Monday, October 29, 2018

Google Inc. - Risk is High

Would you go out in this?

Overview:

Alphabet, Inc. is a holding company, which engages in the business of acquisition and operation of different companies. It operates through the Google and Other Bets segments. The Google segment includes its main Internet products such as Ads, Android, Chrome, Commerce, Google Cloud, Google Maps, Google Play, Hardware, Search, and YouTube. The Other B)ets segment includes businesses such as Access, Calico, CapitalG, GV, Nest, Verily, Waymo, and X. The company was founded by Lawrence E. Page and Sergey Mikhaylovich Brin on October 2, 2015 and is headquartered in Mountain View, CA.

Founded: 2015
Number of Employees: 80110
Headquarters: Mountain View US
CEO: Lawrence E. Page

Analysis Methodology:

This will be a general analysis reviewing the following areas: earnings quality, growth, value and dividends.  We'll also look at R&D investment as an indicator of potential competitive advantage, sales per employee as an indicator of efficiency and relative earnings growth compared to price growth.

It will be a peer based analysis as it's a good way to give the results context and an opportunity to uncover other opportunities.

We'll use as a peer group the group of stocks popularly known as FAANG, but we'll substitute in MSFT instead of NFLX.  These are the biggest companies in North America, if size was the only qualifying factor, we'd also include Berkshire Hathaway.  We're going to exclude it as this group is technologically focused.

Peer Group:

Stock Name (Symbol)Last Price (Oct 28, 2018)Market Cap
Microsoft Corporation(MSFT:XNAS)$106.96821.4528B
Facebook Inc(FB:XNAS)$145.37420.2647B
Amazon.com, Inc.(AMZN:XNAS)$1642.81800.0485B
Apple Inc.(AAPL:XNAS)$216.301.0475T
Google Inc.(GOOG:XNAS)$1071.47745.6853B

Quality of Earnings

It's a fact that earnings can be manipulated and changed by accounting-driven decisions.  We want earnings that are persistent, can be expected to repeat and aren't the result of one-off events or management tinkering.  I use an nine part quality of earnings framework based off the work of two academics, Lev & Thiagarajan.  You can read their original paper here.  You can read my adaptation here.

The framework looks at nine areas in the financial statements: inventories, receivables, capital expenditures, research & development, gross income, selling-general-administrative expenses, sales per employees, tax rate and audit opinion.  The first two, the fourth, fifth and six are compared to sales levels, capex and/or r&d are compared to industry averages (I use a peer group average as a proxy), the tax rate measures seeks to remove the effect of an earnings bump from a reduction in the tax rate and the a last one looks for a clean audit opinion.  When any of these measures give a favourable signal, it gets a score of one.  All the scores are summed to get a total out of nine, the higher the better.

GOOG at 4/9 isn't good.  We have to be skeptical of their earnings results now.  FB is great, It's actually perfect - 8/8 as they don't carry inventories (everyone else does).  I almost never see perfect scores.

Growth

Year over Year Growth in Earnings

This metric calculates the number of times the company is able to grow its earnings compared to the previous year.  Each time the company increases its earnings relative to the previous year it earns a score of one.   We'll use seven years of data so the maximum score is six.  Here are the results in tabular form:

GOOG5/6
FB5/6 
AMZN4/6
MSFT4/6
AAPL3/5 - missing year seven data

These are all decent results, especially of course GOOG and FB.  As a point of interest, GOOG missed increasing earnings between the most recent year Y and the year previous Y-1 and FB missed between year six and seven.

Remember the quality of earnings, GOOG's aren't as trustworthy as FB's.

Earnings Growth Relative to Price Growth 

This measure is known as the earnings yield and it's the reciprocal of the PE ratio, however I tweak it so that rather than a static number, earning divided by price, I take the change in earnings over a period of time divided by the change in price over a period of time.  I'm looking to see if earnings growth has outpaced the growth in price of vice versa.  If the number is greater than one, I consider that a good sign, if it's between 1 and 0 I consider it less promising.  The period of time used to measure the change is three years.

The change in earnings and the change in price for GOOG is almost equivalent.  On the other two extremes, FB has seen more earnings increase than price and AMZN has seen more price increase than earnings change.

Value

We'll work with four value metrics - P/E ratio, EV/EBITDA, Ohlson Clean Surplus (OCS) and Discounted Cash Flow (DCF).  We're looking for consistency in the value story.

PE Ratio

I debated using this one because it's so similar to earnings yield we already used.  I decided to because it's so ubiquitous and its handy to know what a dollar of earnings cost.

GOOG trades at 47x earnings.  How do you feel about that?

EV/EBITDA

Similar to a PE ratio, this valuation model looks at what one dollar of earnings costs the investor, but using enterprise value and EBITDA instead of price and earnings strips out the effects of different capital structures and lease versus purchase decisions.  Since we've already got a PE ratio, I thought that looking at this metric over time would give us more information.   This metric is the current EV/EBITDA divided by the EV/EBITDA from three years ago.  A value greater than one means the stock has become relatively more expensive.  Between 0 and 1 and the stock has become less.

Except for FB, they've all become more expensive and GOOG has increased its dearness the most.

OCS

The OCS is an interesting valuation model that calculates a theoretical stock value.  While I don't hold it out to be an exact value, it can give a decent ball park or at least an indication whether the stock is over, under or fairly valued.  For a detailed explanation of the model, please review this article.   Academic testing demonstrates that the model has predictive results two to three years out.

All of these companies look over-priced.  There are tweaks that can be made to the model, but even with adjustments GOOG is still trading at a premium. 
The graph below shows by how much the stock is trading over its theoretical price.

Google is trading at 5x its theoretical price.

DCF

This model can get elaborate with individual rates for each future year.  I'm going to keep it simple.  I'm using the most current free cash flow per share figure, the firm's rate calculated for the OCS (which isn't a WAAC, it's just the risk free rate + the company's beta x the market premium using 7% as the expected rate of return for the market) and I'll do a range of terminal growth rates 0%, 1%, 2% and 3%.

SecurityFCF/ShareFirm's rate0%1%2%3%
FB5.91440.08302771.2380.9993.84111.54
AAPL7.30770.7521697.16112.05132.35161.62
AMZN13.14.084888154.82175.49202.53239.43
MSFT2.51.09155927.4030.7635.0640.75
GOOG33.98.091472371.47417.06475.42552.76
Again, on the surface, these stocks all appear over-valued, however we're used to seeing these companies command a large premium.

Income

GOOG doesn't offer a dividend so this analysis won't delve into income.  Just as information, AAPL and MSFT have dividend yields of 1.56% and 1.7% respectively.

Other Factors

We'll look at a couple of other factors in this analysis: R&D spend as a percentage of sales and sales per employee.  The former can inform us how "relevant" they may be in the future and the later gives us an idea how efficient the company is.

R&D as a Percentage of Sales


GOOG's is the second highest spend of the group and it's spend has been increasing moderately over time, both factors are appealing.

Sales per Employee


GOOG looks good according to this metric.  Although it's middle of the road compared to its peers, it's been trending up over time.

Conclusion


The GOOG's potential investment story is growth, not income, not value.  Growth can be measured in different ways but I think the most pragmatic and important measure is earnings.  Earnings are what turns companies in their stock market firmament.   The question then becomes a) how good are those earnings and b) how expensive is that growth?  Let's start with the first question.

GOOG doesn't have the quality of earnings and it's earnings growth has been good, but I'm bothered by the fact that the one year it didn't grow was its most recent year.   If I'm making an investment decision based on earnings, I want to feel good about them.  I don't.  Not as good as I'd like if I was going to pay 47x earnings.

Which brings us to the second factor.   A aura has developed around these big tech players and it seems that the usual valuation laws don't apply to them.  I will concede that their cultures encourage innovation.  I will concede that they are very well managed.  And I will concede that they've changed the world at least once and may do so again.  Those three factors may allow for some valuation rules to be more flexibly applied.  What one is willing to pay for growth is a bit of a personal question.

Based on the information in this analysis, relative to its peers, GOOG is middle of the road on OCS, Price to Theoretical Price  and DCF.  But relative to three years ago, it's become 38% more expensive using the EV/EBITDA measure.  That's the biggest jump of the group.

This is a difficult conclusion to make so I'm only going to speak of what I would do.  I don't like the cost of those earnings when I question how good they are.  I wouldn't buy.  I would also take profits if I was long. 

This analysis indicates that FB might be a good candidate - it's got the high quality earnings and the stock is less expensive relative to the group.  I do want to point out that AAPL and MSFT may have merit that wasn't fully explored in this analysis because they both have an income component.

Disclaimer

Part of intelligent investing involves taking on risk levels appropriate to one's circumstances.  We don't know what your's are and this analysis should not be construed as investment advice.  INVRS, its parent company, its officers, directors and employees cannot be held responsible for any investment decisions you make.

Sales Pitch

You can do amazing things with INVRS - build investment models, do peer based analysis and create investment reports.  Wouldn't you like to see for yourself?  Sign up for a free two-week trial and put the effort into learning the software using our myriad of learning tools.  If you're a numbers geek with a curious and creative mind, we're your ticket to unique investment insight.



Friday, October 26, 2018

Power Up Your Investment Analysis Using Probability

Investing & Probability
It's a numbers game, maybe like Bingo.

Nobody knows the future, but developing our skills in probability analysis will make us better at preparing for it.

We can use probability at any level - global, country, market, industry, company.  We can use it for an event, for example the probability of the price of gold increasing or the trend of interest rates.

For this example, we'll use probability at the U.S. market level.

The question we'll attempt to answer using probability is "does the bull market have more to run, or are we at the top?"

Step 1 - Identify the key factors


We'll begin by listing the factors that influence, not just any bull market, but this one.  Remember, the factors I choose and the probabilities I assign are my decisions.  You may come up with different factors and different probabilities.

In my opinion, this bull market was created in the aftermath of the global financial crisis.  It was built on earnings, incredibly loose monetary policy and a new tool called quantitative easing.  As those factors change the nature of the market will change.

In considering what I think are the key factors of this market, I'll look at other factors coming into play: fiscal stimulus, tariffs, a movement toward less globalization/more isolation and less friendly immigration policies.

Finally there is always a wild card, a black swan event - a surprise event that packs a wallop but seems obvious in hindsight.

Having selected the factors we want to use, we build an equation:

Market change = a(earnings) + b(monetary policy) + f(black swan)

Where a, b, c, are the probabilities associated with the factor they are attached to.

Step 2 - Assign Relative Weights


The next step is to relatively weight each factor.  For me, I think that monetary policy has been twice as important than earnings earnings and a black swan event could be twice as important as monetary policy.  I therefore give weights of 1, 2, and 4 for earnings, monetary policy and black swan respectively.

Step 3 - Evaluate and Assign Probabilities


The next step is to look at what could impact the factors.  Once the factors are evaluated, we must decide on a probability between -1 and 1.  A positive probability indicates that I believe the outlook for the factor is favorable to a continued bull run (in this example).  A negative probability indicates that the outlook is not favorable.

Earnings


Tax cuts may increase earnings.  Companies may be able to keep more of what they earn and their sales might increase if people have more disposable income.  Earnings might decrease because of rising inputs from tariffs and wages.  Out of country sales may drop in retaliation for tariffs and antagonistic international policies.  Population growth will slow if immigration becomes more difficult which indicates less demand for goods and services.

In my opinion, the earnings effect has run it's course.  There are more factors now to weigh on earnings than to support them.  The sign is therefore negative and I also feel the probability is relatively high.  Let's say -70%.

Monetary Policy


This past 10-year long cycle has been unique with it's use of quantitative easing.  The policy poured an enormous amount of liquidity into the market and kept interest rates very low.  It's in in the process of unwinding now; the bonds that were purchased during QE are maturing and not being replaced.  This reduction in bond demand is pushing up yields.  The federal reserve has also been raising it's benchmark rate and has signaled that further hikes are in the cards.

If stock market started to drop, could the Fed change course and re-instate QE?  Yes they could (not that they would) if inflation isn't a factor.  If it is, they will have to make that their priority, in my opinion.

Currently it looks like the Fed is doing a good job of normalizing monetary policy.  They've gotten rates up and inflation is under-control.  However, it would be imprudent to ignore the inflationary factors currently in play: tax cuts, tariffs, full-employment.  If inflation starts to kick in and I believe it will, they'll have to tighten things up.

I feel the probability of the monetary policy becoming more restrictive to be high and the effect to be negative.  I'll estimate -80%

Black Swan


A black swan event is by definition difficult to predict.  It could be anything, but is should have some relevance in what's going on now.  Here's some ideas: the collapse of sovereign monetary systems and the development of an international, gold backed cyber-currency.  Trade war that heats up to hot war. Trump's unconventional and unprecedented policies work out in a spectacular fashion.

You could give probabilities to all the black swans you identify or you can just work with the one you think is most important or likely.

I'll work with all three for this example.

Let's say they all warrant a relative "4" for strength of impact.  What counts next is the probabilities.  The first example, I'm going to give a probability of .5%.  The second 15%, the third 7%.  The signs are negative, negative, positive.  Because they all have the same weighting I can just sum the probabilities of the individual black swan events to get a black swan probability.  The probability of a black swan event in this example is -.5%-15%+7%=-8.5%.

Note, use a weighted average if you decided the strength of impact numbers should be different.  For example if you think the numbers are 3, 4 and 5, the formula would be -.5*(3/12) - 15*(4/12) + 7*(5/12).

Step 4 - Put It All Together


We then plug the numbers into the equation we already created:

Market Change = -.7 x 1 -.8 x 2 -.085 x 4 = -.7-1.6-.34 = -2.64

The model indicates that the bull market will change into a bear market.  It doesn't say "when" however, but the magnitude of the number is relevant.  This equation could range in theory from a value of -7 to +7, but you'll never have a probability of 100% on any of the factors so in reality the range is less than that, maybe -6.3 to 6.3

As you work with probability and get better at it, the final number's magnitude will begin to communicate something to you about the timing.

Thanks for reading.


Thursday, October 25, 2018

Twilio - Growth Isn't Reasonably Priced

Twilio Analysis
This must mean something to somebody.

Overview:

Twilio, Inc. engages in the provision of communications software, cloud-based platform and services. Its developer-first platform approach consists of programmable communications cloud, super network, and business model for innovators. The company was founded by John Wolthuis, Jeffery G. Lawson, and Evan Cooke.

Founded: 2008
Number of Employees: 996
Headquarters: San Francisco US
CEO: Jeff Lawson

Analysis Methodology:

We'll keep TWLO's business model in mind as we analyze it.  They're an enabling company - they provide tools to help other companies deliver on their objectives.  They help their customers focus on their core business by providing a robust platform where they can quickly, easily and for less money (presumably)  build the ancillary features they need to be successful, namely customer support.  They're a B2B business using a SaaS model.  They are "developer-centric".  I interpret this to mean they are focusing on the developer in their sales cycle - creating something that solves problems for them and in turn, the developers become evangelists, paving the way for a "yes" with the actual decision makers. 

TWLO and the other companies in their peer group can be interesting.  They have the ability to dominate a niche, dig a decent moat and create value for shareholders.  I read one analysis on them which claimed they are a commodity business.  I don't agree.  Part of this analysis will look at competitive advantages now and into the future, as well as risks. 

This will be a peer based analysis.  None of the peers are competitors to TWLO, but they're all (except one) in the same sector and industry - technology services and packaged software.  Most of them are like TWLO-offering services to other companies.  It will be peer-based analysis because it's the best way to give the analysis numbers context.  It's also a chance to find other opportunities.

The analysis will search for an investment story in the three main genres: value, income or growth.  It will also review the quality of earnings.

Peer Group:

Stock Name (Symbol)Closing Price-Oct 17Market Cap
Trade Desk, Inc. Class A(TTD:XNAS)$128.285.2736B
Aspen Technology, Inc.(AZPN:XNAS)$104.057.2347B
Pivotal Software, Inc. Class A(PVTL:XNYS)$18.944.7719B
DocuSign, Inc.(DOCU:XNAS)$47.526.9989B
Okta, Inc. Class A(OKTA:XNAS)$62.266.2770B
Zscaler, Inc.(ZS:XNAS)$37.914.3474B
Paycom Software, Inc.(PAYC:XNYS)$136.517.5519B
Sabre Corp.(SABR:XNAS)$24.336.4709B
2U, Inc.(TWOU:XNAS)$66.933.6860B
Fair Isaac Corporation(FICO:XNYS)$212.766.0613B
LINE Corp. Sponsored ADR(LN:XNYS)$36.298.5574B
Nuance Communications, Inc.(NUAN:XNAS)$17.514.8426B
Open Text Corporation(OTEX:XNAS)$34.879.2849B
Trend Micro Incorporated Sponsored ADR (TMICY:OOTC)$60.358.3786B
Nutanix, Inc. Class A(NTNX:XNAS)$42.297.1667B
Twilio, Inc. Class A(TWLO:XNYS)$74.017.3005B

Quality of Earnings

It's a fact that earnings can be manipulated and changed by accounting-driven decisions.  We want earnings that are persistent and aren't the result of one-off events or management tinkering.  I use an nine part quality of earnings framework based off the work of two academics, Lev & Thiagarajan.  You can read their original paper here.  You can read my adaptation here.

The framework looks at nine areas in the financial statements: inventories, receivables, capital expenditures, research & development, gross income, selling-general-administrative expenses, sales per employees, tax rate and audit opinion.  The first two, the fourth, fifth and six are compared to sales levels, capex and/or r&d are compared to industry averages (I use a peer group average as a proxy), the tax rate measures seeks to remove the effect of an earnings bump from a reduction in the tax rate and the a last one looks for a clean audit opinion.  When any of these measures give a favorable signal, it gets a score of one.  All the scores are summed to get a total out of nine, the higher the better.

Most of the companies in the group don't have inventories.  The score for them is out of eight.   The four that do have inventories (TMICY,  PAYC, LN & NUAN) their score is out of nine.

Here are the results:
TTD          5/8
AZPN       3/8
PVTL        3/8
DOCU      4/8
OKTA       7/8
ZS             6/8
TMICY     5/9
PAYC        8/9
SABR        4/8
TWOU      5/8
LN             3/9
NUAN      4/9
OTEX       3/8
NTNX       6/8
TWLO      4/8

I don't consider TWLO's score of 4/8 to be a good result.  We have a strong basis for skepticism if any of the possible investment reasons involve earnings.

Companies to keep our eye on include OKTA and PAYC.

Growth

TWLO's management identified their key metric as base revenue growth according to their Q2 2018 conference call.  We'll also look at sales per employee but we'll start with earnings growth.

Year over Year Growth in Earnings

TWLO's been beating on quarterly earnings estimates lately, but I prefer to look at annuals - annual statements are audited and quarterlies are not and there's a lot noise in quarterly statements.
Let's see how many times the company has been able to grow its earnings year over year.  Each time the company increases its earnings relative to the previous year it earns a score of one.   We'll constrain it to five years of data as that's all that we have for TWLO.  The maximum score is four.

You have to hit the "Next 10" button to find TWLO as the results are organized from highest to lowest.  They scored one.  That was actually in the most recent period, which is a bit of a boost.
PAYC earned the highest score possible four out of four years of earnings growth.  I consider that a strong result, given it also did so well in the qualities of earnings section.

(There are notes to this section of the analysis, please check the notes section at the end of the article.)

Revenue Growth

The chart below shows the year over year growth in revenue.

Security Y/(Y-1)-1 (Y-1)/(Y-2)-1 (Y-2)/(Y-3)-1 (Y-3)/(Y-4)-1
TTD 0.5189 0.7826 1.5554
PVTL 0.2238 0.482
DOCU 0.3593 0.5229
OKTA 0.6216 0.8663 1.0948
ZS 0.5127 0.5651 0.4956
TMICY 0.093 0.181 -0.0516 -0.0207
PAYC 0.3157 0.4651 0.4885 0.4027
SABR 0.0667 0.1393 0.1252 -0.1371
TWOU 0.3929 0.3707 0.3624 0.3262
FICO 0.0577 0.0508 0.0631 0.0613
LN 0.1511 0.2992 0.2216
OTEX 0.2288 0.2559 -0.015 0.1399
NTNX 0.5067 0.7236 0.8429 0.8991
TWLO 0.4388 0.6615 0.8787 0.7798
Strong absolute numbers but year over year revenue growth has been declining.  The most recent growth is half what it was two years ago.  TWOU's numbers have been accelerating
Sales per Employee
Let's look at sales per employee.

Nice results here - they've got the second highest sales per employee of the group.

Value

Although I don't expect this to be value story, it will still be useful to look at a couple metrics price/sales (PS) and price to sales growth (PSG) to get an idea of relative price.  I'm not using the PE ratio because TWLO had negative earnings in it's most recent year.

PS

This metric tells us what it costs to buy $1 of sales.  The higher the ratio, the more expensive the stock is.  The rule of thumb is between one and two and less than one indicates its pretty cheap.

That rule of thumb would be for a broad universe of stocks.  I would bump it up for technology stocks like this, but not as high as this group.  The average is almost 12 and TWLO is well over it at 18.  The other two companies with possibility OKTA and PAYC are expensive too, but I would use an earnings based valuation measure for PAYC as they are profitable.

PSG

This ratio takes into account the growth rate of the company in calculating its relative value.  According to Backroom Analyst, a writer a Seeking Alpha, a PSG between 0 and .2 is the sweet-spot.  Obviously as the ratio increases it gets more expensive.

We can see that TWLO is slightly above average, however we've got a couple of stocks that might be skewing the results.  When I remove AZPN (sales growth of 3%) and NUAN (negative sales growth) we get TWLO just below the average.


(There are notes at the end of the analysis).

Income

TWLO not surprisingly doesn't offer a dividend.

Hopes & Fears

The biggest competitive advantage a company can have is to be a monopoly.   That's not the case for TWLO and I don't think they ever will be. There are other players in their niche, perhaps not doing exactly what they are but companies do have choice when it comes to building out their customer care program. 

However, they can build a moat with an excellent product and their strategy of becoming the "developer's choice" might pay off.  It looks like they are actively expanding their suite of offerings, which is a good model.  If someone comes over for one solution and they like it, the hurdle to buy more solutions is lower.  Basically the more they can tilt the "buy versus build" (in this case it's "rent" versus build) argument in their favor, the better off they'll be.

Another advantage a company like TWLO can have is to be the dominant player in their space.  I don't think they've achieved that level of success yet, but there's ample evidence this is what they are striving for it.  They've made a couple of purchases of late, including one that was announced on October 16th.  Strategic acquisitions are a good idea for them to achieve fast growth and market dominance.  In my opinion, I think they were lucky to strike this all-stock deal at this moment, given their current price.

Their 'developer-centric' model is great so long as they keep an eye on the actual decision makers, cost/benefit is always an important consideration.  The SaaS model can be expensive over the long term.   Tangential to this is the need to hang on to customers as they grow.  They lost Uber and the reason seems to be that TWLO wasn't flexible on the pricing, Uber wanted a volume discount.  I'm an outsider and I don't know the full story, but I question whether that was a good move.  It raises a red flag for me about the management, it seems imprudent.

Another risk that other analysts have identified is a behemoth coming into their space, Amazon Connect, specifically.  Meh, competition is always a risk.

Conclusion - Growth at an Unreasonable Price

The only story I see at this moment and at this price is speculation, the belief that they're going to pull something magic out of their hat and keep the party going.  I would like to see growth at a reasonable price but they don't have earnings yet and with the exception of last year, they've been actually growing their loss year over year.  They have growing revenue, but the rate of growth is slowing down.  The two value indicators we looked at point strongly to an expensive stock.

I wouldn't buy right now and I'd consider taking profits if I were long.

PAYC could be interesting - it's got a good quality of earnings score and it's actually achieving earnings which have been growing, year over year.  It's expensive though.  Further analysis if and when the price drops could reveal an opportunity.

Analysis Notes

Year over Year Growth in Earnings - not every company had five years of earnings.  TTD, PVTL and DOCU only had three years of data.  The maximum score they could earn is therefore two.  OKTA, ZS & LN had four years of data, their maximum score is therefore three.
PSG - PS is calculated as price dividend by sales per share.  G is calculated as the year over year growth in sales from Y-1 to Y.

Disclaimer

Part of intelligent investing involves taking on risk levels appropriate to one's circumstances.  We don't know what your's are and this analysis should not be construed as investment advice.  INVRS, its parent company, its officers, directors and employees cannot be held responsible for any investment decisions you make.


Sales Pitch

You can do amazing things with INVRS - build investment models, do peer based analysis and create investment reports.  Wouldn't you like to see for yourself?  Sign up for a free two-week trial and put the effort into learning the software using our myriad of learning tools.  If you're a numbers geek with a curious and creative mind, we're your ticket to unique investment insight.
Thanks for this analysis request, we hope you've enjoyed reading it as much as we enjoyed creating it.


Monday, October 22, 2018

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Sunday, October 21, 2018

Expedia Lacks A Compelling Investment Story

Overview: 

Expedia Group, Inc. is an online travel company, engaged in the provision of travel products and services to leisure and corporate travelers.

It operates through the following segments: Core OTA, trivago, HomeAway, and Egencia. The Core OTA segment offers full range of travel and advertising services to worldwide customers through a variety of brands including: Expedia.com and Hotels.com. The trivago segment involves in sending referrals to online travel companies and travel service providers from its hotel metasearch websites. The HomeAway segment operates an online marketplace for the vacation rental industry. The Egencia segment manages travel services to corporate customers worldwide.

Founded: 1994
Number of Employees: 22,615
Headquarters: Bellevue US
CEO: Mark D. Okerstrom, MBA
Expedia as an investment
Alas, we don't see the case for an upward trajectory.

Analysis Methodology

This will be a general analysis reviewing the following areas of EXPE: earnings quality, growth, value and dividends.   We're also going to look at R&D investment as an indicator of potential competitive advantage for the group.

It will also be a peer based analysis as there are advantages to performing a peer-based analysis over a single stock one including the ability to compare, benchmark as well as find other opportunities.

Peer Group:

Stock Name (Symbol)Last Price Oct 19th, 2018Market Cap
Despegar.com, Corp.(DESP:XNYS)$15.621.0793B
Booking Holdings Inc.(BKNG:XNAS) (formerly Priceline Group (PCLN:XNAS)$1805.7486.2500B
TripAdvisor, Inc.(TRIP:XNAS)$46.606.4085B
Ctrip.com International, Ltd. (ADR)(CTRP:XNAS)$32.6317.7905B
Rakuten, Inc.(RKUNF:OOTC)$7.219.7328B
Expedia, Inc.(EXPE:XNAS)$118.3217.6982B


Quality of Earnings

It is a fact that earnings can be manipulated and can be changed by accounting-driven decisions.  We want earnings that are persistent, can be expected to repeat and aren't the result of one-off events or management tinkering.  I use an nine part quality of earnings framework based off the work of two academics, Lev & Thiagarajan.  You can read their original paper here.  You can read my adaptation here.

The framework looks at nine areas in the financial statements: inventories, receivables, capital expenditures, research & development, gross income, selling-general-administrative expenses, sales per employees, tax rate and audit opinion.  The first two, the fourth, fifth and six are compared to sales levels, capex and/or r&d are compared to industry averages (I use a peer group average as a proxy), the tax rate measures seeks to remove the effect of an earnings bump from a reduction in the tax rate and the a last one looks for a clean audit opinion.  When any of these measures give a favourable signal, it gets a score of one.  All the scores are summed to get a total out of nine, the higher the better.

However none of the companies in this group have inventories, therefore the score is out of eight. 

Here are the results:
DESP - 4
BKNG - 4
TRIP -2
CTRP - 6
RKUNF - 5
EXPE -5

A score of 8 out 8 is excellent, 7/8 very good, 6/8 good, 5/8 tolerable, 4/8 meh, 3/8 bad, 2/8 very bad and 1 or zero out of 8 terrible.  EXPE is tolerable.

Growth

This measure looks at the number of years the companies have been able to achieve year over year growth.  I'm looking at a six year time period so the maximum occurrence is five.

BKNG achieved the maximum score of 5.  If this analysis was focused on them I would look at the possibility of a growth story here, paying attention to the correlation between earnings and price growth. 

However, our focus is on EXPE and with a score of 3/5, it doesn't look like a growth story.  The following graph lends credence to that.  It shows the percentage price change over 52 weeks for each stock.

EXPE has lost 21% over the past year.  They've all lost except TRIP which is up 15%.

Value

We'll look at a couple of valuation measures - Ohlson Clean Surplus (OCS) and enterprise value divided by earnings before interest, taxes, depreciation and amortization (EV/EBITDA).

OCS

The OCS is an interesting valuation model that calculates a theoretical stock value.  While I don't hold it out to be an exact value, it can give a decent ball park or at least an indication whether the stock is over, under or fairly valued.  For a detailed explanation of the model, please review this article.   Academic testing demonstrates that the model has predictive results two to three years out.  Let's see what it looks like for this group:

According to the model EXPE is overvalued, as is the rest of them except RKUNF.  I did play with model inputs for EXPE (I increased the ROE and decreased the dividend payout ratio) and it was still overvalued.

EV/EBITDA

Similar to a PE ratio, this valuation model looks at what one dollar of earnings costs the investor, but using enterprise value and EBITDA instead of price and earnings strips out the effects of different capital structures and lease versus purchase decisions.

EXPE is showing a below average multiple compared to the group and it also has the second lowest value of the group at 14x, however it's still on the high side.  Note, three years ago this number was 13x, so it has increased.

In my opinion there is no value play here.

Income

EXPE and RKUNF are the only companies offering a dividend and EXPE's rate is $1.16/share for a yield of almost 1%.



Competitive Advantage

Regardless of the fact that people are price shopping on online travel agencies (OTAs), this is not a commodity industry and I think it would be a mistake for a company to get caught in that trap.  From unique trips to an excellent interface to superb customer service there many different ways to differentiate and gain competitive advantage. 
Although the R&D spend doesn't tell the full story of competitive advantage, it may hint at the company's priorities. 

R&D as a Percentage of Sales

The travel industry was one of the first to be disrupted with the advent of the internet.  There is still ample room for innovation and in fact, without constant fresh thinking, the OTAs could find someone has disrupted them.  R&D spending is therefore important.   Of the group, EXPE appears to budget a constant ~9% of sales.  This however puts them second from the bottom in terms of percentage spend.

It's a HOLD

In my opinion this company is a hold if you own it and a wait for a better price if you are considering buying, although I don't see a compelling reason to buy it.

It's middle of the road in almost all of the factors - it's market cap is almost right in the middle, it's quality of earnings is acceptable - neither cause of concern or celebration.  It doesn't look like a growth or a value play.   It's got a dividend that has been growing, but it's a surprise to see they have one at all - it seems like they should be reinvest excess earnings in the company.  To think the industry has matured and it is time to start returning cash back to investors seems a bit premature.

Disclaimer

Part of intelligent investing involves taking on risk levels appropriate to one's circumstances.  We don't know what your's are and this analysis should not be construed as investment advice.  INVRS, its parent company, its officers, directors and employees cannot be held responsible for any investment decisions you make.

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Monday, October 15, 2018

A Value Opportunity in Bausch Health

Overview:

Bausch Health Cos., Inc. engages in the development, manufacture, and market of a range of branded, generic and branded generic pharmaceuticals, medical devices and over-the-counter products. It operates through the following segments: The Bausch + Lomb/International, Branded Rx, and U.S. Diversified Products.

The Bausch + Lomb/International segment consists of the sale of pharmaceutical products, over-the-counter products, and medical devices products. The Branded Rx segment comprises of pharmaceutical products related to the Salix product portfolio; dermatological product portfolio; branded pharmaceutical products, branded generic pharmaceutical products; over-the-counter products; medical device products; Bausch + Lomb products sold in Canada; and the oncology, dentistry, and health products for women. The U.S. Diversified Products segment refers to the sales in the U.S. of pharmaceutical products, over-the-counter products, and medical device products in the areas of neurology and certain other therapeutics classes, including aesthetics and generic products in the U.S.

Founded: 1994
Number of Employees: 20,700
Headquarters: Laval CA
CEO: Joseph C. Papa, MBA

History

Valeant, BHC's predecessor, is notorious in an industry rumoured to be one of the most cut-throat and crime-ridden.(1)

It lost over 70% of its market value in approximately 100 days in Q2/Q3 of 2015, eventually bottoming out at $11.20 from a high of $347.84.  Lawsuits, investigations, criminal charges followed.  It replaced CEO Michael Pearson and installed Joseph Papa.  Papa has divested some of the purchases made under his predecessor, reduced debt and changed the company's name to Bausch Health.




Analysis Hypothesis:

I believe that much of Valeant's problems stemmed from its culture.  When a company falls in such a spectacular fashion, more likely than not, there's a management component and in a situation like this, when a new company rises from the ashes of the old one, we need to know if there is still rot at the core.

Has BHC fundamentally changed from Valeant and does its future look promising?

Methodology

This analysis will review the board of directors and management team, the company's financial health, R&D investment, debt, growth potential, valuation and income outlook.

Board of Directors and Management Team

A Globe and Mail article, published on July 30, 2015 less than a week before the beginning of the Valeant crash, unintentionally and ironically wrote a treatise on what was probably at the core of Valeant's issues, a policy of aligning management rewards with share performance, to the determinant of building long-term value.

There are currently ten members on the board of directors, only one remains from its days as Valeant.  It is also a reasonably diversified group, drawing on people with different backgrounds and expertise.  It's also a largely independent.

The Management Team is likewise very diverse and probably has a good blend of new blood while still preserving the knowledge base of people from its Valeant days.

Both elements of leadership look strong.

Financial Health

We'll look at BHC's quality of earnings to determine company's financial health.

It is a fact that earnings can be manipulated and they can be improved by accounting-driven decisions.  We want earnings that are persistent, can be expected to repeat and aren't the result of one-off events or management tinkering.  I use an nine part quality of earnings framework based off the work of two academics, Lev & Thiagarajan.  You can read their original paper here.  You can read my adaptation here.

The framework looks at nine areas in the financial statements: inventories, receivables, capital expenditures, research & development, gross income, selling-general-administrative expenses, sales per employees, tax rate and audit opinion.  The first two, the fourth, fifth and six are compared to sales levels, capex and/or r&d are compared to industry averages (I use a peer group average as a proxy), the tax rate measures seeks to remove the effect of an earnings bump from a reduction in the tax rate and the a last one looks for a clean audit opinion.  When any of these measures give a favourable signal, I give it a score of one.  All the scores are summed to get a total out of nine, the higher the better.

BHC scored a three out of nine, an abysmal score.  The company has recently announced a return to profitability, and the graph below demonstrates it.  However given their quality of earnings score and a simple review of their declining gross margin and revenue (accelerating decline in revenue's case) it looks though they managed it with manipulation, but I need to be clear.  I don't mean they created fictitious sales or anything like that.  I just mean they made accounting choices that goosed their earnings.





I usually feel strongly about good quality of earnings, but should it be overlooked in this case?  I imagine righting a ship that capsized in a maelstrom is tough work.  Maybe Papa should be the given the benefit of the doubt, at least for a time.

Research and Development

One of the features of the company's Valeant days was little spending in R&D.  Let's look at BHC's R&D spend as a percentage to sales.

It's good to see R&D going up (although keep in mind that revenue has been declining for the past couple of years.  However even at it's peak of 4.35% of sales, it's a small number.  When I look at the R&D to Sales spend of some of BHC's competitors, we can see that they are below the average of 10%, but within the range.



Debt

The company has been lauded for reducing debt and streamlining its focus, undoing part of what boosted its price before August 2015.

Let's say we're from Missouri and want to see for ourselves.

Indeed the debt has come down relative to it's peek, however it's still well above it's 2013/2014 levels and what it's paying out in interest is concerning.  The pre-tax interest coverage ratio, EBIT/interest, is still declining. meaning its debt burden is getting worse (although at a slower pace).


Growth

I believe that if there's an investment opportunity, it'll be either a growth, income or value story.  You might even have two out of the three.  So, is BHC a potential growth company?

There's not a lot of data for Papa's tenure at BHC and the stock hasn't returned to the highs it experienced when Papa was first brought on.

However we'll look at how many times the company has increased its quarterly EPS over the past seven quarters.  Usually I would work with annual results, but there isn't enough information in this case.  These are the quarterly values:

Q (June 2018)
-3.215
Q-1
-9.7137
Q-2
1.8434
Q-3
4.625
Q-4
-0.1479
Q-5
2.369
Q-6
-1.9615
BHC has increased it's quarterly EPS three out of a possible six times.  This doesn't look like a growth story and coupled with the poor quality of earnings results I wouldn't buy the stock for growth.

Valuation

We're going to look at several valuation measures - the Ohlson Clean Surplus (OCS), Enterprise Value/Earnings before Interest, Taxes, Depreciation and Amortization (EV/EBITDA), the PE ratio, and the Discounted Cash Flow Model.

OCS

The OCS is an interesting valuation model that calculates a theoretical stock value.  While I don't hold it out to be an exact value, it can give a decent ball park or at least an indication whether the stock is over, under or fairly valued.  For a detailed explanation of the model, please review this article.   Academic testing demonstrates that the model has predictive results two to three years out.

Using the OCS, BHC does appear to be undervalued.  Using a discount rate of 15% (the calculated rate is strange owing to its negative beta) and the current return on equity of 43% gives a theoretical price of $94.  However that's a fairly high return on equity.  Reducing it by 55% bring the price of the stock into fair valuation territory.  So provided the future ROE is something greater than 24%, the stock is undervalued.

EV/EBITDA

The EV/EBITDA for the most recent year is 10.46, dropping from 18.16 in Y-3.    Looking at BHC's peers we can see an average EV/EBITDA of 14, another clue BHC might be undervalued.

PE Ratio

BHC's TTM PE ratio of 2.9 is quite low.

DCF 

I put together a quick and dirty DCF using the firm's rate of 15% used in the OCS, free cash flow per share and growth equal to zero.  The calculation of 7.41/.15 = $49.42, a premium of 45%.

Income

BHC is not currently offering a dividend so this is not an income story.

Conclusion

The analysis suggests BHC could be a value play.  Although I don't like a situation with a bad quality of earnings score, I would consider forgiving it for the reasons above.  However this company's predecessor was involved in activities that could have destroyed it.  The market may not be so forgiving and I don't just mean the stock market.  The company has a lot of work ahead of it to regain the trust it lost with its customers.

Disclaimer

Part of intelligent investing involves taking on risk levels appropriate to one's circumstances.  We don't know what your's are and this analysis should not be construed as investment advice.  INVRS, its parent company, its officers, directors and employees cannot be held responsible for any investment decisions you make.

Research Notes

(1) http://www.louisaonline.com/hwa/hw-louisaonline-august-2015.pdf
(1) https://www.taylorfrancis.com/books/9781135072902
(1) https://www.macleans.ca/news/canada/barry-honey-sherman-murders/

Sales Pitch

You can do amazing things with INVRS - build investment models, do peer based analysis and create investment reports.  Wouldn't you like to see for yourself?  Sign up for a free two-week trial and put the effort into learning the software using our myriad of learning tools.  If you're a numbers geek with a curious and creative mind, we're your ticket to unique investment insight.



Tuesday, October 2, 2018

An Income Opportunity in UPS

Shielded Dividend Stream?

Analysis Origin & Methodology


We created this analysis on request.  Analyses of this sort are general -we don't know the requester's circumstances and we don't know what kind of an opportunity, if any, the stock presents.

Therefore, we look broadly at the stock including quality, value, growth and income.  In this analysis, we looked at UPS with a group of peers.

Some areas will have additional notes.  This will be indicated at the conclusion of the section and can be found at the end of the report.

Company Overview


United Parcel Service, Inc. is a logistics and package delivery company, which provides supply chain management services. Its logistics services include transportation, distribution, contract logistics, ground freight, ocean freight, air freight, customs brokerage, insurance, and financing.

The company operates through the following segments: U.S. Domestic Package, International Package, and Supply Chain and Freight. The U.S. Domestic Package segment offers a full spectrum of U.S. domestic guaranteed ground and air package transportation services. The International Package segment includes small package operations in Europe, Asia-Pacific, Canada and Latin America, Indian sub-continent, and the Middle East and Africa. The Supply Chain and Freight segment offers transportation, distribution, and international trade and brokerage services.

The company was founded by James E. Casey and Claude Ryan on August 28, 1907 and is headquartered in Atlanta, GA.

Number of Employees: 280,000

CEO: David P. Abney

Peer Group

Stock Name (Symbol)Last Price (as at Sep 17, 2018)Market Cap
FedEx Corporation(FDX:XNYS)$255.8965.4095B
Brink's Company(BCO:XNYS)$70.403.6746B
Hub Group, Inc. Class A(HUBG:XNAS)$47.551.6519B
Forward Air Corporation(FWRD:XNAS)$68.121.9052B
Expeditors International of Washington, Inc.(EXPD:XNAS)$73.7812.9853B
C.H. Robinson Worldwide, Inc.(CHRW:XNAS)$96.7113.3805B
Air Transport Services Group, Inc.(ATSG:XNAS)$22.321.2123B
Atlas Air Worldwide Holdings, Inc.(AAWW:XNAS)$63.551.5793B
ZTO Express (Cayman) Inc. Sponsored ADR Class A(ZTO:XNYS)$17.1410.4481B
United Parcel Service, Inc. Class B(UPS:XNYS)$119.09105.7714B


Earnings Quality


It is a fact that earnings can be manipulated and they can be changed by accounting-driven decisions.  We want earnings that are persistent and grow and that aren't the result of management tinkering.

I use an eight part quality of earnings framework based off the work of two academics, Lev & Thiagarajan.  You can read their original paper here.  You can read my adaptation here.

The framework looks at eight (or nine) areas in the financial statements: inventories, receivables, capital expenditures (and/or research & development which is not used in this analysis), gross income, selling-general-administrative expenses, sales per employees, tax rate and audit opinion.

The first two, the fourth, fifth and six are compared to sales levels, capex and/or r&d are compared to industry averages (I use the peer group average as a proxy), the tax rate measures seeks to remove the effect of an earnings bump from a reduction in the tax rate and the a last one looks for a clean audit opinion.

When any of these measures give a favourable signal, I give it a score of one.  All the scores are summed to get a total out of eight, the higher the better.

Here are the results:


UPS's score of four is mediocre. Brinks and Air Transport Services are quite good. See analysis notes for more details.

Earnings Growth


This measure looks at the number of years the companies have been able to achieve year over year growth.  I'm looking at a six year time period so the maximum occurrence is five.

UPS is not a growth story with a score of three.

How about HUBG with a perfect score of five?  I am skeptical of their results given they achieved the worst score of all the companies in the quality of earnings category.  I wouldn't consider a long position in a company with a score of two.

There are notes to this section.

Earnings Growth Relative to Price Change


This measure is similar to the earnings yield (which is the inverse of the PE ratio), but I tweaked it to compare growth rates in earnings and price, rather than values at a single point in time.

The growth period is over three years and the calculation for the numerator is the earnings for the current period (Y) divided by earnings for the for the period three years ago (Y-3), minus one.  The calculation for the denominator is current price divided by price 36 months ago, minus one.

A value greater than one indicates that earnings have grown more than the price has grown, a favourable signal, especially if it is coupled with high quality of earnings.

Here are the results:
Great numbers for FDX and UPS, their earnings growth has outstripped the growth in their price (on a percentage basis.  As mentioned, HUBG is no longer a consideration.

See the Analysis Notes section for more details.

Valuation


I like to look at multiple valuation measures in order to confirm a consistent valuation message.  We'll look at PE ratio, enterprise value over EBITDA and Ohlson's Clean Surplus (OSC).

For more information on the OCS, please see this article.

PE Ratio


The average of 23 is fairly high.  UPS is below average at just under 20.

EV/EBITA


UPS is basically equivalent to the group average of 12. By traditional measures it is somewhat high.

OCS


The OCS is an interesting valuation model that calculates a theoretical stock value.  While I don't hold it out to be an exact value, it can give a decent ball park or at least an indication whether the stock is over, under or fairly valued.

Stock    Theoretical Price    Actual Price  (Premium)/Discount
FDX         182.60                255.89                 (29%)
BCO             6.15                  70.40                 (91%)
HUBG           41.81                  47.55                 (12%)
FWRD           31.56                  68.12                 (54%)
EXPD           29.27                  73.78                 (60%)
CHRW           37.89                   96.71                 (61%)
ATSG             5.91                   22.32                  (74%)
AAWW         100.45                   63.55                    58%
ZTO             8.77                   17.14                  (49%)
UPS       4171.26                   119.9               (3,403%)

Most of the group is over-valued with the exception of AAWW and UPS. 

In the case of UPS, the theoretical price and the indicated discount is rather ridiculous, but when I examine the model I can see it has a very high ROE.  One of the assumptions in the model is that it uses the most recent ROE and it will persist into the future (another similar assumption is used for the dividend payout ratio).

I examined UPS's ROE over the past few years - it's been consistently high.  Using the average ROE over five years reduces the theoretical price to $936.  Cutting the ROE in half turns the theoretical price to $246, still a 107% premium.

It's also possible the dividend payout ratio will increase.  UPS isn't a growth story and so returning money back to shareholders seems reasonable.

A higher dividend payout ratio brings the valuation down quite quickly.  Increasing the payout ratio by 52% brings the stock into fair valued territory (without adjusting for ROE).

Regardless, according to this valuation technique, UPS seems to be undervalued.

Bonus - Quick and Dirty Discounted Cash Flow (DCF)


I wanted to see the results of the DCF model.  I only put it together for UPS and I made a number of simplifying assumptions - I used dividends as the cash flow proxy, and I only used the most recent year's.

For the discount rate I used the firm's rate calculated in the OCS and I used a growth rate of 6%, which is lower than the past three years of dividend growth for UPS (7%, 9% and 8%).

The quick and dirty DCF calculation is 3.32/(.0635-.06) = $949.  This is very close the value arrived at using the OCS when the average ROE is used.

It's a bit of a mixed story on whether UPS is under or over-valued. There seems to be more indicators that it is undervalued, however.


Dividends


Not all the companies in this analysis offer a dividend.  The ones who do are FDX, BCO, FWRD, EXPD, CHRW and UPS.

We'll look at the current dividend yield, dividends per share and the dividend payout ratio.  We'll also look at the free cash flow trend.  Although this can't definitely say how secure the dividend is, it can give us a clue.

Dividend Yield


UPS has the highest yield and we can see that it keeps its dividend in a range, as do the other companies.

Dividends Per Share


Strong dividend growth for UPS.

Dividend Payout Payout Ratio


With the exception of one year, UPS pays out a consistent portion of its earnings as a dividend.  The other companies are similar in that respect as well.

Free Cash Flow


UPS's free cash flow had been terrific up to the most current year.  The reason's for the drop are several.  They paid almost $8.8 billion into their pension plan, a sizable increase over previous years'.  Capital expenditures were also up.  To pay for this, they took on debt and reduced their FCF.

Conclusion


Stocks have different stories - some are growth stories, some are value, some are income.  You won't find all three at once, but you can find a stock strong in one or two areas.  UPS may be undervalued and it certainly has an attractive dividend.  Although it's earnings quality is so-so, that could be cautiously overlooked.

Analysis Notes


Earnings Quality - HUBG, EXPD, CHRW and AAWW do not report inventories and FWRD and ATSG do not report SG & A expenses.  Therefore these six companies would actually have a score out of seven, rather than eight.

Earnings Growth - there is no EPS information for ZTO for the years prior to the fiscal year ending December 31, 2014, it's score is out of three.  It grew it's earnings three out three times (not four out of five).

Earnings Growth Relative to Price Change  - Price information for ZTO begins in 2016, so there is no value for this stock.

Disclaimer


We hope you've enjoyed this analysis.  Please let us know if you have any questions or require clarification on any of the points.

This report does not constitute an investment recommendation.  INVRS, it's parent company, the employees, directors and officers cannot be held responsible for any investment decision you make, how so ever made.