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

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 

 

Amazon Shares Pierce $1,430 And Sit Firmly Above 3x 2018 Forecasted Revenue

Valuing shares of Amazon (AMZN) has always been a difficult task since the company does not at all care about short-term profit margins. Investors are left with trying to estimate, based on the company’s various businesses, how large each will get and what type of margins will likely be achieved once each reaches maturity.

Of course, such an approach becomes nearly impossible when you have no sense of which businesses Amazon will choose to enter over time (or maybe the better question is which they will “not” enter). Traditional retail was one thing, but now with cloud services and advertising revenue, margins are going to be all over the map.

I recently trimmed many of my clients’ positions, as I have done once or twice since I made the investments beginning in 2014. My methodology has been inexact, to account for the aforementioned issues regarding Amazon’s various ventures, but it generally involves looking at AMZN on a price-to-sales basis and then seeing what margin/multiple assumptions are baked into such valuations. For instance, if you think they will ultimately earn a 10% profit margin at maturity, you might be willing to pay 20 or 30 times normalized profits, which would equate to 2-3 times annual revenue.

Given the company’s growth, my personal view is that anything up to 3x revenue is at least somewhat reasonable, as I don’t see margins going above 10% given the company’s desire to remain value-based in the eyes of consumers, and anything over 30x profits for a growth company makes me nervous. And if someone argued that they will never reach 10% margins and a 30x multiple is too high, I can totally understand that view. I just think some valuation flexibility is warranted given that Bezos might actually get as close as anyone in business to total world domination.

So below I have posted updated graphs that show Amazon’s stock price over the last two decades or so (not very helpful when trying to evaluate the valuation), as well as their year-end price to trailing 12-month revenue ratio (far more helpful in doing so). Note: the 2018 data points are based on today’s stock price and consensus 2018 sales estimates.

As you can see, AMZN stock hovered around the 2.0x price-to-sales ratio level between 2004 and 2014, with a range of 1.5x-2.5x or so. In recent years, as momentum stocks have led the market higher, that number has surpassed 3x and currently sits around 3.2x.

Given that position sizing in portfolios is always important to me, this graph tells me that now is not a bad time to trim AMZN. Trading above 3x revenue would seem to indicate that investor sentiment is quite high. There may be good reasons for that, of course, but as the company gets bigger and bigger, its growth rate is sure to slow. In fact, in order to grow by the 29% rate that Wall Street analysts are expecting in 2018, total sales need to rise by a stunning $51.5 billion. That very well might happen (and acquisitions like Whole Foods will only help), but when growth slows to only 10 or 15%, investors might not want to pay 3.2x revenue any longer. In my mind, anything above 3.0x tells me to tread carefully.

What do you all think? What kind of profit margins do you think AMZN will earn at maturity (i.e. when its growth rate is in-line with the average company)? What multiple of revenue seems right to you?

Full Disclosure: Long shares of Amazon at the time of writing (even after selling a chunk at $1,400 recently), but positions may change at any time

No Bitcoin Bubble Here: Pink Sheet Listed CRCW Market Cap Hits $10 Billion

If you were an active investor back in the late 1990’s you probably remember what the climate was like during the dot-com bubble. All a company needed to do was issue a press release announcing they were going to launch a web site to sell their product online and their stock price would skyrocket. This CNET article on oldies music marketer K-Tel, which saw a 10x jump in share price in just a month back in 1998, offers a good refresher.

The current bubble in cryptocurrencies is worse, in my view, because unlike the Internet (which many will agree was the most important innovation of that generation) it is not clear that we really have any need for virtual coins, which like any collectible will see their value swing wildly based on what someone is willing to pay for them on any given day. Maybe I am just ignorant and will be proven wrong in coming years, but I don’t see why a bitcoin is any different than a piece of art, a baseball card, or a beanie baby. They all have a finite supply and little or no intrinsic value.

If you need evidence of a bubble in bitcoins and the fact that the price has gone from $3 when I first heard about them in January 2012 (Featured on Season 3/Episode 13 of CBS’s “The Good Wife” – streaming available for free on Amazon Prime Video) to $17,000 today is not enough, look no further than shares of The Crypto Company, an unlisted stock trading on the pink sheets under the symbol CRCW.

On November 15th, The Crypto Company announced financial results for the third quarter. There is no business here. Revenue came in at whopping $6,000 (consulting fees). Cash in the bank stood at $2.6 million, plus another $900,000 worth of cryptocurrencies.

How much is a company with a few million dollars of assets and no operating business worth? Well, the stock closed that day at $20, giving it a market value of $415 million (~20.7 million total shares outstanding).

But wait, that’s not the crazy part.

Shares of CRCW have surged nearly 24,000 percent in just 30 days since then, valuing the company at $10 billion. That is a bubble, folks.

 

 

 

 

CenturyLink/Level 3 Merger: 1 + 1 = 1/2 ?

A year ago my local phone company, CenturyLink (CTL), announced a $34 billion deal to acquire Level 3 Communications (LVLT), one of the leading business communications carriers in the nation. The deal was widely seen as a way to preserve CTL’s $2.16 per share annual dividend, coverage for which was coming under pressure as cable and streaming companies continue to take market share in the local consumer phone, video, and data markets. Combining with Level 3 would result in a larger player (competing nationally with AT&T and Verizon) with roughly 75% of revenue coming from business and wholesale customers.

Over the course of the 12 months it took for the two companies to close the deal, the consumer business continued to erode, and CTL’s stock price fell from $28 to below $20 per share. Competitors like Frontier, which acquired a lot of Verizon’s FIOS customers and proceeded to lose many of them, have investors fearful that the consumer business can never be repaired. Over the last month, CTL has fallen even more and today trades for $14 per share.

I happen to agree that competing with cable and streaming offerings is not a viable business model long term. CenturyLink is constantly going door to door here in Seattle peddling high speed internet. Despite general disdain for Comcast, their service is more reliable and similarly priced, so CTL really has no way of taking market share in the consumer market.

And that is why this Level 3 deal is so interesting, because the new company is 75% enterprise.  Investors and computerized algorithms treat Frontier and Windstream just like CenturyLink, even though the latter company just completed a transformational transaction that puts it in the top three corporate providers alongside AT&T and Verizon.

Perhaps the best part of the deal is the fact that Level 3 CEO Jeff Storey will take over as CEO of CenturyLink in 2019. Storey’s focus on the business customer sheds light on the future direction of the company. His track record at Level 3 since joining in 2008 and being named CEO in 2013 has been superb (revenue doubled and free cash flow went from zero to over $1 billion a year). As an investor, it is refreshing to listen to him on quarterly earnings conference calls because he talks more about maximizing free cash flow per share than he does about TV and internet bundles. If there is a better CEO to integrate these two businesses, focus on the business client, and maximize cash flow for the owners of the business, I do not know of one.

CenturyLink’s $2.16 per share annual dividend is on center stage as this new company begins to come together. Management has been firm in its desire to maintain the payout, but investors are looking past them. At $14 per share, the yield is a stunning 15%.

On the face of things, it does appear that CTL can pay this dividend comfortably from cash flow, in addition to funding about $4 billion of annual cap-ex. Pro-forma free cash flow will likely come in around $1.5 billion in 2017. Add in $1 billion of expected cost synergies, and $600 million of annual cash tax savings (LVLT has nearly $10 billion of net operating loss carryforwards) and there is a clear path to $3 billion of annual free cash flow if management can keep the business stable (business growth offsetting consumer decline) over the next couple of years. In comparison, the current dividend amounts to about $2.3 billion annually.

It appears that Wall Street is set on painting CTL with the same brush as other regional carriers who have been unable to halt the decline in their consumer-led businesses, which has promoted repeated dividend cuts. To me, the dividend itself is relatively meaningless (stocks are valued based on profits, not dividends). Today CTL’s equity is valued at roughly $15 billion, which would be 5x annual free cash flow post-synergies. Regardless of what their dividend payout ratio is, if Jeff Storey and Company can execute on the business and focus on their enterprise customers, it is reasonable to assume that CTL performs much more like a Verizon or AT&T than just another regional consumer-focused phone company.

With the stock price having been halved since the deal was announced a year ago, nobody seems to think that buying Level 3 changed CenturyLink’s business outlook. And they also do not seem to care about Jeff Storey’s track record of creating shareholder value (LVLT stock more tripled during his 5 years as CEO). In other words, the bar has been set immensely low.

Full Disclosure: Long shares of CTL as well as CTL debt securities at the time of writing, but positions may change at any time.

 

Even After 30% Decline, Equifax Shares Not Cheap

It seems that data breaches are going to become the norm globally, if they have not already, so whenever a company is hit by hackers and the stock price declines as a result, I try to take a look and see if there are investment opportunities. The best example was Target several years ago, when hackers pierced the retailer’s in-store credit card scanners and stole customer payment data. While the media would have had you believe people were going to abandon the chain for life, after 6-12 months (and many more hacks of other companies), it was business as usual.

Equifax (EFX) might be a different animal given that they are in the business of collecting credit data, but most corporations do not seem to be much of a match for professional hackers. So while it is easy to argue that their security should have been stronger than Target’s, I am not so sure that a year from now Equifax’s business will be materially harmed. It is worth watching, however, since there are other data providers corporate clients can use.

What is interesting to me is that even after large drop (in recent weeks EFX shares have fallen from the low 140’s to today’s $103 level), the stock is not cheap. In fact, it appears it was quite overvalued leading up to the hack disclosure, making a 30% decline less enticing for value investors.

I went back and looked at Equifax’s historical valuations and found that the stock has ended the calendar year trading between 14x and 23x trailing free cash flow since 2010. I would say that 20x is a fair price for the company.  But pre-hack the shares had surged more than 20% year-to-date and fetched roughly 27x projected 2017 free cash flow. So at today’s prices they still are trading at the high end of recent historical trends at ~20x.

For investors who think this hack will come and go without permanently damaging the Equifax brand, the current price is a discount from recent levels but hardly a bargain. If you are like me and would want to see how financial results come in over the next 6-12 months (to see if customers are bailing), you would want a far better price if you were going to start building a long position now. And even when you felt comfortable with the long-term prospects of the business, the current price would hardly scream “buy” at you.

The stock seems to be acting well in recent days, which suggests many are taking the bullish view. While I don’t necessarily think that is the wrong move, recent history suggests the stock isn’t worth the $140+ it was trading at prior to the hack.

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

AutoZone’s Numbers Don’t Suggest Amazon Will Replace Them Or Their Competitors

After a huge rally over the past five years, shares of auto parts retailer AutoZone (AZO) have taken a beating in recent months as investors fret over Amazon’s ability to become a full service parts supplier.

What is interesting, however, is that auto parts industry observers are far less optimistic about Amazon’s desire and ability to break into a business that often requires super fast delivery (far less than even two hours) and a huge selection of SKUs. Simply put, auto body shops suddenly dumping their relationship with AutoZone seems unlikely. In that case, AZO’s share price slump from $800 to $500 lately is probably unjustified.

There is little doubt that non-time sensitive auto-related purchases have a place in the online world. If you want to stock up on car air fresheners or get a new license plate holder, Amazon is a good place to look. But for more specialized needs, where price is not always the most important factor (getting your car back as soon as possible is), the distribution networks powering the large national auto parts retailers should still provide certainty, comfort, and value.

To see exactly how much AutoZone’s business has been impacted by Amazon, I looked back over the last 15 years to see the trend for the company’s sales per retail square foot. After all, if auto part sales are moving online in a material way, the average AutoZone retail store should be seeing sales declines. This would show up in sales per square foot since a store’s size is constant even if more stores are built.

Here is a graph of AutoZone’s sales per square foot since 2003:

Can you see Amazon’s impact in that graphic? When did they really accelerate their auto parts selection? Does it look like they are having the same chilling effect on AutoZone’s business as they are on, say, JC Penney? I just don’t see it.

For those expecting the impending doom of auto parts retailers like AZO, I think their death may be greatly exaggerated in Wall Street circles lately. In fact, it is notable to point out that over the last five years (when e-commerce growth has really started to disrupt traditional retailers), AutoZone’s revenue has grown from $9 billion to $11 billion, leading to an increase in free cash flow from $27 to $34 per share.

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

Is the Enthusiasm for Charter Communications Getting Overdone?

Shares of cable operator Charter Communications (CHTR) have been on a roll lately, rising more than 50% during the last 12 months. You would think after such a big run that the company must have had a dramatic change of fortune, but really it is just a traditional cable company offering customers bundles of services while consolidating smaller regional competitors.

The story might sound a lot like Comcast (CMCSA) because they are pretty much in the same business. Comcast owns NBC Universal, so they have a content wing as well, but the two companies are the nation’s leading cable businesses in the United States, with nearly half of all U.S. households (~50 million residential customers cumulatively).

Investors would therefore likely conclude that Charter and Comcast were being afforded similar public market valuations, but you would be wrong. After Charter’s magnificent rise from $250 to nearly $400 per share (during which time Comcast shares have risen a more modest 20%), the smaller player now trades at a huge premium.

As the chart below shows, Charter fetches a 35% premium on EBITDA and a 60% premium on free cash flow:

It appears that merger chatter involving Charter may be behind a large part of the stock market move lately. Verizon (VZ) and Sprint (S) are both rumored to be eyeing a deal that would morph them into more than a cell phone provider, and perhaps adding wireless to the cable / internet / landline phone bundle would bring down costs and prove synergistic.

What investors seem to be missing, however, is that there is nothing unique about Charter’s business. The company still gets 40% of its revenue from cable video services, which are declining due to cord-cutting. The only strong business segment is broadband, which accounts for about 35% of revenue, but there is a limit there too. Population growth has slowed dramatically in the U.S. and offsetting cable losses by raising prices on internet service will only work for so long.

Charter has been an amazing investment since emerging from bankruptcy in 2009, but the stock appears very expensive. As more and more consumers move to streaming services for video content and drop their landline phones, cable companies are going to feel the squeeze. Perhaps that helps explain why a cable/wireless tie-up might make sense in the long run, but at nearly 12x EBITDA, there is very little margin for error in Charter stock. In contrast, Comcast appears to be a relative bargain.

Full Disclosure: Long shares of Verizon and Sprint debt at the time of writing, but positions may change at any time