were targeted by larger firms but had deals fall through (Pfizer walked away from a deal to buy Allergan, AbbVie did the same with Shire). Perrigo today announced that its CEO is leaving to replace Pearson at Valeant, after rebuffing a buyout offer from Mylan for $205 per share. Shire quickly pivoted after its failed AbbVie tie-up and agreed to buy Baxalta.

You can see why these stocks are down anywhere from 33% to 60% from their highs. Lots of noisy news flow over the last year. But if you strip all of that out you are left with strong companies with lots of free cash flow generation ability.

Lastly, I think it is important to note that the idea that growing through M&A in the drug sector is a red flag should be reevaluated. Just because Valeant borrowed more than $30 billion and systematically overpaid for acquisitions does not mean that any drug company that acquires other companies is a suspect investment. Consider that the single best launch of a new drug ever was Gilead’s Sovaldi ($10 billion in sales its first year), which was acquired via the acquisition of Pharmasset in 2012. Before that, one of the best-selling drugs of all-time was Pfizer’s Lipitor, which peaked at over $13 billion in annual sales. Lipitor was developed by Warner Lambert, a competitor Pfizer acquired 15 years ago. As with any acquisition, it all comes down to what you get and how much you pay. The idea that investors should shun drug companies that have a history of M&A, without looking any deeper, is strongly misguided.

Full Disclosure: Long shares of Allergan, Horizon, Perrigo, and Shire at the time of writing, but positions may change at any time

Oil Slump Shines Light on Weakness of Fracking Business Model

It remains to be seen if the U.S. is in the midst of a popping bubble in shale oil and gas exploration, or if a temporarily supply glut will merely be a bump in the road, but the last couple of years have served to shine a light on what should be alarming for those who continue to be bullish on the equities of fracking companies.

The biggest crack in the long fracking investment thesis has to be the amazing lack of free cash flow generated by these companies. When oil prices were hovering around $100 per barrel investors were content with capital expenditures that far exceeded operating cash flow in the name of “growth.” Leading frackers like Continental Resources (CLR), Pioneer Natural Resources (PXD), and Range Resources (RRC), among others, borrowed billions of dollars in order to continue acquiring land and drilling for oil and gas. As long as in-ground reserves increased, investors did not worry much about negative free cash flow or the lack of material dividend payments or debt repayment. They simply valued the companies based on the value of their millions of barrel of reserves.

Such events are not that surprising during a boom, but the strangest thing is what happened after oil prices cratered. At current prices, the fracking companies are rushing to slash operating costs and focus only on their lowest cost wells in order to bring cash operating costs per barrel down as low as possible. Doing so allows them to continue to service their debt and wait for commodity prices to turn around (at least for those companies with above-average acreage and manageable leverage).

What I find so disturbing is what has happened to the cash flow statements of these fracking companies during this transition away from rapid growth and towards operational efficiency; most of them are only able to operate at free cash flow breakeven, at best. The economics of fracking are so poor that even when you are supremely focused on minimizing operating costs and extracting from only your most productive wells, you still cannot generate free cash flow. And yet, these circumstances are exactly when you would expect profits to be highest (again, your best wells operating at the lowest possible cost). Simply put, the economics of fracking for low-cost producers should be very strong right now, but they are not.

What does this say about the fracking business model? Why should investors be putting their money into these stocks?  If you care at all about the quality the businesses you invest in, and you judge quality at least to some degree by how profitable the model is, this energy cycle should be very illuminating. If the best companies in the industry cannot generate material free cash flow today, then when?

The pipeline stocks look better and better to me every day.

Full Disclosure: No positions in CLR, PXD, and RRC at the time of writing, but positions may change at any time

LinkedIn: Another Overvalued Tech Stock Crashes Back To Earth

LNKD

Looking at the quote for career-minded social networking site LinkedIn (LNKD) today might convince you the company is in serious trouble. However, if you read the company 2015 financial results press release you will see that revenue hit $3 billion in 2015, double 2013 levels. Operating cash flow rose 42% to $800 million and the company forecast 2016 revenue of $3.6 billion, up 20% versus last year. So how on earth is the stock down nearly 50% today after releasing their results?

Valuation. Valuation. Valuation. Yesterday the company’s equity was valued by the market at $25 billion. Investors were willing to pay 8 times annual sales, more than 30 times operating cash flow, and more than 80 times annual free cash flow. That price was, to put it mildly, quite rich. The result was a bar that was set so high that it was quite likely LinkedIn could not jump over it. And then the stock gets crushed as investors realize they too can (and will) stumble relative to high expectations.

So should investors go out and back up the truck on companies like LinkedIn? Here’s the problem. The price was so high before today that even after a 45% decline, it is still not cheap. For example, LinkedIn reported $300 million of free cash flow in 2015. If you assume that figure will grow in-line with sales in 2016, it would reach $360 million this year. Not only does the stock still trade at 40 times free cash flow after today’s decline, but as a fast-growing technology company LinkedIn issues a very large amount of stock-based compensation. In 2015 it amounted to a whopping $510 million. In other words, if the company paid their employees with cash only, rather than cash and stock, the company would generate negative free cash flow. Accordingly, it is difficult to ague that investors are getting a bargain even with LinkedIn trading at $106 per share, down from a high of $276 within the last 12 months.

As is usually the case, sky-high valuations set companies and investors up for big problems down the road. High-flyer buyer beware.

Full Disclosure: No position in LNKD at the time of writing, but positions may change at any time

Keeping Perspective: S&P 500 Corrections Since 2010

Has January 2016 been rough for stock market investors? Absolutely. One of the most important things to do, in my view, is to keep perspective and not make swift, emotional changes during times like these. With the help of the media, many investors see this kind of drop in such a short time (10% in a few weeks) and immediately think back to 2008. That financial crisis was the worst recession in 80 years. It is not a common occurrence. What is common are regular market corrections triggered by some macroeconomic event that are characterized by stock prices reacting far worse than underlying economic and corporate performance would indicate is rational. That is very likely what we are seeing right now. In fact, it might surprise people that we have actually witnessed many such events just since 2010.

SPX-drops-2010-2016

For long-term investors (time horizon of 3-5 years or more), these are almost always opportunities to buy rather than sell.

The Oil Shale Revolution Is A Double-Edged Sword

Back in the old days falling energy prices were a clear incremental tailwind for the U.S. economy. Some economists even went as far as to argue that low gasoline prices were the equivalent of a tax cut for consumers, but that line of thinking never made sense to me. After all, a tax cut implies that you have more money in your pocket, but when gas prices go down you have the same amount of money. You are simply able to reallocate some of it away from gas and into other things, as your total spending stayed the same.

Then the shale revolution came to the U.S. and technological advances resulted in states like Colorado, Ohio, Pennsylvania, and North Dakota having large slices of their regional economies linked to oil production. The tide shifted and the U.S. economy now was tied to oil production as opposed to simply consuming oil imports from Canada and the Mideast. When oil prices were high that was a good thing, but now that oil has cratered from $100 per barrel to below $30 we can clearly see the other side of the double-edged sword.

To understand why the stock market is reacting so much lately to falling oil prices, we simply have to think about the ripple effects now that we have so many more domestic oil producers. Most of these shale firms are relatively new companies that borrowed billions of dollars to acquire land and start drilling. Their business models were predicated, in most cases, on oil prices of $75-$100 per barrel. Once prices dropped below $50 certain companies no longer could produce oil profitably. As prices have continued to fall, more and more companies fall into that category. Very, very few can make money sub-$30 per barrel.

So what happens in this scenario? Frankly, many smaller oil companies will not survive. Without profits they will not be able to pay the interest on their debt (let alone the principal), which causes multiple problems. Most importantly for investors and financial markets, as debts go unpaid lenders will lose a lot of money. The energy sector owes tens of billions to banks and investors who hold their corporate bonds. Much of that debt is held in mutual and exchange traded funds, so the losses will accrue from the biggest banks all the way down to small investors. And without knowing how low oil prices will fall, and for how long it will stay there, there is no way to know exactly how many companies will survive and how much debt will go into default. That uncertainty is impacting financial markets today, this month especially.

The other issue worth mentioning is why exactly oil prices have not been able to stabilize after so many months of decline. The problem of excess supply is not self-correcting as quickly as many might have thought (the cycle looks like this: high prices result in too much drilling, prices fall due to oversupply, production is curtailed due to unprofitable prices, supply comes down to balance the market, low prices spur demand, prices stabilize and rebound).

For these shale companies want to hang on as long as they can, they simply need to keep paying the interest on their debt. If their debt does not come due for another 2-3 years, the companies can continue to sell oil at prices above their cost, so long as they have a little runway left on their bank credit lines and they can generate enough cash to cover interest payments. The reason we have not seen many oil-related bankruptcies yet is simply because very little of the debt has come due. But that time will come, and as long as oil prices remain low the banks and other lenders will not shell out any more money. Only then will companies stop producing, which will start to bring the supply/demand picture back into balance.

Coming back the stock market specifically, it is important to note that the non-energy sector is doing just fine (S&P 500 companies actually grew earnings in 2015 if you exclude the energy sector). Lenders will take some losses on their energy loans, but the size of that market is small relative to the rest of the economy. For that reason, it is fair to say that the current stock market correction is sector-specific and not indicative of a widespread, systemic problem (unlike in 2008 when banks were in danger of closing, this time they will simply take losses on a part of their loan book).

For comparison purposes, today’s situation reminds me very much of the dot-com bubble that peaked in early 2000. As was the case with oil in recent years, back then there was a bubble in one sector of the domestic economy (tech and telecommunications). While it caused a recession in the U.S. the problem was contained to that one area, which allowed for a relatively swift recovery. In fact, S&P 500 corporate profits peaked in 2000 at $56 before falling by 30% to $39 in 2001. Earnings began to rebound in 2002, got back to even in 2003, and hit a new all-time record of $67 in 2004.

The goods news is that this time around things should turn out considerably better because the energy sector peaked at 15% of the S&P 500 index in 2014, whereas the tech and telecom sectors comprised 30% of the S&P 500 in 1999. Therefore, energy should have only about half of the impact compared with the technology sector 15 years ago. Even as oil prices collapsed in 2015, S&P 500 profits only fell by 6% from their peak. While that number could certainly get a bit worse if oil stays at current prices for the duration of 2016, there is a floor in sight; in terms of market value the energy sector today only represents 6% of the S&P 500.

Market Volatility Is Back, And That’s Okay

You might be freaking out now that the U.S. stock market has dropped more than 8% during the first two weeks of 2016. With only nine trading days under our belt (including today) it has been a rough start to the new year. It has not helped our mental conditioning that from 2011 to 2015 we had a four-year stretch of no market corrections. Over the last six months we have now seen drops of 10% or more on two separate occasions. It also does not help that the national news typically only covers the stock market on days when the Dow drops 300 or 400 points, rather than giving equal time when it rebounds.

All of this is going to be okay. The shift from human to electronic trading has allowed computers to take over the process, which means much faster transacting. The result is that moves up and down now happen much more quickly. Market shifts that once took week or months can now come and go in a matter of minutes or hours. A 10% market correction might have taken three months a couple decades ago but now can take three days.

The ever-changing global economy also contributes to the volatility. We never heard much about China twenty years ago but now our financial markets can react violently to swift declines in Chinese stocks, even when their impact on American companies is minimal. As the United States matures and other countries grow faster and contribute a higher portion of global economic output, we become less shielded from international markets and therefore we will feel more ripple waves. And that’s okay.

Advances in technology more generally have also had consequences for those of us who are investing for our futures. Information can now be transferred across the globe in a matter of milliseconds. While that is great for a level playing field and means we can research our investments more quickly, easily, and cheaply than ever before, it also means that there is more to react to. More information and quicker dissemination of that information has its drawbacks; namely volatility. Engineers are now even programming computers to automatically place buy and sell trades based on information delivered online. So not only do we get information faster, but we can act on in it much faster too.

And then there are new financial products being created all of the time. More ways to “play” means more money flowing in different directions, which also increases volatility of the underlying prices for assets. As the great new movie “The Big Short” conveys so well, financial derivatives allow more money to be wagered on various outcomes than ever before. As the analogy goes, you used to be the only one who could buy insurance on your own house or car, but now an unlimited number of people can do so. Imagine how volatile the price of insurance will be when it trades daily and anyone can buy it on practically anything.

By now you are probably thinking that I have changed my mind in a few paragraphs and everything will not be okay. Nope. The saving grace is that business profitability does not swing nearly as much as asset prices do. And over the long-term asset prices are going to track the underlying fundamentals of a business. As long as we are willing to not panic and sell when things turn south for a little while, the near-term price gyrations should not matter. And no matter how hard it is to accept this fact and not panic, that is what investing requires. I try to do the best job I can reinforcing this with my clients, but it is a tough job. Emotional reactions are natural and difficult to ignore.

My focus right now is on fourth quarter earnings reports and 2016 commentaries which are getting under way. Doing so will allow investors to separate what is going on daily in terms of asset prices and how the underlying fundamentals of companies look. After all, five years from now stock prices will reflect underlying earnings more than anything else. Five days or five weeks from now they can reflect anything at all.

PS: Some people may argue with that last point. After all, if markets get wacky five years from today what is to say that the underlying profits of the company will matter? That is a fair statement, to some extent. I think it is important to point out that history has shown that stock prices, while volatile, do not have an unlimited range of outcomes. The S&P 500 has traded as low as 7-8 times earnings during periods of double-digit interest rates and as high as 25-30 times earnings during bubbles. But it has never traded for 3 times earnings or 100 times earnings.

Why is this important? Let’s say you buy a $100 stock today that trades for 10 times earnings and pays a 5% annual dividend. Your underlying investment thesis is that it will grow earnings per share by 10% annually for the next five years and continue to pay the dividend, which will be increased at the same rate as the underlying earnings grow.

If your fundamental analysis of the company turns out to be accurate, and you do not sell the stock (even during times of market panic), five years from now you will have collected more than $30 per share in dividends and the company’s earnings will have grown from $10 to $16 per share. Assuming this plays out, what is the worst case scenario in terms of investment return? Even if the stock trades at only 7 times earnings, the stock will still trade at $112 per share. Add in the $30 of dividends you collected and your total return would be more than 40% over a five-year period, or about 8% annually.

Simply put, you are not going to lose money on that investment, as long as your thesis about earnings and dividends is right. This is important because we could not say the same thing if we only look out five weeks or five months into the future. If the stock drops to 7 times earnings in the short-term you would lose 30% on paper even if the company’s fundamentals were on track. As long as you do not overpay for something, being right on the fundamentals and holding for the long-term becomes a winning proposition. That is why I spend the bulk of my time researching companies and hammering home the long-term nature of my investments.

Even With New E. Coli Cases, Chipotle Shares Not Yet Cheap

Shares of casual dining chain Chipotle Mexican Grill (CMG) have been hammered since reports of E. coli outbreaks across the country have caused a material decrease in customer traffic during the fourth quarter (double-digit same store sales declines have been confirmed by the company). After peaking at more than $750 in August, the stock now fetches a little more than $500 per share.

cmg

This is definitely the kind of short-term sell-off I pay close attention to as a long-term, contrarian investor. History tells us that restaurants dealing with outbreaks like this see a drop in customer visits but eventually recover. Within a year or two, after the headline news has abated and the health issues rectified, people revert to their previous dining habits. With a perennially high valuation stock like Chipotle, a negative event like this can often be one of the only ways investors can get a bargain for their portfolio. So am I loading up on the shares at the current ~$520 price?

Not yet. Simply put, I don’t find the price extremely compelling, even after a 30% decline. Before the E. coli cases came about, Chipotle was having quite the year from a financial standpoint. Revenue was tracking at about $4.7 billion for 2015 (+15%) with operating cash flow approaching $800 million (about as high a profit margin as you will find in the industry). I estimate maintenance capital expenses for the company’s existing restaurants to be quite low (less than $100 million annually), so CMG’s existing units were on pace to produce free cash flow of $700 million per year before the outbreaks.

The problem for value investors like myself is that the stock’s valuation has gone from insanely high ($24 billion at the peak, or about 34 times free cash flow) to a lower level today (23.5 times free cash flow) which is still fairly high. Despite CMG’s growth outlook, I would have valued CMG at 20 times free cash flow before the recent drop (~$450 per share). Now that customer traffic has dropped more than 10% and will likely take at least a year to recover, I would want a discounted price to reflect the time it will take for the company to fix the problem once and for all and see visitors return to their normal habits. A 25% discount would mean a stock price in the 330’s. Accordingly, I do not think I will be bottom-fishing in CMG shares anytime soon. There are just too many other restaurant chains that I think are meaningfully more attractive from a valuation perspective.

Full Disclosure: No position at the time of writing, but positions may change at any time

CEO Steve Wynn’s Huge Purchase Reinforces That Wynn Resorts Stock Is Dramatically Undervalued

Wynn Resorts (WYNN) announced on Tuesday evening that its Founder, Chairman, and CEO Steve Wynn purchased more than 1 million shares of stock on the open market between December 4th and 8th, bring his total ownership to more than 11 million shares (about 11% of the company). The stock reacted well today to the news, rising $8 to around $70 per share.

I posted earlier this year about my belief that shares of WYNN are very undervalued. After peaking at $249 in March 2014, I began to get interested below $110 in the spring and have been averaging down my clients’ average cost basis during the stock’s swoon.  Wynn’s purchases this month took place when the stock traded between $60 and $66. This insider buy is interesting on multiple fronts. Let me touch on some that come to mind.

1. Owner-operators like Wynn typically sell their shares over time

Founders who continue to run their companies often have large equity stakes. In most instances these folks will sell shares steadily over time for diversification purposes. What makes this transaction so notable is that Wynn already owned 10% of the company (worth nearly three-quarters of a billion dollars) and yet he still bought more stock. This is rare. Think of the times we have heard about the likes of Bill Gates, Mark Zuckerberg, or Jeff Bezos trade in their company’s stock. They almost always sell.

2. Most insider buys are small

Although it doesn’t happen as much as one might hope, when CEOs buy shares in their own company (in the open market with their own cash, not via exercising stock options) the buys are typically relatively small compared with their actual compensation. These kinds of trades are seen by many investors as merely token purchases made for the sake of optics (as opposed to a large financial bet). If a CEO who makes $5 million per year buys $500,000 or $1 million worth of stock once every 5 or 10 years, that hardly signals to investors that they really think it’s a great investment. Wynn’s purchase of 1 million shares is unusual in this respect as well. He spent more than $60 million of his personal funds. That is a lot of money (even for Wynn, who is much wealthier than the average CEO). Think about all of the things he could have bought with $60 million. While it is clear speculation on my part, I think Wynn actually made this move with financial motivations first and foremost.

3. What does this move say about the intrinsic value of WYNN stock?

So why did Wynn buy stock now? After such a huge drop (75% from the peak less than two years ago), should we assume he didn’t think it was undervalued until now? Why not buy at $150 or $100? Did he think the shares were fully valued at $75 or $80? Again, this is pure speculation, but if you buy into my argument that he already has plenty of shares, even if he wanted to signal a vote of confidence he could have done so with a far smaller buy (even $5 million would have been far more than most every other CEO purchase). I would guess that Wynn made this particular move because he thinks the stock’s decline had simply reached “ridiculous” territory. If he is making this investment simply to make money, and he thinks the stock price now is irrational, then why not make a big bet on that view? Conversely, if he was simply trying to stem the stock’s decline with a headline, why not do so after the stock fell by $100 per share? What about after it fell by $150? Instead he waited until it dropped by nearly $200 per share. Why? My guess: because it’s just too darn cheap to ignore, even when you already own 10 million shares.

4. How does my view of the stock change with this news?

It doesn’t. I thought the stock was materially mispriced the day before the news hit and I feel the same way the day of the announcement. Will I load up on even more shares now that Wynn is buying? Probably not anymore than I would have already. While his confidence is a positive signal, it’s pretty hard to objectively argue that the stock has not been undervalued for quite some time. The fact that Steve Wynn likely has the same opinion should not come as a surprise.

5. Should investors jump in now, based on this news?

Wynn stock popped 13% on this news, probably mostly due to short covering. In most instances moves like that are short-lived, either because the news is forgotten in a matter of days, or because the next material news item for the company will likely be deemed more important. I would guess that the stock gives up much, if not all, of this pop over the coming days and/or weeks. After all, the next big catalyst for the stock is the opening of the new $4.1 billion Wynn Palace property on the Cotai strip, which has been pushed back from the end of Q1 2016 to the end of Q2 2016. Until then, the same concerns that have plagued the stock for the last year (the huge slowdown in Macau gaming revenue) are unlikely to abate.

Full Disclosure: Long shares of WYNN at the time of writing, but positions may change at any time

Sorry Goldman Sachs, Apple Is A Hardware Company Plain and Simple

Shares of Apple (AAPL) are rising $3 today to $116 after Goldman Sachs added the stock to its “conviction buy list” and raised its price target to $163 per share (from $145). Goldman’s thesis is that Apple is transitioning from a hardware company to a recurring revenue services business, which will allow it to garner a higher earnings multiple on Wall Street (which in turn would lead to meaningful price appreciation). While many of my clients are long Apple stock, I don’t buy this “Apple is really a software company” argument.

If we take a look at the numbers it is hard to argue otherwise. In fiscal 2015 Apple derived 9% of its total revenue from services, with 91% coming from hardware (led by the iPhone at 66% of sales). Okay, so Apple is a hardware company today but maybe the services segment is growing so fast that it will ascend quickly to be a huge part of Apple’s business? In fiscal 2014 services represented 10% of sales. In fiscal 2013 it was 9%. The mix isn’t changing at all.

So what services business will really start to grow in the future and allow this software thesis to play out? Goldman Sachs, among many others, point to Apple Pay. Apple’s receives a cut of every credit card transaction processed through its Apple Pay iPhone app (the press has reported the rate to be 0.15% but Apple will not confirm this). So if Apple Pay continues to gain market share in credit card processing, will that make a big difference to the company’s financial results? Not at all.

Total U.S. credit card volumes are staggering; more than $2 trillion per year. Let’s be optimistic and say that Apple Pay can grab 25% of all credit card transactions. The result would be about $900 million of Apple Pay service revenue. That sounds like a lot of money until you realize that Apple is booking more than $230 billion of sales annually. An extra $900 million comes to less than one-half of one percent of incremental sales. Even if we model that as 100% profit, it would add just 16 cents to Apple’s annual earnings per share. It’s a rounding error.

The bottom line is that Apple is a hardware company. Could that change in 5-10 years? Perhaps, but it’s not going to happen anytime soon and as a result, investors should not expect the company’s P/E multiple to expand materially. That is not to say the stock won’t perform well, I just don’t think it’s going to trade at or above the valuation of the S&P 500 index, which would be required if the stock is going to see $163 anytime soon.

Full Disclosure: Long shares of Apple at the time of writing but positions may change at any time.