Are Stock Buybacks Really A Big Problem?

I read a recent article in the Wall Street Journal entitled The Real Problem with Stock Buybacks (WSJ paywall)  which spent a lot of time discussing multiple pitfalls of stock buybacks and touched on some lawmakers in Washington who would like to limit, or completely outlaw, the practice. To say I was dumbstruck by the piece would almost be an understatement.

Let me go through some of the article’s points.

First, the idea that the SEC should have the ability to limit corporate buybacks, if in its judgment, carrying them out would hurt workers or is not in the long-term best interest of the company.

To be fair, the authors disagreed with this idea. They were simply bringing to readers’ attention that it was out there. Public companies are owned by shareholders, and those shareholders are represented by the board of directors (whom they vote for). The CEO serves the board on behalf of those shareholders, though admittedly this is a problem when the CEO is also Chairman. As such, the government really has no place to tell boards how to allocate profits from the business that belong to the shareholders. This should be obvious, but evidently it is not to some. The entire activist investor concept is based on the idea that too few times investors pressure boards to act more strongly on their behalf. The system works, and should stay as-is.

The authors, however, do make an assertion of their own that I fail to understand. They claim that the real problem with stock buybacks is that they transfer wealth from shareholders to executives. More specifically, they state:

“Researchers have shown that executives opportunistically use repurchases to shrink the share count and thereby trigger earnings-per-share-based bonuses. Executives also use buybacks to create temporary additional demand for shares, nudging up the short-term stock price as executives unload equity. Finally, managers who know the stock is cheap use open-market repurchases to secretly buy back shares, boosting the value of their long-term equity. Although continuing public shareholders also profit from this indirect insider trading, selling public shareholders lose by a greater amount, reducing investor returns in aggregate.”

This paragraph makes no sense, and of course, the authors (a couple of Harvard professors unlikely to have much real world financial market experience) offer up zero data or evidence to support their claims.

So let’s address their claims one sentence at a time:

“Researchers have shown that executives opportunistically use repurchases to shrink the share count and thereby trigger earnings-per-share-based bonuses.”

This statement implies that a shrinking share count and earnings per share growth are bad, or at least suboptimal. Why? The reason executive bonuses are based, in many cases, on earnings per share, is because company boards are working for the shareholders, and those shareholders want to see their stock prices rise over time. Since earnings per share are the single most important factor in establishing market prices for public stock, it is entirely rational to reward executives when they grow earnings.

“Executives also use buybacks to create temporary additional demand for shares, nudging up the short-term stock price as executives unload equity.”

Insiders are notorious for owning very little of their own company’s stock. Aside from founder/CEO situations, most CEOs own less than 1% of their company’s stock. In fact, many boards are now requiring executives to own more company stock, in order to align their interests with the other shareholders even more. As such, the idea that executives unload stock at alarming rates, and that such actions form the bulk of their compensation, is not close to the truth in aggregate.

In addition, if the stock price is being supported, in part, by stock buybacks, does that not help all investors equally? Just as insiders can sell shares at these supposed elevated prices, can’t every other shareholder do the same? At that case, how are the executives benefiting more than other shareholders?

“Finally, managers who know the stock is cheap use open-market repurchases to secretly buy back shares, boosting the value of their long-term equity.”

This one makes no sense. Insiders buyback stock when it’s cheap?! Oh no, what a calamity! In reality, company’s have a poor record of buying back stock when it is cheap and often overpay for shares. Every investor in the world would be ecstatic if managers bought back stock only when it was cheap.

And how are buybacks a secret? Boards disclose buyback authorizations in advance and every quarter the company will announce how many shares they bought and at what price. It is true that such data is between 2 and 14 weeks delayed before it is published, but that hardly matters.

Again, the authors imply that increasing the value of stock is bad for investors, unless those investors are company insiders. In those cases they are getting away with something nefarious. In reality, each shareholder benefits from stock buybacks in proportion to their ownership level (i.e. equally).

“Although continuing public shareholders also profit from this indirect insider trading, selling public shareholders lose by a greater amount, reducing investor returns in aggregate.”

Huh? Buying back cheap stock reduces investor returns and hurts public shareholders? I can only assume that the authors simply do not understand as well as they should what exactly buybacks accomplish and what good capital allocation looks like. It is a shame that the Wall Street Journal would publish an opinion so clearly misguided.

As Large Cap Tech Continues to Lead, Valuations Begin to Stretch

There is no doubt that the tech sector is where investors will find earnings growth in today’s market, and many money managers are willing to pay full valuations to stack their portfolios with most, if not all, of the big name innovators.

Even though it means sometimes missing out on huge share price run-ups, I tend to buy these companies when they miss a quarter, during a market drop, or any other time when the valuations look “reasonable” (knowing full well they rarely will be cheap on an absolute basis). There was a great opportunity in Amazon (AMZN) in 2014, for instance. Last year, Alphabet (GOOG) in the low 900’s looked like a good bet. Facebook (FB) briefly dipped below $150 earlier this year during a string of negative press, though I regrettably didn’t pull the trigger on that one.

In fact, massive buying of these leading tech companies has resulted in the sector comprising 26% of the S&P 500 index, a level not seen since the peak of the dot-com bubble in March 2000 when tech accounted for a stunning 34% of its value. For comparison, financial stocks peaked at 20% of the S&P in 2007, before the housing collapse and no other sector has ever reached the 20% level. Amazingly, the five most valuable stocks in the index today are tech names:

I have previously written about Amazon’s recent share price ascent and how its price to revenue multiple is getting quite rich — which has not stopped the stock from jumping 20% since — and today I want to dig into Alphabet as well. While that stock around $900 last year looked like a solid GARP (“growth at a reasonable price”) play last year, as it approaches $1,200 today I am a seller.

A big issue with these tech companies is their tendency to dole more and more stock, instead of cash, to employees as part of compensation packages. This allows them to produce inflated cash flow numbers, which investors/analysts then use to justify their investments/recommendations. When I value them, conversely, I use an adjusted free cash flow metric that subtracts from reported free cash flow all stock-based compensation. To me, this adjusted number more fully reflects how much cash the business is actually generating.

Below are some data points for Alphabet, from 2015 through 2018:

As you can see, stock-based compensation at Alphabet equates to roughly one-third of free cash flow. Therefore, when the investing community cites strong operating cash flow, or impressive free cash flow, they are ignoring billions in stock comp. To give you a feel for the magnitude of these numbers, my internal estimates indicate Alphabet’s stock comp will come within striking distance of $10 billion in 2018. It is more than just rounding error.

Despite strong sales growth (the consensus view calls for 20% per year, on average, for 2018 and 2019), investors are paying quite a big price for the stock at current prices. At $1,180 each, GOOG fetches just shy of 50x times my 2018 free cash flow estimate, less stock-based comp, of $25 per share.

As an alternative, using EV/EBITDA, which includes stock comp and gives the company full credit for their large net cash position, the multiple is an unattractive 18x (using my 2018 EBITDA estimate of $41 billion).

While there will always be investors willing to pay up for growth, the main thesis in recent years (“the stocks are not expensive”) might be harder to justify now. As a result, I think it is more important than ever to be opportunistic and focus on taking advantage of near-term pullbacks, rather than buying the biggest U.S. companies indiscriminately just because they have performed so well in recent years.

Full Disclosure: I have been selling shares of GOOG this week

Biglari Holdings: Severely Mispriced Yet Again

I have not written about Biglari Holdings (BH) on this site since late 2014, but that does not mean the company has fallen off of my radar. While BH was once a prime long-term buy and hold candidate, it has become obvious over the years that the controlling shareholder and CEO, Sardar Biglari, not only prefers running an unconventional public company, but often does so at the detriment to its shareholders.

For those unfamiliar, the bulk of BH’s assets (and value) come from a 100% ownership of Steak N Shake and a large stake in two hedge funds run by Mr. Biglari, which are mostly comprised of shares in BH and Cracker Barrel (CBRL). The stock is volatile, sometimes trading quite low and other times approximating fair value for an unfocused conglomerate with little investor recourse.

Given a few too many unconventional moves (buying BH shares on the open market via the hedge funds and holding them for investment, as opposed to buying them at the corporate level and retiring the shares), I have largely been interested in BH in recent years as a trading vehicle — not a long-term investment — buying when the stock is clearly mispriced and selling when it approaches a more reasonable level.

Such an opportunity has once again presented itself after a late April move that resulted in shares of BH being divided into dual classes of stock; A shares and B shares, the former allowing Mr. Biglari to maintain control of the company, with the latter having no voting rights and serving as potential M&A currency.

Prior to the dual class issuance, BH stock was trading around $420 per share. Upon issuance of the new class A shares, the B shares should have fallen in price by roughly one-third according to the exchange ratio, which would have put them in the $280 range. And for a few days that ratio seemed to hold, but then a free fall began. Today BH “class B” fetches around $200 per share (I am focused on the non voting stock because the voting rights are meaningless considering that the CEO controls more than 50% of the votes).

So just how mispriced is this $200 piece of paper? Well, the total equity value at current prices is roughly $630 million. If we ignore the operating businesses (more than $800 million of annual revenue and by my guess, maybe $25M-$30M of EBITDA this year), BH shareholders own (indirectly via ownership of hedge fund LP interests) nearly 4.4 million shares of Cracker Barrel and nearly 1.3 million class B equivalent shares of Biglari Holdings. Since both are publicly traded, we can quickly assign a value to each, which cumulatively comes out to more than $950 million, or $305 per BH class B share. And yet BH class B’s trade for just $200 apiece. As you can see, something is off here.

Now, there are reasons why BH will unlikely ever trade for “full price” based on its assets. After all, many investors would immediately balk at a public stock that owns some companies outright, minority stakes in others through hedge funds, and chooses to buy up but not retire its own shares in the open market. There are other issues too, such as a large unrealized gain on the Cracker Barrel shares, which were acquired for less than $50 each (current price $160), and over $200 million of Steak N Shake debt outstanding.

Still, even if the negatives surrounding BH would result in the operating businesses being valued closer to zero than a more typical $25-$50 per class B share (which I believe they would fetch with a different owner), BH remains mispriced. If we exclude the BH shares owned by the company itself, the equity is valued at about $370 million. To put that into perspective, the Cracker Barrel stake alone is worth $700 million at the current market price, so maybe $600 million net of tax.

At a certain price it is hard to argue against taking a long position in a company that often sees its share price get out of tune with reality due to its unusual composition and low float (due to being small to begin with and having a majority owner). Count me as one who does not think the B shares should trade materially below the $300 level. The recent dual class restructuring has given the small investor a profit-making opportunity.

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

Sports Betting Will Help Many Gaming Companies On The Margins, But Impact Will Likely Be Tempered

Some investors might have thought that last week’s Supreme Court decision that paves the way for legal sports betting in all 50 states would have resulted in skyrocketing stock prices of the largest perceived beneficiaries. And yet, the market reaction thus far has been fairly tame.

Consider Penn National Gaming (PENN), whose pending merger with Pinnacle Entertainment (PNK) will make it the largest regional casino operator in the United States. It stands to reason that from a customer destination perspective, they should benefit immensely from sports bets being taken outside of Nevada. And yet, PENN shares have moved up only marginally (less than 5%) since the ruling was announced:

So why isn’t Penn stock soaring? Won’t there be millions of bets placed at their casino resorts annually once the infrastructure is put into place? Probably, but it is important to keep in mind how much revenue these bets will likely generate for the sportsbooks (hint: it might be less than one thinks).

Americans wager about $5 billion in Nevada sportsbooks each year. It is not crazy to think that the market will be increased by many multiples of that if a dozen or two dozen states take steps to accept bets. With over 200 million Americans of betting age, it is not crazy to think the market could swell by a factor of 10. Annual wagers of $50 billion in total equates to about $200 from each and every American age 21 and over.

However, we must keep in mind that the $50 billion is a gross figure (the “handle” for the betting inclined). In Nevada, the historical hold percentage is around 5%, which is the amount the sportsbooks net after paying out winning bets. As a result, $50 billion of gross bets will generate revenue of just $2.5 billion. Still a hefty sum, but there’s more to consider…

Many states, like New Jersey (which spearheaded the lawsuit that set this entire process in motion), are chomping at the bit to allow sports betting because they see it as a revenue generator. States typically tax casinos heavily in exchange for granting licenses to operate facilities that many constituents would prefer not exist. Those taxes are usually assessed on adjusted gross proceeds (total bets placed less winnings paid out), which eat into casino profit margins quickly. According to this article, while New Jersey taxes casino at just over 9% (among the lowest), most neighboring states charge far more, with New York at 31-41% and Pennsylvania at 16-55%.

So let’s imagine that state legislators decide to tax sports betting revenue at an average of 30%. Now we have gone from $50 billion in “handle” to $2.5 billion of “pre-tax revenue” to just $1.75 billion of “after-tax revenue.” With more than 500 casinos in the country (a Penn/Pinnacle combination would own 40 alone), each stands to generate some incremental revenue ($3.5 million per year, on average), but it will by no means be life-altering for shareholders. Perhaps that explains why Penn National stock is up only a few percentage points since the news hit.

Now, this of course only considers actual gaming revenue from the bets themselves. Resort operators will surely try their best to attract customers to visit frequently and spend some money on food, drinks, and perhaps some slot or table game play while they are there. The tricky part about that strategy, however, is that technology is likely going to play a huge role in nationwide sports betting.

Movie theaters and restaurants are already trying to figure out how to coax customers out to their properties when Netflix and food delivery services are just a few clicks away. The same will be true for the sports betting industry. MGM already has a mobile app for Nevada residents that allows in-state players to place bets from home (or anywhere else). Such capabilities will surely expand to other states now, so why not just watch from your couch and bet on your smartphone?

What is probably a slam dunk, though, is that engagement with sports teams should increase. That is good news for Disney (DIS), whose stock has firmed up lately despite worries about cord cutting and ESPN subscriber losses. ESPN viewership should increase (as can ad rates) as regular games have more importance to the average fan who might throw down twenty bucks on the outcome.

With engagement set to rise, there will be more money attached to these teams and franchise values should continue to rise, perhaps even faster than currently (if that is possible). In addition to Disney, stocks like Madison Square Garden (MSG), which owns the Knicks (NBA) and Rangers (NHL), could see increased investor interest.

All in all, this is an interesting time to be sports fan and market watcher. While there will be billions of dollars generated from legalized sports betting, it is likely that with so many players in the industry set to split the pot, outsized winners are less likely in my view. As a result, there might be very few pure plays from a stock market perspective. Instead, take a company like DIS or PENN or MSG, all of which have dominant franchises already, and assume that sport betting will help them at the margins increase shareholder value over the long term.

Charter and Comcast Shares Fall on Hard Times, Look Ripe for Rebound

It has been about five months since I outlined the valuation disconnect between the two leading consumer telecommunications providers in the United States in a post entitled Is the Enthusiasm for Charter Communications Getting Overdone?  Charter (CHTR) and Comcast (CMCSA) together provide nearly half of the country’s households with cable, broadband, and phone service. A lot has happened since then, so I thought it would be interesting to revisit the situation.

It turns out that my post last August roughly marked the short-term peak, and shares have fallen about 30% since:

Whereas the shares near $400 seemed very overpriced compared with the likes of Comcast (11.5x EV/EBITDA vs 8.6x), they now appear closer to fair value at around 8.8x my 2018 EBITDA estimate. Comcast has also hit a rough patch in terms of stock performance, on the heels of its bid for UK’s Sky Plc, which would further entrench them into the pay television world. While CHTR has fallen 30%, CMCSA has dropped 20%, and now fetches $32 per share, or just 7x my estimate of 2018 EBITDA.

In my mind, Comcast looks very cheap and Charter appears to be reasonably priced, without factoring in any upside they could see from increasing prices on broadband services (they are priced well below Comcast currently), or from their upcoming cellular phone service offering, which promises to look very similar to Comcast’s recently launched and fast-growing Xfinity Mobile service.

My wife recently switched from Sprint to Xfinity Mobile and is paying $12 for every 1 GB of data usage, with no additional charges other than the phone payment itself. Having switched to Google Fi from Sprint earlier this year, I had planned on adding her to my plan upon the termination of her contract, but Xfinity Mobile is actually an even better deal because Google Fi pairs a $15 plan charge along with a $10 per GB data rate. You can add family members for just $10 more )rather than another $15), but it would have cost $20 to add my wife to my plan, whereas Xfinity charges just $12.

With such a compelling price (using Verizon’s network), it is no wonder that Comcast last quarter added more post-paid mobile subscribers than AT&T and Verizon combined. Charter is set to launch a similar service later this year, also using Verizon’s network (pricing not yet available), and I would suspect they will see quite a bit of traction at that point. In fact, with Comcast and Charter in attack mode, it is easier to see why Spring and T-Mobile might think they can get regulators to bless their merger. The big cable companies, along with Google, are truly strong competitors in the marketplace.

And there is the constant merger talk involving Charter, whether they be the buyer or the target. Talks with Verizon and Sprint supposedly dic not progress too far last year, but as a large triple play operator without a dedicated mobile or content business, it is not hard to understand why Charter could continue to be a player in the M&A market (thus far they have simply rolled up a bunch of regional cable companies).

Simply put, Comcast would fetch $40 per share if it just traded at 15 times annual free cash flow, and they have a fairly diverse business as it stands, even without buying Sky. Investors are worried about them overpaying in the M&A world, but the current price seems to account for those fears already. And with Charter stock now trading at a fair price, the risk-reward appears very favorable given that they have optionality in terms of their mobile offering, broadband pricing, and continued M&A activity.  For the intermediate to longer term, I do not see material downside for either stock, and 20% gains would not surprise me.

Investors should also take a look at T-Mobile, now that they are going to try to get a Sprint deal done officially. The stock initially bounced well above $60 on the news, but has faded back into the mid 50’s. They are performing best in the mobile world right now and the stock is not expensive. It looks like it could be a case of “heads, we win” (continued strong operating performance going at it alone, and “tails we win big” (the deal with Sprint has massive synergies) situation.

Full Disclosure: Certain clients of PCM were long CHTR, GOOG, TMUS, VZ, and Sprint debt at the time of writing, but positions may change at any time without notice

After Post-Election Euphoria, Big Banks Start To Look More Attractive After Sideways Action

I was underweighted bank stocks heading into the 2016 presidential election and proceeded to watch as they soared immediately following. I didn’t jump on the bandwagon because although the reasoning was solid (less regulation, higher interest rates) the stocks seemed to get way ahead of the actual fundamentals (in terms of timing). Below is a chart of the KBW bank index during that time:

 

 

 

 

 

 

As is often the case when upward moves appear a bit too steep, the stock have since leveled off and moved sideways for the last year or so. I have gotten more interested lately, not only because valuations are more attractive, but because the regulation relief is indeed occurring now and more normal levels of financial market volatility bode well for banks with exposure to the investment side of the business.

To figure out the best companies to focus on, I decided to see what the valuations today we saying about the profitability of the large banks, relative to the return on equity metrics posted for the first quarter, which is the first period where tax rates have come down to the new, lower level.

Oftentimes investors simply look at price-to-book ratios (the most common valuation metric for banks) and assume that the highest ones are fully valued and the lowest are most attractive. While this may be true sometimes, I am more interested in how the market is valuing these banks relative to their profitability outlook. To judge on that level, I prefer to see where price-to-book ratios are, versus where I think they should be based on each bank’s fundamentals. To do so, I look at return on equity and look for relative mismatches in the data.

Below are current metrics for six of the largest U.S. banks:

 

 

 

 

If we only look at price-to-book, we would want to buy Citigroup and short JP Morgan. But since JPM is a best better managed bank, and earns 50% more on its equity (15% vs 10%), those two banks should not trade at similar P/B ratios.

To balance out the data, I calculate what I call “Implied P/E” which tells us what valuation the market is pricing in, assuming current ROE’s remain constant. On this metric, we see that JPM is trading at 10.9x earnings (if they earn 15 cents for every $1 of equity, a P/E of 10 would equate to a price-to-book ratio of 1.50x). Similarly, Citi trades at 9.8x implied earnings.

All of the sudden, JPM doesn’t look as expensive relative to Citi. The price-to-book premium is 67%, but since their returns are different, the premium us really more like 11%. Framed that way, investors who might have balked before could very well decide they prefer JPM at ~11x earnings, to Citi at ~10x.

The chart above resulted in me being less interested in WFC, even though their recent troubles on the surface appeared to provide long-term investors a good entry point for the stock. Of the entire list, I would say GS and JPM are the best-run companies. To see GS at the top of the list on my preferred “implied P/E” metric really got my attention. Their long-term track record as a public company (since 1999) is quite impressive and as a result, I am quite intrigued by the stock at current prices.

Full Disclosure: Long shares of Goldman Sachs at the time of writing, but positions may change at any time without further notice.

Deal Dead? Express Scripts Has 28% Upside to Cigna Buyout Offer Price

With AT&T (T) and Time Warner (TWX) currently fighting in court to prevail over the federal government in its anti-trust lawsuit, all eyes in the merger arbitrage world are focused on whether so-called “vertical” mergers will be endangered in the Trump Administration. Typically, lawsuits to block M&A transactions have centered on competitors trying to get together to reduce competition and increase pricing power post-combination, but the current fight puts vertical integration in the crosshairs, as the infrastructure company is trying to add content to diversify its business. Given how low sentiment is on Wall Street for paid television content production, investors clearly don’t believe a simple merger would give the content producers monopolistic power, but we will have to see what judges think.

One of the more interesting cases is Express Scripts (ESRX), the large pharmacy benefits management company that was recently (March 8th) offered a 31% premium to be acquired by health insurer Cigna (CI). Many believed that ESRX was in play after becoming the lone major PBM to not have a dance partner. And after CVS Health (CVS) — which owns another large PBM in Caremark — made a bid for Aetna (AET), it was clear that insurance and pharmacy benefits management were consolidating to the point where ESRX as a standalone business was becoming obsolete.

Express Scripts stock was trading at $73 when the $96 deal price was announced, and the stock jumped initially… for a few hours. It now fetches around $70, as investors bet that vertical mergers, even if allowed in the media business, have a steeper hill to climb, in part because multiple deals are pending and allowing all of them to go unchallenged, could be seen as risky by the government.

With ESRX having 28% upside if the deal is allowed, it might seem like a no-brainer risk/reward situation to go long the stock. After all, at current prices the shares trade for just 10x 2017 earnings per share, with that multiple falling to just 7.5x if you believe the mid-point of the company’s 2018 earnings guidance ($9.37), which is getting a big boost from a new, lower corporate tax rate.

The headwind in this case is that Express Scripts is slated to lose one of its biggest customers (Anthem), in 2020. Interestingly, Anthem sold its PBM unit to ESRX in 2009, which paved the way for the current client relationship. However, Anthem is regretting the contract terms (they claim they are being overcharged, whereas ESRX says they are simply abiding by the terms of their contract) and will shift its business to CVS in 2020, while ironically starting their own PBM business internally (again). If only Anthem had kept the business in-house all along…

It does appear that Anthem is getting the short end of the deal. Express Scripts earned EBITDA of $5.29 per prescription claim in 2017 across its entire business, but with Anthem it is making over $10 per claim. So you can see why Anthem is upset and wants a new partner. ESRX will make good money for the next two years — through 2019 — and then will see 1/3 of their EBITDA vanish. And that explains why the stock trades at 7.5x 2018 earnings. Assuming the Cigna deal is blocked, earnings in 2020 are likely to be in the $6.50 per share ballpark, giving the stock an “adjusted P/E” of around 11x, and making Cigna’s offer worth about 14x.

While I have not completed all of my due diligence on Express Scripts, it appears to be worth a look. Absent a buyout from Cigna, the company faces mounting criticism as a middleman in the pharmaceutical sector that supposedly drives up costs for consumers, despite existing for the purposes of negotiating discounts for its corporate clients. The way I see it, if ESRX was not earning its cut, its customers would fire them. Anthem aside, ESRX will see a client retention rate in 2018 of between 96 and 98 percent, according to the company. Without ESRX, employers would have to move their pharmacy plan management in-house, which would probably mean worse results (due to lack of experience), and higher costs (the point of outsourcing in the first place is to save money and resources). If corporations could do what PBMs do, internally and for the same or less money, why would companies like Express Scripts exist at all?

 

Big Question Mark for Facebook: Profit Margins (Not Advertiser Behavior or User Engagement)

There has been a lot of commentary in recent days about how user engagement will change, if at all, in the wake of Facebook’s user data privacy hiccups, as well as how advertisers will react and whether they will shift dollars to other social media platforms. I actually do not think either one of those metrics will materially change in the coming months. What is more important in my eyes is how Facebook’s margin structure could be permanently different in 2018 and beyond.

Sure, there will be some users who stop using Facebook and blame the recent issues, but those users were probably not using the platform much to begin with, and as with most things, people tend to have a short memory. Diners typically return to restaurant chains even after illness outbreaks and shoppers did not abandon Target or Home Depot after massive credit card data breaches.

I also would not expect material advertiser migration. It reminds me of the NFL ratings drama over the last season or two of professional football. Television ratings have declined, in part due to an abundance of games (Monday, Thursday, Sunday), more viewing options that are not easily tracked by Nielsen (streaming services, mobile apps, etc), and more competition for eyeballs (Netflix, etc), but the NFL is quick to point out that despite lower ratings, NFL telecasts still get more viewers than most every other television program. As a result, if you want to allocate ad dollars to TV, the NFL will remain one of the best ways of doing so.

The same should be true with Facebook. If both the user base and the average time per day spent on the app drop a few percentage points, Facebook will not lose its spot as one of the best ways to reach consumers on social media.

The bigger question from an investor standpoint is what Facebook’s margin structure looks like going forward. More specifically, how much expenses are going to rise and whether those costs are on-time or permanent. I suspect they will rise dramatically and will be permanent. After all, up until recently the company really just built the platform, turned it on, and let anybody do pretty much whatever they wanted with users and their data. It is obvious now that in order to maintain trust and their dominant position in the marketplace, they are going to have to [police the platform on an ongoing basis and limit the exposure to bad actors. This will cost money, lots of it, and will not bring in any incremental revenue. As a result, profit margins will fall and stay there, in my view.

This is critical for investors because the stock’s massive run-up in recent years has been due to a growing user base leveraging a scalable cost base. Facebook’s EBITDA margins grew from 48% in 2013 to 57% in 2017, and the stock price more than tripled. That margin expansion is likely to reverse beginning this year, to what extent remains unknown. Could those 9 points of margin leverage be recaptured by rising expenses of running the platform? I don’t see why not.

In that scenario, investors may no longer be willing to pay 10-11x forward 12-month projected revenue for the stock, which has been the recent range. If that metric instead drops to 8x (~$149 per share), it will have implications for the stock (currently fetching $160) even if advertisers and users stay completely engaged with the platform.

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

Facebook Could Become Solid GARP Play If Near-Term Pressures Continue

Facebook (FB) stock debuted less than six years ago at $38 per share and went through two very distinct sentiment shifts. The current environment, as the company faces pressure from multiple sides to better control use of its massive platform, could very well mark yet another shift.

In May 2012, Facebook IPO’d and flooded the market with stock, so much so that anyone could buy shares at the offer price. Investors were skittish that the company could move quickly to capitalize on the move from desktop to mobile usage and the stock quickly fell into the teens. That turned out to be one of the best growth stock investment opportunities in recent memory, because back then very few people understood just how much money the company would earn in just a few short years.

For instance, what if you knew that Facebook would grow revenue from $5 billion in 2012 to $27.6 billion by 2016, and that free cash flow would go from negative to $4 per share that year? Well, the stock probably never would have traded under $20 and I would bet that investors would have gobbled up every IPO share they could at $38 each.

That was very reminiscent of the Google IPO, which many people thought was wildly overpriced, only to be shocked a few years later when the company’s profits made the IPO price look like an enormous bargain (in hindsight only, of course).

As a result of huge profit growth, sentiment in Facebook has shifted dramatically in recent years and the stock had surged to $176 per share by the end of 2017, as free cash flow reached nearly $6 per share last year. While not overpriced necessarily, the bar has certainly been reset quite high, and therefore Facebook is more susceptible to near-term problems, such as how they are controlling the use of their user data and advertising platform.

The chart above shows the entire history of Facebook’s public stock performance and therefore the recent decline barely registers as a blip. If we look at the last year, we see that the shares have largely been moving sideways, and the recent drop is only about 15% from the highs:

So are the shares getting close to an attractive level? It likely depends on two factors; what valuation methodology you use, and whether you think the company can continue to grow per-share cash flow, or if future growth will be hampered by user base maturation and increased costs associated with policing the platform more heavily.

My base case is that they grow, but at materially slower rates, and margins come down some but remain quite high. As far as valuation, I prefer to use free cash flow per share, but I deduct non-cash, stock-based compensation. That metric for 2017 came out to roughly $4.65 per share (versus $5.91 if you ignore SBC). My estimate for 2018 is roughly $6.50 per share, but I realize there is risk in this figure because we really don’t know how much expenses are going to increase in the face of current political and social pressures.

For Facebook to get into the sweet spot as a GARP (growth at a reasonable price) investment, I would have to see a multiple of 20-25x free cash flow less stock-based compensation. On my 2018 estimates, it equates to $131-$164 per share. The current quote, after a 5% drop today, is $163 per share. In other words, FB stock is arguably now finding itself in GARP territory.

Given that near-term sentiment could very well accelerate to the downside, and considering that modeling 2018 growth rates of 35% in both revenue and free cash flow (the current consensus) are probably skewed to the aggressive end of the spectrum, I would probably want to pay less than the current price. However, if the stock reaches the midpoint of my 2018 range ($150-ish), it could very well make for a strong GARP investment from my vantage point.

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

 

New CEO Moving Quickly To Stabilize Wynn Resorts Shares

In the three months since my last post on Wynn Resorts (WYNN) a lot has happened. Steve Wynn has resigned as CEO and Chairman of the Board amid sexual misconduct allegations, long-time executive Matt Maddox has taken over the CEO role, two other directors of the company have vacated their positions, the board increased the annual common stock dividend by 50% (to $3.00 per share), and the company announced a settlement agreement to bring to a close a long-time litigation.

As you can see from the chart below, WYNN shares have found some support and are in the midst of climbing back, as Mr. Maddox settles into his new role and tries to turn the page:

In what turns out to be fortuitous timing, I began to trim back my WYNN positions in late January (around $195) as the stock approached my conservative $200 fair value estimate. Just days later the Steve Wynn news broke, which complicated matters with what to do with the rest of the shares.

Since then I have been sitting tight, waiting for more clarity as to the company’s next steps. Recent days has brought some insight on that front, but two big questions remain in my mind. One, how are Wynn Las Vegas bookings shaping up in the weeks since the news reports made national headlines? And two, what is the fate of the under construction Boston Harbor project?

Although I do not think the company’s Macau business will be impacted, the U.S. market is a different story. As long as Steve Wynn’s name is on the door, even if he is no longer with the company, I could see convention business contract materially, as well as tourist bookings. As far as Boston goes, it would be surprising to me if they put the Wynn name on that property when it opens in the middle of next year. So that begs the question, will they sell it, or get to keep their gaming license and simply rebrand the property?

The answers to these questions are likely to take several quarters to be crystallized. Wynn reported 2017 free cash flow of $942 million, which included roughly $650 million of construction costs for the Boston project. If the company can really generate free cash flow of $1.6 billion from its existing three properties, the stock today remains a great value ($19.3 billion equity value) and could easily fetch $230 per share (15x normalized free cash flow). And that does not even include Boston (the worst case scenario there would probably be them having to offload it at cost). Of course, that assumes that the Las Vegas business stays strong despite the negative headlines, which is a big unknown. I will be watching the data closely on that front in the coming quarters.

There has been speculation that the company may be up for sale, or that Steve Wynn might try to take it private. I think it really depends on whether he plans on holding onto his shares or not. He is 76 years old and could very well decide to retire from the business. If he was open to selling his shares I think the company would look to maximize value for shareholders and auction off the entire business to the highest bidder (and there would be plenty of interest).

If Mr. Wynn wants to hold onto the stock, then Mr. Maddox will have to figure out how to preserve the business value. That would possibly mean taking the Wynn name off of the door (if business does suffer here in the U.S.), or maybe even a more bold move (selling the U.S. assets and focusing on Macau and future growth opportunities like Japan).

In either case it looks like there are plenty of levers for the company to pull to realize full intrinsic value for the business. In that scenario, holding the stock and waiting for even more clarity will probably work out quite nicely. Heads we win (the company is sold and the resorts rebranded), tails we win (they rebrand it themselves with Steve Wynn nowhere to be seen).

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