Reevaluating the Bullish Investment Thesis on The Howard Hughes Corporation

When the Howard Hughes Corporation (HHC) was spun off from General Growth Properties during its bankruptcy process in late 2010 it was an underfollowed, relatively unknown collection of unrelated real estate assets mostly located within a few master planned communities in Hawaii, Maryland, Nevada, and Texas. The communities were vibrant residential and commercial hubs in their respective local markets and HHC owned thousands of acres of vacant land that would allow for decades of future development, either by the company itself or by third parties who would buy the land or partner with HHC.

The investment thesis was very compelling for long-term investors willing to wait 5, 10, or even 20 years; HHC will sell vacant land to homebuilders and use the proceeds to build and lease office buildings, retail shopping centers with ample restaurants, multi-family residential buildings, hotels, etc. to make the area even more desirable. The population growth would lead to ever-increasing land prices and the process could be repeated until there was no land left to build on, creating plenty of value for shareholders.

The key aspect that set HHC apart from other real estate developers was that they owned the vacant land already, enough for 2 or 3 decades of construction activity, which meant they could fund commercial construction projects with cash generated from land sales, not by borrowing from banks and racking up debt like most of their peers. That strategy would allow for less leverage and more value would accrete to equity holders rather than creditors.

The success of HHC stock in the eyes of their investors over the last decade varies greatly depending on when each of us got in (as one should expect). Most of my clients have made money in the name, but I also bought some when sentiment was high and it was fully priced in the near-term (the idea was that for a such a long-term investment, the entry point was a little less important than in other situations) and those blocks are flattish at best and slightly down at worst.

The exact buy price probably would have been relatively unimportant had the thesis played out exactly as expected. But, that has not been the case. Now I am left with a stock that is up nicely from its 52-week lows and remains included in many accounts I manage (as well as my personal portfolio). The question is, should we sell or keep holding it?

First, let me share some data to illustrate why HHC has not been the very unique public real estate developer many had hoped for since 2010. The bull thesis (that HHC would handsomely outperform other similar public real estate stocks) hinged largely on the idea that debt financing needs would be reduced due to a constant stream of cash coming in from vacant land sales. On the face of it, this looks like it should have played out, as HHC has booked cumulative land and condo sales of $4.32 billion from 2011 through September of 2019. Gross profit on those sales comes to a whopping $1.85 billion.

Flush with cash, HHC did what it said it would do; build a heck of a lot of leasable commercial real estate and own the properties long term to generate a consistent stream of rental income (that Wall Street would theoretically love). Sure enough, HHC’s rental income had risen from $95 million in 2010 to $396 million by 2018.

If HHC had simply reinvested the $1.85 billion and generated an incremental $300 million of annual rental income (worth about $3 billion of equity value at a 10x multiple on gross revenue), the total return for shareholders on that investment would have been 62% and proven out the bullish thesis in a powerful way.

So far so good, right? Maybe, but there is one problem; debt at HHC has soared right alongside land sales, construction activity, and rental income. Rather than build properties with minimal debt financing, setting themselves apart from their peers, HHC has funded their construction costs via traditional methods. At the end of 2010, total net debt on the books was merely $34 million ($285 million of cash against debt of $319 million). As of year-end 2018, that figure had swelled to a stunning $2.68 billion ($500 million of cash against $3.18 billion of debt).

If you realized what HHC was in the early days once it started trading, it was undervalued enough that none of the above mattered. The stock closed its first trading day in November 2010 at $38 and nearly doubled to $73 by year-end 2012. However, since then the ever-rising debt load has held back the stock, which closed out 2013 at $120 and has been treading water ever since (albeit in volatile fashion which has afforded investors trading opportunities along the way):

The company ran a strategic review process in the second half of last year that resulted in a stock price spike, allowing me to pare back and/or hedge most of my positions in HHC. There was a glimmer of hope after no buyers for the company emerged in that management announced it would sell non-core properties, focus on its main master planned communities, materially cut G&A costs, and use excess cash flow to repurchase stock that they felt was undervalued. That plan resonated with me and gave me hope that the debt pile would stop rising so fast and perhaps some equity-friendly moves were on the horizon.

That optimism was short-lived, however, with the December 30th announcement that HHC agreed to acquire from oil giant Occidental 2.7 million square feet of office space for $629 million, to be funded with $231 million of equity and $398 million of additional debt.

Bulls would argue that given their plans to sell part of the assets being acquired (a campus outside of the Woodlands), the remaining deal to buy 2 office towers within their most mature community is a good move. And considered by itself, perhaps they are right. My issue with it is that it represents more activity that does not set HHC apart (using internally generated cash flow to grow their commercial property portfolio). Having HHC borrow money to buy existing buildings at fair market prices is the playbook that every other real estate company is employing, which means the long-term unique investment thesis for the company remains elusive.

There have been other missteps too. The South Street Seaport in New York City was supposed to be a trophy asset for the company, as it held a long-term ground lease and planned to rebuild much of the area around Pier 17 as a premier destination for locals and tourists alike:

What management had originally thought would generated above-average returns quickly turned into a money pit. The original construction budget of nearly $500 million was supposed to generate double-digit returns, but delays and redesigns has seen the cost estimate surge past $700 million. Management is still maintaining the goal of the property eventually earning $40 million to $50 million annually (making it an average project, at best), but the Seaport is currently losing money and will take years to reach that goal, if it ever does.

To make matters worse, we learned last year that HHC has decided to move away from its typical business model (leasing space to tenants) and instead has co-invested in many of the Seaport businesses, even choosing to operate some themselves. They claim there is more upside potential by structuring deals as joint ventures, but they are supposed to be landlords collecting rent and leaving the risk for the business owners. Now they have business losses offsetting rental income, which will reduce returns on the project further.

The nail in the coffin for me was their $180 million purchase of a parking lot adjacent to the Seaport in mid 2018. As they began due diligence on erecting a building at the site, they discovered that the parking lot had once been the site of a thermometer factory and contained toxic levels of mercury, as well as petroleum leaks. Parents of student from a nearby school are freaking out at the prospect of a demolition project potentially exposing children to toxic chemicals, which is delaying HHC’s timeline for hiring professionals to clean up the site. Count me as one who hoped HHC would find a buyer for the Seaport last year when they shopped the company’s assets, but no such luck.

All in all, without a path forward that includes revenue growing materially faster than debt, I am not sure there is a unique story here for HHC investors anymore. Between December 2013 and September 2019, rental revenue has grown by 165% while gross debt has grown by 139% and net debt by 282%. It is hard not to think that is a major reason why the stock price has barely budged during that time. Unless and until the financial strategy changes, maybe HHC isn’t all that special. While it seemed like the ultimate long-term buy and hold stock when I first discovered it back in 2011, today it might no longer warrant such praise.

Full Disclosure: At the time of writing, the author and some of his clients were long HHC, but those holdings are currently under review for possible sale and positions may change at any time.

As 2020 Begins, Low Volatility and Investor Complacency Warrants Some Caution

As the new year has begun the same way the prior one ended (a slow melt-up in stock prices without much in the way of concern from any corner of the market), I can’t help but get the feeling that complacency is extremely elevated and investors are mostly bullish.

Can the U.S. equity market keep up this trajectory:

Can market volatility remain this benign, as the Wall Street Journal reported this morning:

“The S&P 500 is in one of its longest streaks without a 1% daily move in the past five decades, highlighting how the latest leg of the stock-market rally has been a gradual climb rather than a euphoric surge. The broad equity gauge hasn’t moved 1% or more in either direction since mid-October, its sixth-longest streak since the end of 1969 and third-longest since the end of 1995, according to Dow Jones Market Data. Driving the extended period of calm trading: An initial U.S.-China trade deal and lower interest rates around the globe that have eased fears of a sharp economic slowdown.”

A big indicator of investor complacency continues to be the popularity of index funds. The sheer number of indexes being created should give us all pause. Consider the following two stats:

1) As of the end of 2017, there were more than 3 million stock market indices worldwide, more than 70 times more than the number of public companies (43,000).

2) The story is similar in the U.S. alone: as of 2016, there were about 4,000 U.S. stocks but more than 5,000 indices containing them, according to Bloomberg:

While I don’t have updated data, it is safe to assume the gap is even wider now that a few years has passed and the trend is not slowing down. It boggles the mind, really. Imagine a professional sports league with more teams than actual players. It is just not logical.

After a decade where the main index, the S&P 500, posted 14% average annual returns, it is easy to see how recency bias is forcing investors to conclude that indexing is the only strategy worthy of consideration. But let’s not forget that the markets are cyclical, just like the economy and investor sentiment. With the P/E on the market now above 20x, a level that historically has warranted caution, and the 5 largest stocks now comprising nearly 20% of the S&P 500’s market value, there are real signs that investors have set everything to auto-pilot and expect the tech sector to continue to drive the indices higher indefinitely.

All of these factors taken together make me nervous. That is not to say that it has top end soon and in dire fashion (there are plenty of plausible outcomes), but I would not want to make a strong consensus bet that the next 1-0 years will look similar to the last 10.

GrubHub Merger Logical Bridge To Food Delivery Consolidation

Press reports this week indicating that online food delivery operation GrubHub (GRUB) was exploring strategic alternatives, including a possible sale or merger, jump-started the stock but now the company is refuting the sale process part of the equation. Regardless of which route they prefer, this sector is in dire need of a structural realignment and I suspect we will see that transpire this year.

For the food delivery companies, the business model is just really, really difficult. There is no way that a restaurant and a third party delivery service can both make reasonably good margins if I want a burger, fries, and shake delivered to my house in an hour or less. GRUB does a lot of business in high density urban areas like New York, where delivery routes are more efficient than in the suburbs, but still the company barely makes any money. EBITDA per order between 2014 and 2018 averaged anywhere from $1.01 to $1.18 depending on the year. Imagine the volume you must do to build that into anything worthwhile. No wonder investors have soured on the stock:

It’s just as bad for consumers trying to navigate the ordering process with so many competitors popping up to embrace this horrible business model. Here in Seattle, my wife and I have food delivered relatively frequently and in a big city like this we have DoorDash, GrubHub, Postmates, and Uber Eats to choose from (we had Bite Squad at one point too, before they were absorbed by Waitr and left our local market). It is a huge pain to scroll through 4 apps to figure out what restaurant you want, the fee structures between them differ, and places switch from one service to another all the time. There just isn’t room for more than 1 or 2 players in this space, assuming they can figure out how to make it work financially.

So what should GrubHub do now, as the first mover and only pure play public company that is getting pounded by the newer entrants? David Faber on CNBC this morning nailed the answer to this question; they should merge with Uber Eats.

Uber is bleeding cash but the ride sharing business is actually profitable in mature markets, whereas the food delivery business is losing a few bucks on every order. If you merge Uber Eats into GrubHub you have a stronger, clear #1 player in the space that remains a public company and can try and figure this business out. It would probably force further consolidation (why not have Postmates and DoorDash merge instead of both pursue an IPO?) which benefits everyone.

And it does something else (which for those of us who recently bottom-fished Uber because it looks like a cheap stock would be wonderful) by ridding Uber of the cash-sucking food delivery division. Uber shareholders would get stock in the newly formed GrubHub/Uber Eats company and Uber stock itself would likely rise materially as they easily push up their profitability timetable by a year or more. It just makes sense to separate these two business models, as one is likely to be very profitable at scale (ride sharing) and one is far more uncertain (food delivery).

Uber stock has already rallied from the sub-$28 price I jumped in, so maybe I am getting a little greedy, but a deal like this probably sends the stock into the 40’s and perhaps to the IPO price of $45. And it just makes sense from a business and financial perspective. Hopefully the executives and bankers were watching CNBC this morning and realize how great of an idea Mr. Faber shared on the air.

Guess The Valuation – Inaugural Edition

As a fundamentally and valuation driven investor, I am continuously amazed at some of the equity valuations the public market bestows on growth companies, even in an age of near-zero interest rate borrowing conditions.

So for those valuation-driven readers, let me present the first of what I will simply call “guess the valuation.” I present you with financial metrics and you tell me how much you think a growth investor, at most, should be willing to pay in total equity market capitalization terms.

Before the comments start coming, understand that I am fully aware that this exercise is overly simplistic and one would want to have more data before answering such a question. Humor me please to play along, and feel free to give the company below the benefit of the doubt (within reason).

Unidentified Company X

Financial results for the first 9 months of 2019

Revenue: $1 billion (+50% yoy)

Gross Profit: $600 million (+50% yoy)

R&D Expenses: $250 million (+50% yoy)

Marketing Expenses: $350 million (+35% yoy)

General/Admin Expenses: $125 million (+60% yoy)

Operating Loss: $125 million (-35% yoy)

Operating Cash Flow: $20 million (N/M)

Okay, guess the equity value assuming zero net debt on the balance sheet…

November 2019 Reader Mailbag – Part 2/2

Thank you to everyone who submitted questions for this blog’s first ever “Reader Mailbag.” Below is the second half of this month’s 10 questions and answers. 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) and I will publish the next round after we get enough submissions.

Question #1: “I am wondering how you think about the renewal risk to Wynn Macau with respect to valuing Wynn Resorts. I am also curious how you view the relative merits of investing in Wynn Macau vs. Wynn Resorts particularly at this point.”

There is a lot of market chatter about the risk of the current U.S./China trade war impacting how Macau officials will approach the process of allowing U.S. resort operators, such as Wynn Resorts (WYNN) to renew their gaming licenses.

My view is that Macau is very unlikely to conclude that it is in their best interest to kick out the U.S. operators, either directly or by making renewal costs overly burdensome. Firms like WYNN have great long-term track records of building attractions that Macau wants and has asked for (more entertainment, less focus on gaming) and they have access to relatively low-cost capital to continue to build and improve their resorts. Forcing them to sell to less financially secure and less experienced operators (to exit the market) would probably not benefit the region. If renewals costs are so big that they materially reduce returns in the region, companies will invest less as a result. I am betting they make an economic decision in 2022 with respect to gaming license renewals, as opposed to a politically motivated one.

In terms of investing in WYNN vs their Macau subsidiary, I think it really depends on what exposure you are looking for. If someone wanted to get international equity exposure and chooses a Macau gaming stock to check the box for that region, that seems logical. Since I invest mostly in U.S. businesses, I prefer having the diversity of WYNN’s exposure to Las Vegas, Boston, and Macau, especially since the company only has 5 resorts in their total portfolio. They are concentrated enough as it is, leaving little reason for me to go further and invest only in 2 instead of 5.

Full disclosure: I am long WYNN personally and for my clients, as I expect free cash flow to ramp materially beginning in 2020 and the stock looks cheap relative to where I see cash flow going on a per-share basis over the next few years.

Question #2: “Within the U.S. do you expect active value investing to make a comeback over passive investing?”

Much like the economy and the financial markets, I think passive investing is also cyclical. This decade the S&P 500 has averaged about +13.5% annually. Active managers can’t really keep up with that kind of bull market, hence passive investing has exploded in the last 10 years.

But what happens when the market stops going up so impressively? Will people still throw all their savings in index funds, assume low double-digit annual returns forever, and plan early retirements (as some folks in their 30’s are doing this cycle)? Seems unlikely to me.

History also supports this view. Were people piling into index funds and singing the praises of passive investing during the decade that immediately preceded the current one? Was Warren Buffett telling people to buy index funds while at the same time doing the exact opposite himself (and hiring active managers to eventually replace him)? Certainly not, but the important question is why?

There is only one reason that I can see; because the S&P 500 started trading at 1,469 in January 2000 and closed out December 2009 at 1,115. That’s a 24% loss that even an entire decade of dividends could not completely offset.

I suspect the next secular bear market will disappoint a lot of people who relied too much on the passive investing concept. The combination of inadequate thoroughness in strategic planning and some bad luck with respect to their timing will inflict plenty of pain in that scenario.

Question #3: “Charles Schwab is up quite a bit since you wrote about it. Are you selling or still holding long-term?”

Talk about a perfect example of how the daily Wall Street pricing mechanism is inefficient in the short term, even for well-followed, large cap companies (that many believe “the market” gets mostly right most of the time).

I wrote about Charles Schwab (SCHW) on October 10th, after the stock dropped 15% after voluntarily giving up about 4% of revenue by cutting trading commissions to zero. Not only was that downward stock move excessive, but the chatter after every competitor followed suit was that more industry consolidation was coming. In that case, why would Schwab not participate? I was in the majority camp that thought AMTD would buy ETFC, but SCHW jumping in first and grabbing the former, if the deal winds up closing, is a brilliant move.

As for the stock, when the news of the AMTD bid hit the wires on November 21st, SCHW stock topped $50 and I hit the sell button quickly (unfortunately, it was a relatively small position so I was only mildly thrilled). A reasonable fair value was probably in the 40’s and if the AMTD deal is 15-20% accretive by (as they have guided to), then $50-ish today seems about right to me.

Looking at the bigger picture: when a stock jumps 40% in 6 weeks, it really can change my thinking as to whether to continue to hold it or not. If you get 2-3 years’ worth of gains in less than 2 months, there are probably better uses for that capital. Since I had other stocks that I liked better than SCHW (at that $50 quote), I didn’t hesitate to sell and move on. Just because a company would be a good long-term holding does not mean that price does not play a role in that characterization. And when prices change dramatically, so could/should your plan.

Question #4: “I know from your writings that you bought Amazon at a great price several years back, trimmed it back on the way up, and completely exited last year. With the shares moving sideways for a while now, are you looking for a re-entry point? If so, at what approximate level?”

Good memory. I wrote about paring back the position at around $1,425 and exited completed in Q2 2018 at $1,700. The stock peaked last year at $2,050 and has been marking time ever since, fetching mid $1,700’s these days.

While I would certainly buy it back if another good opportunity presented itself, I am not paying closer attention to that stock than any other. I am a big fan and customer of Amazon, but even as the stock has been moving sideways, I am not compelled to buy at current prices.

My strategy for valuing Amazon has always been to assume a certain profit margin and valuation once the company reaches maturity, which gives me a good idea of what price-to-sales ratio I feel is appropriate. As long as they are growing 20% annually and spending so much money, current year or even forward 12-month earnings seems like a tricky way to value the stock.

At current prices, AMZN trades for about 3.2 times 2019 revenue. That is about as high as the valuation has gotten in recent years and it seems rather rich to me. Put another way, if they can ever reach 10% net profit margins, would I be a willing investor at a 32x P/E ratio? Probably not. I might answer differently if they were earning 10% margins today, as 20% growth coupled with a 32x P/E seems like a more than reasonable price for a high growth company. But they are not earning much money even nowadays.

In fact, it looks like 2019 free cash flow, adjusted for stock based compensation (I know many of my readers hate that I deduct SBC from free cash flow to arrive at my view of AMZN’s underlying profitability, but I have no plans to abandon that calculation) will come in around $8 billion, or about 3% of sales. At today’s prices, that puts AMZN’s shares at more than 100 times free cash flow. No matter how much I like the company and the business, I cannot come to the conclusion that such a price is an attractive entry point. For comparative purposes, my purchases in 2014 were made at less than 2x sales.

Question #5: “How about a new stock idea, one that you have yet to write about? Breaking news!”

Okay, you win, I can’t resist.

EnLink Midstream (ENLC) is an energy pipeline company that has been crushed lately, falling from $11 to under $5 so far this year. Lower oil prices and less drilling activity from their customers has constrained cash flow growth and the dividend ($1.13 per year) now looks strained. The 23% current yield tells me that the market is going to force the company to cut the payout.

Investors realize this, but as recently as early November, the CEO stated that the board still believes the dividend is appropriately sized. Not surprisingly, investors are betting on a dividend cut and despite the fact that some people repeatedly insist that stocks should rally on such news, that is rarely true in the short term because plenty of people own stocks solely (and mistakenly in my view) because of a high dividend yield.

The end result here looks to me like the stock is being priced off a dividend cut and not the underlying business. Stocks should be valued on profits, not on the distribution of such cash flow. A dividend cut is warranted and ENLC almost certainly will cut it (absent a buyout offer from someone). While a cut will impact near-term price action, it does not change the value of the business.

To me, this appears to be a classic case of near-term market inefficiency. Investors are valuing the stock based on near-term events, not long-term earnings power. While there may be some more weakness immediately following a payout reduction, the company is likely materially undervalued unless the business itself gets significantly worse. As for what intrinsic value might be, I will leave that exercise to you.

Full disclosure: I am long ENLC personally and for my clients.

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.