Category: Featured

In-depth analysis or commentary on companies, securities, or the economy

Will Coronavirus Kill the New Media Tech Giants? $FB $GOOG

We’re all locked inside. And that means we’re all watching Netflix, shopping Amazon, and perusing Facebook & Instagram and googling places we wish we could visit. That means all of these companies will benefit from the virus, right?  Facebook and Google must be killing it with advertising revenue.

Facebook just put out this somewhat misleading press release. In a gist, it says app usage is skyrocketing…


“Much of the increased traffic is happening on our messaging services, but we’ve also seen more people using our feed and stories products to get updates from their family and friends. At the same time, our business is being adversely affected like so many others around the world. We don’t monetize many of the services where we’re seeing increased engagement, and we’ve seen a weakening in our ads business in countries taking aggressive actions to reduce the spread of COVID-19.

Both Facebook and Google make money off of small-and-mid-sized businesses. While having a lot of users allowed them to begin charging businesses for ads, it doesn’t necessarily mean they are making money off all the users. More on that later.

The interesting thing about them is that they have been fast growing through the past ten years, but weren’t really around in the past. Therefore, the business model hasn’t really been tested through a real recession.

Advertising is cyclical. This makes some intuitive sense. When business is going well, you have extra funds left over that can be used for generating more sales. Or competition is higher because there is room for it and so you need to maintain market share. YOU may even be the new entrant trying to gain that share.

In a downturn, cuts have to be made. If I am a restaurant, I can’t really sacrifice much on food costs or labor or else my customers may have a bad experience.  If I also have a feeling that consumers don’t really want to spend money right now (e.g. unemployment is going up) then why not cut my advertising spend? It ripples through the chain.

As the saying goes, “Half the money I spend on advertising is wasted; the trouble is I don’t know which half.” This has historically resulted in cuts to spend since CEOs don’t feel like they are getting the bang for the buck.

Here is a snapshot of “old school” advertising companies’ peak-to-trough in the Great Financial Crisis (GFC).

Note, for the TV broadcasters I am using 2-yr average results given election years play a factor in results.

I also use gross profit given incremental margins matter so much in advertising. Quick Segway: If I have an existing network of 10 billboards in a town and 9 of them are on rent, you can see how getting that last billboard on rent would result in meaningful profit to the bottom line. My sales go up ~11%, but my costs barely go up. True in nearly all advertising and very true for Facebook and Google. Ok back to the main points.

What Can We Expect from the Tech Behemoths

I highly doubt many people are truly thinking about Facebook or Google’s earnings declining at all in 2020, but it’s something worth pondering.

Facebook on its Q4’19 earnings call stated there are now, “140 million small businesses that use our services to grow.” Google, in its filings, specifically discusses how its targeted ads let small businesses connect with customers.

If the virus ripples through our economy, taking down small restaurants and bars, local gyms, and people pull back on buying cars from their local auto dealer — that could clearly impact Facebook and Google’s results. With most restaurants closed right now, why would I advertise as much?

Unfortunately, it’s impossible to see where Facebook and Google make their money by segment. It’s much easier to know that Yelp generates most of its money from restaurants looking to promote themselves in a competitive field. Not true for the tech behemoths though.

We have some financial history with Google, given its IPO was in 2004. The problem is that it was secularly growing during the GFC. Google does $162BN of revenue today. It did $16.6BN in 2007 at the “market peak”. It kept growing through the GFC, though growth did slow to just 8.5% in 2009 over 2008.

Sell side estimates currently expect 16.7% growth in 2020 for Google… on much larger numbers. Facebook is expected to grow 20%. These may prove aggressive.

Impact from the Virus

I do not think it is out of the realm of possibility that we could see sales growth slow meaningfully for the tech giants. This will lead to a reset of expectations, though admittedly, the two ad tech giants trade for reasonable multiples (believe FB is 12x earnings ex-cash). My larger fear is the reset of investors’ view of the business as whole — they may no longer be bulletproof.

That said, if I am in charge of an ad budget, this may accelerate my shift away from traditional media and to Facebook and Google. People are at home, shopping online, then why not. Plus, its super-high ROI advertising spend. In other words, I don’t pay Google unless someone clicks on the ad, so I’m only paying if the ad works.

This dynamic may finally get rid of the adage I mentioned above – I now know if my ad is working. And because of this we could see more resiliency out of the new advertising names and it could be a bloodbath for traditional names. However, it still holds true that I’m not going to buy an ad, or at least as many, when I’m struggling to pay payroll or rent.

Separate Challenges for Google

Google has been expanding in the travel space, in fact encroaching on ground owned by Booking’s Kayak or Expedia. Booking said in its latest 10-K:

Some of our current and potential competitors, such as Google, Apple, Alibaba, Tencent, Amazon and Facebook, have significantly more customers or users, consumer data and financial and other resources than we do, and they may be able to leverage other aspects of their businesses (e.g., search or mobile device businesses) to enable them to compete more effectively with us. For example, Google has entered various aspects of the online travel market and has grown rapidly in this area, including by offering a flight meta-search product (“Google Flights”), a hotel meta-search product (“Google Hotel Ads”), a vacation rental meta-search product, its “Book on Google” reservation functionality, Google Travel, a planning tool that aggregates its flight, hotel and packages products in one website and by integrating its hotel meta-search product into its Google Maps app.

 This is a problem for Booking and Expedia because they use Google to generate leads for their own sites. While Google may eventually consume these businesses, they also represent non-trivial amounts of their revenue.

Booking stated,

 Our performance marketing expense is primarily related to the use of online search engines (primarily Google), meta-search and travel research services and affiliate marketing to generate traffic to our websites.

How much was “performance marketing” expense?  $4.4BN in 2019 for Booking and $3.5BN for Expedia.

I bring all of this up for a reason: While Google may eventually compete away these businesses, but today they matter. And those businesses are likely being crushed by the lack of travel demand right now, which will mean less spending with Google. These are just two companies, but ~5% of sales for Google. Now imagine every hotel chain, restaurant, airline and so on also pulling back… Now weave in the incremental margin we discussed earlier…

This virus is truly something we haven’t seen before. It permeates everything we touch. Long-term, I think Facebook and Google are amazing businesses to own, but don’t be surprised if 2020 is a hiccup and expectations are reset.

Scary headline for banks. Blackstone, others, tell portfolio companies to draw down their revolvers. $BX $KKR $BAC $WFC $JPM

Yesterday, not too long after Boeing announced it fully drew its revolver (see what that means here), we are now hearing that major private equity firms are telling their portfolio companies to fully draw down on their revolvers.

It isn’t just Blackstone, it also is Carlyle, KKR and HIG. Why is this a scary headline? These firms are huge and are likely invested in hundreds of companies each of varying size. While drawing on their revolver may provide liquidity for them, it makes banks put capital to work all at once… This is similar to a run on a bank, except in this case it isn’t deposits trying to exit, its borrowers calling their capital.

All that being said, banks are extremely well capitalized this go around vs. 2008. And they must undergo significant stress testing. I think banks will be OK through this, but it shows how a virus can spread into something even more viral and squeeze the financial system. You could also see the Fed and ECB backstop again.

Boeing draws down on its revolver – what does that mean? $BA

Boeing will fully draw its revolver to shore up liquidity. If you don’t know what that jargon means, a revolver is like a large credit card for a company to maintain liquidity, or spare cash on the side. Most of the time, investment grade companies like Boeing don’t draw on their revolver. They keep it as back up for their 2008 / financial crises scenario. On the other hand, some companies like distributors need to use this capacity to fund inventory and accounts receivable during the year.

So Boeing clearly has had issues this year. The 737 Max disaster has clearly increased company costs and cancellations are piling up. Sprinkle in the COVID-19 scenario, which will no doubt in my mind result in a decline in air traffic this year, and the value chain for Boeing starts to face a wrinkle.

Like I said, Boeing is an investment grade company, so lenders were very willing to give the company a $13.8BN revolver when things were going well. They probably thought it’d never get drawn and they’d collect a small fee. Well, Boeing drew $7.5BN on it last month and has now apparently maxed it out.

This is problematic and its no wonder why the stock fell 18% today.

Typically, companies fully draw on their revolvers right before they file for bankruptcy. Companies draw on the revolver because they are facing a liquidity crunch or they do this to to shore up cash before a bankruptcy filing (paves the way for better terms). Other than that, companies do this because they fear credit might be cut off from them soon, so they prep for the day today.

I think its probably this latter case. Boeing will face a crunch this year, but longer term the business hopefully will turn around. Its possible the government even steps in given Boeing is a national security interest. Time will tell.

March 12th Update: Several other companies have drawn down on their revolver. Wynn Resorts, Hilton Hotels.

I find it interesting because companies could be saying, “look, we have liquidity. We’ll make it through.” Instead, investors view it as a sign of real trouble. It reminds me of 2008 when banks refused a bailout because it would be a negative sign – so the fed made them all take them.

By the way, has all this happened before where it resulted in bankruptcy? Yes, literally all the time. Here are a few examples:

Is it time to buy cruise lines? Intrinsic value impact following short-term demand shocks $CCL $RCL $NCLH

People are saying that no one will ever take a cruise again. It’s over. Done. Pack those cruise ships up and send them home… But do people actually not remember the PR disaster Carnival dealt with in 2013? Here’s a great headline from that time:  “Stranded cruise ship on which ‘sewage ran down the walls’ and ‘savages’ fought over food finally docks amid jubilant scenes“. This came not too long after Costa Concordia wrecked and the Captain jumped ship (literally). 32 people died. I bet you can imagine what happened to Carnival’s sales in 2013 then?
Oh, that’s right – they were up. In 2014 they were up… they’ve basically been on an uninterrupted pace for a long time. In fact, many of these cruise lines have been public for so long that you can see how they performed after SARS, 9/11, 2008, Zika, Ebola – they pretty much kept on humming. Apparently nothing will stop college kids and boomers from taking a cruise.
I’m not saying you should buy them today, but they’ve historically traded at 10-13x EBITDA and are now trading at 5x. The market is currently pricing in death. I can confidently say that because they now are trading below the book value of cruise ships as well.
Now, cruise companies do have ship deliveries, which is something to monitor. This could crimp liquidity as they also take a demand hit in the next year.  But they also likely have tools to pushback on shipbuilders during times of stress. These are the shipbuilders main customers, so not like they want their customers to go into bankruptcy either.
However, some names like Roayl Carribean are investment grade and “December 31, 2019, we had liquidity of $1.5 billion, consisting of $243.7 million in cash and cash equivalents and $1.3 billion available under our unsecured credit facilities, net of our outstanding commercial paper notes”. Norwegian just announced at $675MM revolver with JPM priced at L+80bps.
I think the liquidity situation is fine to support a year of weakness, though admittedly, I’m not sure they could survive a whole year of lost revenue. Plus, the ships must be very expensive to dock and that is an ongoing fixed cost….
Lets just try to understand if this virus or 1 year impact should have that much of an impact on cruises (people will fight me on this, but I don’t think cruises are dead… people will still take cruises) but this is relevant for all businesses right now.
Here is a company that is expected to earn $10 in EPS in year 1 and grow ~2% a year. I discount these earnings, and the terminal value, back at 10% to arrive at ~$120 in value, which foots to a 12x P/E. P/E is just short hand for a DCF and that is what I am trying to show here so you can think about if a multiple compression actually makes sense.

*Note: terminal value is the value of a the future cash flows of a business beyond the forecast period, assuming a constant growth rate, in this case 2%.

Now lets say year 1 earnings are toast – they get cut in half. But year 2+ are the same because demand comes back. As you can see below, this had a ~4% impact on the intrinsic value of the business… not 50%! People may say, “well investors only look at earnings over the next year or two, so applying a 12x multiple to $5 in EPS is why the stock gets crushed.” Thanks – I realize that, but the math says that is wrong and an opportunity to make money.
Buying cruise lines is risky right now and up to you. Sorry for the headline, but hopefully you use this as a tool to find other companies who have not had their intrinsic value meaningfully impacted.

The Case for Credit Acceptance $CACC

I think despite Credit Acceptance Corp’s incredible stock performance, it still looks interesting.

Credit Acceptance Corp (“CACC”) is “non-bank lender”, essentially meaning they make loans to borrowers who are deemed to be low credit quality. How low? As of the end of 2018, 96% of borrowers had FICO’s below 650.

The majority of CACC’s loans go to purchase automobiles. Without credit, these customers would not be able to buy a vehicle. Their incomes are typically strained and most likely they have damaged credit. Vehicles are necessary in most parts of the US to get to your job so there is a reason why there needs to be some sort of credit provider for these borrowers. In exchange, CACC charges high rates of interest (more on this later).

I think CACC will continue to compound earnings at a high rate – perhaps even better than recent history. Trading at 12.5x 2020 EPS and 2.6x book value is way too low. My thesis is not predicated on any catalyst, but more so on long-term capital appreciation.

  • CACC has averaged ~35% ROE over the past 10 years. In 2008 & 2009, it earned 22% and 35% respectively.
  • Median and average ROE since 2000 is 26% and 30% respectively
  • Credit performance has been stronger than you think = buying a strong management team
  • Performance has been hindered by strong credit and competition, but this is typical of a cycle. Credit is overextended and then pulls back – historically an opportunity for CACC

But you may be asking yourself, “Hey – doesn’t that mean CACC is making extremely risky loans?”

Not quite. As stated in this article from the FT,

“When economists created models of consumer behaviour late in the 20th century, they tended to assume that if a household was going to default on its debt, it would do so in a particular order: first credit cards, then car loans and, last, mortgages. That was the historical pattern, and it seemed to make sense given the cultural importance of housing. In the early years of the noughties, though, it seems that this sequence began to change. Consumers started to default on mortgages before auto loans and credit cards (seemingly because it became more acceptable to walk away from a house, but Americans still needed credit cards to live).”

So first and foremost, American’s have shown they are more likely to walk away from their home than they are to walk away from their car. It makes some sense if your car is the only way to work. If you don’t go to work, you don’t have any realy income.

Second, unlike unsecured consumer credit loans, CACC’s loans are actually backed by the automobile. This means if a borrower defaults, the car’s value helps the recovery value of the loan. CACC is listed as the lien holder on the vehicle’s title in ~70% of the loans outstanding.

Typically the way it works is that a dealer will receive a down payment on the car as well as a cash advance from CACC to finance the purchase. In exchange, CACC receives the right to service the loan. Servicing the loan means that CACC will be responsible for collections and the collections coming in will first go to pay down collection costs, pay servicing fee (~20% of collections), reduce the balance advanced, and lastly pay back the dealer once the advance has been recovered (which they call the Dealer Holdback). The “waterfall” of this is shown below:

This puts CACC near the top of the stack. After underwriting each loan, the company forecasts what its collection will be. Roughly 22% of the recovery comes from the spread (interest) and balance comes from paying down the advance. There will be defaults, but what this table essentially shows you is that (i) the company bakes in significant defaults and (ii) they’ve typically been right on target.

What is notable about this table is that the spread was at the high end of the rand in 2009 and 2010 when competition was unusually favorable to CACC (when the tide goes out, you can see who has been swimming naked).

Somewhat counter-intuitively, some of the best years CACC has are when the credit markets were very tight. Since credit has been loose, more entrants have emerged and made the field more competitive. Like I said above though, quoting Warren Buffet, the way new entrant lenders typically gain share is by offering credit at more aggressive terms than its peers. CACC has been operating since the 1980s, so I trust their track record and management team.

In my view, I think CACC’s earnings then are actually being depressed by competition and the company will be somewhat countercyclical – they should outperform in a recession. This also makes some sense given the labor market is extremely tight and we’ve started to see some wage growth and overall credit quality of borrowers has improved dramatically. These are all headwinds to CACC’s available pool of customers.

How have CACC’s returns been?

As shown, the company generates really solid returns on equity.

Let’s take a look at growth in book value assuming the average ROE since 2005 or the median ROE for the past 20 years (30%). Compounding is a beautiful thing.

However, this is a bit too simple to analyze the stock given the company trades for 3.4x the latest book value and 2.6x FY+1 book value.

Let’s say the company trades for 10x earnings by year 10. That foots to a $4,000 stock price or a 25% IRR for investors. Does 10x earnings makes sense? That foots to a 10% discount rate and assumes no growth in net income after year 10, which seems conservative. Another way to think about it is if the company decided to distribute 100% of net income to shareholders and stop growing. $400 a year foots to a 10% yield on a $4,000 stock price.

As shown above, ROEs for the company could compress by ~10 percentage points (20%) and the multiple could compress to 10x and we’d still have a pretty good return. At this point in the cycle, there is no question that competition has increased. CACC historically hasn’t always been the cheapest option, but it’ll be there through the cycle – something its competitors can’t say.

New Accounting Standards May Create Opportunity

Under a new impairment model called CECL (current expected credit loss), new standards will now require CACC to change its accounting. Essentially, it is based on expected losses, rather than incurred losses.Since CACC effectively takes the loan over from the dealer, an allowance must be recorded for the difference between the initial balance and the NPV of the future cash flows.

When CACC underwrites new loans in 2020, the timing that it recognizes income will change significantly – essentially recording provision for a loan loss up front at around 12-15% of the loan amount. So that will be a large, upfront expense that usually did not occur. The amount of loan income over the life of the loan and the actual economic value of the loans will not change, but 2020 may create confusion for investors and may cause CACC’s results to look worse than they have been in the past.

I would view this as an opportunity.