With New Market Darling Tesla Surging, Is Its Stock The Next Amazon?

Before today’s pullback, shares of Tesla (TSLA) had more than doubled since the beginning of the year as bears capitulate and admit their bet that the company was on shaky ground financially appears to have been wrong. The company has always had cult-like followers who planned to hold the stock forever, but now with shorts scrambling to cover and momentum traders seeing a near-term opportunity, the stock touched $968.99 yesterday after fetching around $400 a month ago. Profit taking today has the shares in the mid 700’s, which equates to a market cap of roughly $140 billion.

While the last few days feel like an unsustainable bubble, one can make a bullish longer term argument based on wild growth assumptions over the next decade. Even at current prices, TSLA trades for about 5 times projected 2020 revenue, which is not out of line with its history (2.5-4.5x trailing revenue in recent years). The biggest question is not whether 5x sales is crazy, but rather if it is warranted for a manufacturing business. After all, TSLA’s 2019 gross profit margin was just 17% and the overall trend in that metric is hardly positive:

Prior to Amazon (AMZN), it would have been easy to dismiss the investment merits of a $140 billion market value company that posted a net loss of $862 million in 2019, but Bezos and Company have changed the dynamic for growth stock investors. Now anybody who can imagine large amounts of profits being generated by a business a decade or two into the future can make a bullish argument and justify nearly any stock valuation today.

The narrative that Amazon has lost money during most of its life is a bit of an overstatement (they posted losses in the first 6 years post-IPO and in the subsequent 17 years have earned profits every year except for 2), but the Tesla investment story is the same; they are changing the world and current profits are meaningless. In the 10 years TSLA has been a public company, they have lost money every year.

If Elon Musk does succeed in becoming the number #1 global car maker eventually, and other businesses develop over time to diversify into something other than a low margin manufacturing company, then the Amazon comparison is likely reasonable. With that in mind, I was curious what kind of numbers Amazon was posting when it was Tesla’s current size, and how Wall Street was valuing the stock at the time. This can tell us whether $140 billion for Tesla today is on par with what is likely the most successful business started in the last 30 years. Interestingly, the financial paths are not dissimilar:

In 2009, Amazon posted revenue of $24.5 billion, gross margins of 22.6%, and grew revenue to $34.2 billion in 2010, with similar gross margins.

In 2019, Tesla reported revenue of $24.5 billion and gross margins of 16.6%. The current consensus estimate for 2020 revenue is $32.2 billion.

There are two core differences, however. First, Amazon had racked up 7 straight profitable years by 2009, earning a $900 million profit that year, whereas Tesla lost $862 million last year on the same revenue base. Second, Amazon’s equity market value entering 2010 was $60 billion, less than half of Tesla’s current market value. Add in the fact that Amazon has moved into high margin businesses since (like AWS and advertising), which has allowed them to nearly double gross margins to 41% by 2019, and it seems that Tesla’s stock is far ahead of an Amazon-like trajectory.

So while Tesla might very well be the next Amazon, the current market price is far more exuberant than Amazon’s was a decade ago. That won’t necessarily stop TSLA stock from rising over the long term, but it does imply that its gains over the next decade are unlikely to approach those of Amazon during the prior one.

Meet Apple: The New Consumer Staples Stock

In recent years, Apple (AAPL) bulls have argued that the company is morphing from a seller of technology hardware to a software and services business, which should result in a meaningful increase in the earnings multiple of the shares. I was never really able to buy into that framework because sales of the iPhone were north of 60% of Apple's total business and services was stuck in the low double digits. Getting hardware from 90% down to 80% or even 75% of the company didn't seem like enough of a shift to warrant P/E expansion from the mid teens to the mid 20's, but plenty of folks firmly believed that Apple should have the same multiple as Starbucks or Coca Cola.

Those bulls have been waiting patiently and in recent months the value of their holdings has surged. During Apple's 2019 fiscal year (which ran from October 2018 through September 2019) the company's stock price fell from $226 to $224. In lockstep, the company's GAAP earnings per share fell by the same amount (from $11.91 to $11.89). During those 12 months, the stock's P/E ratio was (obviously) stable and it was clear that the days of P/E's in the 10-12x range were long gone. With slowing revenue and earnings and a reasonable valuation, I held no position in the shares.

Oh what a difference four months makes (evidently). Apple stock since September 30th has been on a tear, making a new high today at just shy of $320 per share. That is a gain of more than 40% in about 16 weeks. What on earth is going on? Well, the multiple expansion thesis is playing out, and fast, even though there seems to be minimal fundamental change in Apple's business.

After declining in fiscal 2019, earnings per share for the company are expected to increase in fiscal 2020, with the consensus forecast now sitting at a hair above $13 per share (10% growth). At $319 and change, Apple's forward P/E is now above 24x. When was the last time Apple's P/E was in the mid 20's? More than a decade ago! Most interesting is that Apple was much smaller and growing revenue extremely quickly back then (annual revenue growth of 47% between 2008 and 2012 thanks to the iPhone, which was released in mid 2007).

Apple shares have more than doubled over the last 12 months, despite little change in the business and hardware as a percentage of total revenue still above 80%.

Congrats to those who hoped Apple would garner a consumer staples multiple in the mid 20's a la Proctor and Gamble, McDonalds, Starbucks, or Coca Cola. I have no view on where the stock goes from here, especially since I never expected the P/E to ascend to this level. All I know is that for a stock that traded between 14x and 17x earnings between 2011 and 2017, when its organic growth was far faster, the current price implies investors are banking on a lot of good news in the coming years. So while the bar was previously set quite low for the company, due to trading at a material discount to the market, Apple's financial results will have to meet or exceed far elevated expectations to maintain a premium valuation. In a way, it signals that investors are banking on growth once again, and the dividend yield is now down to only 1%.

It will also be interesting to see how Wall Street analysts react to this latest stock price spike. Will they keep raising their targets or go to a more neutral stance? Amazingly, the average consensus price target for Apple among the 44 analysts who cover the name is $290 per share, or about 10% below the current quote. Only about half (23) have buy ratings.

While I would not short Apple unless than P/E got to nosebleed territory (say, 30+), I see little reason to own it at 24x forward earnings after a massive run. If investors value it more like a blue chip consumer brand going forward, the current price indicates that its equity returns will likely fall into that category as well.

Reevaluating the Bullish Investment Thesis on The Howard Hughes Corporation

When the Howard Hughes Corporation (HHC) was spun off from General Growth Properties during its bankruptcy process in late 2010 it was an underfollowed, relatively unknown collection of unrelated real estate assets mostly located within a few master planned communities in Hawaii, Maryland, Nevada, and Texas. The communities were vibrant residential and commercial hubs in their respective local markets and HHC owned thousands of acres of vacant land that would allow for decades of future development, either by the company itself or by third parties who would buy the land or partner with HHC.

The investment thesis was very compelling for long-term investors willing to wait 5, 10, or even 20 years; HHC will sell vacant land to homebuilders and use the proceeds to build and lease office buildings, retail shopping centers with ample restaurants, multi-family residential buildings, hotels, etc. to make the area even more desirable. The population growth would lead to ever-increasing land prices and the process could be repeated until there was no land left to build on, creating plenty of value for shareholders.

The key aspect that set HHC apart from other real estate developers was that they owned the vacant land already, enough for 2 or 3 decades of construction activity, which meant they could fund commercial construction projects with cash generated from land sales, not by borrowing from banks and racking up debt like most of their peers. That strategy would allow for less leverage and more value would accrete to equity holders rather than creditors.

The success of HHC stock in the eyes of their investors over the last decade varies greatly depending on when each of us got in (as one should expect). Most of my clients have made money in the name, but I also bought some when sentiment was high and it was fully priced in the near-term (the idea was that for a such a long-term investment, the entry point was a little less important than in other situations) and those blocks are flattish at best and slightly down at worst.

The exact buy price probably would have been relatively unimportant had the thesis played out exactly as expected. But, that has not been the case. Now I am left with a stock that is up nicely from its 52-week lows and remains included in many accounts I manage (as well as my personal portfolio). The question is, should we sell or keep holding it?

First, let me share some data to illustrate why HHC has not been the very unique public real estate developer many had hoped for since 2010. The bull thesis (that HHC would handsomely outperform other similar public real estate stocks) hinged largely on the idea that debt financing needs would be reduced due to a constant stream of cash coming in from vacant land sales. On the face of it, this looks like it should have played out, as HHC has booked cumulative land and condo sales of $4.32 billion from 2011 through September of 2019. Gross profit on those sales comes to a whopping $1.85 billion.

Flush with cash, HHC did what it said it would do; build a heck of a lot of leasable commercial real estate and own the properties long term to generate a consistent stream of rental income (that Wall Street would theoretically love). Sure enough, HHC's rental income had risen from $95 million in 2010 to $396 million by 2018.

If HHC had simply reinvested the $1.85 billion and generated an incremental $300 million of annual rental income (worth about $3 billion of equity value at a 10x multiple on gross revenue), the total return for shareholders on that investment would have been 62% and proven out the bullish thesis in a powerful way.

So far so good, right? Maybe, but there is one problem; debt at HHC has soared right alongside land sales, construction activity, and rental income. Rather than build properties with minimal debt financing, setting themselves apart from their peers, HHC has funded their construction costs via traditional methods. At the end of 2010, total net debt on the books was merely $34 million ($285 million of cash against debt of $319 million). As of year-end 2018, that figure had swelled to a stunning $2.68 billion ($500 million of cash against $3.18 billion of debt).

If you realized what HHC was in the early days once it started trading, it was undervalued enough that none of the above mattered. The stock closed its first trading day in November 2010 at $38 and nearly doubled to $73 by year-end 2012. However, since then the ever-rising debt load has held back the stock, which closed out 2013 at $120 and has been treading water ever since (albeit in volatile fashion which has afforded investors trading opportunities along the way):

The company ran a strategic review process in the second half of last year that resulted in a stock price spike, allowing me to pare back and/or hedge most of my positions in HHC. There was a glimmer of hope after no buyers for the company emerged in that management announced it would sell non-core properties, focus on its main master planned communities, materially cut G&A costs, and use excess cash flow to repurchase stock that they felt was undervalued. That plan resonated with me and gave me hope that the debt pile would stop rising so fast and perhaps some equity-friendly moves were on the horizon.

That optimism was short-lived, however, with the December 30th announcement that HHC agreed to acquire from oil giant Occidental 2.7 million square feet of office space for $629 million, to be funded with $231 million of equity and $398 million of additional debt.

Bulls would argue that given their plans to sell part of the assets being acquired (a campus outside of the Woodlands), the remaining deal to buy 2 office towers within their most mature community is a good move. And considered by itself, perhaps they are right. My issue with it is that it represents more activity that does not set HHC apart (using internally generated cash flow to grow their commercial property portfolio). Having HHC borrow money to buy existing buildings at fair market prices is the playbook that every other real estate company is employing, which means the long-term unique investment thesis for the company remains elusive.

There have been other missteps too. The South Street Seaport in New York City was supposed to be a trophy asset for the company, as it held a long-term ground lease and planned to rebuild much of the area around Pier 17 as a premier destination for locals and tourists alike:

What management had originally thought would generated above-average returns quickly turned into a money pit. The original construction budget of nearly $500 million was supposed to generate double-digit returns, but delays and redesigns has seen the cost estimate surge past $700 million. Management is still maintaining the goal of the property eventually earning $40 million to $50 million annually (making it an average project, at best), but the Seaport is currently losing money and will take years to reach that goal, if it ever does.

To make matters worse, we learned last year that HHC has decided to move away from its typical business model (leasing space to tenants) and instead has co-invested in many of the Seaport businesses, even choosing to operate some themselves. They claim there is more upside potential by structuring deals as joint ventures, but they are supposed to be landlords collecting rent and leaving the risk for the business owners. Now they have business losses offsetting rental income, which will reduce returns on the project further.

The nail in the coffin for me was their $180 million purchase of a parking lot adjacent to the Seaport in mid 2018. As they began due diligence on erecting a building at the site, they discovered that the parking lot had once been the site of a thermometer factory and contained toxic levels of mercury, as well as petroleum leaks. Parents of student from a nearby school are freaking out at the prospect of a demolition project potentially exposing children to toxic chemicals, which is delaying HHC's timeline for hiring professionals to clean up the site. Count me as one who hoped HHC would find a buyer for the Seaport last year when they shopped the company's assets, but no such luck.

All in all, without a path forward that includes revenue growing materially faster than debt, I am not sure there is a unique story here for HHC investors anymore. Between December 2013 and September 2019, rental revenue has grown by 165% while gross debt has grown by 139% and net debt by 282%. It is hard not to think that is a major reason why the stock price has barely budged during that time. Unless and until the financial strategy changes, maybe HHC isn't all that special. While it seemed like the ultimate long-term buy and hold stock when I first discovered it back in 2011, today it might no longer warrant such praise.

Full Disclosure: At the time of writing, the author and some of his clients were long HHC, but those holdings are currently under review for possible sale and positions may change at any time.

As 2020 Begins, Low Volatility and Investor Complacency Warrants Some Caution

As the new year has begun the same way the prior one ended (a slow melt-up in stock prices without much in the way of concern from any corner of the market), I can't help but get the feeling that complacency is extremely elevated and investors are mostly bullish.

Can the U.S. equity market keep up this trajectory:

Can market volatility remain this benign, as the Wall Street Journal reported this morning:

"The S&P 500 is in one of its longest streaks without a 1% daily move in the past five decades, highlighting how the latest leg of the stock-market rally has been a gradual climb rather than a euphoric surge. The broad equity gauge hasn’t moved 1% or more in either direction since mid-October, its sixth-longest streak since the end of 1969 and third-longest since the end of 1995, according to Dow Jones Market Data. Driving the extended period of calm trading: An initial U.S.-China trade deal and lower interest rates around the globe that have eased fears of a sharp economic slowdown."

A big indicator of investor complacency continues to be the popularity of index funds. The sheer number of indexes being created should give us all pause. Consider the following two stats:

1) As of the end of 2017, there were more than 3 million stock market indices worldwide, more than 70 times more than the number of public companies (43,000).

2) The story is similar in the U.S. alone: as of 2016, there were about 4,000 U.S. stocks but more than 5,000 indices containing them, according to Bloomberg:

While I don't have updated data, it is safe to assume the gap is even wider now that a few years has passed and the trend is not slowing down. It boggles the mind, really. Imagine a professional sports league with more teams than actual players. It is just not logical.

After a decade where the main index, the S&P 500, posted 14% average annual returns, it is easy to see how recency bias is forcing investors to conclude that indexing is the only strategy worthy of consideration. But let's not forget that the markets are cyclical, just like the economy and investor sentiment. With the P/E on the market now above 20x, a level that historically has warranted caution, and the 5 largest stocks now comprising nearly 20% of the S&P 500's market value, there are real signs that investors have set everything to auto-pilot and expect the tech sector to continue to drive the indices higher indefinitely.

All of these factors taken together make me nervous. That is not to say that it has top end soon and in dire fashion (there are plenty of plausible outcomes), but I would not want to make a strong consensus bet that the next 1-0 years will look similar to the last 10.

GrubHub Merger Logical Bridge To Food Delivery Consolidation

Press reports this week indicating that online food delivery operation GrubHub (GRUB) was exploring strategic alternatives, including a possible sale or merger, jump-started the stock but now the company is refuting the sale process part of the equation. Regardless of which route they prefer, this sector is in dire need of a structural realignment and I suspect we will see that transpire this year.

For the food delivery companies, the business model is just really, really difficult. There is no way that a restaurant and a third party delivery service can both make reasonably good margins if I want a burger, fries, and shake delivered to my house in an hour or less. GRUB does a lot of business in high density urban areas like New York, where delivery routes are more efficient than in the suburbs, but still the company barely makes any money. EBITDA per order between 2014 and 2018 averaged anywhere from $1.01 to $1.18 depending on the year. Imagine the volume you must do to build that into anything worthwhile. No wonder investors have soured on the stock:

It's just as bad for consumers trying to navigate the ordering process with so many competitors popping up to embrace this horrible business model. Here in Seattle, my wife and I have food delivered relatively frequently and in a big city like this we have DoorDash, GrubHub, Postmates, and Uber Eats to choose from (we had Bite Squad at one point too, before they were absorbed by Waitr and left our local market). It is a huge pain to scroll through 4 apps to figure out what restaurant you want, the fee structures between them differ, and places switch from one service to another all the time. There just isn't room for more than 1 or 2 players in this space, assuming they can figure out how to make it work financially.

So what should GrubHub do now, as the first mover and only pure play public company that is getting pounded by the newer entrants? David Faber on CNBC this morning nailed the answer to this question; they should merge with Uber Eats.

Uber is bleeding cash but the ride sharing business is actually profitable in mature markets, whereas the food delivery business is losing a few bucks on every order. If you merge Uber Eats into GrubHub you have a stronger, clear #1 player in the space that remains a public company and can try and figure this business out. It would probably force further consolidation (why not have Postmates and DoorDash merge instead of both pursue an IPO?) which benefits everyone.

And it does something else (which for those of us who recently bottom-fished Uber because it looks like a cheap stock would be wonderful) by ridding Uber of the cash-sucking food delivery division. Uber shareholders would get stock in the newly formed GrubHub/Uber Eats company and Uber stock itself would likely rise materially as they easily push up their profitability timetable by a year or more. It just makes sense to separate these two business models, as one is likely to be very profitable at scale (ride sharing) and one is far more uncertain (food delivery).

Uber stock has already rallied from the sub-$28 price I jumped in, so maybe I am getting a little greedy, but a deal like this probably sends the stock into the 40's and perhaps to the IPO price of $45. And it just makes sense from a business and financial perspective. Hopefully the executives and bankers were watching CNBC this morning and realize how great of an idea Mr. Faber shared on the air.