Retail Carnage (Part 3) – Sorry Wall Street, Balance Sheets Do Matter

Can you name a retailer than has gone out of business without having any debt on their balance sheet? The common characteristic of the recent retailing bankruptcy announcements is highly leveraged balance sheets. In more cases than not, private equity firms took over the companies, loaded them up with debt, and the interest payments became too much to handle as sales and profits declined due to excessive competition and the “race to the bottom” in terms of discounting full price merchandise. Recent examples include Sports Authority (2006 private equity deal), Limited Stores (2010 private equity deal), Payless Shoes (2012 private equity deal), and J Crew (2011 private equity deal), which has been fighting to avoid bankruptcy recently.

It may seem overly simplistic to simply equate lots of debt with bankruptcy and vice versa, but in today’s investment world where folks opt to trade exchange traded funds and computerized algorithms treat all retail stocks as if they are identical, it seems clear that strong balance sheets are being undervalued by investors.

Put another way, if a retailing company has no debt and generates positive free cash flow, it should not trade at a similar valuation to a competitor with lots of debt. The challenge for companies with strong balance sheets is not survival, but rather growth (or in many cases merely maintaining their existing market share).

To illustrate how Wall Street appears to be getting it wrong with regard to balance sheet analysis (or lack of interest), consider two retail stocks that recently reported first quarter results below analyst expectations and saw their stocks crater; Express (EXPR) and Francesca’s (FRAN).

$6.68 per share, 78.5 million shares = $525 million equity value
No debt, $191 million cash onhand = $334 million enterprise value
2016 financials: $2.19B revenue, EBITDA $187M, free cash flow $88M
Valuation: 2x EV/EBITDA, 6x FCF

$10.46 per share, 36.8 million shares = $385 million equity value
No debt, $48 million cash onhand = $337 million enterprise value
2016 financials: $487M revenue, EBITDA $87M, free cash flow $50M
Valuation: 4x EV/EBITDA, 8x FCF

These two companies are in no danger of going bankrupt. Will they have to fight hard to compete for shoppers’ dollars given how crowded the apparel and accessories space is in the U.S. right now? Absolutely. But both of them are going to be around for a long, long time.

Let’s contrast Express and Francesca’s with a couple of other retailers with debt and see if Wall Street is segmenting the sector in a rational way. Consider Barnes and Noble (BKS) and JC Penney (JCP):

Barnes and Noble:
$6.68 per share, 72 million shares = $485 million equity value
$180 million net debt = $665 million enterprise value
2016 financials: $3.95B revenue, EBITDA $150M, free cash flow $11M
Valuation: 4.5x EV/EBITDA, 44x FCF

JC Penney:
$4.75 per share, 313 million shares = $1.5 billion equity value
$3.7 billion net debt = $5.2 billion enterprise value
2016 financials: $12.5B revenue, EBITDA $938M, free cash flow ($93M)
Valuation: 5.5x EV/EBITDA, No FCF

If you look at the stock charts, you will see that the public equity markets are saying that these four companies are essentially the same. However, it is not a hard argument to make that both a traditional department store and a retailer of all things “Amazonable” (physical books, toys, etc), with quite a bit of debt, are in a worse competitive position than a chain of women’s boutiques and an apparel brand focused on a 20-30 year old customer that now gets 25% of its sales from e-commerce (up from zero 10 years ago), both of which are debt-free. And yet the latter two are cheaper on a valuation basis and the stocks of all four look like they are headed for the graveyard in the same vehicle.

I know it does not fit with the media-driven narrative in retail right now, but balance sheets matter. It is short-sighted to simply categorize all bricks and mortar retailers as dead and call it a day. Can you name companies that go out of business with no debt? Other than a select few examples when a company does something illegal and gets shut down by the government or a regulator, or can’t come up with enough cash to pay a large jury award, I cannot think of any. At some point, investors will take notice (I think, anyway… there are no sure things in the investing world!).

Full Disclosure: Long shares of EXPR and FRAN at the time of writing, but positions may change at any time.

Retail Carnage (Part 2) – Shopping Center Landlords Evolve Their Properties

Last week I discussed why I believe many of the traditional bricks and mortar retailers are mispriced based on cash flows, despite intense competition and the acknowledgement that U.S. retail is not a growth business. Interestingly, many of the big box stores own a lot of their own stores, so they have a built-in margin of safety due to the optionality of being real estate developers if the retail business dries up.

So the natural next step in the conversation is to look at the pure play real estate companies. From a valuation perspective the mall owners are the most interesting. For a while the owners of the best malls in the country (GGP, Simon, Macerich, Taubman) were maintaining their premium valuations (roughly 20x FFO, or funds from operations), while the secondary malls in smaller cities were getting beaten up pretty good (single digit multiples of cash flow and double-digit dividend yields). Lately the narrative has changed such that many are saying even the best malls in the country will struggle to fill space as more retailers prune their store portfolios.

In fact, one of the prominent investors featured in The Big Short, Steve Eisman, recently commented on CNBC that he was short Simon Property Group (SPG), widely considered the best high end mall operator in the country) because he didn’t think there was any such thing as a good mall anymore. The reasoning: he just “counts the boxes” sitting on his doorstep when he gets home from work.

As a result, the aforementioned “big 4” high end mall owners have seen their shares drop about 30% on average over the last year, which now sport mid teens FFO multiples. Interestingly, you would be hard pressed to find a transaction in which an “A” mall has been sold for those kinds of prices. Not only that, it was only 2015 when Simon offered to buy Macerich for $95.50 per share and the offer was rejected as being inadequate. Macerich’s current stock price: $59 per share. I have little doubt that if management reconsidered their willingness to sell, Simon would be willing to still do that deal today.

So why are the “A” mall owners so optimistic about their ability to navigate this retail environment, reimagine their properties, and continue to grow their profits over the long-term? After all, if they can succeed on that front, the stock are very likely good buys at ~15x annual FFO.

I can think of a few good reasons. One, location. They have some of the best locations in major cities across the country. Two, incomes and populations are still growing so it is not like they do not have the built-in consumer base to shop their centers. Three, development expertise. These mall companies are developers first and forefront. They are experts are designing destinations that people want to visit.

So while tastes change and maybe 2017 does not bring with it the same thirst for apparel stores that 1997 did, the landlord can adjust. They can bring in more restaurants, more concert venues, more hotels, more office space, more apartment buildings. Rather than having the mall be a place to come and buy clothes, it can be a mixed use destination that serves as a primary entertainment venue.

And don’t forget, interest rates are very low. Developers need funding to expand and/or reposition their properties and money is cheap. If a Sears or a JC Penney closes shop, the mall owner can take that 100,000 or 150,000 square foot box and the huge parking lot that sits next to it and build whatever it wants. The real estate is extremely valuable and any number of uses would make a lot of sense in a densely traversed area that everyone already knows about.

I urge you to read through the conference calls for these mall owners and see how they are thinking about their properties. Take a look at the types of redevelopment properties they are embarking on and decide for yourself if Steve Eisman is right and there is no such thing as a “good mall.” There is a lot of talk in the industry that we have 1,000 malls today and that number needs to come down. And I do not doubt that is true. But every big city can support a couple nice malls. Here in Seattle, for instance, there is Southcenter Mall (owned by Westfield) to the south, Northgate Mall (owned by Simon) to the north, and Bellevue Square (privately owned) to the west. All of these are higher end malls that have plenty of customer traffic. From I-5 you can see all of the building going on around Northgate Mall (including a new light rail stop at the mall itself). The Bellevue property is adding hundreds of residential units around the retail hub.

The financial results of these companies bear out the thesis that they can navigate the changing times. For instance, Simon is projected to earn FFO of $11.50 per share in 2017, which would be a record high level of profitability. Three years ago that figure was $9. Six years ago it was $7. These companies own the land and have access to cheap capital. They really can control their own destiny.

Some other assets are also being dragged down as everyone obsesses over enclosed mall properties, not just the smaller town focused “B” malls. Take outlet malls for instance. The “race to the bottom” in retail these days has made it such that the more you discount the better you do. Chains like Burlington and TJ Maxx and doing great even though they own hundreds of bricks and mortar retail stores. Why? Because consumers have been trained to seek out bargains because it does not take long to find them anymore. Who pays full price for stuff, many will ask.

In that environment, I would think that the open-air outlet malls would have staying power here in the U.S. But a company like Tanger (SKT) has seen its stock price drop from $41 to $26 in the last 10 months. Maybe I am missing something, but I would think that outlet malls will outlast most of their shopping center competitors. But today you can invest in Tanger at just 11x FFO and a dividend yield north of 5%. I would not be surprised if this was a unique opportunity for bargain shoppers, both at their properties and in the stock market.

For investors who are leery of the retailing sector and the threats from Amazon, etc, the real estate owners should be a less risky way to bet on the idea that human beings, even with their Amazon Prime and Netflix accounts, will still find plenty of time to go outside.

Retail Carnage (Part 1) – Perception vs Reality

As a value investor, it should not be surprising that I have been spending a lot of time on the retail and restaurant sector over the last year or so. The space has been pummeled by Wall Street in recent quarters, as the thesis gains steam that we have essentially reached “game over” for traditional businesses. We will buy all of our stuff from Amazon (AMZN) because it is the only rational choice when we are offered a vast selection, great prices, and fast delivery. The same goes for our dining habits; why not have our groceries and meals delivered too? That way we can binge on our favorite Netflix (NFLX) shows without ever being bothered to leave the house to run errands.

I am not going to tell you that these trends are not real. Heck, I am an Amazon Prime member who subscribes to Netflix. The only time I visit an actual pet store is when Amazon is temporarily sold out of the pet food I need. I get it.

I guess my background as a fundamental evaluator of stock prices, though, tells me that the simple “macro” call (which is to avoid investing in any business that is being “Amazoned”) is not automatically the right one. I have always followed the premise that stock prices are a function of the underlying cash flow of the business. As a result, as long as a public company is producing free cash flow, it has value. Accordingly, if the financial markets are mispricing the intrinsic value of that cash flow, there is an opportunity for investment gains. Just because the internet has changed the landscape in many sectors of the economy, it does not follow that the link between cash flow, company values, and investment returns has somehow been rendered obsolete.

But if you have been watching the stock action in these industries you can not help but realize that Wall Street is not really valuing these stocks on cash flows right now. Good luck trying to justify Amazon’s stock price with numbers. Instead, investors simply conclude (correctly, if you ask me) that they are going to take market share in any number of sectors and the end result will almost surely be a higher stock price years down the road. It is more of an “over/under” bet (the line being their existing business today) than it is a prediction about exact profit levels.

And the flip side is also true. Bricks and mortar retailers are being valued at some pretty insane levels in many cases, especially if you happen to have stores in malls. But you can justify that if you ignore the actual numbers and simply make a more general prediction that 5 or 10 years from now there will be no reason to visit a mall or open air shopping center.

For a while now I have been trying to pick and choose attractive investments in these sectors where the sentiment does not line up with the actual financial results of the businesses. It has been a frustrating endeavor with very mixed results. It has become clear to me than in many cases the stock prices are simply not going to line up with the underlying profits or asset values, unless the company takes a proactive role in narrowing the gap (e.g. through a sale or some sort of transaction that “proves” the values). As the market continues to underprice retail-related assets, I think we will see more and more companies take a proactive role, though movements on this front have been muted so far.

But until that happens, I have concluded that the better way to proceed is perhaps to focus on the companies that not only are generating profits over and above what their stock prices would indicate is possible or likely, but moreso on those that are paying a substantial percentage of those profits out in dividends. After all, if Wall Street does not believe the cash flow is sustainable, market participants may never price a public share at a fair price. However, if your investment thesis is that the profits will be there, and they are paid out to you on a quarterly basis, then the stock price itself becomes less important. Put another way, you do not necessarily needs others to agree with your investment thesis for it to be profitable. The commonly referenced Keynes quote applies here: “the market can remain irrational for longer than you can remain solvent.”

Let me give you two examples that show what I mean. Let’s venture into the lion’s den and look at two department stores; Dillards (DDS) and Kohl’s (KSS). I happen to think both are severely mispriced, but the financial community has concluded that these entities will not survive long-term as profit-producing businesses. Let me quickly throw out some bullet points for each to argue that while they might not be well-positioned competitively, their stocks are mispriced.

At $36 and change, Kohl’s shares trades at a market value of $6.3 billion (net of debt the enterprise value is a little less than $8.5 billion). Over the last five years the company has produced cumulative free cash flow of more than $5.2 billion. I estimate free cash flow in 2017 of roughly $1 billion.

Quite frankly, at 6x free cash flow, the equity at current prices is being priced as if the company’s profits are on a perpetual path of double-digit annual declines. And yet if we look at KSS’s revenue pattern over the last five years, it does not appear to be so bleak. In 2012 revenue was $19.28 billion. Estimates for this year are $18.49 billion. That is a 4% drop over a 5-year period. Hardly catastrophic. But I know… it’s a department store, how on earth could anyone invest in a department store in 2017? Well, because they are earning $1 billion a year and trade at 6 times that figure.

What is even more interesting is that there is a margin of safety even if revenue starts to decline at 5% a year instead of the recent path of 1% per year.  You see, Kohl’s owns more than half their stores outright. For more than 1/3 of their store base they also own the land underneath the building. On their balance sheet, the gross book value of the owned land and buildings stands at more than $9.1 billion (less than the current enterprise value). And real estate prices go up over time, so there is a good chance that the $9.1 billion figure is understated relative to current market value.

Next, let’s talk about Dillard’s. DDS is another department store chain but it is seen as being in even worse shape because they operate mostly as anchor boxes in enclosed malls. At $48 per share DDS carries a $1.5 billion market value ($2.0 billion enterprise value including net debt). Last year free cash flow was more than $400 million. This year I project $300 million. So again we have a company that trades at an insanely low multiple of annual free cash flow. It is even cheaper than Kohl’s, with the cumulative free cash flow of the last five years totaling more than $1.9 billion.

And again you would think the business was in free fall based on the price of the stock. But when you look closer you will see that five years ago annual revenue was $6.6 billion and this year it is on track to be $6.1 billion, so it will take a long time for DDS’s business to go away.

Dillards also owns a ton of its stores, even more than Kohl’s. Of the company’s 49.2 million square feet of selling space, they own 44.1 million. The gross book value of the land and buildings at the end of last year was just under $3.2 billion (vs a $2 billion enterprise value). And again, that number is probably too low. In fact, at current prices DDS stock trades at roughly $45 per share foot of owned real estate. To give you an idea of how low that is, Sears recently spun out more than 250 of its stores into a publicly traded company that the market is valuing at $75 per square foot. Obviously Dillards and Sears store space is similar given that they are both anchors in enclosed malls.

So what is an investor to do? Most right now are simply taking the position that stocks like Kohls and Dillards are “uninvestable” because surely department stores are going to vanish. And yet they keep producing hundreds of millions of dollars of free cash flow every year. Clearly that profit stream has value.

A year ago I would have said I preferred Dillards over Kohl’s because it appeared to be even more undervalued. But the market does not seem to care about actual values, and there is no indication that these companies will take steps to demonstrate their intrinsic value by going private or selling stakes in their owned real estate, or whatever other options there might be.

If you asked me the same question today I would choose Kohl’s because they pay a big dividend and that might be the only sure way of earning a return on my capital given the current sentiment in the market. In fact, KSS just raised their annual dividend by 10% to $2.20 per share. I am sure that many people saw that headline and thought it was crazy. How can Kohl’s raise their dividend? Aren’t they dead in the water? Others who simply see the dividend yield of 6% on their computer screens probably come to the conclusion that the payout ratio is unsustainable. After all, since when do retailers pay out a 6% dividend? In the past 3% was a high yield for a retailer and reserved only for bellwethers like Wal-Mart.

So why am I confident that Kohl’s can pay the 6% dividend? Because last year they paid out $358 million in dividends but earned free cash flow of $1.38 billion. They only paid out 26% of their earnings in dividends! In fact, they actually repurchased more stock ($557 million) than they paid out to shareholders. Needless to say, the dividend is safe. In fact, they will probably increase again next year. All of this is true because the stock price and the underlying cash flows of the business are out of whack.

The issue for Dillards investors is that they are choosing to buy back stock and not pay out a large dividend (they do have one, but it is a measly 0.5% annually). While buying back undervalued stock is accretive to investors, it will be tough for those investors to be happy if the stock price is perennially mispriced and the company does not take action to fix the problem. Absent a deal to take the company private or monetize their real estate, it is not clear how the stock price will ever be at a more rational level.

So I think dividends need to be placed higher on the importance scale within the retail sector than they ever have before. They allow investors to lock in some of their expected capital return without worrying about what the stock market claims their shares are worth. As they say, “money talks.”

Stay tuned next week for Part 2 of my Retail Carnage post. For that I will be focusing on the public real estate investment trusts that serve as the landlords for retailers, as they are also stuck in the market’s current disgust of anything related to bricks and mortar retail.

Full Disclosure: Long shares of Amazon and Kohl’s at the time of writing, but positions may change at any time

Buffett Sells IBM, Jumps On Apple Bandwagon – Blessing Or Curse?

Warren Buffett’s decision to invest a large sum in Apple (AAPL) in recent quarters was so surprising because he once regarded tech companies to be outside his so-called “circle of competence.” Then six years ago he started buying IBM (IBM) shares, which only served to confirm that the legendary investor indeed should probably steer clear of the sector and focus on the areas of the economy he knows best.

In recent days we have learned that Buffett has begun selling off his IBM position (about 1/3 thus far), but his new tech favorite is clearly Apple, which he has been accumulating so much that it now represents his second largest single stock investment in dollar terms behind Wells Fargo (WFC).

His timing with Apple appears to have been quite good, although I suspect that is more due to luck than anything. For the last year or so, Apple bulls (other than Buffett) have been touting the idea that the company is not actually a hardware company, but rather a software and services company with valuable recurring revenue. It should follow, they say, that Apple stock deserves a much higher earnings multiple than it traditionally has received (below the S&P 500 due to the perceived fickle nature of technology products, especially on the hardware side of the business).

I am not convinced that this argument makes sense, at least yet. Every quarter we hear investors tripping over themselves about Apple’s service revenue growth, and yet whenever I look at the numbers I still see a hardware company. Consider the first half of Apple’s current fiscal year (which ends September 30th). Service revenue made up 11% of Apple’s total sales, versus 67% for the iPhone, 10% for the Mac, 7% for the iPad, and 5% everything else. Clearly, Apple is not a software company.

Now I know that services have higher margins, so although they represent 11% of sales, they contribute more than that to profits, which is a good thing. But in order for software and services to really become a large contributor to Apple’s bottom line, the revenue contribution has to rise materially, in my view. And that is where I think the “Apple is a services juggernaut” thesis gets shaky.

Over the last six months, services made up 11% of total revenue. Okay, so clearly that number must be accelerating pretty quickly given how bullish certain shareholders are about Apple’s earnings multiple expansion potential, right? Well, in fiscal 2016 the figure was also 11%. In fiscal 2014 it was 10%. In fiscal 2013 it was 9%. Services thus far are not growing much faster than hardware, which actually makes sense when you think about the Apple ecosystem.

If you want more people to buy the services, they have to buy the hardware first. So maybe the two go hand in hand. Put another way, if many iPhone owners have not subscribed to Apple’s services yet, why would they suddenly begin to adopt them at higher rates in the future? At least, that is the argument for why services might not become 20 or 30% of sales over the next few years.

Interestingly, since Buffett started buying more Apple, the earnings multiple has increased. Much of that likely has to do with the prospect for corporate tax reform and the potential for the company to repatriate their large cash hoard ($30 per share net of debt) back home at a low tax rate, but some probably is linked to the idea that services are about to explode to the upside. Color me skeptical on that front.

Year-to-date Apple shares have rallied from ~$116 to ~$152 each. On a free cash flow basis, the multiple on fiscal 2016 results has risen from 12x to nearly 16x. As a holder of the stock, I am certainly happy about that, but I wonder how much more room the multiple has to rise. And will it turn back the other way if services growth disappoints or if tax reform is less aggressive than hoped? Perhaps.

If that happens, the stock price could very much depend more on Apple’s future product lineup than anything. On that front, I am nervous about the company. In recent months I have come to the conclusion that Amazon (AMZN) might be the “new Apple” in terms of tech innovation. Not too long ago it was Apple that would be first to market (the iPad, the iPhone, etc), and then everyone else would copy them (and fail). Lately it seems that Amazon has taken over that role and Google (GOOG), Microsoft (MSFT), and Apple then copy them.

I am thinking about Amazon Echo, which Google quickly copied and rumors are that Apple is not far behind in doing the same. With Amazon’s announcement this week about Echo Show I had the same thought. Dash buttons – same thing. Drone delivery – same thing. Apple is reportedly funding original TV shows and movies now (years behind the curve). The Apple Watch wasn’t first to market, etc. Oh, and the attempt to build an electric car in Cupertino? The perfect example of mimicry.

If that is the case, then Apple’s hardware growth, which has been halted, may be difficult to accelerate. And if services need to pick up the slack, there is a lot of work left there as they seem to be stuck as a percentage of total sales.

While I am not bearish on Apple as an investment – their ability to generate cash remains more than formidable – with the recent earnings multiple expansion I am starting to think about where future upside will come from. If the most exuberant bulls are right and the stock can garner a multiple a la Coca Cola (KO) or McDonalds (MCD) (20-25x earnings), that is definitely the answer. I am just not sure sure that makes sense, at this point anyway.

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

Wynn Resorts Coming Up Aces For Investors

It has been about 18 months since Steve Wynn purchased more than 1 million shares of his own company’s stock, Wynn Resorts (WYNN), at prices in the low to mid 60’s. While he had better timing than I did (I initially started buying earlier in 2015 at higher prices), which would be expected, his insider purchase has been immensely profitable.

WYNN shares surged this week after the company reported strong earnings, breaking through the $125 level for the first time in more than two years. Bargains hunters like me who bought at multiple times on the way down have had to be patient, but buying great companies at discounted prices often works out very well for those who are willing to wait.

Now that Wynn’s second Macau resort has opened (last August) and is ramping up nicely, I thought it was a good time to revisit the investment. My thesis since 2015 has been that with the addition of two more resorts (the aforementioned Wynn Palace and the forthcoming Wynn Boston, set to open in mid 2019), WYNN’s free cash flow would move materially higher and justify a stock price of at least $150 per share (a relatively conservative 15x multiple on $1 billion of annual free cash flow).

Wynn’s recent results do nothing to shake my confidence in that investment thesis. In fact, it may very well turn out to be too conservative. Based on recent numbers for the company’s Macau properties, it is entirely possible that WYNN could be looking at reaching that cash flow goal before their Boston property opens.

Considering that the company could reasonably expect a 10-15% return on both its $2.4 billion investment in Boston, as well as the recently announced Las Vegas expansion (a golf course that earns $3 million of profit per year is being replaced by a $500 million development project that could earn $50-$75M per year), there appears to be nice upside potential to my price objective. For instance, an incremental $350 million of EBITDA at a 12x multiple would equate to $4.2 billion of added value, compared with estimated construction costs of just $2.9 billion. Tacking on $1.3 billion to Wynn’s valuation would equate to roughly $13 per share, making a stock price of over $160 distinctly possible by 2019.

As an investment manager position sizing is always a consideration, but that aside, I remain intrigued by Wynn stock even after its recent rise. As they say at the tables, I am likely going to “let it ride” for quite a while longer.

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

Will Anybody Step Up And Buy Whole Foods Market?

Activist hedge fund Jana Partners has amassed an 8% stake in Whole Foods Market (WFM) and is urging them to work harder harnessing strategies to maximize operational efficiencies and also test the waters in terms of possible takeover interest. I have been a fan of the company for a long time, and of the stock ever since it cratered into the 30’s several years back. The original investment thesis hinged on long-term square footage growth (8-10% annually) but the company has now decided to slow new location development. As a result, we are now left with more of a cash cow business with minimal growth (same store sales have been falling 2-3% for over a year).

The stock recently traded in the high 20’s (too low for even a slower growth outlook) and Jana seems to have timed their purchases very well during February, March, and April at prices of between $28 and $32 each. Even without a buyout I believe WFM stock would be fairly valued in the low 40’s (far lower than I would have said when they had a stated objective of reaching 1,200 stores (versus less than 500 today). Wall Street does not agree, as even with the Jana-related bump the stock fetches $34 per share.

The easiest way for WFM to realize a more fair price would be to find a buyer, but the company would be a big target ($11 billion market value at current prices). As a shareholder, I would not be thrilled with anything less than a $13.5 billion acquisition price. But who would acquire WFM?

The press reports that Amazon contemplated an offer last year seems odd. They simply prefer to build businesses internally. With no track record of large M&A deals, the odds that Jeff Bezos would all of the sudden offer eleven figures for WFM seems remote.

The second possibility would be a strategic buyer, as in one of WFM’s grocery store competitors such as Kroger or Albertson’s. One could make the argument either way on this line of thinking. The traditional stores have been successful recently copying the WFM product offering, which has resulted in negative comps for the organic pioneer, so they really don’t need to buy WFM. On the other hand, one less competitor means less pricing pressure industry-wide, which could be attractive in such a cut throat market like grocery retailing. I could understand both sides of the coin very easily.

The last option in my view would be a private equity buyer. This makes the most sense from a financial point of view, as PE could use debt to fund much of the acquisition cost without endangering the company (WFM’s balance sheet is pristine). Other grocery store chains have far more leverage which limits their ability to borrow more money. I suspect banks would allow a near-term leverage ratio of up to 5x for a Whole Foods leveraged buyout, which would equate to roughly $6 billion of debt financing and $7 billion of equity capital (assuming a purchase price of $13 billion).

The biggest hurdle for private equity is that $7 billion equity requirement. That is a very large deal for one company to take on alone. More likely a consortium of PE firms could get together and pitch in $2-3 billion each. I have no doubt that many firms are taking a look at this type of option.

All in all, a buyout of WFM is possible, but not probable, in my view. The price tag would be high in absolute terms and there is enough concern about the company’s competitive position that pulling the trigger on a deal might be tough for most of the parties that do in fact kick the tires. If I were setting the odds, I would say there is a 60% chance WFM stays public, a 25% chance private equity makes a play, a 15% chance another chain bulks up its store base, and a <1% chance Amazon is serious about a deal.

Full Disclosure: Long shares of Whole Foods Market and Amazon at the time of writing, but positions may change at any time

Valuing Software Companies Getting Tougher As Firms Trade Short-Term Profits for Growth

There is little doubt that the technology sector is so dynamic today that investors trying to identify the big winners of the next decade or two are probably correct to be engaging in such an exercise. The proliferation of software-driven innovation is truly staggering, as are the number of new companies trying to capitalize. The IPO market is bringing new software companies to the public exchanges, ensuring there is no shortage of investment candidates.

So while there is enormous potential with these companies as we look over the next 10 years or more, it is also getting more difficult to analyze these stocks from a valuation perspective. There are hundreds of examples of investors who buy the right company – just for the wrong price – and wind up being disappointed with their return.

I say it is getting harder to determine what a fair price is for these small, high-growth companies because they have adopted what I call the “Amazon model.” The Amazon model is simply the idea that you should sacrifice short-term profitability for growth, especially in nascent industries where the first mover can oftentimes distance themselves from the competition.

Before Amazon came along very few companies were willing to have public shareholders and purposely avoid making material profits. The consensus view was that once you IPO, profits matter. And while Amazon bears tried to debunk their model for many, many years, the company’s success has proved that it can work. Simply put, if you grow fast enough and come to dominate a particular market, investors will eventually assign a fair value to the franchise you have built. If Amazon’s stock price performance in recent years does not reinforce that view, I don’t know what could.

Not surprisingly, tech companies are now copying the Amazon model and investors are okay with it. There are dozens of public tech stocks today that are growing at 20% plus annually (some much faster) and are losing money or simply breaking even. Maybe they are marginally profitable if you wave your magic wand and pretend that stock-based compensation is not a real expense (some firms have positive cash flow but if you then subtract stock-based compensation you realize they really aren’t profitable).

Valuation conscious investors who look at the financial statements of these companies cannot help but scratch their heads when trying to understand the Wall Street valuations. After all, it is hard to explain why a money-losing software company is worth 10 times forward-looking revenue.

A closer look at the income statement reveals that in addition to stock-based compensation there is another line item that is impacting profitability to a huge degree; obscene sales and marketing expenses. Why is this number so high? Because according to the Amazon model growth and market share are crucial in the short-term. As a result, the amount of money these companies are spending on sales and marketing dwarf anything we have really seen before.

Consider some of the largest, more mature software firms. Below is a list of several, along with what percentage of sales each spends on sales and marketing:

Google 12%
Microsoft 17%
Oracle 21%
Intuit 27%
Adobe 33%

Given how high the margins are on software itself (especially now that it can be downloaded rather than boxed and sold at retail), these kinds of numbers (sales and marketing costs of no more than one-third of revenue) make it relatively easy for companies to earn net profit margins of 10-20% or higher. And once investors can see those profits it is easier to assign a fair value to share prices.

The tricky part is what we see with today’s newer companies.  Below is a list of smaller, higher growth public software companies,. along with their sales and marketing expenses as a percentage of revenue:

Workday 37%
Zillow 45% 47%
Zendesk 54%
Palo Alto Networks 56%
Splunk 69%

I don’t care how cheap it is to make your software or how high of a price you charge for it, if you are spending 50% of your revenue on sales and marketing, you aren’t going to be able to make a profit. And that does not even account for the fact that these same companies are paying out a ton of stock as compensation (instead of cash) in order to be able to cover the cost of sales and marketing.

As long as investors are willing to give these companies a pass (which is likely as long as revenue growth continues), there is nothing wrong with spending money in this fashion. The bigger problem for investors comes when they try and figure out how much to pay for the stock of a company they want to invest in. In order to do you need to have some idea of how profitable the business model is. And with this much money being spent on sales and marketing, in order to maximize growth, there is no way to really know what a “normalized” level of profitability will be when the business matures and most of the market share has been divided up. Some firms might be able to earn 25% margins at that point, whereas maybe others will be 10%. There is just no way to know.

So what happens when you find a small company and love the story but look at the financial statements and see that they are losing money and then you look at the stock price and it trades for 10 times annual sales? Do you close your eyes and buy, or cross your fingers that they miss  a quarter or two and the stock falls to 5 times annual sales?

For me, it is hard to justify the former option. Amazon and Apple trade for 3x forward sales. Google and Microsoft: 5.5x. Facebook and Netflix: 11x.

For something to be worth 10x sales it really needs to be the second-coming of these tech giants. Sure, there will be a handful that make it into that exclusive group, but will most of them? How hard is it to pick and choose correctly? It is a very tough task.

So what should value-oriented investors do? Well, try and find companies that trade closer to 3-5x sales. If they will fetch a similar multiple once the businesses mature, and you think they have a lot of growth ahead of them, the growth itself will boost the stock (in the absence of multiple compression). Also look for companies that are growing quickly but maybe are only needing to spend 20-30% of revenue on sales and marketing. That could indicate they are more efficient with their spending, or perhaps they have fewer competitors (and therefore less need to hundreds of salespeople hunting down prospective customers).

Those are some ways you can reduce your risk with high multiple stocks.


Freshii: Can This Recent Restaurant IPO Deliver Despite High Expectations?

Just when I thought the restaurant sector was dead on Wall Street, we see that fast casual, Canadian-born Freshii (FRII.TO) has pulled off an impressive IPO, offering shares recently at $11.50 each (CAD). With the stock near $14, Freshii’s market value is approaching $430 million (CAD). Adjusting these figures into a U.S. dollar equivalent, FRII stock fetches around $10.25 with a total equity value of $320 million.

Today the company reported 2016 revenue of $16.1 million and EBITDA of $3.7 million (both in USD). Based on those numbers, it would appear that Freshii shares are quite overvalued, but there are reasons that many investors are impressed with the company.

When I reviewed the IPO prospectus, what jumped out at me was the extraordinarily low unit build-out cost ($260,000). For a 99%-franchised fast casual chain, such a low initial investment requirement will make it relatively easy for the company to grow quickly. While average unit sales in 2016 were only $468,000 per location, a reasonable 10% margin would net franchisees a mid teens return on investment (including the initial franchise fee).

I recently visited the lone Freshii location here in Seattle and I was impressed with the food offerings. The average entree price point is pretty much in-line with the fast casual industry ($7.50) and seems especially reasonable given the quality and healthy nature of the food.

On the surface, the Freshii concept appears to be well suited for rapid growth, especially in younger, more health conscious urban areas. But when we look at the stock, it already reflects very high expectations. Freshii collects a 6% royalty on gross sales and system-wide revenue in 2016 was $96 million. If we assume that the company can earn industry-leading margins due to its high franchise percentage, EBITDA at maturity could rise to the mid 40’s in percentage of revenue terms.

Freshii predicts total units will surpass 800 by the end of 2019, which would bring in upwards of $25 million in annual recurring royalty revenue, and possibly ~$11 million of EBITDA. Accordingly, based on expected 2019 profits, Freshii stock currently trades at roughly 30x EBITDA. Yikes.

In addition to valuation, a big concern for investors should be Freshii’s limited operating history coupled with a lightning fast expansion plan. Just three years ago Freshii had 70 locations globally. Today that figure is around 300, with more than 150 new opening planned for 2017. To reach the company’s 2019 goal, new units would need to accelerate to around 200 per year in both 2018 and 2019.

Can a small company like this grow that quickly without running into any roadblocks? Will the next 500 units perform as well as the first 300 locations? These are risks that are real and should not be ignored.

Of course, if Freshii becomes the next Subway investors stand to do very well. It will be interesting to see how well the company can deliver against the hype (the founder and CEO, Matthew Corrin, is only 35 years old).

I have not figured out if there is a certain price at which point I would be interested in initiating a position in the company. What I do know is that the current price is a little bizarre (~$1 million per opened location, despite the fact that the build-out cost is just $260,000 and Freshii doesn’t actually own the location).

I will probably want to see how new units perform for a little while before I nail down a possible entry point. After all, the company is set to increase its unit base by 150% between 2015 and 2017. Moving at that rate could very well give investors buying opportunities (read: volatility) along the way. Regardless, Freshii is one fresh restaurant idea to watch.

Does Buffett’s Big Buy Signal A Top In Apple?

For decades legendary investor Warren Buffett refused to buy technology stocks. He missed the huge bull market in the mid to late 1990’s and people repeatedly questioned his decision in light of the obvious tech revolution. After the dot-com bubble burst he looked brilliant, for a while at least. Interestingly, Buffett avoided tech stocks not due to some core issue such as high valuation, but instead because he simply did not understand the industry. As someone who popularized the term “circle of competence,” his lack of deep understanding of the sector meant that he did not feel like he could analyze these companies well enough to make an investment.

Then in 2011 something changed. Buffett started to amass a huge stake in his first technology investment; IBM. Close followers of the Oracle of Omaha, especially those who knew a decent amount about the tech sector, were doubly shocked at hearing this news. Not only had Buffett violated his decades old rule, but he had chosen for his first tech investment a giant that was widely seen within the industry as being a symbol of “old tech” – one that was only going to be marginalized by newer companies and technologies.

Fast forward six years and Berkshire Hathaway’s 2016 annual report shows that Buffett’s firm owns a staggering 81.2 million shares of IBM. Since purchasing 63.9 million in 2011, he has increased his position by another 27% in subsequent years. That stake was worth $13.5 billion as of year-end 2016. The annual report also discloses his total cost basis in IBM; $13.8 billion. Given a cumulative loss since the initial purchase in 2011, it is hard to argue that Buffett should have ventured into an industry he admittedly knew little about.

While the IBM story is old news for Buffett watchers, I think it is noteworthy given his recent comments on CNBC two weeks ago that during the month of January he acquired 76 million shares of Apple. Buffett admitted in the interview that he did not have an iPhone and that he queried his young family members to see how they like Apple products.

Apple shares have been on a tear in 2017, in part due to news that Buffett was buying.

I have to wonder if this second step into the tech world will share any of the same characteristics of the IBM investment.

Perhaps the bigger point is this idea of one’s circle of competence when it comes to investing. When I look back at my own career managing money it is obvious that my batting average is far higher within industries I am more familiar, and vice versa. There are multiple instances where I have lost money on energy exploration stocks and early stage biotech stocks, to name a couple of areas outside my circle. While I have never instituted a rule that prohibits me from buying stocks in certain sectors, over the years I have definitely allocated more capital to sectors I know best.

That decision does not always help me, especially when investment managers are compared with very diversified indexes. For instance, since the election of President Trump, companies focused on manufacturing, construction, and infrastructure have performed very well. I own very few of these types of names, and in some cases none at all. That lack of exposure to a strongly performing group has materially impacted my short term performance.

My hope is that my clients would rather me avoid sectors I don’t understand well (even if that means poor relative short-term results), as opposed to feeling like I need to have exposure to a little bit of everything in case sectors outside my circle of competence happen to perform well for a while. If I am going to be judged on mt ability to pick individual securities, I may as well stack the odds more in my favor, right?

Regardless, I can’t help but believe that such a strategy makes the most sense, even if it does not always pay off in spades. And if I had to guess, that probably goes for most other (both professional and amateur) investors too.

As for Apple stock, while I continue to hold some both personally and on behalf of clients, the recent run-up to $140 per share probably means that future returns will be more muted, as the stock now trades for roughly 15 times annual free cash flow per share.

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

U.S. Stocks Reach Valuations Rarely Seen, Making Material Earnings Growth A Requirement For Strong Future Returns

In the face of the current highly ebullient stock market, close watchers of valuation metrics are frequently dismissed as ignoring the prospect for accelerating GDP growth and lower corporate tax expense, but I will step onto that turf anyway. It may make me look foolish, as Warren Buffett recently played down concerns about the market’s valuation, even though his often-preferred metric in years past (total stock market value relative to annual GDP) is dangerously high, but that’s okay.

Here is a look at my preferred valuation metric; a variant of the P/E ratio that uses “peak earnings” (the highest level of corporate profits ever produced in a 12 month period) instead of trailing 12 month earnings (impacted solely by the current economic environment) or forward earnings estimates (usually overly optimistic). We’ll go back more than 50 years, not only to get an idea of historical trends, but also because that is the data I have.

When people ask me about my view of the market, I tend to give a tempered response because it is hard to argue that we should really get any earnings multiple expansion. After all, we now sit above 20 times “peak earnings” and that has only happened once in the last 55 years. As you can see, that one time (the dot-com bubble of the late 1990’s) is not exactly a time we probably want to emulate this time around.

It is important to note that high valuations do not guarantee poor future returns. There is a high correlation, but you can map out mathematical scenarios whereby P/E ratios mean-revert and stock prices don’t crater. Simply put, it requires extraordinary earnings growth that can more than offset a decline in P/E ratios (which we should expect if interest rates continue to increase). Right now the U.S. market is banking on this outcome, so earnings and interest rates are probably the most important things to watch in coming quarters and years when trying to gauge where the market might go from here.

Author’s note: The use of “peak earnings” is not common, so it is worth offering a brief explanation for why I prefer that metric. Essentially, it adjusts for recessions, which are temporary events. If investors use depressed earnings figures when they value the market, they might conclude stocks are not undervalued even if prices have declined materially. This is because they inherently assume that earnings will stay low, even though recessions typically last only 6-12 months and end fairly abruptly.

As an example, let’s consider the 2008 recession. The S&P 500 fell 38% that year, from 1468 to 903. S&P earnings fell by 40%, from ~$82 to ~$50. If we simply use trailing 12-month earnings, we see that the P/E multiple on the index was 18x at the beginning of 2008, and was also 18x at the end of the year. So were stocks no more attractively priced after a near 40% fall? Of course they were, but using traditional P/E ratios didn’t make that evident.

If we instead used “peak earnings” (which were attained in 2006 at ~$88), we would have determined that the market was trading at ~17x at the outset of 2008 and had fallen to just 10x by the end of the year. By that metric, investors would have realized that stocks were a screaming buy when the S&P traded below 1,000.