Category: Columns

When buybacks fail… a quick look at IBM’s performance $IBM

I typically look for underappreciated, high FCF businesses that are shareholder friendly. As I was screening for new ideas, an old giant popped up – IBM. This is a personal opinion, but with so much focus on Google, Facebook, Amazon, Microsoft and Apple it seems as though no one even discusses IBM anymore. Could this be a Microsoft-in-2011 moment? At that time, MSFT was trading at a P/E of 9-10x and was viewed as a slow, lagging behemoth, and certainly not exciting anymore… just a dividend paying stock. They got a new CEO after many years of Balmer and reignited excitement and ingenuity at the company. The rest is history.

IBM currently trades with a 4.8% dividend yield, 9.5x 2020e EBITDA and 10.1x 2020e EPS. The business looks like it hasn’t grown much at all in the past, but does have some exciting segments like Watson (“Cognitive Solutions”) which is wildly profitable – in 2018, Cognitive Solutions had nearly 68% gross profit margins and 38% EBITDA margins…

Should we compare Microsoft then to IBM? Clearly over the same time frame as Microsoft, IBM has been floundering.

Cognitive Solutions is clearly an exciting segment, but at the end of 2014 the company did $93BN in revenue and $24.6BN in EBITDA. In the past 12 month, the company did $77BN in revenue and $16.6BN in EBITDA. Moreover, if we go back to the end of 2003, the company’s market cap was $161BN. When they reported Q3’19 results, IBM’s market cap was $120BN. Meaning after nearly 16 years, no real value had been created.

So what happened? What were the drivers of these abysmal returns?

Clearly, a significant driver is the changing technology landscape. Over this time period, IBMs standing as a leader in tech has been eroded by competition. Over this time period, net income is up only $1.2BN, from $6.5BN to $7.7BN, which is a 1% CAGR.

With its changing position, investors no longer valued the company as an exciting leader. At the end of 2003, IBM was trading at 24.5x LTM earnings. By the end of Q3’19, it is trading at 15.5x LTM earnings. That de-rating of 10x had a significant impact on its stock performance.

Secondly, I think the company made some really poor investments. What investments you ask? Buying its own stock in large amounts. Admittedly without these buybacks, the price performance of IBM would have been abysmal.

I pulled the company’s cash flow statement over these ~16 years and analyzed what it did with cash. While we have hindsight bias, the company deployed too much into its own stock instead of trying to strengthen its position in a changing climate. You could even argue that they should have done more acquisitions. Excluding the recent RedHat acquisition, which was $33BN, the company did not actually spend that much on acquisitions over this time frame.

Outside of acquisitions, you could even argue that they should have just distributed cash to shareholders with special dividends. Again in hindsight, that would have allowed investors to purchase other businesses that are allocating capital for growth.

Let me be clear, I am a huge fan of buybacks and not trying to beat the drum that politicians like to use (buybacks aren’t an efficient use of resources and stifle growth etc.). One of my favorite companies is LyondellBasel (ticker LYB). While it is a cyclical, commodity chemical company operating near peak, they’re capital allocation decisions make sense. First, invest in their equipment for safety. Second, ensure that they are well prepared in an evolving landscape. Third, return cash to shareholders while managing a prudent balance sheet. They have bought back 10% of their outstanding shares each year for the past few years.

In this case, it seems like IBM bought back shares just to buyback shares. I wouldn’t be surprised if we see an activist approach IBM. Following Elliot’s success with AT&T, it seems like an activist could approach IBM regarding a spin-off or sale of its Cognitive Solutions business. I think a split of “old business” and “new business” similar to what happened at HP could be very interesting.

 

 

CorePoint Q3’19 results weak, as expected, but once again asset sales are the real story $CPLG

CorePoint reported weak Q3’19 results, but as I said in my last post where I decided to exit my long call on the stock, this was expected.  In positive news, the company came to an agreement with Wyndham on its booking issue and will receive $17MM from them to settle their tax agreement. In total, the company will get about $37MM in awards from Wyndham and Wyndham will have to create a new system for them.

Now for some bad news. Results continued to be very weak on the portfolio. Comparable RevPAR was down 6.3% with nearly 550bps of market share loss. Occupancy was down 250bps Y?Y and hotel EBITDA margins were down 520bps, from 26.3% of sales to 21.1%. This was a bad print by any measure.

The company also reduced its outlook for the rest of 2019, calling for RevPar to be down ~4.5% for the year vs. their August expectation of -3.5%. EBITDA was also lowered from $155MM to $147MM, though $2MM was from asset sales and the rest was from Hurricane Dorian (which I noted in my last post) and its outlook revision reflecting weaker macro trends. Unfortunately, on the call the company said,

“Although we’re not providing guidance for 2020 at this time, we are expecting to face several headwinds in the business next year. In addition to slowed industry expectations, we will be impacted by everything we just discussed with respect to the performance of our portfolio, the timing of the full functionality of the new tools as well as limited visibility at present into any near-term potential lift from being part of the Wyndham distribution network.”

So not overly confident in the 2020 outlook.

But here is the interesting thing: There is still a strong dichotomy between what the private and public markets are willing to pay for these assets. CPLG is literally selling its worst assets for well above where they trade in the public market. The public market also seems to completely ignore this phenomenon. The company announced with this release that they sold 7 hotels that they previously noted in Q3, but also 18 others in 12 different markets for $70MM. The multiple was 38x EBITDA of 2.4x sales… They also sold 12 hotels for $42MM so far in Q4 for 2.4x sales and 29x EBITDA… They also have 25 more hotels for sale for $115MM, though unclear what the multiples are.

Recall, these assets are operating well under the threshold for what the company considers its “core portfolio.” I continue to believe they should continue to sell the company off piece-by-piece AND including the core portfolio assets. When you are trading for ~0.5x book value and 8-10x EBITDA, there is no better way to create shareholder value than to sell assets for higher than where you trade and either buyback stock or pay dividends.

Stepping to the Sidelines on CorePoint ahead of Earnings $CPLG

While I typically view myself as a long-term investor, I also try to read the tea leaves and understand how a company’s fundamentals are shaping up. That way, I won’t be totally surprised when the company reports earnings. Sometimes, it makes sense to take signals appropriately and reduce a position you think is shaping up for failure.

This is a tough decision to make, but I think it makes sense to reduce CorePoint ahead of earnings. I say that based on the following:

  • Booking Issue Lingered: We know the booking “disruption” from Q2 has lingered in Q3. This literally means they are losing customers because they can’t book on the site. They said it on the call.
    • On July 30, 2019, we gave notice to LQ Management that we believe there are several events of default under the management agreements relating to all of our wholly owned properties” – so they waited until one month into the quarter to serve a default notice…
    • “On our first quarter call, we noted we were seeing early indications of disruption, in particular, a decline in ADR from the transition and integration of our hotels to the Wyndham platform in April. Unfortunately, that has not yet abated, and July’s RevPAR on a comparable basis was down 5.2% with continued market share loss.” – so we know in July RevPar was down ~5% compared to -6% for Q2.
    • While this should be temporary, I think they clearly tried to signal that the impacts would linger.
  • Oil price and rig count is down: We know that CPLG has heavy exposure to Texas and the oil producing regions, which is why some look at oil as a proxy. As shown below, this does not bode well for improving results or an increase in guidance compared to Q2’19.
  • Hurricane Imelda: There is a chance that Hurricane Imelda had a significant impact on results. While not discussed as much as Hurricane Florence and Irene, Imelda caused significant flooding in Texas. We already saw what Hurricane damage did to CPLG before, so I am thinking it likely pressured results in some way (e.g. took some rooms of the table).
  • CPLG’s price has recovered: CPLG’s stock was at $10.9 before it reported its last atrocious quarter and now is at $9.7. While I think it is technically cheap, I also think the stock price will follow fundamentals. I think the chances are higher that I’ll be able to nab at a better price post-quarter.

How could I be wrong? Well, I am essentially trying to trade CPLG around earnings, which is usually a losers game. The company also could have resolved the booking issue much faster and that will improve their outlook. Lastly and more importantly, I think the story continues to be around the asset sales. With the stock at such a low p/BV, selling assets above book is very accretive. This is where I am the most concerned on reducing.

Unfortunately, I think this means guidance will have to be reduced from $155MM at mid-point. The company previously guided RevPar to be flat to up 2%, then revised it to down between 2.5% and 4.5%. That new guidance, while abysmal, banks on a recovery in the 2H that I just do not see happening.

Is management stepping in to buy stock? This could be a good signal of how the quarter was shaping up, how they view the prospects of the company, how fundamentals are moving etc.

Sadly, no. Only a director bought right after Q2 ($4,400 ain’t much) and I don’t see any other members of management stepping up.

Eurozone Equities are NOT that Cheap $VGK $EZU $IEUR $IEV

Are European equities cheap? I keep hearing that European that they are cheap relative to the US at least. It follows then that because the US has outperformed so much over the past 10 years, there is bound to be a reversion to the mean. This chart is often thrown around with no real context other than lower P/E means great buy:

I wanted to break that down and test the hypothesis. I downloaded the holdings for the S&P500 (from iShares IVV) and the Eurozone equities fund (EZU). But before we go through that, check out the relative performance.

Bottom line: Europe has gotten its A$$ kicked.

But wait – this isn’t totally true. We can’t forget currency’s impact on performance. The dollar has strengthened massively (since the US is the best house in a bad neighborhood). Here is the hedged Euro performance. Not nearly as bad as some pundits might have you believe over the past few years…

So how do the companies that make up the index compare? Here is my simple pivot tables using the weighted avg to assess the relative forward P/E multiples.

Note: the amounts don’t add to 100% due to rounding plus a small amount of cash held in the ETFs.

As we can see, looking 2 years out the S&P trades at 20.8x earnings compared to 16.0x for Eurozone. That does indeed seem steep. What is driving it?

Several sectors stick out: Consumer Discretionary, Tech, Real Estate and Financials.

Why does Consumer Discretionary trade so much higher in the US?

One word: Amazon. The company is labeled as consumer discretionary vs. Tech. Watch what happens when I relabel Amazon as a tech company.

It drops precipitously! Given Amazon is such a big weight in the index, it has a dramatic impact on the sector. It is still high relative to Eurozone, but not crazy.

Technology:

I personally thought that the US would rank higher in P/E solely because of Tech. And that does seem to be a big driver. Including Amazon, Tech weighs in at almost a quarter of the S&P500. If I include Facebook and Google (currently in the communication sector) it would be close to 30%!  

 

While remnants of the tech bubble make this a concern, I would rather have these businesses than not and think they actually trade at reasonable valuations. They grow 20% a year and are secular growth stories while also requiring little capital to grow.

So another adjustment here, but we’re starting to parse out the large drivers here.

Real Estate:

One reason for the high multiples in the US is REITs. These entities pay no income taxes and should therefore trade for higher multiples. However, that’s not the whole story. Think about the best businesses in the REIT space: oligopolies, contractual rent escalators, increasing demand each year… Yes the tower REITs.

American Tower, Crown Castle and SBA Communications dominate the real estate sector. Arguably tech exposed as well, this is the big driver. In addition, they are investing heavily for growth and REITs tend to carry higher leverage. This means increased EBITDA but EPS can be pinched by interest in the short-term.

Financials:

Last but not least… Financials. Look at where they trade in the US vs. Europe. More importantly, look at their relative weights. We all know the struggles of European banks due to (i) negative interest rates and (ii) weaker economies. Do I want to own those banks? Perhaps because some day their troubles will reverse… but for now, I’ll pass.

Bottom line: I don’t think Eurozone equities are THAT cheap. The further and further you peel back the onion, the more I want to buy the US vs. Europe. Is the multiple higher than Europe? Yes. Is it a concern how big tech has become in the US indices? Yes, but I also want to own those companies. As they continue to disrupt and change the way we do things, Europe’s older economy may be left holding the bag.

As one final comparison, here is what you are buying. In my view, missing secular growth and asset light businesses in exchange for “cheap” cyclical names (banks, Oil and  Gas, Autos, Chems). I think the US will compound at a much higher rate going forward as well and should perform much better in a recession. If you think the US$ will depreciate or that we are headed for a tech crash, then sure, go with europe.

Why I Think Okta Stock is Overvalued $OKTA

My firm recently began using Okta for security log-in purposes. In line with what Peter Lynch would recommend, when you hear about adoption of a product, go and check out their stock. Often times, Lynch would hear his children talking about a new toy, he’d buy the stock and profit as the rest of Wall Street caught up to the story.

While Okta is not a toy company, it is a hot topic for today’s investors. In my experience, I’ve seen Okta used as a security portal for employees in order to access the cloud where important files or information may be held. A benefit is that its simple to use and its multi-factor login creates a secure authentication process without multiple log-ins.  For its customer platform, you and I may be logging in to JetBlue’s website and everything looks right, but behind the scenes Okta is powering the customer experience and making it secure.

The bull case for Okta is that as Cloud adoption grows, so will security needs. We’ve all seen and heard about data breaches in the past, so it will clearly be a big focus in the future.

Peruse any one of Okta’s filings and it is clear they are bullish on the cloud and what it means for them. In fact, Cloud is mentioned 285 times in their S-1 and they note, “According to International Data Corporation, or IDC, in 2016, the Cloud Software market is expected to be $78.4 billion and the Custom Application Development market is expected to be $41.2 billion. We believe that our platform is well positioned to address a meaningful portion of these markets.”

Notice they don’t say that is their addressable market. The fact is, it is likely a fraction of that, but undoubtedly it will be big. This growth has started to show in Okta’s numbers. In the FY ended Jan-2016, Okta did just $86MM in sales and in the LTM period Jul-19, they did $487MM. That is a 64% CAGR!

As expected, Okta’s growth has started to slow. It is simply impossible to sustain that rate forever. Analysts expect however that it will grow top line ~30% through 2021.

Getting to the valuation:

Let’s just say we think Okta can grow at a 30% CAGR for the next 7 years. Their GP margins, given it is a subscription model mostly, grow at high incremental rates. I will assume 88%. Given security is a constantly evolving business, I will assume that R&D is fixed as a % of sales, but roughly half of sales and marketing is fixed vs. variable (and grow at inflation) and G&A and back office are 75% fixed (likely an assumption, honestly).

What we see above is that if everything goes right and they grow at a massive rate, the company is still trading at 20x EBITDA 7 years from now…. I don’t see why I would buy this when Facebook is growing 20% a year and trades at just 10.5x 2020.

So what do you need to believe? I would have to say investors are banking on AT LEAST 40% top line CAGR with massive EBITDA growth (negative to $1.4BN) and that still only gets you to 10.7x EBITDA…. looking 7 years out. To me, this is crazy.

While Okta has some benefits of being “entrenched” in its customer base, I don’t think switching costs are that high. My firm used something before we moved to Okta… we could move again if we deem we are more protected or offered more for the same price. This is a constant occurrence in Tech and especially in cyber security… constant cannibalization and forming something new and better… often at the expense of incumbents.