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Hotel stocks – buying opp or stay away? $MAR $HLT $PK $AIRB
Reading Time: 9 minutes

I have the opportunity to again share the work from a friend & prior guest poster – the same author who imparted his views on cruise stocks in a prior post. This time, he’s back with some thought-provoking views on the hotel industry and the hotel stocks. Enjoy.

In #Is It time to Buy Cruise Stocks? Pt 2, we went into the heart of the Covid storm, and found that there may be solid upside if the risk sits well with you. For this article we’ll move to some of the “lighter” outer bands, as at least some portion of revenue stream continues for hotels, whereas cruise departures have been completely halted. Let’s start with some high-level thoughts on the industry, and then dig into some of the players.

Macro thoughts

If we break down hotel stays between business and pleasure, it seems reasonable to say that ~40% of booked hotel stays are business related. For the time being that implies a complete halt on 40% of hotels’ revenue. Assuming the other 60% of revenue is vacation related, it may be reasonable to assume ~50% of the vacation bucket is attributable to Loyalty Program members (see snipit from 2019 10-K below).

Digesting the above, it seems like (i) 40% of hotel revenues are completely compromised, and (ii) possibly another 30% is disrupted, as Loyalty Program members develop a lot of their status from business travel.

Enter Airbnb. Its presence represents an approximately decade long build of disruption to the hotel industry. In terms of annual revenue, it looks like Airbnb falls somewhere above HLT but less than MAR – it had approx. $1bn of revenue in Q4 19 (assume $4bn annually at this rate) – we can potentially get more details this year if they move ahead with IPO. Note that when considering HLT and MAR revenue, I’m excluding “Cost reimbursement revenue”, as there’s corresponding expense with this item (e.g. franchisor pays some expenses, and franchisee reimburses). Airbnb is a sizable force in the markets, but I’d also assume it does not have and cannot really get a share of business travel yet (easier from liability perspective to encourage employees to stay at big name hotels, rather than with miscellaneous landlords). What does this mean in Covid?

  • I’d guess Airbnb is benefiting from the suffering of hotels. Would you rather stay in an isolated mountain/lake house, or in a hotel resort teeming with tourists? Assuming you’re not a Covid denier, then probably the former.
  • While business travel should in theory return to the big-name hotels, this may not come for a longer time – why would a business risk Covid outbreaks for the sake of business travel? Seems unlikely unless business travel is essential to the functionality of the business. Further, a blow to business travel inevitably means some level of reduction to vacation stay for hotels.
  • Similar to analysis in Covid so far, showing e-commerce adoption has accelerated, it could be the same that Airbnb share has also accelerated (hence why they may be pushing for an IPO despite a terrible operating year…)

While hospitality may not be an awesome industry to be in at the moment, can we still find businesses that will persevere, and potentially emerge well once the dust settles? In exploring MAR and HLT below, we’ll discover that a sizable portion of their businesses come from franchisor/franchisee relationships. This leads to another question – is it better to be the franchisor or the franchisee? We can explore Park Hotels and Resorts Inc (PK) to get a flavor for the differences. Unlike the Cruise Pt 2 analysis, less of the below focuses on whether these companies have the liquidity to survive Covid – cash is still coming in the door, even if the demand recovery may not be as a resilient. It instead explores more of the pre-Covid operations for MAR and HLT, and thoughts on what that means going forward.

MAR and HLT

Historical revenue demonstrates a push to franchisor/manager business, rather than own and operate. Note that HLT spun off PK and Hilton Grand Vacations Inc (HGV) (owned hotel and timeshare businesses) at the very beginning of 2017, hence why you’ll see the change in revenue presentation and overall split.

My quick takeaways are:

  • Revenue per Available Room (“RevPar”), hotel room revenue divided by room nights available over the applicable period, has had immaterial changes for each company over the last six years, but MAR converts more $ per room then HLT.
  • MAR derives larger portions of its revenue from franchise/management fees than HLT. Given HLT’s spin offs of PK and HGV, it is clear the biggest players see more value in reducing the tangible assets on their books.

I’m not seeing crazy differences in the debt profile of the two. But compared to cruise lines, MAR and HLT are noticeably better capitalized and have generated sizable free cash flows compared to the debt on their books (15-20% each year). But MAR and HLT are noticeably more expensive – EV/EBITDA at 20x+, while cruises were closer to half that.

How well do MAR and HLT translate revenue into cash? #What Drives Stock Returns Over the Long Term? pointed out that growth in free cash flow per share often drives long term value. In looking over a 6 year horizon, the below free cash flow illustrations seem to speak to this point, with better overall performance from MAR.

In the above, I removed timing differences between reimbursement revenue and expenses; these items are supposed to offset one another over time, so it seems more appropriate to exclude noise from these pieces.

So, what does this mean going forward? MAR and HLT’s stock prices are down ~32% and ~18% since beginning of 2020. As you’d expect these entities faced losses, largely driven in Q2. However, there are still positive free cash flows, expectedly coming from changes in working capital accounts.

Looking at 2019 10-ks, debt maturities don’t become significant for HLT until 2024 (i.e. less than 40m), while MAR’s are more significant at ~1bn+ each year 2020-2022 (bigger red flag). The cash situation for these two feels better than what we saw in cruise stocks, but I think a significant con is that business travel may not come back for some time (i.e. until a vaccine is found)- I’d be more inclined to bet on cruise demand coming back faster than business need for travel lodging.

The Q2 MAR earnings call transcript may be worth a read. In that, they discuss cash burn with in a scenario where demand doesn’t pick up meaningfully from here. Running a quick liquidity analysis on MAR below, survival horizon for MAR seems around 3+ years.

If you’re quietly optimistic that Covid will be meaningfully resolved next year, then there may be potential upside in these stocks, but if you consider FCF yield then you’re probably disappointed at current stock prices. The 2019 FCF per share were $5.57 and $4.76 for MAR and HLT; if we want a 10% FCF yield that implies stock prices slightly above and below $50, but meanwhile the stock prices are around $100 and $90. Additionally, it’s probably going to take some time for FCF per share to come close to the 2019 levels. Not attractive points from a cashflow perspective.

Let’s explore a player on the ownership side of the house to see if that noticeably changes what we’re seeing.

PK

As noted above, PK was spun off of HLT back at very beginning of 2017. As expected in looking at end of 2019 vs Q2 2020, there’s more debt on books to generate cash on hand, and unlike the above franchisors, the costs associated with maintenance and operations of the hotel real estate is entirely reflected on PK’s income statement. The stock price has declined ~62% since beginning of year (significantly more than MAR and HLT), with its discontinuation of dividend payments back in May further crushing investor sentiment. See below for some quick snipits comparing PK’s 2020 financials to 2019.

Reductions in PP&E, wipe out of goodwill, increase in cash with corresponding increase in debt – all things I’d expect to see in this Covid environment.

The income statement data isn’t any better.

Free cash flows are also already negative – noticeably worse cash situation than MAR and HLT, as those companies have still been able to stay free cash flow positive in 2020 thus far.

PK is a Real Estate Investment Trust (“REIT”) for US tax purposes, meaning there are requirements from the IRS that need to be met for the entity to preserve flow through status (i.e. no entity level income tax for federal tax purposes). These requirements include and are not limited to distributing the majority of taxable income to shareholders (REITs often distribute all of taxable income anyway), holding a certain % of assets in real estate, and ensuring the majority of income is derived from passive real estate sources (see Section 856 of the US tax code for additional details). Hotel REITs include additional complexity, as most hotel REIT structures involve (1) creation of a Taxable REIT Subsidiary (“TRS”) where hotel operations occur, and (2) a lease agreement between TRS and REIT whereby REIT owns the assets and TRS makes payments to REIT for use. The nature of this arrangement is intended to mirror a typical real estate arrangement. Hotel REIT players try to maximize REIT income by ensuring the lease agreement strips most of the kosher earnings out of TRS.

My concern here is more a generally pessimistic view of the recoverability of REITs post recession. Distribution requirements make it hard for a REIT to hold on to cash; there is a concept known as “consent dividends”, whereby REIT shareholders may agree to recognize a deemed dividend in their income without cash actually moving outside the REIT, with this fulfilling the REIT’s distribution requirement. But this obviously does not apply in a public REIT context.

Furthermore, REIT investors are mostly concerned with annual yields generated by investment, making cash collection more impractical. While REITs are able to generate net operating losses (“NOLs”) to the extent that they have taxable losses, NOL usage is done on a “post-dividend basis”, making it tough to monetize them since REITs typically distribute out most of their taxable income.

While I think the above points make it hard for REITs to come back after a downturn, I can see a potential opportunity for prospective Buyers (e.g. Blackstone, Brookfield, etc) with cash on hand to buy real estate at a heavy discount (see WSJ article Public Real-Estate Companies Are the New Way to Buy Distress for example). In looking at PK, I tried to compare the net asset value to market capitalization to assess how discounted PK is currently trading. Below I’m assuming that the FMV of land and buildings/improvements is equal to original cost (likely conservative since most of the real estate was acquired back in late 2007).

I’m estimating market cap at ~2bn and net asset value at ~4.7bn; these quick estimates at least directionally tell me that prospective buyers could likely get a pretty sweet discount if they tried to buy the assets.

That said, I think that you can probably find this trend and opportunity across non-hotel REITs as well, and therefore would be more inclined to pass on buying PK.

Thank you again for this great guest post. My main takeaways from this are:

  1. Cruise lines over hotel operators might be better risk/reward, as at least with cruise lines there are signs that demand is still strong once ships can take-off (so becomes just a liquidity consideration in the near term, which you can bracket)
  2. Not getting paid much for the franchisors. The franchisors, MAR and HLT, are historically good businesses. Asset light and generating strong FCF, but at the end of the day, revenues / performance are going to be tied to how the hotels are doing. Its going to be hard for them to just sit and generate FCF when their franchisee base is struggling. With the stocks currently trading at ~20x peak FCF (2019 levels), it doesn’t feel like you are getting paid for any downside risk (e.g. do the franchisees want forgivable loans or some re-cut of the franchisee agreements to survive)
  3. Airbnb wildcard. Airbnb has been a concern to the industry for years, but frankly the impact hasn’t been too noticeable yet (e.g. hotel revenues continued to march up despite Airbnb’s new presence). However, that may change in the future….
Columns, Security Analysis

Why Hasn’t Autozone Stock Re-rated with Other Pandemic Winners? $AZO #COVID19
Reading Time: 3 minutes

I just did a post where I evaluated my holdings of Apple following its recent surge, which looks to be a quite big move for the US’s largest public company. One thing I didn’t really discuss in that post was that Apple may have re-rated recently due to perception of it being a pandemic winner. If your sales have held in well this year, or even increased, you are viewed as either defensive or on a continued growth trek. In turn, your stock has rocketed up.

Here’s a list of stocks that I would say fall into that category. I can’t include them all, but you get the point:

FB Chart

FB data by YCharts

The S&P total return is ~5.5% at this point in the year.  Home Depot is doing well because housing is holding in well, and the pandemic is causing people to reinvest in their homes. Same store sales were up ~24%+! No wonder Home Depot has surged.

The same is true for other retailers, such as Target or Wal-mart, which despite possibly missing the back-to-school shopping season (which is big bucks) they are reporting some of the best comps in years.

So let me take off some of the true high fliers and compare Autozone stock and other auto part retailers to these names.
FB Chart

FB data by YCharts

If you’re having trouble finding the auto retailers on this busy chart – they’re all at the bottom!

This is odd to me. O’Reilly reported +16% SSS comps for Q2 and a 57% increase in net income. Advance Autoparts has a different fiscal period, but they reported 58% increase in EPS on a 7.5% SSS comp.

Why is that? There are several reasons.

  1. In recessions, people keep their car longer and do more work themselves. See my post on AutoZone for some discussion on their comps after the 2008 financial crisis.
  2. After reaching about 7 years in age, cars tend to need more work. The average age of a car in the car parc today is around 12 years
  3. Retailers focused on cleaning products and other pandemic needs consumers would need and auto parts took the back seat. It’s likely that the pure-plays auto stores picked up share

So I fully expect Autozone’s sales to benefit when they report at the end of September. And if this current crisis persists, then their increased comps will likely persist as well.

I’ve been watching street estimates for Autozone. They still sit around pre-pandemic levels. My guess is AZO handily beats these estimates, though admittedly there are some tough comps (believe there were additional selling days in the prior year).

Look, I’m a long term holder at the end of the day and I wouldn’t recommend trading around a  quarter. All I’m saying is you have (i) a high ROIC business that (ii) historically has returned every dollar of FCF to shareholders that (iii) is probably benefiting in COVID where (iv) estimates might be too low. I like the set up.

Columns, Security Analysis

Should you hold Apple stock here? $AAPL
Reading Time: 6 minutes

I’m an Apple shareholder and the meteoric rise in Apple stock has me questioning whether I should hold on or move on.

One problem with this, and why I don’t think Buffett will sell, is opportunity cost. Selling Apple stock to hold cash isn’t really a great option right now. Yes, yes, cash has option value in itself, but the only reason why I’d be selling is my scant perception is that Apple stock has gone up really quickly and so maybe it is “fully valued” at this point.

Personally, whenever I sell a really high quality company due to valuation – that ends up being a bad decision.

Think about what this would mean right now if you count yourself as someone who is a “traditional” value investor (i.e. someone who looks for low P/E stocks) – this means selling a really high quality company to probably go invest in a lower quality company trading at a low multiple. Not a particularly great trade-off in my view. That multiple is probably low because of low growth, low ROIC, high cyclicality or some other reason.

If I stay on this broad topic, I also think the market is rarely so grossly wrong on a blue chip, top component of the S&P500. Yes, we have had instances in the past where everything just gets overbid in a mania (a la, the tech bubble where even GE was trading at 50x earnings). Also there are plenty of cases where the leaders of the S&P at  the start of the decade aren’t there by the end of it. But largely the market is a pretty good weighing mechanism.

In sum, tech bubbles are rare. But the stock market being a pretty good estimator of company value? Not so rare.  One reason why active management is so hard.

Frankly, if you’re reading this and thinking the stock has gone up too much, you’re probably anchoring to when Apple stock traded at 14x EPS and now trades for 30x without really much thought as to why 14x was right / wrong and 30x is wrong / right.

Ok, back to my view on Apple’s valuation. What do we need to believe here?

First, I like to go a look at Apple’s estimates for some expectations investing. I see that consensus is expecting the company to generate ~$75-$80BN of FCF for 2022-2023.

So let’s say they generate $77.5BN and using a short-hand 20x multiple of FCF (or 5% FCF yield), that’s a $1.5 trillion valuation. Wow. That would be a $363 pre-split price compared to $487 price at the time of writing. What else am I missing?

Well cash on hand is something else. Apple has $93BN of cash & equivalents (another $22/share) plus long-term investments (which is essentially Apple’s hedge fund) which is another $100BN (or $23/share). Yes, Apple has $100BN of debt, but they could have $0 of cash, be 2.0x levered and still be high investment grade. I’m not concerned whatsoever about that debt, so don’t view it as unfair to net the cash.

Add the cash together with the value of the business and you get $363 + $45 of cash, for a quick-hand value of $408 / share. Now, all of this was a very cursory estimate. For example, I change my math from a 5% FCF yield to 4% FCF yield, the price I get is $498/share. At this point, it’s hard for me to say that 4% is any worse than 5%.

I traditionally say my equity IRR over the long-term will approximate the FCF yield + the LT growth rate in the stock. So a 10% FCF yield in a low-to-no growth industrial will probably be around the same return as a 5% grower at 5% FCF yield (as long as you have long-term confidence in the FCF ). Can Apple compound earnings at 6% from here for a 10% total return? Maybe not, but all they need to do is 3% for a 7% return. And for an annuity-like business like Apple, that is as Larry David would say – pretty, pretty… pretty good.

Right or wrong, in a world of 0% interest rates, consistent cash generators will be bid up pretty high. Here’s a quick sample of companies and their FCF yields for 2021. Apple comparatively doesn’t seem crazy.

Of course, there are some other drivers for Apple recently.

The core driver for Apple here has to be the upgrade “super cycle.”

    • If you’ve been invested in Apple for a long time, you understand the stock goes through cycles and I’ve written about it in the past. It’s frankly frustrating, but the function of short-termism.
    • To rehash it, Apple’s sales go through a lull as a large proportion of users upgrade every 2 years or so. So there are big booms and then lulls and the Y/Y comps don’t look great.
    • That’s also when people hark back to the good ol’ days of Steve Jobs and say Apple can’t innovate anymore (right, like the iPad, Watch, AirPods and software moves show the lack of innovation…).
    • The story really has always been the same, but bears repeating. You don’t buy iPhone for the phone, you buy it for iOS. It has always been a software company and they continuously expand on that (AirPods being the latest hardware move, health monitoring seeming to be the next).
    • Heading into a new phone cycle is when people start to realize better results are on the come (and I have no back up, but I would say leading up to the launch is great, after launch Apple then starts to underperform again as people typically expect them to announce a new UFO and are disappointed when it’s just a new phone everyone will buy).
    • ANYWAY – the next upgrade cycle could be huge, especially if Apple is able to launch it with 5G with meaningful new speeds. I’ve seen estimates saying that nearly 40% of iPhone users are due for an upgrade. That would be a huge boon to Apple.

Apple’s bundling could create a “services” powerhouse

    • First you need to understand how profitable “service” business are. Apple has 64% GAAP gross profit margins for services. I assume its CAC must also be much lower than other players, again because of the iOS ecosystem
    • Services is growing well and could become a higher and higher % of earnings over time. Services gross profit has nearly doubled since the end of FY2017 and is now $31BN.
    • Something else to think about: Apple grew Service sales by nearly 15% Y/Y in the latest Q. But COGS only rose by 5%. That’s big operating leverage.
    • These recurring revenue streams are not only valued highly, but has a positive feedback loop in keeping everyone in Apple’s ecosystem!
    • Apple next launched “bundling” most recently and this could be a game changer.
    • Apple reported on its Q3 call that, “we now have over 550 million paid subscriptions across the services on our platform, up 130 million from a year ago. With this momentum, we remain confident to reach our increased target of 600 million paid subscriptions before the end of calendar 2020”
    • Those are huge figures in comparison to a Netflix and Spotify which have 193MM and 140MM paid subscribers, respectively.
    • Again, I view this as classic Apple. They changed the game with iTunes and made it tough to compete. The same could be true with whatever they bundle.
    • Apple could bundle Music, TV+, News, Cloud storage, as well as new growth arenas like gaming and perhaps health monitoring. Charging a low price for all these services / month might mean low profit at first, but huge scale benefits. You also drive your competitors down.

Bundle services… Bundle hardware

    • What if you were offered $100 off a product bundle if you bought a watch, iPhone/Mac, and AirPods together? Look, I only have 2 out of the 3, but I’d be tempted.
    • Apple wins despite the discount because they move more hardware and increase adoption of the iOS ecosystem
    • Then they push the software bundle. Rinse and repeat.

Each of these items make it a bit more exciting to be an Apple shareholder, but more importantly, they may be things that current estimates don’t factor in yet. In other words, especially the latter two items here, there could be further upside surprises.

Nothing I can see jumps off the page to me to say, “holy cow – GTFO.” So I’m staying put.

Featured

Is Dropbox a GARP Stock or a TRAP Stock?
Reading Time: 9 minutes

Perception around Dropbox stock is eerily similar to Facebook. To be clear, investor perception of what is going on with the company seems to be different than reality.

Whenever I used to pitch Facebook stock I would hear things like,

  • “Oh well I don’t use that anymore – does anyone?” Well yeah, Facebook is growing users still and don’t forget Instagram and WhatsApp (the latter of which is very under-monetized to this day).
  • “I’m not sure some of the risks are priced in yet” despite the company trading at 10-12x EBITDA for an extremely high ROIC company growing 20% per year and with no debt.
  • “What’s the terminal value of Facebook? Isn’t it just the same as Myspace?” Let’s not compare a company with like, a third of the planet as monthly active users, to Myspace…

All of this added up to a great GARP stock – growth at a reasonable price. And I still think Facebook is somewhat underappreciated… but that is why I continue to hold. I think over time, they will outperform low expectations.

Today it’s harder to find value across some of these tremendous powerhouses, but there are some pockets of value. Dropbox seems like a name where there are a lot of doubts and a lot of concerns. This could be another GARP stock, but it could also be a value trap.

Common questions I had coming in to analyze Dropbox are:

  • Are they still growing users? And if so, are they monetizing it effectively while also balancing the risk of people leaving?
  • How do they compare to a name like Box?
  • Why has the stock floundered since IPO?
  • If I’m convinced the stock is worth taking a risk on, what’s my downside?

Is Dropbox still growing?

Yep.

Let’s not forget, they were pretty early into the cloud storage game – I think Dropbox might personally be the first one I had ever heard of.

This is an industry that is benefiting from increased storage from mobile devices, while wanting to reach those documents anytime, anywhere across devices. At the same time, companies want to seamlessly collaborate and the cloud is a great solution.

Dropbox is estimated to ~658MM users by Q3’2020, though only 15MM (~2%) are paid. This tells me that there’s room to convert customers to a paid model. And when you look at the growth rate of customers, it’s clear they are converting.

But importantly, they are growing paid customers and extracting more and more value from them (i.e. ARPU is going up). Another thing to note, Dropbox closes inactive accounts after a period of time so these numbers aren’t counting a large swath of ghost accounts or anything like that.

On the topic of increasing value with existing customers, Dropbox has really interesting cohort analysis that they’ve shared twice now, first in the IPO and second for their 2019 investor day.

Here’s what they said at their IPO:

 “We continuously focus on adding new users and increasing the value we offer to them. As a result, each cohort of new users typically generates higher subscription amounts over time. For example, the monthly subscription amount generated by the January 2015 cohort doubled in less than three years after signup.“

And then at their investor day in September 2019:

“So for example, for the 2013 and 2014 segments, we looked at all users who signed up over the course of those 2 years, we then compared their ARR shortly after sign up to their ARR today, which is quantified in the 8x expansion multiple on the right-hand side of the chart. The same logic applies to more recent segments with whom we’ve driven 4x and 2x ARR expansion, respectively, and our cohorts really underpin our highly predictable business model. From the moment a group of users begins their journey with Dropbox, we have a high degree of visibility into their monetization patterns over time.”

I think Dropbox may be an interesting acquisition target.

For example, how much more valuable do other one-trick ponies like Zoom and Slack (with now huge market caps, the latter of which is double DBX’s) get by buying DBX?

They can go to their customers with a much more valuable proposition – “buy the premium version of Zoom and get your document solutions taken care of as well. We’ll integrate everything.”  Supposedly, Dropbox looked at acquiring Slack for $1bn, and that deal makes sense, but was turned down by the board. Now Slack is around $16bn market cap, so now the opposite could happen.

Dropbox historically focused on the consumer end market, not enterprise. I see a risk here that a would-be acquirer may already want someone entrenched in enterprise, but if anything, having ~650MM customers, 15MM of which pay, may help the sale. It may help both of them win with enterprise.

DBX is trying to move into enterprise and it just announced it won a contract with the University of Michigan for its school services, which is a huge enterprise win.

How does Box compare to Dropbox?

The longer-term risk is obviously competition from big platforms already out there. Microsoft has Onedrive, Google has Drive, and Apple and Amazon also offer storage. There’s nothing really sexy about storage, it’s really just how the consumer likes to interact with it. In fact, Dropbox outsources the storage to AWS….

However, I would say Dropbox’s offering is the best I’ve seen for collaboration and while the Michigan contract is just one data point, I do like that the company is growing users, growing ARPU and we’re seeing signs of wins on the enterprise side against incumbents. It seems like Dropbox will win Michigan at a cost (seems like Michigan was unhappy with Box trying to move price and limit storage), but the IRR to DBX is likely high (see LTV/CAC below).

I can’t visibly see where DBX is retracing yet, though obviously the tailwinds in the market are strong, so growth in users not being higher maybe is a concern? Its true that the vertical cloud players are growing 15%+ vs. Dropbox’s 10% growth rate.

If I think about whether their product is getting better or worse, I think it also is clearly getting better. Some of their new add-ins are things like HelloSign, essentially a DocuSign competitor, but one that works seamlessly across platforms (such as integration into Gmail). They also seem to have a password manager, similar to Lastpass.

But this also makes me wonder how they compare to others. I would say Box is actually Dropbox’s main competitor and I think the two will be fighting for the same customers now that Dropbox wants to grow in enterprise.

Perhaps I am biased because I work for a large firm that is concerned about security, but I see little odds they choose a Google product for enterprise. My firm actually uses Box. Maybe we’re not using all the functionality, but it’s nothing to write home about. I did think Dropbox’s Spaces looked very similar, but had some cool features anyone curious should check out. Onedrive is the real competitor if it can make its capability more seamless and allow people to collaborate easily with Word, Excel and Powerpoint. This is what truly scares me….  How do you compete with someone who is fine giving away your core product away for free… But again, Dropbox’s win with U Mich implies they beat Microsoft as well.

Google search trends aren’t that inspirational either, though the tough part about this data alone is that DBX has clearly been growing.

Turning to the financials side, I took a look at some recent figures. From this alone, I would say Dropbox > Box.

For one, Dropbox generates a ton of FCF and much better LTV/CAC. Thinking back to HelloSign and the Lastpass competitor I mentioned, I do think Dropbox’s FCF also provides it room to acquire technology and bolt it on to its existing system. In that case, the acquiree instantly gains a lot of users for that technology and it’s scaled, while also providing a positive feedback to existing Dropbox customers who gain more benefits.

Why has the stock floundered since IPO?

Funny enough, the company has beat analyst expectations every quarter since IPO. They actually made a slide about this in their investor deck. However, I think in DBX’s case it IPO’d with too high of expectations. At one point it was trading at 8x EV/S and 31x P/FCF… now it trades at 4x 2020e sales and 17x P/FCF.  In sum, the stock has stayed roughly flat while the company has grown into the valuation.

 If I’m convinced the stock is worth taking a risk on, what’s my downside?

Buying a stock with low built-in expectations is how I think you outperform. Unfortunately, I’m still not that convinced if DBX is a stock worth the risk (i.e. that expectations are low enough).

On one hand, the company guided to a $1BN of FCF by 2024. At 10x FCF, that would mean there is upside in the stock (maybe 20%, though there will be dilution from now until then, but 10x FCF is a cheap multiple). At 15x FCF (still cheap relatively speaking), it has 75-80% upside.

But I do wonder how investors get over the terminal value question (i.e. it generates cash, but am I just left with a stub piece here? Should I value this like a NPV of a declining annuity?). I don’t see Microsoft going away anytime soon and clearly their stock is ripping due to growing annuity like businesses (the cloud).

Also, when I do some analysis of what the LT operating margin the company should operate at, I get a rate that isn’t much higher than today (LTM op margin is ~20%).

With SAAS companies, generally the new business is negative margin, but it’s all about the renewal business which is very high margin (i.e. you spend all the money to acquire new customers and once they’re locked in, you can figure out the churn math and costs to serve your existing base). That’s why it’s hard to value traditional, early stage SAAS businesses by just lapping a P/E multiple on them.

Here’s my math on Dropbox’s long-term margin potential.

Offsetting this analysis is that management is guiding to much higher operating margins over time – in the high 20s to even 30% range.

That’s great, but when I read how they get there, I have some concerns for the long-term trajectory of the business.

“And so this year, as well as longer term, we plan to drive more efficiency and higher levels of productivity across really each of our operating expense categories. So across R&D, we’ll be prudent with headcount expansion as we drive adoption of the new Dropbox and optimize some of those team-oriented conversion flows that are associated with it and then also as we invest in new high ROI product launches. And then across sales and marketing, we’ll be focusing our spend to support adoption of the new Dropbox. We’ve been doing this already this year while prioritizing our most strategic growth and monetization initiatives.

And I would note that as we execute to our expense targets, we won’t be reducing our investment in our growth engine and new product development. We’ve really carefully considered where we can drive material efficiency improvements across the business while preserving investment in our highest potential product and growth bets. And if you look at our execution over the course of this year, I think that’s emblematic of that philosophy.“

No question, I should be happy when a company is financially prudent, but this is a serious question to ask when you have several 800lbs gorillas. Is this GARP or is this a value trap? I do like how they’ve stated that they aren’t reducing spend in the growth department and like I said, I could also see them just shutting off opex and ramping M&A (the Valeant of SAAS stocks LOL).

I think I’m going to hold off for now on Dropbox, but I am watching it carefully. I think they have a good product and I’m sure I’ll kick myself when I see the M&A announcement eventually come through, but I don’t really see a rush to come in yet or any misunderstanding of the business. Unlike Facebook, I can’t count on Dropbox being a category killer in present time. Facebook concerns were centered around some “known unknown” whereas we know a lot of competitors that could chip away at the company.

If there’s another area where I’m probably wrong, its management. Drew Houston is the founder / CEO of Dropbox (and also a recent addition to Facebook’s board). He seems like a sharp guy. There’s been some mgmt turnover at Dropbox (COO and the CFO). That’s either bad – the company is sinking and everyone is moving on. Or its good – Drew is unhappy and a big shareholder so he’s shaking things up. I guess we shall see. We don’t know who the next CFO is, but the new COO came from Google and was at McKinsey prior to that. Seems positive so far.

Columns, Security Analysis, Uncategorized

Time to Buy Berkshire Hathaway Stock $BRK
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I’ve been watching Berskhire Hathaway stock this year — as many investors do. Berkshire’s annual meeting was timed well as it came during the heat of the COVID-19 crisis. Many felt disappointed to hear (or decipher) that Buffett wasn’t leaning in to the downturn. He wasn’t deploying his “war chest” of $125Bn+ in cash. In fact, he sold his airline stakes, sold some banks, and Charlie Munger even mentioned some businesses might be shutdown. Buffett also mentioned that the amount of cash they have isn’t really a lot to them in the grand scheme of a panic.

Now with the S&P back up to near highs, many are calling out Buffett and saying he’s lost his touch. “Maybe he’s too old now” and “maybe he doesn’t care anymore now that he’s approaching 90 and loaded” or “maybe the oracle has lost his touch”.

I don’t really think that’s the case and think the negative sentiment creates an opportunity in Berkshire Hathaway stock. People who argue that Buffett is too old and “lost it” could have easily argued the same thing when he was 65 going on 70, 75 going to 80… Buffett has that itch that can’t be scratched.

I do think some of his methods are too old fashioned. I can’t actually confirm this is true, but he has said he won’t participate in auctions. What board would actually be able to justify selling to him without a second bid? Especially when times are good and they are a good business.

Do we see Buffett do another elephant sized deal? Maybe. Maybe not. As I’ve written before, I think we could see deals that are smaller than what people expect.  But either way, I don’t think the option value of some deal being done is being appropriately valued today.

I’m taking Berkshire Hathaway’s current market cap and subtracting the market values of his equity holdings (note, I pulled this from Bloomberg, so it may not be 100% accurate). I then subtracted the cash to arrive at the value the market is ascribing to the “core Berkshire Hathaway” business.

I say core, but in reality there are so many subsidiaries within Berkshire Hathaway. You have GEICO, Berkshire Hathaway Energy, BNSF, Precision Castparts, just to name a few well known ones. If interested, I highly recommend perusing the list of subsidiaries on Wikipedia. I bet there are quite a few you didn’t realize he owned.

At the end of the day, you’re being asked to pay <8x earnings for the collection of businesses that Warren has acquired AND you have free upside from the cash if it is ever deployed.

Frankly, the real upside in the stock may be 5-10 years away when Berkshire Hathaway is broken up and people realize the sum of the parts is worth more than the whole.

Either way, look at the impact of Berkshire going out and deploying cash. Earnings could likely go up 30% from where they currently are and even deploying the cash at a worse multiple than where Berkshire trades today (i.e. dilutive), you’re still paying <9x earnings.