The Third & Final (for Now) Article on $NVO

This is the final (for now) installment of the $NVO trilogy.

The trifecta of good quality of earnings, consistent earnings growth and low valuation no longer exist, except for the earnings growth.

The company's quality of earnings had been dropping and its price went up.

However, I'm still long the stock and it's been doing well.

Facebook Still Blows My Mind

But I think there is systemic prejudice against it

Do you remember how Facebook's shares performed when they first went public?  They dropped.  They lost more than half their value in six months.



It was an illogical situation.  Did another one happen again?

Why I'm long

In June 2017 I wrote an article for Seeking Alpha on a powerful valuation method called the Ohlson Clean Surplus (OCS) and as part of it, I ran a valuation on Facebook.  I wasn't long the stock, hadn't looked at it before and I also knew it would present challenges for the model and part of my article was how to deal with challenges.  I had no expectations.

The OCS needed to be modified to allow for the company's growth but it was so high that it just rattled the model.  I had to use pared back growth rates just to keep it from being ridiculous.

I also noticed that although the stock price was growing rapidly, it by no means was keeping pace with earnings CAGR.

The growth rate wasn't the only factor.  The model uses book value per share but a company like Facebook is going to have so much off-balance sheet assets that the number will be wildly inaccurate.

Intrigued, I ran Facebook through another model I have that measures quality of earnings.  Briefly, the quality of earnings measure cuts through manipulations that a company can use to improve their bottom line.  There are eight or nine sub-scores that are added together to get a final score, the higher the better.  It's very useful.  It was high, almost a perfect score.

This stock looked incredible to me and I rolled some of its other features around in my head.  It's got something close to a third of the planet using it or one of its child applications (by child I mean from a corporate structure standpoint, Facebook is the parent, WhatsApp, Instagram etc are children).  It has no peers, it is a monopoly and its moat is not only broad and deep, its infested with radio-active alligators that can bit through a ship's hull and jump out of the water to catch bombs lobbed at the castle.

Remember in the movie, The Social Network, when the Sean Parker character says "You don't even know what this thing is yet," I had the feeling that was still the case, but the "you" was the market.  I felt that I was looking at the world's next most valuable company.

But after Thursday, I wondered if there is some basic dislike of the company, some schadenfreude going on.  It is remarkable in more than one way.  The founder was incredibly young when he experienced mind-boggling, jealousy-inducing success.  The Social Network portrayed the MZ character in an unflattering light.

But that's speculation.  I love facts (especially analytical facts) and I have a quivering respect for the omniscience of the market.

So, should I still be long?  Should you be?  A cardinal rule: don't fall in love with the stocks you pick.  Be objective ALL THE TIME.

So let's look at this, objectively.

Let's get through the easy stuff first:

1) Quality of earnings. 

I ran this model with nine factors against the M-FAANG portfolio to give the number some context relative to "peers".   (M stands for Microsoft; just because FAANG makes a nifty acronym doesn't make it right.  As far as I'm concerned a company that produces software used by almost everyone qualifies as a unique, dominant and formidable company.)  Here's the results:

That's eight out of nine.  What did it fail to get a score in?  Inventories.  FB doesn't have inventory (neither does Netflix).  If you extract it, you get a perfect earnings score of eight out of eight.  How often does this happen? It's the first time I've seen it.

2) Earnings Growth

I think for a growth company it is good to see earnings growing.  Let's see how well FB has grown its year over year earnings.  I'll compare it to the M-FAANG portfolio.


The maximum score is six.  FB didn't have earnings growth in the first year over year growth period, Y-6 to Y-5.

3) Valuation

This is where it gets tricky.

Running a straight up OCS valuation with no changes to the underlying assumption results in a theoretical stock price of $56.  I know that isn't accurate, no one familiar with the model would consider that a correct valuation.  We have to tweak some of the assumptions.

I'm going to look at two assumptions, the starting book value and I'm going to include a growth rate for the return on equity.  I'm going to leave the dividend payout ratio at zero and I'm assuming a stock market growth rate of 7%.

If I use a growth factor on the ROE of 15% I get a price equal to the current share price, $176.
If I increase the book value per share by 2.7 and remove the growth factor entirely I get a price equal to the current share price.
If I double the book value and use a growth factor of 5% I get a price close to the current share price.

How do I feel about the assumption changes?

I feel uncomfortable making a growth call.  David Wehner the CFO advised their growth rates are coming down.  I've spent some time fiddling with the growth numbers and I don't have anything conclusive.

I'm also not comfortable making a statement on what the book value should be.

I will say there is a growth rate, but I don't know what it is at the moment.

I will say there are a tonne of off-balance sheet assets but I won't begin to try to value it.

(Audience base - what's the value of 2 billion people addicted to your platform?
IP - how does one begin to value over 10,000 patents?  Or cutting edge development into AI?
Cultural - When what you do enters into the lexicon and changes the nuance of certain basic words such as "like" and "friend" how does one put a dollar value on that?)

I will say I'm more than comfortable with the modest assumption changes of doubling the book value and a growth rate of 5%.

How do you feel about it?

Existential Risk

Facebook made some blunders with its data and by not caring who paid for advertising.  If management didn't take them seriously, these mistakes would have marked the eventual end of the comapny.  But management did.

That's why their expenses are up, they're investing in mortar to strengthen their citadel.

That's why their revenue growth is down, they're  cutting out dodgy sources and why it will continue to decelerate for a period of time.  The short term perspective says panic.  The long-term view says these changes insure the company's future.

In my opinion, this is evidence of management's long-term vision and it's wise and it's bullish.

Still long

Facebook is a buy and I might pick up some more.

The Second Seeking Alpha Article in the $NVO Series

This was the second article in the $NVO triad, published in October 2017.  It revisited the original analysis framework to see if anything had changed and in fact it had.  The quality of earnings, super high in the first article, slipped a bit, but the target price increased.

https://seekingalpha.com/article/4113793-novo-nordisk-still-buy

The purpose of this post to showcase the kind of analysis INVRS is capable of.  Please note that the circumstances that led to the original buy recommendation are no longer in play.

My First Seeking Alpha Article

I'm going to create links back to some of the articles I've written for Seeking Alpha.  I can't reproduce them in full because of a publishing agreement.

The first links will be from a series of three stories on $NVO.  It includes the very first article I wrote which identified a mispricing in $NVO.  The stock gained about 68% is less than a year.

The balance of the articles kept tabs on the situation as time progressed and new information arose. Here is the first one.

First $NVO article.

The date on the article is January 2017.  Please be aware that the circumstances that created the opportunity are no longer in play.

22nd Century Group, Inc. - Smoke and Mirrors?

Smoke 'em if you've got 'em.

Overview:

22nd Century Group, Inc. is a plant biotechnology company focused on changing the level of nicotine and nicotinic alkaloids in tobacco plants and levels of cannabinoids in cannabis plants through genetic engineering and plant breeding. Its products include X-22, modified risk cigarettes, spectrum government research cigarettes, magic 0 and magic 2, moonlight, red sun, variable nicotine-level research cigarettes, and verfola. 

Founded: 2011

Number of Employees: 79

Headquarters: Clarence US

CEO: Henry Sicignano, III, MBA

Analysis Methodology

After doing some background research on XXII it became clear that the story I need to investigate is whether XXII is a credible company.  Some analysts outline XXII's promising future with their strong intellectual property and the good fortune to be in the business they'e in at this point in time.  Others present what appears to be a well researched tale of fraud and misdirection.

The objective of this article is to separate the hype and find the unembellished fact.  It will cover the following areas: financial analysis, patents, the FDA pronouncement, the market for very low nicotine (VLN) cigarettes, and the company's possible future.

Financial Analysis

The company's most recent quarter was positive but that is due to revaluing their investment in Anandia Laboratories to fair value (which was the correct treatment).  I looked at 10 quarters previous to this one and the company has not been profitable, even at the gross margin level.  In addition to the quarterly review, I looked at seven years of financial history and there hasn't been a profitable year yet.  It did have profitable gross margins in Y-4 and Y-6

This lack of gross margin profitability includes their most recent quarter, despite their claim they did have gross profit in Q1 2018 (see Note 1 and 2 in the Analysis Notes below).   The company did not include expenses in its cost of goods sold (depreciation and amortization) that rightfully should have been.  It was identified in the notes, but not everyone reads those so I found this treatment deceptive.    

This lack of profitable gross income is problematic.  It is unusual to have negative gross income because if you can't cover the expenses related to producing your product, what's the point in being in business?   To have a viable company, you have to have positive gross margin.  If not, the more sales you make the more money you lose.  

I checked to see if there was a positive trend in the gross margin.

Over the last four years the trend has been improving.

Cash

From an operating standpoint only, XXII burned over $12M dollars last fiscal year.  Their need for cash has been growing at an average rate of 23% per year (calculated over three years), again, looking only at the company's operational needs.  They ended fiscal 2017 with just under $63M and ended the most recent quarter with just over $59M, a change of -$3.2M.  Last year the company's cash changed -$2.8M in the same period.  

If we assume their operational burn stays at $12M per year and they don't have to make any capital expenditures (unlikely) they'll have enough money for approximately five years.

Patents

XXII claims to be the only company in the world able to grow tobacco plants with non-addictive levels of nicotine.  I'm skeptical of this claim.  A search on patents.google shows over 12,000 patents for "tobacco genetic modification to change nicotine levels"

Top five assignees are Pioneer Hi-Bred International, U.S. Smokeless Tobacco Company, Centocor, E.I. DuPont and MacGill University.

A search with "22nd Century Limited LCC" as the assignee brings up 10 patents or applications.  One had to do with biomass utilization and one was related to cannabis, of the remaining eight, three were granted patent status and the balance were still in the application stage.

But there are two concerns more important than attempting to tear down their claim.  Firstly, a patent is only as good as your ability to defend it.  In my opinion they don't have the cash resources to take on a deep pocketed competitor in the courts.  And secondly, the lack of competition is not a good sign.  If this is such a good market why is no one else here?

The Recent FDA pronouncement

On the first page of their website, XXII says "FDA shines spotlight on 22nd Century's Technology".  I consider this an exaggeration.

A lot of XXII's recent story had to do the FDA's recent pronouncement made by Scott Gottlieb MD, the commissioner at the FDA.  He said the FDA is "looking at ways to reduce nicotine levels in cigarettes so that they are minimally or non-addictive, while not altering the nicotine content of noncombustible products such as e-cigarettes."  But no where in his speech does he mention XXII by name nor does he discuss or mention their technology (or anyone else's).

However, it is clear that the FDA wants cigarettes to move in the direction of a product that XXII could supply.  Their method is genetic engineering but there are other methods of creating VLN cigarettes and the FDA is keeping its options open.  But I won't deny the FDA statement is good news for XXII.  

I want to highlight another part of Dr. Gottlieb's speech:

"...the nicotine in cigarettes is not directly responsible for the cancer, lung disease, and heart disease that kill hundreds of thousands of Americans each year.  Yes, it got them all addicted and kept them addicted for the long term.  And it got most of them addicted when they were still teenagers.  But it's the other chemical compounds in tobacco, and in the smoke created by setting tobacco on fire, that directly and primarily cause the illness and death, not the nicotine."

He says that phrase "setting tobacco on fire" more than once.  It's clear that in his mind, the harm that comes from tobacco is released when it burns.  I would suggest that he is interested in the demise of cigarettes completely.  That cigarettes become pleasure-less.

Another  of XXII's claims is that their product retains its flavour despite being de-nicotinized.  Perhaps that isn't a feature the FDA is looking for.

Market for VLN cigarettes

Regardless of the speculation above, we do have to consider the future of a product where its greatest pleasure and it's most motivating reason to buy it - nicotine - has been removed and all that remains is a health risk.

Cigarette use in the United States is already on a slow decline,  From 2000 to 2014, the number of smokers dropped from 65M to 54M.  Vaping on the other hand has increased from 2.6% of American adults in 2013 to 10% in 2015.

There is a misconception held by some smokers that the risk in smoking is directly related to the amount of nicotine in the cigarette.  Policy makers are concerned this would lead to more, not less smoking.  This hypothesis was tested in a study conducted by Duke University in North Carolina. 

The results showed that "even if they believed smoking low-nicotine cigarettes was less harmful, people who thought they were smoking VLN cigarettes were more likely to say they would quit within a year if those were the only cigarettes on the market, compared to people smoking cigarettes with low or moderate nicotine levels."

This is strong testament to the possibility XXII has an unusual product.  If it's working properly, people will eventually stop using it.  This in fact would probably be the FDA's goal in approving it.  Are cigarettes a dying technology, being replaced by something else that does the job (nicotine delivery) in a better, in this case less harmful way?  It appears so.

However, given the right support and promotion XXII could be profitable (assuming it overcomes its gross margin issues) for a period of time and the technology could be adopted in other areas of the world.  Eventually though, the music will stop so it is important that XXII sees a future beyond VLN cigarettes.

The Future of Cannabis

XXII has investments in cannabis which will undoubtedly be a growth industry. 

If XXII intends to be a long-term play this is where their future lies. Their focus seems to be around industrial hemp uses, rather than around non-THC cannabiniods for medical uses (although if anecdotal evidence holds any weight this will be a much bigger industry).

My Conclusion

I don't like deceit and their treatment of amortization and depreciation as an operating expense when it should have been a CGS was sly.  They've made more than their share of bombastic claims and I like a company that says less and does more.  

However, contrary to some of the bear analysts, I do think they are a legitimate company trying to accomplish something.  Unfortunately I question whether that is something worth doing because they cannot seem to earn a gross profit.  The more sales they make the more money they'll lose. 

I don't think their technology is a "slam-dunk" but based on their propaganda and the intentions of the FDA it could be a strong contender.  If they solve their gross profit issues, get all the permissions they need to market their product and the FDA goes forward with mandating non-addictive levels of nicotine in cigarettes their stock will pop, I don't doubt it.  But without a new business model to follow up on the success of their VLN cigarette, they will inevitably go into decline.  It is ironic that the FDA's mandate which is key to their success will also underwrite their eventual failure.

Will they have the foresight to see this and move quickly into a new business model?  Let's see how well they do accomplishing this first one.

Notes to the Analysis

Note 1. The Q1 earnings call transcript and the consolidated statement of operations filed with the SEC shows a gross profit in Q1. 

You'll notice that the cost of goods sold figure excludes amortization and depreciation. 

Amortization includes both patent and trademark costs.  It could be argued, but in my opinion patent costs are a cost of good sold because their patent is fundamental to what they manufacture. 

A more obvious situation is the depreciation of cigarette manufacturing equipment, which was included with office equipment, laboratory equipment and leasehold improvements as an operational expense.  The depreciation of cigarette manufacturing equipment is without question part of the cost of goods sold.  

I estimate the depreciate for Q1 on the cigarette manufacturing equipment to be $168,000 (see Note 2).  This alone wipes out the profit even without an estimate for the patent portion of the amortization.

NOTE 5. - MACHINERY AND EQUIPMENT

Machinery and equipment at March 31, 2018 and December 31, 2017 consisted of the following:

		Useful Life		March 31, 2018				December 31, 2017
Cigarette manufacturing equipment		3 - 10 years		$	4,427,251			$	4,302,299
Office furniture, fixtures and equipment		5 years			132,796				110,499
Laboratory equipment		5 years			86,609				32,193
Leasehold improvements		6 years			150,707				106,429
					4,797,363				4,551,420
Less: accumulated depreciation					1,359,901				1,235,373
Machinery and equipment, net				$	3,437,462			$	3,316,047

Depreciation expense was $124,528 and $88,121 for the three months ended March 31, 2018 and 2017, respectively

Note 2. The half way point between 3 and 10 years equals 6.5 years.  Annual straight line depreciation on the December 31, 2017 balance is $661,892.  Three months is $165,473 (this is already enough to wipe out the profit).  Depreciation of the new equipment purchased in Q1 is ($4,427,251-4,302,299)/2/6.5/4= $2,403.  Total estimated depreciation for Q1 2018 on cigarette manufacturing equipment is $167,876.

Disclaimer

We hope you found this analysis useful.

We put the same care into it as we would if we were considering an investment of our own money.  However INVRS, its parent company and its principals cannot be held responsible for any loss you might incur should you take a position based on this analysis.

Thank you for your interest in INVRS.  Sign up for a free trial today.

Morgan Stanley Presents a Rare Conjunction

Overview:

Morgan Stanley provides investment banking products and services to its clients including corporations, governments, financial institutions and individuals.  It operates though the following business segments: Institutional Securities, Wealth Management and Investment Management.  The Institutional Services segments provides financial advisory, capital-raising services and related financing services on behalf of institutional investors.  The Wealth Management segment offers brokerage and investment advisory services covering various types of investments, including equities, options, futures, foreign currencies, precious metals, managed futures, separately managed accounts and mutual fund asset allocation programs.  The Investment Management segment provides equity, fixed income, alternative investments, real estate and merchant banking strategies.  The company was founded by Harold Stanley and Henry S. Morgan.

Founded: 1935

Number of Employees: 57,633

Headquarters: New York, NY

CEO: James Patrick Gorman, MBA

Analysis Methodology:

This analysis will look at what we believe are relevant features of MS in order to determine if there is an investment opportunity.  It'll review price, yield curve, return, earnings, valuation, return measures and dividends.  We'll also review recent news articles and blog posts for relevant information.

This analysis will be peer based.  Peer-based analysis has several important advantages: it provides context for the analysis numbers, the opportunity for bench-marking and it can uncover other opportunities.

Peer Group

MS is in the finance sector and the investment banks/brokers industry.  Peers are in the same sector/industry, have a market cap within 50% of MS and trade on a U.S. exchange.  OTC stocks were not included.

This is the group:

Stock Name (Symbot)	Last Price	Market Cap
Credit Suisse Group AG (CS)	$14.88	$37.7892B
Goldman Sachs Group, Inc. (GS)	$220.57	$83.3106B
Morgan Stanley (MS)	$47.40	$84.0845B

Price:

This daily, 5 year price graph plots MS along with a relevant index, the S&P Financial Select Sector.  It's clear the the two run in tight tandem.

When we look at the price performance of the group we can see CS has lagged behind the other two and that all three stocks and the index have turned down.

Yield Curve

The following chart plots the difference between the nominal 30 year rate and the 3 month treasury bill.  Certainly the curve is getting flatter and February 2018 marked a new phase of flattening around the time the prices on both the individual stocks and the index started to decline.  A flattening curve can impact a banks earnings and we know that short term rates are coming up.  The question is how will the long term rates react?  If they do anything other than increase at least as much as the short term ones, we'll eventually get an inverted curve, indicative of a recession.  

Return:

The return is calculated as the price change over the past four years plus the dividend yield in each of the past four years.  We can see MS has given its shareholders the best return of the group.

Earnings:

This section of the analysis will review quality of earnings and earnings growth.

Quality of Earnings

A bank's financial statements are different from most other organizations.  Therefore we're using a modified quality of earnings calculation to determine how trustworthy the financials are.  The metric subtracts net operating cash flow from the net income available to common shareholders and divides the remainder by the average total assets for the period ((net income - net operating cash flow)/(beginning assets + ending assets)/2).  The larger the difference between net income and cash from operations, the less trustworthy the results.  In other words, the lower the score, the better.

Of the group MS is the best.

Year Over Year Change in Earnings Per Share (Fully Diluted)

This metric looks at how many instances of year over year growth the company has been able to achieve.  We looked at the results of five years so the maximum year over year score is four.

MS has grown its EPS every year, an achievement its peers are not able to match.  This is an especially strong signal couple with the good quality of earnings results.

It is also worth noting that MS's earnings have been positive each year as were GS's.  CS's have been positive only in the two most distant years.

Valuation:

We'll review the PE ratio, the Ohlson's Clean Surplus (OCS) theoretical price (for more information about this interesting technique please see this article) and the Discounted Cash Flow (DCF) model. The price to earnings per share ratio tells us how much we are paying for a dollar of earnings, so a lower value is generally better.  The OCS & DCF models compute a theoretical stock price and the stock is undervalued if it's trading at a discount relative to the theoretical value. 

Please see the analysis notes for assumptions made for the OCS and the DCF model.

Here are the results for the three stocks:

	PE Ratio	OCS theoretical price	DCF
CS	35	$9 (premium 40%)	$9 (premium 40%)
GS	24	$149 (premium 32%)	$207 (fair value)
MS	15	$35 (premium 27%)	$93 (discount 27%)

CS is overvalued, GS is probably overvalued and MS is likely fairly valued.  

PBV, ROE and ROA:

There are three other important metrics to consider when evaluating a bank stock: price to book value, ROE and ROA.  We want to see high numbers for all of these metrics.  It's probably clear why we want a high return on equity and assets but the logic behind the price to book value ratio might not be as clear.

A high PBV indicates a small book value which in turn indicates the ability of the bank to turn it's liabilities - deposits, into assets - loans.  A PBV less than one indicates that the assets/loans are overvalued or the bank is earning a poor or negative return on the assets/loans.  A PBV greater than one indicates the assets/loans are undervalued or the bank is earning a positive return on its assets/loans.

The results of these calculations:

	PBV	ROA	ROE
CS	.88	-.1%	-2%
GS	1.17	.4%	4%
MS	1.23	.6%	7%

Dividends:

Both GS and MS have PBV greater than one but taking all of the factors into consideration indicates that MS is the best in class.

Dividends are one of the most important considerations when making a decision to invest in bank.  We'll look at dividend yield - the annual dividends divided by price and the growth in dividends.

	Dividend Yield	Dividend Growth - 2 years	Dividend Growth - 5 years (average of Year over Year)
CS	1.75%	-32%	-18%
GS	1.31%	7%	9%
MS	1.9%	28%	47%

MS has the highest yield and the highest growth rate.

Conclusion:

Morgan Stanley looks great on it's own but its appeal becomes even more clear when compared to its peers.  Their results are very good on a stand alone basis but when the peer analysis is brought in, it is the best choice in every single metric.  This is rare. 

This is the one to pick if you are looking to add a financial to your portfolio.  A caveat is to stay cognizant of what happens with the yield curve, it may end up having a continuing depressive effect on earnings and share price. 

Analysis Notes:

This article was composed on July 1, 2018 and has not been updated for this blog.

The only assumption used for the OCS model was the projected stock market return of 7%.  The output was reviewed and no other changes appeared to be necessary.

There was one common assumption for the DCF model - the projected market return of 7%.  The balance of the assumptions were tweaked for each individual stock. 

CS - a five-year average for dividends per share was used.  It's been declining year over year but prior to the most recent year it had been in the 70-80c range.  In the most recent year it dropped to 26c.  Also the growth rate was negative so the DSP was divided by the firm's rate.

GS - dividends have been growing so the most recent dividend was used.  For the growth rate, we used the average dividend growth rate over two years.

MS - dividends have been growing so the most recent dividend was used.  For the growth rate, we looked at both the dividend growth rate and the growth in operating income.  Both were so high they resulted in relative results.  The growth rate was then reduced so that there was a small remainder when it was subtracted from the firms rate.

Disclaimer:

We hope you found this analysis useful.

We put the same care into it as we would if we were considering an investment of our own money.  However INVRS, its parent company and its principals cannot be held responsible for any loss you might incur should you take a position based on this analysis.

Sign up for a free trial today.