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

 

Another AMD Comeback: Stock Says Most Certainly Yes, But I’m Skeptical

At first glance you might very well think Advanced Micro Devices (AMD) is having a hugely successful rebirth. Here is two-year chart of the semiconductor company’s stock price:

After so many fits and starts and promises over the last few decades, with little to show for it in the way of sustainable profitability, I had not really looked closely at the shares, even during this huge run recently. Then I read an article in the July issue of Fortune that spotlighted AMD’s bet on new chips that apparently has gotten investors’ attention.

For a company whose annual revenue in 2015 and 2016 ($3.99 billion and $4.27 billion, respectively) were the lowest out of any of the past ten years, AMD’s current market value of $13.5 billion (today’s share price: $14.39) seemed pretty lofty, but I wanted to dig deeper to see if progress is really being made. The numbers are pretty ugly:

The aforementioned revenue trend is poor:

And profitability is hard to come by. Here is free cash flow over the last decade:

Okay, “hard to come by” might be overly generous… AMD has not turned a material cash profit, after required capital expenditures, in any of the past 10 years. Looking at the two-year stock price chart again, it is hard to understand why the share are trading above $14 each.

Evidently, optimism about future products is high, despite some clear setbacks as noted in the Fortune piece. But I suspect the stock may be ahead of those rosy expectations. Including half a billion dollars of net debt, investors are currently valuing AMD at $14 billion. Revenue is expected to reach $5.3 billion in 2018 (sell side consensus estimate), which would get the company back to 2012-2014 sales levels.

So what is a best case for AMD? I decided to try and pinpoint a number in order to draw a final conclusion about the current stock market valuation. To do this I like to assume that most metrics get back to previous peak levels and see what kind of stock price I would get if things go right from here. Call it the “bull case” as many analysts do.

Using the last decade as my data set, I see that gross margins peaked in 2010 at 46%. R&D spending troughed at 19% in 2014. Corporate overhead troughed at 11% last year. Let’s plug in those expense levels (equating to EBITDA margins of 16%) and further assume that AMD can get annual revenue back to $6 billion (40% above 2016 levels and 12.5% above consensus estimates for next year). In that scenario annual EBITDA would come in at $960 million. Let’s call it a billion.

What multiple should we use on that $1 billion of EBITDA? Industry behemoth (and the competitor AMD has never been able to strongly challenge), Intel, trades at 7 times. If we give AMD the same valuation the equity would be worth $6.5 billion, or roughly $7 per share. Even if we are generous and assign a 10x EV/EBITDA multiple, we only get to $10 per share.

At over $14 per share, AMD stock currently reflects very optimistic assumptions about the company’s future growth, profitability, and valuation ($1.4 billion in annual EBITDA, at a 10 multiple, for instance). If the last decade is any indication, the odds are not great that they deliver. As a result, I am not touching the stock. In fact, for those who short overvalued and underwhelming businesses, it might be a solid candidate.

Full Disclosure: No position in AMD 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

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%
Salesforce.com 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.

 

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

The Downward Spiral of the Tech Hardware IPO: Are Acquisitions on the Horizon?

We see this happen so many times. A hot brand new technology hardware company with a cool new product decides to cash in via an IPO. All is good for a little while and then Wall Street’s expectations for growth become too ambitious as competition grows and the need to constant upgrade one’s device wanes. The company misses financial targets for a few quarters in a row and the stock goes from darling to laughingstock in short order. I think we can all agree that fitness band maker Fitbit (FIT) fits the bill. Here is the stock’s chart since the IPO in mid 2015:

Another obvious poster child for this phenomenon is GoPro (GPRO):

To me, it seems the only logical play is for these companies to be acquired by larger technology companies who can best harness the value and loyalty behind these solid brands to maximize their profit potential.

So why should a bigger tech player swoop in and take Fitbit and GoPro out of their misery? Quite simply, the public markets become broken for these young disappointments very quickly. Given the competitive landscape, it will be very hard for either of them to reaccelerate its business to the level that would be required for investors to warm back up to the story. As a result, the stocks are being valued extremely cheaply if you consider the value of the brand and the current user base. As a result, it should be a no-brainer for the big guys to snap up the small fries. This becomes especially true if we consider that the IPO markets have allowed these smaller players to amass large cash hoards.

Take Fitbit, for instance. At less than $6 per share, FIT current equity value is a meager $1.4 billion. The company’s finances are actually is very solid shape, with no debt and a projected $700 million of cash onhand as of year-end 2016. Net of cash, Wall Street is valuing the Fitbit brand and the more than $2 billion annual revenue base (2016 figure) that it brings are just $700 million. For a strategic acquirer, that price should be mouth-watering. Even offering a big premium of 50-100% to persuade current shareholders to sell would not impede value-creation from the deal. Offer $11 per share/$2.7 billion for FIT ($2 billion for the operating business plus cash onhand) and it is unlikely a company like Apple or Google would regret it.

GoPro would be an even cheaper purchase. At the current $8.75 share price, Wall Street thinks the company is worth just $1 billion (net of $200 million cash, no debt). Could Apple not add value to its company by paying $2 billion for GoPro, innovating the product line further, and integrating it into their existing user base around the globe?

So why have these deals not really happened? In some cases, large tech companies firmly believe they are superior to the upstarts. As a result, they prefer to challenge them with internal product development (me-too copycats) instead of merging and taking out one of their competitors. Apple is probably the most prominent company in this category, as they refuse to acquire any meaningful competitor. And yet, it is almost assured that their competitive positions would be stronger today has they bought companies like Netflix, Spotify, Pandora, etc. Instead, we read stories like the one recently that said that Apple is planning to go into the original content business. All I can do is roll my eyes.

The second hurdle for these combinations is seller willingness to merge. From an emotional perspective, the board of GoPro would not have an easy time agreeing to sell the company for $15 or $20 when the stock price was $100 in 2014 and $60 in 2015. If they just come out with one more hit product the sky could be the limit! Same thing with Fitbit; we went public at $20 in 2015, how can we sell out for $10?

To me the playbook is obvious. Wall Street is telling you that your hyper growth days are over. The big guys have more resources and will slowly take your customers. For some reason, nobody realizes that combining forces is probably the best move for both sides in the long run. I will be interested to see if Fitbit and GoPro are public companies a year from now. Heck, maybe Steve Ballmer comes back to Microsoft and sees synergies with a Nokia/Surface/Fitbit/GoPro/X-Box product lineup (kidding, of course).

 

Beware of Seemingly Reasonable P/E’s on Growth Tech Companies

Pop Quiz:

Do all technology companies expense stock-based compensation in their financial statements? Perhaps more importantly, do sell-side analysts include such expenses in their quarterly earnings estimates, on which every quarterly report is judged by Wall Street?

Given that stock-based comp has been a hot button accounting issue for a couple of decades, and the chief accounting rule board (FASB) required GAAP financial statements to include such expenses way back in 2004, I suspect that most investors are not really paying attention to the issue anymore.

Since I am a value-oriented investor, most of my investments are outside of the high growth tech sector, where most of the stock-based compensation resides. Nonetheless, a few months ago I wanted to dig a little digging because I did not understand why market commentators in the financial media were seeming to understate the P/E ratio of the S&P 500. I have been closely watching S&P 500 index earnings for most of my career, so it struck me as puzzling when people on CNBC would claim something like “The S&P 500 trades at 17 times earnings, which is only modestly above historical averages.” In fact, the numbers I saw on the actual Standard and Poor’s web site showed the P/E to be more like 19 or 20x. Given that the historical average is around 15x, there is a big difference between 17x and 20x. So what the heck is going on?

It turns out that there is a large financial data aggregation company called FactSet, which supplies many investors with earnings data on the S&P 500. You can find their earnings data directly on their web site. After reading through it I realized that FactSet was showing higher earnings levels for the S&P 500 (which equates to lower P/E ratios by definition), and that is where the market commentators were getting their valuation information. For instance, the current FactSet report shows that calendar year 2016 earnings for the S&P 500 are projected at $119, which gives the index a trailing P/E of 19.3x. However, the S&P web site shows a figure of $109, which equates to a trailing P/E of 21.1x. Investing is hard enough, but now we can’t even agree on what earnings are? Maybe I’m making a big deal out of nothing, but this is frustrating.

The logical question I needed to answer was what accounted for the gap in earnings tallies. If earnings really were 9% above the level I thought, my view of the S&P 500’s valuation would undoubtedly change. I was shocked when I learned the answer.

It turns out that FactSet’s earnings data does not represent the actual earnings reported by the companies comprising the S&P 500, which is what the figures on the S&P web site show. Instead, FactSet uses the reported earnings that match up most closely with the Wall Street’s analysts’ quarterly forecasts. Put another way, if the analyst community excludes certain items from their earnings estimates, FactSet will adjust a company’s actual reported earnings to reflect those adjustments (for an apples to apples comparison to the Wall Street estimate) and those earnings figure are used when they tell the investment community what the earnings for the index actually are. If this sounds bizarre to you, it should.

Having followed the market for my entire adult life (and all my teenage years too), I immediately knew what accounted for much of the gap between these earnings estimates. Most technology companies still to this day report non-GAAP earnings results right along side GAAP figures in their earnings reports. For reasons I don’t understand (since the issue of whether stock compensation is an actual expense was resolved years ago), the analyst community excludes these expenses in their numbers, so when a tech company reports earnings, the non-GAAP number is comparable to the analyst estimate. As such, the non-GAAP number is incorporated into FactSet’s data. So whenever a stock market commentator quotes the FactSet’s version of the index’s P/E ratio, they are inherently ignoring billions of dollars of employee compensation that is being paid out in shares instead of cash.

To illustrate this point, Consider Google/Alphabet’s fourth quarter earnings report from last night. The analyst estimate was $9.44 per share and Google reported $9.36 per share. So today’s media headlines say that the company “missed estimates.” If you read the financial statements carefully you will see that Google’s GAAP earnings were actually $7.56 per share. The non-GAAP earnings figure, which is the ones that is reported on because that is how the analysts do their projections, was a stunning 24% higher than the actual earnings under GAAP accounting rules.

You can probably guess why there was such a large gap. During the fourth quarter alone, Google incurred stock-based compensation expense of… $1.846 billion! Multiply that by four and Google’s run-rate for stock compensation is $7.4 billion per year! That is $7.4 billion of actual expenses that are being excluded from FactSet’s earnings tally, and that is just from one company (albeit a big one) in the S&P 500 index.

So how does this impact investment decisions? Well, there are many people that look at Google and see an $850 stock price and $34.40 earnings for 2016 and conclude that the stock is quite reasonably priced given the company’s growth rate, at less than 25 times trailing earnings (850/34.40=24.7). Of course, the actual P/E is 30.5x because when you add back stock-based comp Google’s earnings per share decline from $34.40 to $27.85.

The valuation differentials get even larger when you consider younger, smaller technology companies because these firms seem to be addicted to stock-based compensation. Google pays out a lot in stock, but even that $7.4 billion figure is only 7% of the company’s revenue. Paying out 7% of sales as stock compensation is indeed a very large figure, but other tech companies dole out far more.

I looked at some other fairly large ($5-50 billion market values) tech firms and the numbers are staggering. During the first three quarters of calendar 2016, Salesforce.com (CRM) paid out 9% of revenue in SBC, but that seemed quite low compared with some others. Zillow (ZG): 13%. ServiceNow (NOW): 23%. Workday (WDAY): 24%. Twitter (TWTR): 26%. Can you believe that some tech companies pay a quarter of revenue in stock-based compensation? Not total compensation, just the stock portion!

Importantly for investors, these companies are getting very large valuations on Wall Street. In fact, those five tech companies have current equity market values that cumulatively exceed $100 billion. I wonder if investors might view them a little less favorably if they realized they might be less profitable than the appear on the surface.

For me, the takeaway from all of this is that all investors should dig deeper into valuations in general. Don’t just take figure you hear on CNBC or read in press releases as gospel. Just because a web site says a company has earnings of X or a P/E ratio of Y does not mean there isn’t more to the story.