Is Insurance Really a Subscription Service?

Ever since software companies transitioned away from selling software by requiring a large upfront investment and instead offered a cheaper, recurring monthly subscription, the investor community has cheered and rewarded public software firms with much higher valuations. It is very common for “software as a service” businesses to fetch 10 times annual revenue (perhaps double their prior valuations) and less mature high growth subsectors within enterprise software are getting multiple of 20, 30, or even 40 times revenue. Heck, Zoom Video (ZM) currently sports a 46x price to sales ratio based on expected 2021 sales.

Unsurprisingly, anyone who is trying to raise venture capital or goose their stock price is trying to make the case that they offer a recurring revenue, subscription model. What I find odd is that some of the oldest, most mature businesses in the world actually operate this way, but they get ignored. Why shouldn’t Portland General Electric Company (POR) trade for 10 times sales rather than 1.5x? What about Verizon (VZ) and its meager multiple of 1.9x sales? Do they not provide investors with ideal examples of predictable, recurring revenue, monthly subscription business models?

I could shout from rooftops about how all of these businesses should be valued based on their profits rather than sales and that Wall Street has rewarded companies with predictable revenue (fewer quarterly surprises relative to expectations) with higher valuations for decades. “It’s 2020, baby, get with the program dude,” others would yell back. Yes, I guess I am a dinosaur.

With the market doing well, overall valuations extended (the S&P 500 now trades for 22x pre-pandemic earnings) and relatively few undervalued stocks to be found, it has been easier to find overvalued securities. Even if many folks don’t get into the short selling game, I still like to highlight examples of overpriced names, so maybe at least the bulls will consider taking some profits or minimizing their exposure.

There are plenty of candidates, but my choice today is Trupanion (TRUP), a pet insurance company based right here in Seattle. TRUP shares went public in 2014 at $10 and currently trade for $92 each, having made a new all-time high today. The company’s market value is $3.4 billion; a valuation of roughly 5.7x estimated 2021 revenue of $600 million.

If you are blown away by the fact that an insurance company can trade for nearly 6 times forward projected revenue, you are not alone. Oh, well, surely this company has some pretty impressive profit margins to warrant such a premium valuation, right? Not so much…

For the first six months of 2020, TRUP’s revenue was $229 million and net income was $220,000. That was generously rounded up to earnings of 1 penny per share (it actually comes out to 0.6 cents).

So what’s the deal? Well, you guessed right. Trupanion is not an insurance company at all, but rather it’s a recurring revenue monthly subscription service for your pet. Sorry, how could I be so stupid… it says it right there in the company’s income statement:

Let’s not be fooled by terminology. They sell pet insurance and the average monthly policy premium right now is $59 per pet and rising much faster than inflation. I have to wonder how many new pets they will sign up as the price keeps rising towards $100 per month.

However, we should not ignore the company’s growth. Pet insurance was not a big thing in the U.S. a decade ago and younger people seem especially open to the idea now. As of June 30th, TRUP has more than 740,000 enrolled pets (five years ago that figure was below 300,000). Annual retention rates are north of 98% (Author edit 10/15/20: A reader has pointed out that the company actually reports retention in monthly terms, not annual terms. Sorry, I did not catch that. Therefore, >98% monthly retention is more like a mid 80’s annual retention rate).

I am not saying this is a bad business. Rather, I think it is an insurance business and should be valued as such. To illustrate the lunacy of the current stock market valuation, we only have to refer to the company’s own long-term financial guidance (15% operating margins before factoring in marketing costs, interest expense, and income taxes) to deduce that like other insurance products, this business model will ultimately earn net margins in the mid to high single digit range.

Even if one wants to give them a high multiple on those profits (let’s use 40x since they are growing revenue north of 20% per year) and assume a bullish long-term net profit margin (8%), you arrive at a fair value of 3.2x annual revenue. It gets more dire if you instead use a 5% margin and a 30x P/E ratio (1.5x annual revenue).

But don’t take my word for it. Trupanion actually publishes a metric every quarter called “lifetime value of a pet” and the most recent quarterly report pegged this number at $597. This metric factors in the costs of running the business, the monthly cost of the insurance to the pet owner, and the expected number of months each owner will pay based on the demographics of their animals, etc.

If we simply take $597 per pet and multiply that by their current customer base of ~745,000, we arrive at Trupanion’s own estimate of the lifetime value of their current book of business; $445 million.

TRUP’s current market value is more than 7.5 times higher than that, which surely seems to factor in a crazy amount of growth in the future. I have to think that a large chunk of that premium valuation is simply due to the bizarre notion that selling pet insurance is more similar to selling software than to selling human insurance. That seems to be quite a stretch to me, but such is the investing climate these days.

Can Penn National Gaming Live Up To The Hype?

This post is for my buddy Zach, who asked for a Hertz article several times only to have me decline. Spending a lot of time and/or energy on the topic of amateurs day-trading the equity of bankrupt companies just didn’t interest me. For the record, though, I remain long Hertz puts. Hopefully this post makes up for it, Zach, as I dig a little deeper into Penn National, a stock you bought in March in a wonderfully timed contrarian bet provided by that nasty darn virus called covid-19.

This is not the first time I have mentioned Penn National Gaming (PENN), the biggest regional casino operator in the United States. A little over a year ago I wrote about how cheap the stock looked at $18 per share. What has happened thus far in 2020 is worth expanding on.

In late January, with PENN shares trading for $26 each (enterprise value of $5.2 billion) the company announced a deal to acquire a 36% interest in Barstool Sports at a $450 million valuation. PENN will increase its stake to 50% in 2023 on the same terms, and ultimately to 100% if it chooses (at a valuation no higher than $650 million). Barstool Sports is a digital media company with $100 million of annual revenue (2019 figure) that PENN hopes will help it ramp up its online betting platform across the country.

Investors cheered the deal and PENN shares hit $38 per share by mid-February when the stock market was reaching its pre-pandemic peak. At that point, PENN’s enterprise value had jumped by $1.25 billion just from them investing $163 million into a company that both sides agreed was worth $450 million. Unsurprisingly, I saw this as a great chance to take a profit and move on.

At the worst point in March, PENN stock hit a low of $3.75 per share as its casinos were closed due to the pandemic. That’s not a typo. To save cash PENN gave its landlord, Gaming and Leisure Properties (GLPI), the land sitting beneath its Las Vegas casino in exchange for rent credits (full disclosure: while I sold PENN, I remain long GLPI both personally and for clients). That excessive sell-off was short-lived but you might be shocked to learn that PENN stock today fetches more than $55 per share even though its facilities are operating at limited capacity due to pandemic-related restrictions:

So, what the heck is going on? The best I can tell, a couple of things. First, Barstool Sports founder David Portnoy has been live-streaming his new part-time daytrading career (twitter: @stoolepresidente) and the entertainment value has resulted in his followers gobbling up the stock on platforms like Robinhood. Second, Penn’s management team has been talking up the Barstool Sports deal with sell side analysts and many of them are jumping on the bandwagon. Last week Goldman Sachs put a $60 price target on the shares and this week Truist Financial bumped its target from $50 to $62 per share, the highest on Wall Street.

Being the old fashioned quantitative investor I am, the first thing I do is recalculate the increase in PENN’s enterprise value since the Barstool deal was announced ($4.3 billion, with PENN’s E/V now standing at $9.5 billion) and compare it with Barstool’s annual revenue ($100 million) and the valuation Mr. Portnoy agreed to sell for ($450 million). The only logical conclusion is that partnering with Barstool is not worth anywhere near $4.3 billion to PENN shareholders and that this is yet another example of the equity market bubble in “story” stocks where the elevator pitch sounds great but the numbers don’t add up.

As buddy Zach would say, “okay, so what do you do now?” Well, it depends whether numbers or hype inform your investing decisions.

As a numbers guy, I would create a set of assumptions to form an “extreme bullish case” that goes something like this: Penn got a great deal and Barstool is really worth $1 billion, not the $450M they sold it for. In addition, the online gambling venture will boost Penn’s property level profits by 20% long term. Oh, and of course the pandemic will fade and people will eat, drink, sleep, and gamble as they did in 2019 starting in 2022.

If Penn was worth $5.2 billion pre-pandemic, let’s add the 20% and then tack on another $1 billion for Barstool. Let’s even ignore the cash Penn will have to fork over to buy the rest of Barstool. We get to an enterprise value of $7.25 billion, or $39 per share. Call that an optimistic (but not completely insane) fair value estimate (and 50% above PENN’s stock price pre-deal).

The current hype, though, follows none of that math. The bulls see the stock going up and thus believe it will keep going up. The analysts don’t want to look like idiots if they miss it (Penn is a top notch gaming operator after all), so they all slap $60+ price targets and buy ratings on the stock after this huge move higher (and they were neutral when the stock was in the 20’s in 2019 and sub-$4 in March 2020). The Portnoy contingent rejoices and counts their trading profits. Even CNBC’s Jim Cramer is bullish, this morning offering no quantitative evidence despite suggesting “the stock can go a lot higher.” And so it keeps going up, two more dollars today in fact.

What would I do if I bought the stock during the pandemic-induced meltdown and woke up 5 months later to see it trading up 1,400% from the low and being pushed by the Goldman Sachs’s of the world now? You can probably guess… I would be selling into the exuberance and making sure if I stayed long any amount that it was with just the house’s money. You can surely take that advice with a grain of salt, given that I sold based on my sub-$40 fair value estimate, but riding the momentum train has never been my game. I am quite content watching from the sidelines now and collecting the dividends from my boring GLPI shares.

Be careful out there everyone, it’s crazy times.

Even Before The Pandemic Fades, The Death of the Corporate Office Appears Greatly Exaggerated

During every recession trophy assets go on sale in the equity market but sometimes aren’t noticed because most everything looks cheap and the headlines are so ugly. Commercial real estate has served investors well for decades but the pandemic is putting landlords on shaky ground in the near-term as rent collection percentages sink from the high 90’s rate we are used to seeing.

I have long favored investing in real estate by way of the public markets and while these holdings are not doing well right now, I firmly believe the asset class will regain its dominance in time and that certain assets that I did not own coming into 2020 can be had now at amazing prices. I am focusing on office space in prime markets like New York these days, as the media would have you believe that the corporate office will never be the same again and working from home is the new normal. The stock prices are indicating a similar narrative, with share prices down 40-50% from 52-week highs.

Let’s not get too carried away. In fact, there are already signs that my longer term thesis (that workers will largely return to the office, though there will be more flexibility to work from home occasionally) is likely to come to fruition. For instance, on Monday Vornado (VNO) announced that they leased 730,000 square feet of office space to Facebook in New York City. While the press is reporting that tech companies are leading the path toward letting employees work from home well into 2021, they clearly have every intention of bringing people back when it is safe to do so. If you are investing based on the narrative that people are fleeing cities for the burbs (because if offices are not downtown, why be there?) and that the tech sector is going to lead this shift because software engineers can work from anywhere, please ask yourself why Facebook is leading this much space in the middle of NYC.

Even though we are really only in the early innings of the working from home movement, there are already business leaders who are questioning whether they can maintain the same levels of productivity, training, and problem solving when teams are scattered across a city or state. A recent Wall Street Journal article entitled Companies Start to Think Remote Work Isn’t So Great After All framed the issues wonderfully. Below are some excerpts:

“Four months ago, employees at many U.S. companies went home and did something incredible: They got their work done, seemingly without missing a beat. Executives were amazed at how well their workers performed remotely, even while juggling child care and the distractions of home….. No CEO should be surprised that the early productivity gains companies witnessed as remote work took hold have peaked and leveled off….. because workers left offices in March armed with laptops and a sense of doom. It was people being terrified of losing their jobs, and that fear-driven productivity is not sustainable…”

“In San Francisco, startup Chef Robotics recently missed a key product deadline by a month, hampered by the challenges of integrating and testing software and hardware with its engineers scattered across the Bay Area. Pre-pandemic, they all collaborated in one space. Problems that took an hour to solve in the office stretched out for a day when workers were remote, said Chief Executive Rajat Bhageria.”

“Projects take longer. Training is tougher. Hiring and integrating new employees, more complicated. Some employers say their workers appear less connected and bosses fear that younger professionals aren’t developing at the same rate as they would in offices, sitting next to colleagues and absorbing how they do their jobs.”

Perhaps my favorite part of the article was a discussion with the CEO of a company called OpenExchange, which has seen plenty of efficiency problems with remote work:

“Workers on the company’s European team said they could benefit from some in-person interaction during this time of huge growth at the company. So in late July, OpenExchange is renting a house in the English countryside, with about 15 bedrooms, so many of its employees can live and work together, while still distancing. It’s important to have people in a room and see body language and read signals that don’t come through a screen, says the CEO.”

The irony? OpenExchange is a “Boston-based video technology firm which helps run large, online conferencing events.” If a tech firm that build products for remote work is struggling with it, and a company like Facebook (where most employees sit in front of a screen all day) is leasing more office space in New York during the pandemic, maybe the office as we knew it a few months ago isn’t dead.

A rational counterargument to this thesis is that even if, say, 25% of employees work from home post-pandemic (compared with about 15% prior to it) there will need less demand for office space and rents for existing buildings will fall materially. Maybe this is why landlord stocks are down 40-50%. I think this view is overly simplistic.

An ever-expanding economy means that employee counts are almost always growing, which is why new office space is regularly built. Therefore, I would expect that any modest decline in office demand is going to show up first in reduced construction of new buildings, not the abandonment of existing ones.

Consider that maybe a company grows its employee base by 10% over the next 3 years but can get away with using the same office space it currently leases due to more remote work in the future. In that case, existing leases are still going to be renewed. Without a lot of vacancy, rents should be stable. In fact, if new construction really does drop meaningfully, it could actually put upward pressure on rents for existing space, a phenomenon we have seen a lot in recent years in the residential housing market, where in many markets fresh plots of land and skilled labor are in short supply.

The bottom line for me is that it is rare for premier commercial real estate in gateway cities across the country to be quoted on the public market for a deep discount and I think 2020 is one of those times. Fortunately, regular folks can get in on the action via the U.S. stock market rather than needing to buy up properties themselves, which is obviously not financially feasible in most cases.

Is Another Mania In Overstock Stock A Chance To Short?

Overstock.com (OSTK) has long been a volatile and controversial stock, at least in part due to its founder and former CEO, Patrick Byrne. Although I don‘t short stocks very often and do so even less in client accounts (most of the assets I oversee are in retirement accounts, where shorting is not allowed), Overstock is one of those businesses that makes for an attractive short at times; a much-hyped business with relatively poor economics that loses money. Every so often it sees a huge spike in stock price, only to fall back to earth. And then the process repeats itself at some point. Here is a chart of OSTK shares from 2003 through 2019:

During the pandemic, e-commerce businesses have seen an acceleration in sales growth and stock prices have responded, with the likes of Amazon (AMZN), Etsy (ETSY), and Wayfair (W) surging. Overstock, despite being a secondary player, has once again seen its stock soar:

As I often do in situations like this, I checked to see what the borrow charge was to short OSTK (stocks with smaller floats often cannot be shorted due to a lack of available shares - or in other cases investors need to pay a fee to borrow the stock which is often high enough to negate any material gains you could earn). Interestingly, the borrow charge on OSTK right now is immaterial, so I am now short the stock. While this mania in tech-related stocks may not end anytime soon, which could spoil this particular trade (insert “the market can remain irrational longer than you can remain solvent” disclaimer here), I have little doubt that the intrinsic value of OSTK and the stock price have not moved in tandem during the last couple of months.

So how bad is the business? Well, free cash flow has been negative every year since 2015 (EBITDA negative since 2017). Revenue in 2019 was below 2015 levels. For Q1 2020, EBITDA and operating cash flow were both negative. As folks were working from home and needed to bulk up on home furnishings, OSTK saw Q2 revenue jump 109% year over year. EBITDA went from negative $20M in Q1 2020 to positive $39M in Q2 2020, as sales surged 122% quarter over quarter. This strength is likely temporary, as hard goods are typically not high frequency repeat purchases.

Overstock shares were trading for about $9 before the pandemic at the February market peak, bringing the market value gain over the last 5 months to roughly $2.5 billion. Even if Q2 2020 EBITDA was maintained in perpetuity, OSTK currently fetches a multiple of 17x EBITDA. That valuation might not seem crazy, until you consider that the brand is a second tier player, at best, and more importantly, maintaining sales at these rates over the long term is simply not reasonable. Further supporting a negative view on OSTK is the fact that the company has actively shopped the retail business to potential buyers recently and found no takers willing to offer a fair price.

Full Disclosure: Short shares of OSTK at the time of writing, but positions may change at any time

It Sure Looks Like A Bubble Is Forming Again In The Tech Sector

Apple (AAPL) stock has long been a stock market darling, but investors have generally been rational with their pricing of the shares relative to the company’s profits. At the end of each of the last 5 fiscal years, AAPL stock has garnered trailing 12-month price-to-earnings ratios of 19, 19, 17, 14, and 12, respectively (the most recent year, 2019, is listed first). Over the last few years, the market has slowly adopted the bullish thesis that Apple is more of a consumer staples company (a valuation at or above the overall market) than it is a hardware company (a valuation well below the overall market).

But something has changed as the pandemic shapes 2020 thus far. Here is the stock performance year-to-date:

Having started the year at $293 per share, Apple stock has now gained 30% so far in 2020. Has the pandemic boosted their business somehow? Obviously not. The current earnings forecast for fiscal 2020 is $12.40 per share, up mid single digits from the $11.89 they earned in fiscal 2019. The stock’s trailing P/E, assuming they do in fact earn $12.40 this year, has surged from 19 to over 30. The sentiment shift has occurred in just the last two months, despite the fact that the underlying business is essentially unchanged.

The only logical explanation to me is that momentum-driven trading action is sending popular tech stocks to the moon and another valuation bubble is likely forming. Apple’s revenue this year is projected at $264 billion, versus $260 billion in 2019 and $265 billion in 2018. Their business is simply not enjoying an acceleration of growth that would normally cause this type of P/E ratio expansion.

The scariest thing to me is that Apple actually looks cheap on the relative basis compared to other beloved tech stocks right now. For instance, Amazon stock recently crossed $3,000, attaining a market value of $1.5 trillion (joining Apple in that group). Despite the pandemic, Amazon’s earnings are actually expected to fall in 2020 due to outsize growth in expenses. Therefore, being generous and using their 2019 earnings per share of $23.01 puts Amazon’s P/E ratio at an incredulous 131.

And yes, it gets worse. You have the money-losing tech stocks that are getting multiples of revenue that exceed the earnings multiples of many leading American firms. Take DocuSign (DOCU), a leading provider of electronic signature software that is obviously seeing plenty of demand during the pandemic. For the quarter comprising February, March, and April (the height of the pandemic; their “Christmas” so to speak), DocuSign reported revenue of $297 million (up an impressive 39% year over year) and somehow managed to lose $48 million in the process. After more than tripling in price off the March lows, DocuSign’s market cap of $37.3 billion comes out to a price-to-sales ratio of above 31 (if we annualize last quarter’s results). It makes Apple at 30 times profits look darn cheap, doesn’t it?

There are plenty of other examples that most of you are aware of so I will spare you from citing more. This momentum-based market for flashy high-tech is eerily similar to 1999. Back then we were also valuing companies on sales (20-25x multiples were common) because there were no current earnings, only hopes and dreams of a bright cash cowing future. Amazingly, the revenue multiples are higher now in many cases than they were back then. And for leading firms that are making money, Cisco, Sun Microsystems, Nortel, and Intel at 80 or 100 times earnings 21 year ago does not look as egregious as the likes of Amazon or Tesla today.

I have no idea how this will play out, but having seen something similar firsthand in the 90’s, it makes me nervous. I have no intention of putting client money or my own into things trading at such sky-high prices. I will leave that to the new Robinhood crowd.

Suicide by Robinhood User Shows Some Folks Should Consult With Investing Pros

The stories behind the Robinhood generation of investors is getting worse:

Rookie trader kills himself after seeing a negative balance of more than $700,000 in his Robinhood account

It seems that startups bringing free trades and app-based investing to the uninformed masses might need to be reined in a bit. The narrative in recent years has been that investing can be a low-cost, do-it-yourself kind of thing, where paying professionals a fee is a complete waste of money and only eats into your returns. Of course, that is only true if the small investors have as much knowledge and experience as the professionals and therefore would get zero value from the professional advice (that caveat is rarely mentioned in the same conversation).

Now yes, I am an RIA so I have a dog in this fight and you might say I am just talking my book here. But assets managed by RIAs are growing, not shrinking, and it’s not because the professionals are taking advantage of anyone. There are simply millions of people out there who know they won’t be very successful on their own because they lack the knowledge, time, and/or ability to take emotions out of the equation enough, and therefore they would rather outsource the bulk of the investing work to a pro (and gladly pay for that service). That is not to say that everyone will, or should, fall into that bucket. But many will and if you do not, then great, by all means manage your own portfolio.

Apps like Robinhood that have turned investing into more of a game like Candy Crush are making it easier for novices to venture into waters that are too deep given their background and skill set. As we saw in the story linked to above, such services probably need to have more risk controls in place and higher thresholds for advanced trading strategies (like dabbling in options and penny stocks). Instead, the opposite seems to be happening and they don’t seem to want to take responsibility (at least not yet - maybe that will change).

It reminds me of the social media companies who have created sites where anyone can sign up for an account (without verifying their identify), and then can post anything they want to the world (even anonymously). If bad things happen, the companies claim they are only serving as a platform for free speech and can’t control what people do or say. It seems pretty obvious that such a business model could pose real societal problems, but there was no plan to deal with that side of the equation.

While I can’t control what apps like Robinhood do, I can give advice. And on that front I say that only educated and experienced investors should manage their money entirely on their own without any help. That help can take many forms and does not have to mean you hire an RIA to manage your account for you while you close your eyes and pray for good results. I know myself and many pros that would gladly serve as sounding boards for investing ideas and/or in the role of a second opinion for those who want to make the final calls and actual trades themselves. If you have others to bounce ideas off of and to give you the opposing side of an investing thesis (or explain the downside risks in more speculative waters like options or penny stocks), I suspect your returns over the long term will be higher than they would otherwise. And that is even after you account for any advisory fees you might pay for such advice.

Just some food for thought… please be careful out there everyone.

Concerning Trends From Novice Investing Community

As if a global pandemic is not enough to worry about, there are troubling signs that the novice investing community is growing and trading, well, like one would expect novices to trade. If this does not remind you of the folks who quit their day jobs in the late 1990’s to become full-time day traders, it should. That did not end well and we have seen similar examples outside of the financial markets since. Remember when every day it seemed like ESPN was airing hours of World Series of Poker (WSOP) coverage from Las Vegas? There were a lot of people who quit their jobs to become professional poker players (I knew one personally) and it is safe to assume that most did not last more than a few months.

The signs in the financial markets have been growing. I wrote about the rapid and unexplainable rally in shares of soda bottler Coca Cola Consolidated (COKE) last May, which some attributed to small investors on Robinhood mistaking it for Cola Cola (KO) stock, which comes with the less obvious ticker symbol.

We are now hearing of grade schoolers who used to spend the bulk of their time playing Fortnite jumping into the Robinhood bandwagon, though it should be hard for minors to open real brokerage accounts (their parents would need to be the custodian for a UGMA account and hand over trading to their kid.

The result is some crazy trading action in low dollar stocks, regardless of underlying company fundamentals. Consider Genius Brands (GNUS) going from 30 cents to nearly $12 in about a month thanks to some turbo-charged press releases.

And then there are the rapid ascents and trading volumes of bankrupt companies, led by Hertz (HTZ), which was so stunned by the trading action in its own stock that it is trying to get permission from the court to sell fresh stock in order to help pay creditors in bankruptcy. The shares still fetch $2 each even though the company’s own disclosures explicitly state that they do not anticipate the equity being worth anything but zero. The company’s $1 strike puts expiring 6 months from now can be had for 65 cents, which is pretty good upside if one takes their risk disclosures seriously. We have seen similar moves in other bankrupt firms (e.g. J.C. Penney has tripled from its low of 11 cents).

With the S&P 500 only down 8% from its peak despite the pandemic, a resurgence of day traders among the novice crowd, and some crazy valuations in the tech-related space (any takers for Zoom Video at 37 times pandemic year revenue? How about 45x for Shopify?), it is hard to make sense of what is going on in the U.S. equity market. Some might try to keep it simple and come to the only logical conclusion; the risk-reward currently being offered by the market is far from overly attractive for the next, say, 3-5 years. Some professionals such as Jeremy Grantham at GMO are taking it even further than that.

Pandemic Trading Action Reinforces Importance of Simplifying One's Investing Approach

With the stock market rallying in recent weeks over optimism for a relatively smooth nationwide reopening of the economy, and daily trading becoming a little more calm (day traders speculating in bankrupt equities notwithstanding), I am able to take a breath now that earnings season is mostly over and reflect on the past few months. Of course, a second wave of virus could quickly bring back volatility and fear, but let’s stay positive.

The tables have turned pretty quickly and I am now actually finding opportunities to lighten up on securities that I was buying during the height of the recent market meltdown. As was the case when I was bargain hunting with fresh client cash in March, I am trying to keep things simple.

Take a stock like Starbucks (SBUX). Great business. Blue chip stock that typically fetches a premium (and deservedly so). Today it trades 8% below its February 19th (market peak) level. Seems about right to me, as their business is likely not permanently impaired at all by the pandemic, but sales volumes and margins will take time to rebound to pre-covid levels. At its worst point SBUX was 45% below its $90 pre-covid print, which was most certainly irrational given that about half of their locations remained open during the stay-at-home orders. Buying SBUX in the 50’s was obvious and came with minimal risk. Paring it back in the 80’s seems obvious too.

It can be easy to get stuck in the weeds during massive market drops, but when most securities are on sale, it is best to stick with the simplest stories. Take a company like Bright Horizons (BFAM), a leading daycare provider. Sure it is financially stressing for the company when the bulk of its centers are closed, but the bearish thesis for BFAM over anything but the short term seemed odd at best and downright silly at worst; post-pandemic everybody is going to work from home, care for their children in the next room, and maintain the same level of productivity and/or sanity? I don’t think so. And yet BFAM shares sank from $175 on February 19th to the mid 60’s in March. Down by two-thirds for a leading daycare company with a strong balance sheet? These are easy and simple bets to make if we look out 6 months or a year.

One last example is Vereit (VER) a commercial landlord for single tenant buildings. While tenants like drugstores and dollar stores kept paying, VER still only received 75-80% of contractual rent payments for April and May. Should the stock have fallen on that? Of course. But how much should a REIT fall if they are collecting the bulk of rent and are still fully covering operating expenses and debt service? In this case, investors felt that 65% was the right number, as the stock fell from $10.00 to $3.50 per share at its low point. In fact, the entire real estate universe fell by 50-80% regardless of actual rent collections.

In each of these examples, the simplicity of the story should have given investors a sense of confidence when allocating capital into falling markets. The leading global coffee retailer is a survivor. Parents will keep sending their kids to daycare post-pandemic. A landlord collecting 75% of rent should not see its stock trade down by 65%.

Now, this is all easy to say and harder to do. Did I also find myself delving into more complex and riskier bets, rather than putting all of my capital into BFAM, SBUX, and VER? Yes. Consider taking the plunge into an airline, cruise operator, or hotel company and ask if the undervalued nature of the stock was as easy to see (and pinpoint to an exact figure). It is rare to be able to maintain such focus and discipline and only target the most obvious buys in a sea of bargains. But as value investors when we look back and grade ourselves a year after a bear market, it is usually the case that the simplest stories brought with them the best risk-adjusted returns.

Full Disclosure: Long BFAM, SBUX, and VER (as well as CCL, LUV, and PEB) at the time of writing, but positions may change at any time

Yes, Amazon Should Buy AMCX, not AMC.

If you were baffled by the rumors in recent days that Amazon (AMZN) had held talks about acquiring movie theater giant AMC Entertainment (AMC), you were not alone.

Putting the general strategic rationale for Amazon owning theaters aside, AMC is in serious financial trouble. Loaded with more than $5 billion of debt, the company’s meager free cash flow generation put it on thin ice even before the global pandemic. AMC booked $162 million of free cash flow cumulatively in the decade ended December 31, 2019. The company’s interest expense in 2019 alone was $293 million and they recently added $500 million of high cost debt (10.5% per year) just to stay solvent through the rest of the year.

The idea that Amazon would be dumb enough to make a buyout offer (which would need to top the debt load in dollar terms simply for the equity holders to get anything) during this pandemic is questionable reporting, at best. Given that movie production is shut down, there will be a big delay in new releases even after theaters reopen and consumers get comfortable visiting them. It sure seems like the pandemic is only going to accelerate AMC’s path to bankruptcy, and as a result, Amazon should just wait it out and try to buy the assets during the court proceedings.

Late Tuesday there was a spike in shares of AMC Networks (AMCX), on unconfirmed reports that the content production and distribution company was running a sale process, and that Amazon was actually kicking the tires on that company, not the similarly named theater chain. That rumor makes sense and it was actually nearly 2 years ago that I suggested the combination in an article for Seeking Alpha (Amazon.com Should Buy AMC Networks To Beef Up Content Business). Full Disclosure: I own shares of AMCX personally and for clients, and recently added to the position around $25 per share.

While publicly traded, AMC Networks is controlled by the Dolan family, who have shown a willingness to sell when it makes sense and the price is right. That latter point may be a tricky issue. AMCX brought in free cash flow of $6.60 per share in 2019 but the shares trade in the 20’s, which highlights the reason going private or selling the business makes sense.

As long as AMCX gets a lot of revenue from cable television advertising and distribution fees, Wall Street is likely to continue painting it with the “cord-cutting” brush and mark the stock at a discount to intrinsic value. That discount has only gotten deeper lately, but the Dolans are not dumb; the company bought back $86 million worth of stock during Q1 despite the pandemic and continued buying into April. There aren’t many companies executing buyback programs right now but AMCX’s financial condition is rock solid.

AMCX generates a ton of cash and despite lower ad revenue this year, projected on their Q1 call that free cash flow in 2020 is expected to be above 2019 levels of $377 million. Paused production is helping offset lost revenue and say what you will about the cable business, but per-subscriber fees keep rolling in.

Wall Street is also not paying attention to AMCX’s move into streaming, likely due to the fact that it is a drop in the bucket compared to Netflix or Disney+. Still, AMCX just pushed up the timetable for its goal of 3.5-4.0 million streaming subscribers (across multiple platforms: Acorn, Shudder, Sundance, UMC). Due mostly to the pandemic, the company expects to hit that level by year-end 2020, versus prior expectations of year-end 2022.

If we value those subs similarly to Netflix’s current valuation (AMCX will make a profit on them , whereas Netflix is still losing money), and adjust for the delta in monthly cost (AMCX’s plans run $5-$6 per month), AMCX’s streaming business alone would be worth $1.2-$2.0 billion by the end of the year. Not bad for a company with a current equity market value of $1.5 billion.

The Amazon rumor continues to make perfect strategic sense. They clearly want to beef up their Prime Video offering to compete with Netflix and Disney+ and adding shows like The Walking Dead and Better Call Saul would only help that. Toss in a few million streaming subs, whose plans are already sold on the Prime Video platform, and AMCX instantly bulks up Amazon’s content library and media executive team. Heck, having AMCX CEO Josh Sapan take over the entire Prime Video operation would be a wise move too.

All in all, I am glad there is some speculation that Amazon is kicking the tires on AMCX. I hope that it is not getting more press than it deserves simply because the AMC (no X) rumor didn’t make sense given their precarious balance sheet. If Amazon is willing to pay a fair price, I think the Dolans would sell. As a shareholder in AMCX, it is frustrating to see the public markets mark the stock at such a big discount to any reasonable estimate of intrinsic value.

So what is a reasonable price? It’s a great question, obviously. And a fascinating one given that Amazon likely doesn't want to pay a big premium, even if it is justified on paper. They played hardball negotiating with Whole Foods Market years ago.

This type of deal reminds me of Discovery’s purchase of Scripps a couple years back. Scripps was also heavy into cable, with its ownership of networks like HGTV and Food Network. Still, they were able to get their shareholders a big premium and a decent price of 12x free cash flow and 10x EV/EBITDA. Not sky high prices, but levels that shareholders could live with since the public market was not going to give it to them anymore.

I certainly think that AMCX is worth a similar price on paper, which would come out to at least $80 per share. They won’t get that. Cord cutting has gotten worse in the last 2 years, we have a pandemic right now, and digital video platforms are only getting more competitive. Still, if I were the Dolans I would probably not sell for less than 10x free cash flow or 7.5x EV/EBITDA; which equates to $60-$65 per share.

As you can see, the recent price in the 20’s is kind of silly, but investors are simply uninterested in owning this stock regardless of the profit the business churns out year after year and the streaming products they are building. Hopefully Mr. Bezos will take us out of our misery. If not, we will just wait for the cash flow to come through and fund stock buybacks at insanely cheap prices (having peaked at 74 million in 2014, the share count is now down to 54 million).

Virtual Annual Meetings and Premature Bankruptcies

A list containing the number of ways this recession is unique is quite long, which is making navigating these waters as an investor much more difficult. While unrelated, below is a brief mention of two that are on my mind.

1) Virtual annual meetings

With in-person annual shareholder meetings cancelled, every investor can now attend meetings online without booking a flight and a hotel. Not all meetings are created equal. Some have long Q&A sessions for shareholders and in-depth slide decks, while others stick to business and offer little in the way of helpful data points for investors. So while it may be a hit and miss activity, for those companies you follow closely and are contemplating adding or shedding shares, look to take advantage of virtual meetings this year.

2) Premature bankruptcies

Navigating the corporate bond and preferred stock markets these days is really tough, as liquidity and solvency are tougher to drill down. Making it even harder is the fact that many companies appear ready to file Chapter 11 before they need to. They probably figure that the pandemic offers a great excuse and management can keep their jobs after the businesses emerge. Why not take the opportunity to clean up the balance sheet and be stronger coming out of this?

Consider Diamond Offshore, an offshore oil driller than just filed. The company disclosed assets of $5.8 billion of assets, $2.6 billion of debt, and cash onhand of $435 million, according to Bloomberg. In addition, DO announced that they do not need any debtor in possession financing and will use existing cash to operate while proceeding through court. I cannot recall a time when a company has filed with so much cash onhand and didn’t need a loan to continue operating. And they are not alone, JC Penney is reported prepping for bankruptcy despite having $1 billion of existing liquidity.

These are truly unique times. Good luck out there everyone.

Full Disclosure: Long puts of DO and JCP at the time of writing, but positions may change at any time