November 2019 Reader Mailbag – Part 2/2

Thank you to everyone who submitted questions for this blog’s first ever “Reader Mailbag.” Below is the second half of this month’s 10 questions and answers. If you would like to submit a question for the next mailbag series, you can leave a message in the comments or send a direct message via Twitter (@peridotcapital) and I will publish the next round after we get enough submissions.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Okay, you win, I can’t resist.

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

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

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

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

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

November 2019 Reader Mailbag – Part 1/2

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

Alright, here we go…

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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