Microsoft/LinkedIn: Maybe The Folks In Redmond Will Finally Get An Acquisition Right, But Don’t Hold Your Breath

I am often asked why some companies trade for sky-high valuations even when a majority agree that the price does not make a lot of sense. In part, the answer is that there are always people who perceive value differently and will overpay for companies. The saying goes that something is only worth what someone else is willing to pay for it. That might be true in many instances (in the short term especially), but many stock market investors would argue that a company’s worth is actually tied to its future free cash flow. And that is what makes a market.

If you had to pick a tech company that has a miserable history with acquisitions, it would be Microsoft (MSFT). Just in the last nine years MSFT has paid $6.3 billion for online advertising firm aQuantive, $7.6 billion for Nokia’s phone business, and $8.5 billion for Skype. That is more than $22 billion for three companies that have all struggled under Microsoft’s ownership. The most logical from a strategic perspective, Skype, seems to be a flop. With its huge installed based of Windows, Outlook, and Office users, Microsoft had a huge opportunity to build and integrate the world’s most dominant audio and video corporate communications platform. Oh well.

Today Microsoft announced they are paying more than $26 billion for corporate social network LinkedIn (LNKD), a 50% premium to last week’s closing stock price. Will this deal finally be the one that gives MSFT deal credibility? The odds seem long. Product synergies seem sparse and even industry pundits are using odd justifications for the deal. One tech commentator thought this was a boon for Microsoft’s Azure cloud business because LinkedIn is big and growing quickly, and therefore would give MSFT a lot more data flowing through its cloud infrastructure. So LinkedIn doesn’t use Azure now but it is a smart deal because the tie-up will force them to use Azure in the future? Yikes.

If I was a Microsoft shareholder I would be most concerned with the $26 billion all-cash price tag (to be funded entirely with debt). In 2015 LinkedIn had free cash flow of $300 million. Subtract non-cash stock based compensation of $510 million and you can see that LNKD is not “profitable” really, non-GAAP accounting aside. EBITDA in 2015 was about $270 million, so the deal price equates to a trailing EV/EBITDA multiple of roughly 90 times. Even if one believes the strategic rationale for the deal is sound, making it worthwhile from a financial standpoint is another story.

While it totally makes sense that Microsoft feels its relevancy fading, and thus wants to make a splash and try to get “cooler” in the world of tech, there are plenty of obstacles in front of them. It will be tough task to make this move one that we look back at in a few years and say “Wow, that LinkedIn deal really paid off.” So even with a new CEO, maybe MSFT has not changed all that much at all. Time will tell.

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

Will People Continue To Buy Clothes In Stores?

It is always interesting to me when Wall Street takes a few select situations and uses them to make dramatic conclusions about how the world will change forever. If you have read much about consumer spending in recent months you might come to a few conclusions, such as:

  1. Millennials are the only consumer group that brands should care about because they now outnumber baby boomers
  2. Millennials don’t spend money on clothes
  3. Instead Millennials spend money on travel, eating out, live experiences, and consumer electronics

I want to focus on where consumers are spending money because I think the idea that retail shopping is dead due in large part to a de-emphasis on clothing and accessory purchases is presenting excellent investment opportunities right now. Many leading department store chains as well as specialty retailers focused on apparel and accessories have been crushed in the public markets. They are trading at equity valuations that imply their businesses are in permanent decline due to a combination of shopper preference changes and increasing market share for online-only retailers. Even though the bricks and mortar companies have spent billions of dollars building out their online capabilities to complement their store networks, investors largely do not believe these investments will show solid returns.

First, I find it odd that investors do not want anything to do with the apparel and accessories category right now. Are we going to somehow stop wearing clothes? If not, are there technological advances in the space so great that wearing clothes will no longer result in them wearing out and needing to be replaced? The view that there is an irreversible trend toward spending materially less on clothing and related products appears suspect to me.

If you agree, then it makes sense to continue down the road and examine other supposed reasons why retail is supposedly “uninvestible” today. For instance, I hear many people point to the fact that Amazon is going to surpass Macy’s in clothing sales in the United States. Even if this is true, should we conclude that Macy’s is therefore doomed? If I think about it, it seems logical that Amazon will surpass many retailers in various categories. After all, Amazon allows any company to list their products on their site. Conversely, Macy’s has a limit to how many items they can sell, as both their stores and distribution centers have finite capacity. Isn’t this therefore an apples and oranges comparison? Honestly, I would be concerned if Amazon could not sell more clothing than Macy’s given their vastly different business models.

Macy’s stock has dropped from $73 to $33 per share in the last 12 months, bringing its equity value down to $10 billion. To give you a sense as to how negative investors view the company’s prospects, it has been widely reported that the Macy’s flagship store in New York’s Herald Square (which they own) is worth at least $3 billion. Add two more valuable stores in Chicago and San Francisco and there might be $6 or $7 billion of real estate value in just three of Macy’s 800+ store base across the country. This discrepancy tells me two things; 1) there is a large margin of safety in Macy’s stock, and 2) investors don’t think very much of the company’s retail business despite more than $25 billion in (very profitable) annual sales. Another interesting fact is that Macy’s stock currently yields 4.5%, which is higher than the yield on Macy’s corporate bonds that mature in 2023 (about 4.1%). Typically investors accept lower income payouts on equities in return for more capital appreciation potential. And in case you were wondering, Macy’s is more than adequately covering the dividend with free cash flow.

There are many other examples of retail stocks that I believe are being mispriced today. Some have inherent real estate value due to owned stores vs leased stores. Others have high dividend yields that actually point to undervalued stocks rather than distressed operations. Others have no dividend or owned real estate, but instead have real growth opportunities ahead of them and simultaneously are trading on public markets as if they are shrinking in size. Because the opportunities vary in shape and size, I recently began buying a basket of five names that I find particularly attractive as a way to spread the risk around (retail will always be an extremely competitive business) but make a macro bet on the apparel space continuing to operate quite profitably. There are many values to be found if you, like me, believe that clothing and accessories is a retail category that will remain in style for decades to come.

Full Disclosure: Long Macy’s and many other retailers at the time of writing, but positions may change at any time

Chesapeake and SandRidge Alum Tom Ward Just Admitted How Bad The Energy Exploration Business Model Really Is

Those of you who follow the energy exploration and production industry probably know Tom Ward very well. He co-founded Chesapeake Energy with the late Aubrey McClendon in 1989 and later left to start SandRidge Energy in 2006. With Chesapeake struggling mightily these days (there were whispers of a bankruptcy filing earlier this year and shares trade below $4, down from an all-time high of $74 back in 2008) and SandRidge having filed bankruptcy just this month (Ward was fired as CEO in 2013), Ward’s two companies are wonderful examples of how the need to grow via debt financing can cripple energy exploration firms. Undeterred, Ward founded Tapstone Energy in 2013 as act number three.  Tapstone’s web site reads “Tapstone Energy: A Tom Ward Company.” I’m sorry, but given Ward’s track record that’s quite humorous.

I just saw Tom on CNBC discussing the current state of the domestic energy market and one of his comments was very instructive for energy investors. He said the industry’s “dirty little secret is that you cannot spend within cash flow and grow production.”  This comment was following his assertion that lack of access to capital was the real hindrance to the industry right now because banks “want you to spend within cash flow.”

I guess banks only want to lend money to energy companies that can operate at free cash flow break-even at a minimum. This is very logical of course, as it means that the profits from the oil and gas sold can cover the interest payments due to the banks. I find it amusing that Ward is in a way criticizing the banks for being so strict so as to want to ensure they can be repaid.

But the “dirty little secret” comment is most important in my view. What Ward is saying is that energy exploration companies cannot grow their production without borrowing money to do so. Put another way, this means that drilling for oil and gas does not generate any free cash flow (after all, if it did there would be excess cash to drill more wells and thus grow production). In financial speak, maintenance capex (the amount of reinvestment requires to maintain a steady level of output) eats up every dollar of operating profit.

This is crucial for investors because stock values reflect the present value of future free cash flow. If free cash flow is never above zero, there is no profit left for equity holders after creditors are repaid. From a strictly textbook definition, that would mean that all of the common stocks are worth zero.

I wish I had heard this comment many years ago, as it might have allowed me to realize a lot sooner just how bad of a business model most independent energy producers are employing. What is amazing is how many people continue to want to invest aggressively in the sector.

Despite Strong Fundamentals, Restaurant Stocks Struggle To Deliver

There is a long list of things to like about the restaurant sector from an investment perspective. Secular trends such as dual-income households have led many families away from frequent home-cooked meals around the dinner table. The busier we are, the more likely we will rely on restaurants of all shapes and sizes. Add in low gas prices and one would think restaurant stocks would be among the stock market’s best performing groups. And yet it has been quite the opposite lately.

I have always liked to invest in the sector, not only for the reasons above but also because it is relatively easy to understand and analyze. Chains often try to differentiate themselves, but the general recipe is the same for most. Suffice it to say I am finding so many bargains in the sector lately it is difficult to choose which ones should make the cut in a portfolio. Valuations are about as low as I have seen them since I began investing more than 20 years ago.

So why are these stocks having so much trouble with both secular and cyclical tailwinds? I think a big issue has been a very strong market appetite for well-known restaurant IPOs. Consider that there are more than 50 publicly traded restaurant stocks in the United States, and more than 20 of them have IPO’d since 2010. Just as these companies are having to compete for customers, they are also competing for investors’ capital. Given that restaurants are a small subset of the consumer sector, there is a finite amount of investment dollars being allocated to the group. With more and more options boarding the public market train, many are simply being discarded.

And despite low gas prices and a propensity to eat out or carry out meals, there are operational challenges all of these chains are facing. The biggest in my view is simply the sheer number of new locations being opened by restaurant chains generally. The number of food options these days can often be overwhelming. At some point it is reasonable to assume the U.S. is going to be facing an overbuilt restaurant sector, at which point many will start to see material declines foot traffic, sales, and profits.

That said, I firmly believe that there are many attractive investment opportunities within the restaurant space. Within the small cap arena there are many companies that offer a compelling business model and meager valuation. A great example is Kona Grill (KONA), a sit-down concept that will deliver over 20% unit growth in 2016 and end the year with 45 locations across the country. The company averages $4.5 million in annual unit revenue and 17-18% unit level profit margins, with a build-out cost of $3 million per location.

At the current $11 share price, which is down a stunning 50% from its 52-week high, the stock trades at a total market value ($127 million) below its $135 million replacement cost (note: replacement cost is how much money it would take to replicate the company’s assets if you started from scratch today). Throw in a long runway of future expansion potential and you have a very attractive long-term investment that Wall Street is completely ignoring. And there are many other bargains out there to be found if you look closely.

Kona Grill (KONA) – 2-Year Chart

kona

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

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.