Category: Security Analysis

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.

 

 

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.

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.

 

Hudson Q2’19 Recap: Earnings in-line with pre-release, negotiations with PNC continue. No change to thesis $HDSN

Hudson’s earnings were in-line with the pre-announcement. Unfortunately, there is no real update with the covenant relief. As stated in my last post, HDSN is in violation with its covenant with PNC. PNC can either bankrupt the company, likely taking a haircut on their debt or owning the re-org equity in a tiny company, or provide relief and continue to collect interest and possibly full payment. These discussion are ongoing, but I have a feeling PNC And the other lenders will choose option 2 over option 1.

As larger refrigerant manufacturer Chemours noted, refrigerant prices were impacted in Q2 by illegal imports into Europe. This pressured prices which eventually bled into US prices. As such, HDSN reported a 19% sales decline to to price, but a 12% increase in volumes. The volume growth is pretty good in the context of unseasonably cool Q2.

Moving to the forward look, the company noted this on its earnings call (my emphasis added):

As we move through the back half of 2019, we draw closer to the end of R-22 production. In June of this year, 3 largest allocation holders notified that customers that they have discontinued the sale of R-22. This information reinforces our belief that stockpiles are dwindling and that possibly, by the end of this cooling season, the industry may have worked through its stockpiles. Upon the elimination of R-22 to stockpiles, we expect that the R-22 market will operate within a traditional supply demand model and that the negative price influence we’ve seen during the past 2 seasons will be alleviated. It’s important to note that the pricing pressures of the last 2 seasons were created by the 3 largest allocation holders, which we believe related to market dynamics, that had nothing to do with R-22 demand in the U.S. rather we believe these pricing pressures were associated with shortfalls in other areas of our businesses.

Given the existing installed base of R-22 equipment and with the elimination of Persian production, we expect to see a shortfall in the supply of R-22, and we believe our ability to reclaim and resell R-22 creates a tremendous opportunity to position Hudson to address the anticipated supply shortage and become the leading producer of R-22. Currently, we’re seeing R-22 pricing of approximately $9 per pound, while this pricing dynamic has negatively impacted our 2019 selling season to date, we expect that the R-22 market will demonstrate more traditional supply-demand behavior once production has stopped, which will result in increased pricing for R-22.

In sum, management’s thesis is unchanged.

As for the debt, the company disclosed it will be getting a $9MM payment from Airgas for a working capital adjustment. That may seem small, but helps with some breathing room. PNC has been getting monthly details on HDSN’s performance so seems like it knew there would be a breach so hopefully conversations end soon.  Can’t help but like this statement:

We didn’t generate cash relative to our increased interest rates and debt services and so forth. So that really [indiscernible] get into what cash we generated, but the we had to have a little bit more borrowings during the period. We’re good at come out of that cycle though. We originally thought we would generate about $20 million of free cash flow. We’re not going to generate that level but certainly, with the cash award that we have with the Airgas, we’ll probably end up being in the mid-teens for the year. So you’ll start to see the dead coming down and the availability increase over the remainder of the year.

Mid-teens FCF on a $20MM market cap company… I’ll take it.

The company also mentioned its looking to tap new lenders in the 2H’19.

Certainly, we should and have publicly said that we will be looking to seek new lenders in this back half of ’19. That is our intention. But we also need to resolve the matter with the current lenders relative to a wavier and amendment to get that behind us

These likely will be more of the “special situation” type lenders, so may come at a price (and possibly new equity or some hybrid type of security that might include PIK interest to help cash flow, but I’m just hypothesizing here). This too is good news. No bankruptcy is good news.

Hudson Technologies delays 10-Q filing due to covenant negotiations. Disclosure seems positive, all things considered $HDSN

After close on Friday, Hudson filed a late filing notification with the following statement:

Hudson Technologies, Inc. (the “Company”) was not in compliance with (i) the total leverage ratio covenant, calculated as of June 30, 2019, set forth in its Term Loan Credit and Security Agreement, as amended, with U.S. Bank National Association, as agent, and the term loan lenders (the “Term Loan”) and (ii) the minimum liquidity covenant under the Term Loan at July 31, 2019. The Company was also not in compliance with the minimum EBITDA covenant for the four quarters ended June 30, 2019 set forth in its Amended and Restated Revolving Credit and Security Agreement, as amended (the “Revolving Facility”), with PNC Bank, National Association, as administrative agent, collateral agent and lender, PNC Capital Markets LLC as lead arranger and sole bookrunner, and such other lenders thereunder.

 

The Company is currently seeking a waiver and/or amendment from its lenders under both the Term Loan and the Revolving Facility, which the Company is working to complete on or before August 14, 2019. As a result of the impact of foregoing discussions, the Company is not in a position to file its Quarterly Report on Form 10-Q for the quarter ended June 30, 2019 (the “10-Q”) on a timely basis. The Company is working diligently to resolve these matters and management currently believes that the Company will be in a position to file the aforementioned 10-Q not later than August 14, 2019.

This should be relatively in line with market expectations, given Hudson is trading at ~$0.50 which implies the market is expecting bankruptcy.

Although Hudson will not comply with its covenants, I think it is relatively positive language that was posted. Clearly, PNC is negotiating with the company. This makes sense. Does PNC really want to take this tiny company to bankruptcy? If it did, it probably would only recover some of its par amount of debt and would own the re-org equity of the company, which would be highly illiquid. Alternatively, PNC can give some leeway, allow the company to continue operations, and hopefully realize a full recovery.

I take it as a positive that they’ll have an answer by Wednesday, August 14th. My base case is PNC will require some debt paydown or higher rate in exchange for relief, but we shall see. Net, net – I “PNC” the light…

Hudson also noted:

For the quarter ended June 30, 2019, the Company’s revenues were $56.0 million, a decrease of 3% compared to $57.8 million in the comparable 2018 period. The Company recorded lower of cost or net realizable value adjustments to its inventory of $9.2 million and $34.7 million during the second quarter of 2019 and 2018, respectively. Due in part to the impact of the inventory adjustments referenced above, the Company’s preliminary net loss for the second quarter of 2019 was $13.7 million, or ($0.32) per basic and diluted share, compared to a net loss of $30.6 million or ($0.72) per basic and diluted share in the second quarter of 2018.

The sales line is relatively in-line with my expectations. I was expecting ~flat sales, driven by 5% lower sales pricing, offset by higher volumes, but my guess is temperate weather reduced demand.

We know net loss is $13.7MM.  From this, we can bridge to what EBITDA likely was:

This seems less than ideal, but remember that PY was negative $2mm so all things considered, I guess we’ll call that improvement. It’s lower than my $5mm estimate, though. Hopefully the company drew down on inventory, which it still has $100mm in value of, to generate some cash and pay down debt. Recall the company repaid $30MM of debt in Q4 of last year, mainly driven by a release in W/C.

What will really matter is Q3 outlook. I presume pricing has not improved for refrigerants, but I also think Q2 was impacted negatively by weather (which was called out by Watsco and Lennox, among other building products names). If Hudson’s Q3 looks more favorable, perhaps PNC will be more lenient.