November 2019 Reader Mailbag – Part 1/2

Thank you to everyone who submitted questions for this blog’s first ever “Reader Mailbag” post. This month I will answer 10 reader questions, split across two separate posts. If you would like to submit a question for the next mailbag series, you can leave a message in the comments or send a direct message via Twitter (@peridotcapital).

Alright, here we go…

Question #1: “Are we heading for a 2001-type correction for “revenue growth at all costs” companies that do not generate consistent EBITDA?”

For those who do not recall, or were not investing nearly 20 years ago, the internet bubble of the late 1990’s (peak in early 2000) resulted in the Nasdaq dropping 80% from peak to trough. The main culprit was simply a reversion to mean valuations, which for large tech companies had reached north of 100 times earnings. Many telecom related firms were booking losses as they tried to build out and sell network capacity, etc.

The good news is that the market today is not really being propped up at exorbitant valuations by the tech sector. Twenty years ago the P/E for the S&P 500 was north of 30x because tech comprised 30% of the index. Interestingly, today’s biggest tech companies, which make up a large portion of the S&P 500, are actually not the most overpriced. Think Apple, Microsoft, Google, etc. So I don’t see the tech sector bringing down the market all by itself.

On a more micro level, there are certainly certain pockets of tech that remind me a lot of 1999, namely cloud software stocks that fetch 10-20 times revenues and aren’t showing any profits. The valuations of these stocks look extended, though perhaps not “bubblish.” The good news is that selling software is not a flawed business model, in the sense that these companies could make money if they needed to. They would simply scale back sales and marketing expenses and stop hiring new employees. All of the sudden a 10 or 20% negative operating margin could become a positive number very quickly. Of course, revenue growth would slow if they opted for that route and the valuation multiple would contract.

More likely than a bubble popping, where software stocks fall 80% as a group within a matter of six months or a year (a la 2000-2001), I suspect these stocks will simply mark time and provide unimpressive returns for investors while the actual businesses catch up to the valuations. Consider a company that is growing 25% annually and trades for 10 times sales. Maybe a normalized valuation is really 5x sales. Sure, if the stock was cut in half overnight, the valuation issue would be solved, but more likely we will watch the stock flatline for 3 years while the business continues to grow at 25% per annum. After 3 years, that 10x sales multiple would be down to 5x as sales double and the stock remains the same.

This is not to say that none of these stocks will fall 50-75% or that none of them can keep going higher from here. What is a fairly safe assumption, however, is that on average, stock prices will rise more slowly than the underlying business, which will allow for valuations to mean revert to more sane levels.

Question 2: “What are your thoughts on long-term care cost preparation? Long term care insurance vs whole life with a long-term care rider?

I have never seen a whole life insurance policy or annuity contract that I have liked for the customer. The problem with financial products that combine insurance with investments is that too many people need to get paid before the customer ever has a chance to make a good return on their investment. The salesperson needs to make their commission when the product is sold, the insurance company gets an annual fee for guaranteeing the payouts, and the investment manager gets their annual fee to manage the upfront and/or regular premiums coming in the door before claims are paid. By the time all three parties take their cut, the customer is typically left with meager scraps relative to what they should earn.

So, I am not a fan of whole life policies with LTC riders. Buying a straight LTC policy is generally a better move (fewer people are taking a cut), but those policies are not cheap, especially since many underwriters have mispriced them over the last 20 years and are now paying the price with an influx of claims.

I like to remind folks that you do not need to buy coverage that covers the entire monthly cost of LTC. After all, if you are forced into a facility, many of your current expenses are covered in part or in full, and in general you will have savings and assets to use to help fund part of the expense. So, if you are looking for coverage of $5K or $6K a month or more, and get sticker shock (even though oftentimes policies only pay for up to 3 years of care), take a close look at your budget and nest egg and figure out how much of that monthly cost you could actually cover yourself from reallocating living expenses and/or selling assets that would no longer be needed (cars, your home, etc). Many times people realize they only need to buy coverage for a portion of the expected LTC monthly cost, which is far more doable for one’s budget.

Question 3: “When should investors believe the hype and when should they not? What are some markers that show hype vs substance?”

Hype is a hard thing to quantify and analyze. I would distinguish between business hype and financial hype. The latter is easier to pinpoint because it is relatively easy to figure out if a valuation implies a future scenario that is impossible, or just a stretch. For instance, regardless of your view on the plant-based meat alternative sector, when BeyondMeat stock fetched a $15B equity valuation, there was absolutely no way to justify that, even if you took a very rosy scenario on the market size and BYND’s market share. A food company simply cannot justify a forward P/E of 700x or a forward price to sales ratio of 30x. With only 3% of the population identifying as vegetarian, there is no way BYND could be worth 50% of KraftHeinz.

Business hype is a lot harder, though, because a lot can evolve over 10 or 20 years. First, I think you need to understand the space somewhat before ever dipping your toe into a hyped-sector. Never simply take someone’s opinion as being enough to convince you of something. If you know about a company or an industry and the idea seems reasonably promising to you, and other smart people you respect agree, then you can move on to the valuation question.

And for hyped, high growth, long-term businesses, the current valuation does not have to be super attractive, or in-line with the market. It just can’t be absolutely untenable. There is a difference between buying a money-losing company like Beyond Meat for 30 times sales and buying a money-losing software firm for 10x sales. It is pretty much impossible to make money on a food company at 30x sales over a 5-year period because food stocks trade for somewhere between 0.5 and 2 times sales.

Finally, be on the lookout for companies that do one thing but claim they are special. WeWork was overhyped in part because they claimed to be a tech company, not a commercial landlord leasing out office space. Investors in Tesla today can’t think it is solely a car company, because it is worth more than General Motors. If Tesla is just a car company, the stock is setup to be a dud from here. If it is something more, like Amazon was more than just a book seller in hindsight, then maybe the stock can work over the next 5 years.

Overall, there is no magic thing to look for to identify overhyped stocks. If the valuation makes sense using optimistic BUT reasonable assumptions, and you know enough about the business to understand and believe that it has real promise, then you can begin to consider an investment. If not, I would be concerned there is more hype than underlying business and investment potential.

Question 4: “What do you think of Howard Hughes Corp (HHC) now that the strategic review is over and they failed to find a buyer?

As I wrote back in June when the strategic review was announced, I thought the prudent move was to trim back my long position on the heels of the surge. What was most surprising to me about the end of the strategic review was that they were most interested in selling the entire company to a single party. Given the wide geographic footprint of HHC’s assets, finding a single buyer seemed unlikely. I was hoping they would be able to accomplish something more realistic, such as selling the Hawaii assets and/or the South Street Seaport. Focusing on MPCs in Maryland, Nevada, and Texas likely would have been welcomed by investors.

Instead we are left with a company that will simply sell off non-core assets, trim G&A (which was way too high), and perhaps implement a modest buyback. Is that scenario super exciting? Not exactly. While I don’t think the stock is excessively priced now (around $110), I do not believe the market will assign a market price anywhere near the purported NAV (between $150 and $200 per share if you ask the bulls). In order to get to such a valuation, you need to assign full value to land that will be sold and/or redeveloped far in the future, and I suspect public investors will continue to heavily discount those non-guaranteed projected future cash flows. If you focus on the assets that are leased today, or under construction, and discount the land holdings a bit, it is not hard to arrive at an NAV of $130-$140 per share, which is essentially where the stock was trading during the review process.

While I still like the HHC assets and the investment thesis, and will continue to hold some for the long-term, it does not strike me as a super compelling option for fresh money right now, as my upside base case has been tempered in recent years. The biggest disappointment has been the failure of the company to truly deliver on the idea that land and condo sales would fund operating asset development, making outside financing needs minimal. That business model would truly be unique in the real estate development sector and allow for outsized value creation, as most other firms are structured as REITs and have to borrow a lot of money for each and every project.

Unfortunately, HHC’s debt has been on the rise for years now. Consider the path of total debt: $700M in 2012, $1.5B in 2013, $2B in 2014, $2.4B in 2015, $2.7B in 2016, $2.9B in 2017, $3.2B in 2018, and $3.6B as of September 2019. In 7 years HHC has increased its debt load by 5.15x, while annual operating asset revenue has grown from $170M to $450M, or by 2.65x. That is not the kind of capital recycling that many, myself included, were hoping for when we initially bought shares. Unless that changes, it will be a tough task for HHC to close the gap to supposed NAV.

Question 5: “Are there any “busted IPOs” that have come down enough you are starting to get interested, even if they are money-losing right now?

I have written a lot of negative stuff about money-losing tech companies that raise a bunch of money via IPOs, which will fund their loss-making businesses for a long time, and help them pay their employees more and more in stock (which also serves to limit cash burn). I did make a point to mention that I do not have a hard and fast “no loss-making companies in a portfolio” rule when I discussed the potential of Teladoc (TDOC) over the next decade.

Since stock prices should reflect the present value of future free cash flow, losses now are not always the end of the analysis. If I can find a dominant business, that I think will continue to grow and has the ability to make money a few years down the road, I will consider investing provided I am not paying too much for the privilege. So while that usually eliminates things fetching 15 or 20 times sales, other times you can find interesting situations that fetch reasonable prices.

Recently, I have been looking closely at Uber (UBER), as an example. The stock is trading around $26 after pricing the IPO at $45. In the near-term there are concerns about the lock-up expiration and insider selling, which could pressure the stock in the short term, but I don’t care too much about the short-term.

In Uber I see a dominant franchise with a sustainable business that is not just U.S. focused (like Lyft). They have an experienced CEO now, which should help them make the transition from start-up to large cap public company. And I think they have a lot of pricing power that has yet to be run through their business yet. A few extra dollars per ride is not likely to result in customers digging out their phone books and calling their local yellow cab franchise. Simply put, it appears that Uber is here to stay.

In terms of valuation, the current consensus for 2020 is revenue is north of $18B, versus the current market cap of $44B. Call me crazy given their current losses, but I don’t see a 2.5x price to sales ratio as being overly demanding. And they have $12B of cash in the bank to bridge the gap from now to profitability. If one were to assume a terminal P/E ratio of 20x, and work backwards to figure out what kind of margins they ultimately have to earn to make the stock a good value today, I don’t think the assumptions required are overly aggressive (though of course are far from assured). Now, obviously a company losing $1B of EBITDA a quarter comes with plenty of risks, but I would choose Uber at 2.5x sales over a cloud software company at 15x sales on most days of the week.

Charles Schwab’s Long-Term Outlook Likely Remains Bright Despite Acceleration of Commission Free Trading

Although the equity market had a quick and violent negative reaction to the news that Charles Schwab (SCHW) would be proactive in driving online trading commissions down to zero for the bulk of the industry, I actually think the move was aggressive, made from a point of strength, and does not hinder their ability to grow from here.

Much was made in the press that SCHW had to do this to avoid losing material share to upstarts like Robinhood, but that view ignores the fact that Schwab’s core business is not to provide young people with relatively low account balances a limited set of free services. Simply put, as the world’s largest custodian for RIAs, the Schwab and Robinhood customer bases don’t typically overlap much.

What Schwab was able to do was distance itself further from other traditional online brokerage firms like E*Trade and TD Ameritrade, which get a much larger portion of their revenue (25-35%) from trading commissions than Schwab does (less than 5%). Peers have had to quickly match the zero price point and will now have to reevaluate their business models after losing a huge portion of their revenue. Schwab, meanwhile, can easily withstand a 3-4% hit to revenue and will continue to focus on their core business of asset gathering.

Interestingly, Schwab stock has fallen 15% on the prospect of losing less than 5% of their revenue by moving to free online trading:

The narrative has been that this puts the company now much more in the “bank” category, as it will need to rely even more on net interest income to generate profits. As such, with interest rates falling and the yield curve flattening, the near-term outlook for their business is muted and investors should value the shares accordingly.

While I think that view is likely to be correct near-term, I don’t think it alters the chances that Schwab can continue to be a dominant franchise in their category and grow nicely in the future. If one looks out 3-5 years or longer, there are few peers who can match their service offerings and I doubt they will stop making bold moves when opportunities arise. However, the stock price today is hardly reflective of that after the latest sell-off.

In recent years, SCHW has traded for around 30 times annual earnings, likely due to their standing as one of the most dominating franchises for investing. From 2013 to 2017, the stock ended each calendar year in a relatively narrow valuation band between a 30x to 32x P/E ratio. This also equated to a price-to-book ratio between 3.2x and 3.8x (ROEs of 10-12%).

Given a more interest rate sensitive business model recently and a slowing economy since the one-time jolt we saw from the tax cuts in early 2018, we definitely should expect that valuation to contract. In fact, today SCHW shares fetch just 13.8x 2019 forecasted earnings and 2.3x book value (despite ROEs now around 16% thanks to lower tax rates).

So what is the “right” valuation for Schwab? Should we simply treat it like any other large bank, such as Bank of America and JP Morgan, which both trade for 11x earnings?

Schwab’s profitability ratios suggest to me it should trade at a premium, with returns on equity of 16% in 2018 and earnings set to grow 6% this year. At a 15x P/E ratio, still a discount to the market, we would project a fair value of 2.4x book value. That would put the stock today at an 8% discount to fair value, which is a pretty good price considering that Schwab’s future growth outlook is unlikely to be stunted.

Just how can a business with the size and scope of Schwab grow from here? Well, total company revenue has doubled between 2013 and 2019 despite near-record low interest rates for the bulk of that time period. That kind of growth cannot be matched by large traditional banks. If Schwab continues to maintain its leadership position in the industry, even if it grows at half that rate in the coming six years (or 6% annually), earnings growth could push 10% annually during that span.

Add in a near 2% dividend yield and a stock that appears to be at least 8% undervalued today and one can quickly make an argument that Schwab shares are worthy of no less than a detailed look by contrarian-minded, value-oriented investors focusing on the long term.

Full Disclosure: I have started to nibble at SCHW stock for some clients in recent days and could very well build larger long-term positions over the near to intermediate term

As Bidding Surges for TV Reruns, Content Is Still King, Despite Wall Street’s Collective Shrug

With media companies like Comcast, Apple, and Disney quickly mapping out their answers to Netflix and Prime Video the prices being paid for rights to stream old television programming are surging. In recent weeks HBO paid $425M for the global rights to stream Friends and another $500M for The Big Bang Theory. After losing The Office to NBC (again, $500M), Netflix offered the same $500M for Seinfeld and “won.”

We can question how much hit shows are really worth in this context, as it is essentially impossible for a streaming service or cable channel to pinpoint the ROI for a single series. But one thing is certain; prices for content are strong and getting stronger. With per-episode production costs for new shows now crossing into the ten figures in some cases (whereas $1-$2M used to be considered expensive), it is often cheaper (and less risky) to go with a known quantity and buy rerun rights.

A logical reaction on Wall Street, in the face of such prices being paid, would be for content owners to see their share prices catching a bid. But as has been the case lately, logical moves are being shrugged off and content company stocks have done nothing. Investors would rather focus on money-losing, fast-growing tech companies like Uber, or real estate companies trying to get tech-like valuations (WeWork).

While frustrating for value-oriented investors, it is important to keep in mind that low prices allow these companies to gobble up and retire cheap shares, boosting our stakes with no incremental investment from us. Since popular video content brings in a lot of cash (whether it be from resale agreements, advertising, or affiliate fees) no matter Wall Street’s near-term sentiment levels, longer term things will shake out in our favor.

Companies like AMC Networks and Discovery will continue to grow free cash flow by creating great content, and stock buybacks below intrinsic value will result in per-share profit growing faster than in absolute terms. Since 2015, AMCX’s share count has been cut from 73M to 57M and total revenue is up 20%. DISCK’s share count peaked at 858M in 2010 before falling to just 576M in 2017 (M&A activity has boosted the figure above 700M today but buybacks are just now restarting) as revenue nearly doubled.

Even more impressive, these financial metrics have improved during a time that streaming services and cord cutters were supposed to have killed these businesses. Since 2011, Netflix’s streaming subscriber base has grown from 20M to 60M in the U.S. alone but outside content producers are still doing well, in part by licensing their shows to streaming providers.

The more Wall Street ignores the prices being paid for content, in an ever-increasingly competitive streaming landscape, the more value the companies will be able to create for their investors over the long term. The fact that such an opportunity exists is odd, given the high profile attention large streaming rights deals are getting, but the stock market in recent years seems to be myopic, focusing on revenue growth and collectively shrugging at the real cash cows. Let the stock buybacks continue!

Full Disclosure: The author is long shares of AMCX and DISCK, both personally and on behalf of clients, at the time of writing, but positions may change at any time

Nordstrom: A Retail Survivor With Potential Upside Catalysts

It was just last year when the Nordstrom family explored a deal to take their retailing company private for $50 per share in cash. The board of Nordstrom (JWN) rejected the offer as insufficient and bankers will unwilling to lend more capital to the family at attractive rates in order for them to raise their bid. With the stock now trading around $28 there are reports that suggest the family is looking at ways to up their stake, even if 100% ownership is not possible due to board obstruction.

It looks to me that JWN is a long-term survivor in the competitive market for apparel and accessories. Wall Street is shunning the stock due to its department store exposure, but the Rack business (a higher end version of TJ Maxx) is overlooked and should continue to grow.

The traditional weaknesses that have plagued larger format clothing-focused chains in the past, most notably high leverage and a bloated store base, are pretty much non-issues for JWN. The company’s capital structure is conservative (net leverage of ~1.5x EBITDA) and there are only about 120 Nordstrom full-line department stores in North America, compared with over 800 for JC Penney (JCP) and over 600 for Macy’s (M).

With such a small relative store base, JWN has been able to build locations only in very strong, upscale markets and has avoided geographic concentration. And since interest expense is minimal relative to store-level cash flow, the company can service debt easily and still invest for the future. The end result is a company that has built out a strong e-commerce business (30% of total sales) all while producing free cash flow year in and year out to fund a generous dividend (over 5% at the current share price) and impressive stock buybacks (share count has dropped from 220 million in 2009 to 156 million in 2019).

With the stock at nearly half the price the Nordstrom family offered last year, JWN shares are dirt cheap (4.5x my estimate of 2019 EBITDA) and pay a great yield of 5.2%. The dividend is also well-covered by cash flow. Unless you think the Rack business is set for declines, like many predict for their 120 full-line department stores, JWN is unlikely to see a material drop in sales and earnings. We can debate how fast they can grow in the future, but Wall Street is pricing the stock as if growth is impossible anyway.

And then there is the chance that the family makes a bid to increase their now 30% stake to 50% or more. I would guess a tender offer at $37 would get a lot of action, and investors could partially cash out at a 30% premium to the current price. Simply put, before we lump JWN in with M and JCP perhaps we should consider the entirety of their company, the large insider ownership, and the cash flow and balance sheet characteristics of a business with fewer than 400 stores open globally across both the namesake and Rack banners.

Full Disclosure: The author and/or his clients were long shares of JWN at the time of writing, though positions may change at any time.

Are Money-Losing Companies Ever Worthy of Value-Oriented Investors’ Time?

As a valuation-based contrarian investor, it is relatively easy for me to make a strong case against allocating investment dollars to money-losing tech IPOs that pay out stock compensation equal to 20% or 30% of revenue to boost their “adjusted EBITDA” and GAAP free cash flow metrics and trade for 15 or 20 times that revenue. Simply put, the growth required for a company to “grow into” a 20 times revenue multiple, or a 100 P/E multiple, is so enormous that 90%+ of all businesses will never get there.

Of course, there are some that will and investing in those stocks can be very rewarding. Josh Brown, CEO of Ritholtz Wealth Management and frequent CNBC commentator, is quick to point out to television viewers that he is generally opposed to avoiding unique growth stocks solely due to valuation concerns. He walks the walk too, considering his purchase of shares in Shake Shack (SHAK), a regular ol’ restaurant chain currently trading at more than 6 times 2019 revenue and more than 50 times 2019 EBITDA.

Shares of Shake Shack surged out of the gate after an IPO in 2015 at $21 but insane valuation levels could not sustain the 4-fold rise for very long. After a period of consolidation, the valuation is once again getting frothy as the stock regains its former highs.

Just because I don’t think SHAK is worth its current valuation, even if it does reach its goal of over 400 domestic locations (vs ~150 today) and tons of franchised units overseas, I could be wrong. If the company becomes the second coming of McDonalds (MCD) 20 years from now, Josh will be right and we will all look back and say the $3.6 billion equity valuation in 2019 was a great entry point! So… if you feel that strongly about a company, and there is enough market opportunity for them to ultimately grow 5x or 10x bigger, a high growth investment can pay off regardless of the initial price paid.

Since I have been poking fun at folks paying 20 times sales for cash-burning, cloud-based software companies, I wanted to be transparent with my readers about the client portfolios I manage. Believe it or not, there is one high growth, money-losing stock that I have parked in some client portfolios; Teladoc (TDOC).

TDOC is the global leader in the relatively nascent telemedicine provider space. Just as technological innovation is disrupting many traditional sectors of the economy, TDOC is trying to make it commonplace for patients to access medical care via teleconferencing technology. Imagine how many visits to doctor offices do not actually require in-person consultation. Accessing medical providers remotely is not only more convenient for the patient, but it can reduce costs across the system.

Clearly the telemedicine trend has yet to take off globally, as it is very early on in being rolled out. It is gaining a lot of traction in certain subspecialities, such as behavioral and mental health, and I believe it could be very common a decade from now. TDOC has established itself as the leader, and with equity currency from the firm’s 2015 IPO, they have the ability to use M&A to further their position worldwide.

All of that said, you may have guessed that TDOC is losing money. Like many tech firms I scoff at, they are content to operate at a loss to build their leadership position and hopefully dominate the market over the very long term. In terms of growth, so far they are succeeding. TDOC’s annual revenue has gone from $20 million in 2013 to what should be well north of $500 million in 2019. Such growth explains the generous valuation implied by the current $58 per share stock price; an equity value over $4 billion and price-to-sales ratio of 6x on 2020 estimates ($675 million). My internal estimates show EBITDA in 2019 to the tune of negative $40 million.

To conclude, I think Josh Brown is right – sometimes valuation does not matter for growth stocks. That said, when dozens of businesses are trading at crazy prices relative to underlying sales and earnings, we should assume that most of those won’t work out for long-term investors if they overpay. I would have to be pretty confident that the upside potential is worth the risk. And in the case of TDOC, I can envision a scenario where telehealth is huge and TDOC dominates the field, but time will tell if they are the right horse to bet on.

In Large Cap Media Space, Fox Looks Undervalued

One of the things I try to do with this blog is highlight attractively priced securities that I might not have room for presently in client portfolios, but that warrant attention for value-oriented investors. As I have been active in media stocks in recent years, and many content providers are trading at meager valuations due to fears over cord cutting and increasing competition in content creation more generally, I don’t really have a lot of room for more media and entertainment exposure at the present time. However, if I did and I was looking for well established blue chips names in the sector to allocate investment dollars, recently slimmed down Fox Corporation (FOX) would be near the top of the list.

Not too long ago, 20th Century Fox was a large, diversified media company. The recent deal to combine much of that legacy business with Disney (DIS) has left behind a more focused Fox, which trades for $35 per share and sports an enterprise value of $25 billion.

The new company is focused on cable news, live sports networks, and Fox broadcast stations. They have essentially sold the higher cost, riskier, production and creative content creation business and kept the simpler, lower cost stations that focus on live programming and have less competition. The company is using free cash flow to also make small, strategic acquisitions to boost growth, such as a 5% stake in The Stars Group (TSG), which will partner with Fox Sports on sports wagering, and a 5% stake in streaming platform operator Roku (ROKU).

Fox recently reported their latest fiscal year results and booked revenue north of $11 billion, EBITDA above $2.6 billion, and free cash flow per share of $3.69. On an EV/EBITDA basis Fox trades for ~9.4x cash flow.

Given their dominant position in live news and sports, coupled with a strong balance sheet and superb cash flow generation potential, it appears that FOx shares at $35 each can offer investors an attractive, low risk opportunity to benefit from multiple avenues of value creation over time. While this is not a high growth, high return situation, paying less than 10x EBITDA for the franchise, which does not factor in assets such as the Roku stake (worth $750 million and rising) or operational upside from any of the company’s strategic investments, seems like a bargain.

From a capital allocation standpoint, Fox pays a 1.3% dividend (which is likely to increase over time), and free cash flow north of $2 billion annually will allow for a material reduction in share count over time. As a result, free cash flow per share should grow in the mid to high singles digits long term. With rising per-share cash flow and the potential for multiple expansion (why can’t this company trade for 10-12x EV/EBITDA?), there appears to be an attractive risk/reward opportunity here, though I understand it is far from a sexy pick in a climate where money-losing, high revenue growth entities are leading the way. If you like somewhat boring cash cows that are well positioned to maintain their franchises, Fox looks like a good bet.

Wynn Resorts Analyst Day Confirms Upside Scenario

Back in May I outlined a fair value range for gaming operator Wynn Resorts (WYNN) that suggested upside to at least $155 per share, if not 10-20% higher. That thesis was predicated on a 12-13x EV/EBITDA multiple and $2 billion of EBITDA in 2020.

Last week the company hosted an analyst day at its recently opened Encore Boston Harbor property and took analysts through a more than 75- slide Powerpoint deck that included projected company-wide growth between now and 2021. Overall, I was pleased with the guidance they provided, as their internal forecast for 2021 EBITDA is roughly $2.3 billion, which equates to 28% growth versus the current trailing 12-month figure of ~$1.8 billion.

It is quite common for companies to issue rosy guidance that factors in most of what could go right and little of what could go wrong, so the 2021 projection is far from assured. Still, I felt good about my $2 billion 2020 number beforehand and management’s presentation did nothing to shake that confidence.

That said, I am looking to trim my WYNN position around $145 per share, which is less than 7% from the low end of my fair value estimate. There have been several great opportunities to buy WYNN materially below current prices over the last couple of years and I have built up some fairly large positions in the name. With the stock on yet another upswing, I am hoping to pare it back as a source of funds.

Why not sell it all? Well, I can certainly assign a reasonable probability that WYNN does reach its $2.3 billion EBITDA target over the next 2-3 years. Using my 12-13x EV/EBITDA fair value multiple, the stock would reach $200 per share at the midpoint ($190-$210), which is enough upside potential for me to keep WYNN in client portfolios. However, since that scenario assumes no unexpected outcomes in Vegas, Macau, or Boston, and the stock has rallied around 40% in 2019 so far, an outsized position is getting less attractive.

Howard Hughes Corp: A Lesson in Price vs Value

I was planning on writing a bullish piece on real estate developer Howard Hughes Corp (HHC) today, as the stock has been crushed in recent months and closed yesterday at $92.59 per share, 35% below its 52-week high.

Well, that idea quickly went out the window when CNBC’s David Faber reported shortly after the opening bell that HHC’s board has hired Centerview Partners to explore strategic alternatives, including a possible sale, joint venture, or spin-off of all or parts of the business. To say that the stock is reacting positively to the news would be an understatement. As I type this HHC shares are up $29, or 31%, to $121 each.

So rather than explain why the stock appeared dramatically undervalued in the low 90’s, which I was apparently one day too late in sharing, I will instead offer up the observation that Warren Buffett’s often-quoted mantra “price is what you pay, value is what you get” is notable in this case.

Some investors give more credence to that concept than others, mainly because while value investors try to find situations where value > price, more short-term and/or technically-inclined investors use the market price as their guide and believe that the daily matching of buyers and sellers across the globe corrects most any material pricing inefficiency. Not surprisingly, I am in the former camp.

HHC is an interesting case because most fundamental analysts believe that the company’s assets are worth between $130 and $170 per share, net of debt, and that those same assets should grow in value nicely over time given their strong locations within the local trade areas they serve. Of course, if this is true, and markets are quite efficient, then the stock should not have closed yesterday at $92 and change.

Typically, bulls and bears are left arguing back and forth about who is right, but sometimes we get a better sense through actual corporate action. We won’t know whether HHC finds a buyer for some or all of its assets for at least several more months (and if so, at what price) but today’s trading action seems quite odd.

I would say that it is rare that a stock surges more than 30% on news that the company has hired bankers to approach possible buyers because we are still very far away from getting any idea as to how many interested parties there are, or what prices they might be willing to pay. Stock moves like this are usually seen late in the process, when a journalist gets word of who is bidding and what the range of bids has (roughly) been. In this case, CNBC’s Faber merely confirmed the hiring of advisors because the process has just begun.

What that tells me is that investors seem to believe a few things. First, that HHC’s net asset value per share is, in fact, materially higher than yesterday’s closing price. Two, that the market believes that there will be ample interest in HHC’s assets such that bids are likely to materialize (though of course no deal can be assured). And three, it probably helps HHC that interest rates have recently come down and lending capacity from financial institutions, hedge funds, and private equity firms appears robust, though obviously that can change quickly in today’s world.

I say all of this because I think it firmly supports the notion that markets in the short term can be quite inefficient. Up until today, HHC stock did not have many fans, but that changed in a matter of minutes as the fundamental story changed (or more precisely, a layer was added; the fact that the board is open to strategic alternatives). Conversely, if it was true that the market was efficient and the consensus view among HHC’s close followers was that the business was worth somewhere close to Wednesday’s closing price, we would not see the stock surging today.

The beauty, of course, is that now we might very well be able to settle the debate about HHC’s net asset value (or at least the opinion of that NAV among folks who want to buy the assets and have the cash to do so). The next few months should be very interesting.

Full Disclosure: Long shares of HHC at the time of writing, though I have been trimming positions into today’s strength, as Wednesday’s announcement confirmed they are open to selling, whereas the stock is acting as if a deal is nearing completion.

*Author Update* 4:30pm ET

HHC stock leveled off for a while and then surged again late in the trading day, closing at $131.25, up nearly 42% for the session. In the spirit of full disclosure, I have continued to sell more at prices as high as $131.50 and have also written some $140 covered calls against shares that remain in client accounts.

Simply put, I understand HHC is a unique company with great properties and I have no doubt that some bidders will emerge to try and pull some of them away from HHC. That said, this one-day move is pretty remarkable and I think it is overdone in the short-term. Accordingly, I think it is silly to not sell any stock at these levels, and would welcome a scenario where it cools down and I can buy back some of the sold shares at lower prices. Tomorrow (the last day of the quarter) should be the second-most intriguing trading day for HHC this year! 🙂

Lastly, some people are speculating that this announcement was all about juicing up Bill Ackman’s portfolio right before the end of the quarter and nothing truly will come of it. While a deal might not happen, I don’t think Bill’s HHC position is big enough (just 2% of disclosed portfolio value as of 3/31/19) for him to have orchestrated this whole thing just to show a better performance figure for Q2. After all, Pershing Square was already having a great year and another 100 basis points is a small prize for such an effort. Just my two cents…

While Publicly Traded Plant-Based Meat Alternative Companies Are New, The Products Are Not

First, there was cannabis seller Tilray (TLRY), which saw its stock price peak at $300 per share just a few months after a mid-2018 IPO that priced at $17. A buying frenzy among individual/retail investors resulted in a more than 17-fold surge, but as it usually the case, sanity returned. Today TLRY can be purchased in the 40’s.

This chart does not show the intra-day high of $300 but it did indeed peak at that price

With the cannabis craze now passed, as well as that of bitcoin, which stole the show in 2017, we have another round of exuberance with Beyond Meat (BYND), the plant-based meat alternative seller which priced its IPO at $25 last month and this week topped $200 per share.

While I lacked helpful fundamental insights into TLRY, outside of the always important valuation discussion, the “alt-meat” sector is something I know a little about because my wife is a vegetarian and we typically have very little in the way of actual meat products in our house. As a result, over the last decade or so we have tried most of the products out there. Some impress, others do not.

What I find perhaps most interesting about the last month is that because BYND is the first pure play plant-based meat alternative company to go public, those who follow the financial markets (but don’t eat the products), seem to think that this market is brand new and that BYND (and fellow upstart Impossible Foods) are the first two companies to launch plant-based meat products. If there was indeed some sort of first-mover advantage, and the market for these items was brand new and growing like crazy, I guess one could justify paying a huge valuation for BYND. Though I think the current $10 billion equity value is beyond rich for even such a scenario.

The problem with that viewpoint is that plant-based burgers, ground beef, and chicken nugget alternatives are not new. Brands like Morningstar Farms, Quorn, Lightlife, Gardenburger, Boca, Field Roast, and Gardein have been at this game for a long time. In fact, market leader Morningstar Farms (owned by Kellogg), with annual sales estimated at $750 million, was started all the way back in 1975!

I suspect that people are noticing them more today because both Beyond and Impossible have been aggressively marketing their products and have succeeded in getting them on restaurant menus over the last couple of years (the legacy brands have typically focused on grocery store distribution). Sure, there are more vegetarians and vegans today than there were 20 or 30 years ago, but it would be a mistake for investors to assume that a couple of new companies are going to dominate the market and have no competition.

The market size is also an interesting topic, because in 2017 only 3% of Americans identified as vegan or vegetarian. If 5 companies battle each other for maybe ultimately 5% of the meat market in the U.S., it might be hard for investors to justify anywhere near a $10 billion market value for BYND, let alone a handful of players combined.

Some people are saying that meat eaters will eventually become big customers, but I doubt that will be true. Surely there will be some, as I enjoy many of the items with my wife (even though I do eat meat, poultry, and fish at restaurants), but I don’t think specific situations like ours will be all that common, even five years from now.

So while these products are real, in many cases quite tasty, and the businesses are growing, the stock valuations are clearly out of whack. There is no way BYND is worth $10 billion when Kellogg’s equity is valued at $19 billion and Conagra (the owner of Gardein) is worth $14 billion. Those companies have total annual revenue of $13 billion and $10 billion, respectively, while Beyond is projected to book sales of $300 million in 2020.

Much like cryptocurrencies and cannabis, many investors seem to be overestimating the alt-meat market opportunity (through insane stock market valuations). This is not to say there won’t be winners and profits won’t be made, but in a rush to want to own shares of what could be the “next big thing” valuation gets thrown out the window in favor of momentum and excitement. That typically does not end well. After all, the saying “buy low, sell high” was never shortly replaced by “buy high, sell higher” mainly because that strategy rarely works over the long term. Tilray speculators learned that and I suspect BYND bulls will as well.

Lastly, if you are curious and want to try some of the legacy alt-meat products (and compare them with BYND to see if they really have a better mouse trap), here are our favorites:

The IPO Market Has Taken The Baton From Large Cap Tech And Is Running Like Crazy

For several years until recently large cap technology companies were carrying the U.S. stock market on their backs. The nickname of FANG was even coined to describe the group, which included Facebook, Apple, Netflix, and Google. However, all of those companies saw their stock prices peak in 2018 and move in sideways fashion since, which has resulted in the S&P 500 doing the same over the last year:

With the tech sector comprising more than 30% of the S&P 500, as big tech stocks see their rapid ascents halted, so does the overall market…

However, with the economy doing well and stocks having rebounded from their Q4 2018 swoon, there are going to be pockets of strength in the market regardless. For a while it was cannabis stocks but now it appears to be the IPO market.

While the valuations are not as extreme as they were in 1998-2000 with the tech bubble, they nonetheless don’t jive with the underlying financial profiles of the companies. Beyond Meat, which will wind up being among dozens of alt-meat competitors, should not be valued at $10 billion (for example). Unlike high margin tech companies like Facebook or Google, traditional businesses like food manufacturing or general merchandise retail have low margins and therefore will not result in large price-to-sales multiples over the long term.

I bring up the latter category because today’s IPO winner du jour is online pet store (CHWY), which price its IPO at $22 per share and nearly doubled to more than $41 before 11:30am ET. At that price, CHWY’s market value is $17 billion.

Chewy is growing very fast and could very well reach $5 billion in annual sales this year. That sounds great, and at a tad over 3 times annual sales, maybe the stock is not mispriced? Well, let’s not forget that Chewy sells pet food online and ships it to their customers. This is not a revolutionary business model, and it certainly is not cheap to operate. Cost of goods for Chewy is above 75% and operating margins are negative. If the company decided to grow more slowly and cut marketing expenses from 10% of sales to 5% of sales, they could perhaps breakeven.

Even in a world where Chewy reaches $10 billion of sales and manages to turn a profit, the valuation should be relatively meager. General merchandise retailers like Costco, Target, Wal-Mart, and Best Buy all trade for less than 1x annual sales in the public market. This is because margins are relatively low (EBITDA less than 10% of sales) and retailers tend to trade at or below market multiples because they are simply middlemen/resellers of products that someone else makes.

Will the share of pet care continue to move in the direction of online e-commerce transactions? Almost certainly. Will Chewy be forced to price very competitively to win share from Target, Amazon, and Petco? Absolutely. Will they be able to ever make big profits by selling cat litter online and shipping it to your house? Of course not.

If Chewy trades at 1 times annual sales five years from now, it has to grow its business by 28% annually during that time to be be worth today’s price in 2024. For investors who buy it today and expect a 10% annual return over the next five years, Chewy would have to grow 40% per year through 2024.

So is Chewy the next big thing or just the most recent example of an overpriced new IPO? I would bet on the latter and will be paying close attention to see if high valuations persist when many recent IPO are available to short with minimal cost.

Full Disclosure: No position in Chewy at the time of writing

(Author’s note added at 6/14/19 12:40p ET – Petsmart bought Chewy in 2017 for $3.35 billion, so they are sitting on a 5x return in 2 years, to give readers a sense of the valuation inflation going on here)