For profit education rally is just beginning

I have a current working theory that the rally in for profit education stocks is just beginning.

The Obama administration was critical of the for profit education industry. The Department of Education proposed various regulations on the industry, like the 90/10 rule, which states that a proprietary education company cannot receive more than 90% of its revenue from Title IV loan programs, and the gainful employment regulation, which mandates loan repayment be less than 20% of discretionary income after graduation or 8% of total earnings.

Trump appears intent on rolling back many regulations placed under the previous administration. Newly appointed head of the Department of Education Betsy DeVos appears very unlikely to pursue further regulation of for-profit colleges, and I think there’s a good chance that the gainful employment regulation and the 90/10 rule are both rolled back.

In the meantime, the industry has been working hard to fix its problems. The industry has invested to lower dropout rates and increase employment post-graduation. Moreover, in a strong economy, more of these students can count on finding jobs when they graduate. Tuition has actually come down across the industry while tuitions at non-profits continue to rise. The schools seem to offer a better value proposition now.

And there may be more demand than ever for the types of technical degrees and certification programs that for-profit colleges excel in offering. I have read a number of reports that there is a “skills gap” that is partially to blame for the slow hiring in manufacturing, for example, this report from the manufacturing institute. Manufacturing companies are automating their processes, and new workers will have to certified in the technical skills necessary to operate in these highly automated factories. This is a secular trend in favor of companies that offer technical certifications.

Despite an impressive rally since the election, the companies still appear to trade at reasonable multiples, especially if you expect growth to pick up under the new administration.

I bought in a little cheaper than current prices in early March. Here are the multiples as they stand today:

Company P/Sales EV/Sales P/E EV/EBITDA EV/EBIT EV/FCF 5-yr Revenue Growth
DV 1.16 1.08 26.34 12.38 27.01 14.14 -3.1%
STRA 1.98 1.69 25.08 9.81 12.94 23.72 -5.7%
LOPE 3.75 3.74 22.05 11.53 13.76 N/A 14.3%

 

DeVry Education (DV)

DeVry Education looks interesting. It may be a good turnaround situation. It appears to have a similar P/E to the rest of the group, but it has one-time charges of a large asset write-down in the year ended June 2016, and a fine imposed on it by the Obama-era FTC in the current fiscal year. Adjusted for the fine and the asset write down, the company earned $176 million in operating income in the TTM period, as compared to the unadjusted figure of $74 million. The EV/EBIT goes from 26.05 to 10.94.

DeVry also has large restructuring charges. I am not sure whether the entire amount of restructuring charges can be added back as a one-time expense, but the restructuring charges do appear to be declining year over year, so I think its reasonable to expect that these expenses might continue to shrink.

Meanwhile, DeVry has been cutting down on administrative and overhead costs as well. SG&A is down from 37.8% of revenue to 34.4% in the TTM period.

That means, even with a slightly negative top line, DeVry can experience significant bottom line growth as restructuring charges shrink. Adjusted for a 50% reduction in restructuring expenses, the operating income at DeVry would be $200 million, putting the EV/EBIT at 9.64.

The risk with DeVry is that the reputation of the company has been tarnished after the FTC’s investigation. In the meantime, numerous competitors have sprung up without the baggage of a federal investigation, fines, and litigation. Management hasn’t had the attention or resources to defend against this competition, and has been cutting costs to get by, so it may be falling behind in its offerings.

I read gradreports.com, and I was surprised to see the amount of positive feedback on DeVry. It seems that students aren’t particularly deterred by federal investigations or general stigma against the industry. It was among the highest rated undegraduate experiences.

DeVry has a focus on healthcare education that puts it in enviable position. Healthcare has been one of the strongest areas of the economy in recent years

Strayer (STRA)

Strayer has finally managed to turn around a multi-year streak of negative revenue growth, eking out a 3% gain last year. However the operating margin has deteriorated, dropping from 18.3% in 2014 to 13.0% in 2016. I don’t think the drop in margins has been all bad news – 3% of the drop can be explained by increased marketing expenses. This was probably a big factor in turning around those revenues, and the investments in marketing may pay dividends for years down the road.

The rest is mostly made up of “Instruction and educational support costs”, but again, these costs may pay off longer term. Strayer appeared to have the worst reviews overall of the for-profit group, with many complaints that they are overly promotional and place pressure to sign up for classes, but abandon students once they have signed up. The increase in instruction and educational support costs as a percent of revenues seems to indicate that management is trying to address the problem.

The risk here is that the investments in educational resources and marketing don’t pay off. However, mitigating this risk is the low capital requirement of the company. It has a much lower invested capital, and thus, a higher ROIC, than the other for-profit colleges. Capital expenditures are also rising at Strayer, up from $6.9 million in 2014 to $13.1 million in 2016. If this capital has a return similar to the past, one might expect rising earnings in coming years.

Grand Canyon Education (LOPE)

Grand Canyon Education is probably the for-profit college that most resembles a traditional non-profit college. It ran as a private, non-profit, Christian university for 55 years, but transitioned to a for-profit college in 2004 to get additional investor funding. In the same year, it began to offer online courses. In 2008, it went public to get more funds.

The company is an exception to the rule in the for-profit industry. It has continued to grow enrollment and revenues and it reinvests a huge amount of capital back into the university. It has Division I NCAA sports teams for its campus. And, rather than refocusing on associates degrees and certification programs, it has doubled down on its full undergraduate offerings and graduate degrees.

In 2014, it was actually mulling over the decision to go back to a non-profit status, to avoid the stigma and regulations associated with the for-profit label. The stock price languished for 2 years despite consistently growing revenue and earnings. However, the election finally unleashed the stock and it rocketed up 50% over a short period of time.

It formed a base around $60 and has recently broken out again. I don’t think there is any telling how far this goes.

The company has no free cash flow, as it is continually reinvesting in its campus and its offerings. This currently doesn’t appear to be a problem as it is getting a pretty good return on its investments and growth shows no signs of slowing. If you own a stock that reinvests at a high rate, your investment can compound for several years until the company hits saturation or runs into competition issues.

I had figured that Grand Canyon would get good reviews because of its large investments, and overall, it seems to rank about the same as most average non-profit colleges.

I put the largest stakes of my investment in DeVry and Grand Canyon, and a small stake in Strayer. The group is up broadly since I invested about a week and a half ago. I plan to hold until I see reversal of the trend. I expect that we ought to hear some news announcements about DeVos rolling back regulations that will be positive near-term catalysts for this group.

Under Armour – Closing the Short, Taking a Victory Lap

Sometimes you nail it. I think it’s important to be objective and analytical regarding wins as well as losses – you have to see what you did right and attempt to replicate this in the future.

I started getting bearish in May of 2016 and looking for shorts. Unfortunately, we have been in a downright bull market ever since, and the economy is roaring. Luckily, I decided to focus on individual stocks to short, which worked out much better than if I had just gone short the whole S&P.

My original rationale

In June I got short Under Armour. At the time I wrote:

Under Armour is running into issues with its distribution channels, and I think its trying to cover it up. They announced a new inventory management system – I think the channels are stuffed and they can’t move the inventory. Inventories and Accounts Receivable are both rising faster than revenues – a huge red flag. Sports Authority went BK, a sign of the troubles at its distributors. It’s biggest customer is Dick’s Sporting Goods, which hasn’t run into trouble yet, but Dick’s is also launching its own athletic wear line to compete with UA. Oh yeah, and the Steph Curry’s are probably the worst reviewed shoe of all time, plus the Warriors lost.

My main motivation centered on inventory management. I felt like something fishy was going on when the company announced a new inventory management system at the same time GAAP financial statements were throwing out tons of red flags. Moreover, I could easily see an alternative rational for rising inventories – awful sales at the major retailers. 2016 saw some of the worst same store figures in years for all the major department stores. These department stores were huge holders of Under Armour inventory. I reasoned the trouble down the channel ought to affect Under Armour eventually.

I also cited the high valuation – 70X trailing earnings at the time – as a huge motivation for the short. I knew that a PE of 70 was generally expensive compared to a PE for Lululemon of 37, and a PE for Nike in the mid-20’s. I felt that Under Armour’s growth was going to decelerate to the rate of growth for the general athleisure industry. This is a problem of a) growing too large, b) increasing competition, and c) fewer channels of distribution to expand to. If Under Armour’s growth was slowing to the rate of the industry, then it deserved the same PE as the rest of the industry. I knew the high valuation gave the short room to run on the downside if things started to work out.

It’s tough shorting a market darling in a bull market

It wasn’t easy to hold the short. Here’s what I wrote in September:

UA is starting to stress me out. The latest quarterly earnings really bore out core points of my short thesis – the accounts receivable continue to rise, and inventories continue to climb, with management making a mountain of excuses. But I was troubled by one comment they made on the call. Management compared the number of distribution outlets UA has to the number that Nike has, with the argument they still had substantial room to expand distribution.
A big chunk of my thesis was that UA had benefitted for years from growth in distribution channels. But I figured that it was running out of new channels to grow into, and would start to suffer lower growth. I also postulated that the recent Sports Authority’s bankruptcy and weak same-store sales from the department stores were contributing to the bigger charge-offs and inventory build-up, and I thought that management was trying to obfuscate this by announcing they were changing their inventory management system.
The problem with this thesis is that if UA can still expand distribution – like they just announced with Kohl’s – there may be a while left before the negative fundamentals start to catch up.

I also was stressing out because my rationale on valuation wasn’t working out. Instead of the valuation of Under Armour going lower, Lululemon and Nike went up. I was also stressed because I saw David Einhorn covered his short in UA and thought most of the downside was already in. In retrospect, one of the cardinal traits of good investors is the ability to be able to bet against investors you respect when your thesis remains intact. This will be a lesson going forward to focus on doing my own work, and not rely too heavily on off-hand comments in a hedge fund’s latest quarterly letter.

But there were signs things might work out after all

There were a few things that strengthened my short thesis in the fall of 2016. Competitive pressures started to intensify. With Lululemon doing so well, it was bound to take athleisure market share. I saw more and more athleisure coming out from generic lines and smaller market share brands, like Gap’s Athletica.

The other piece that added to the short for me was the investment in connected fitness. I think in the long run, these investments may be a great way of differentiating Under Armour, and may establish the brand as a stand out from its competitors. But it may take years for these investments to pay off, and in the short run, it sucks out capital and pushes profit margins lower.

Pushback often helps clarify your thesis

My articles on betterstockideas.com get cross-published to Seeking Alpha. On SA I got some pushback on the international growth at UA. But here was my argument on why the fast international growth at UA didn’t matter… yet:

“Thanks for the insight. I may be getting myopic based on my focus on my home market, and I may be rationalizing here, but here’s my argument on that point.
International makes up 15% of UA’s revenue as of the Q2 2016. When UA was growing in a nascent market in North America, it grew revenues at about 30% a year, and I’d assume it will expand in International markets at approximately the same rate.
N.A., in the meantime, will probably grow at a maximum of 10% (and more likely in the mid single digits) because of the constraints of 1) lack of new distributors to expand to, and 2) an increase in the number of competing products.
That means overall growth will be stuck at approximately 13% for the next two years, as opposed to the 25% that management has been projecting. If the market is believing management, then the growth will be half of what’s expected currently, and the P/E ought to contract correspondingly. Moreover, the hits to gross profit from possible accounts receivable write-downs and inventory liquidations mean that the damage on the bottom line ought to be magnified.
I’m not saying UA won’t succeed in its goal of grabbing market share globally, and in the long run it may be a great investment. I just think that any meaningful impact to operating profits from the international and connected fitness business lines are at least 3 years out. In the meantime, I think it will take a hit to earnings, and it’s already at a high P/E. Some of the macroeconomic variables look negative and I think it’s a good time to hold some shorts. UA seems to fit the bill.”

And,

[30% international growth] may be an underestimate. You could also argue that management has learned lessons from the U.S. rollout that allow it to expand faster internationally.
I hadn’t yet looked at trailing International growth, which was 69% for 2015. I don’t think 100% is reasonable, but it could be something like 60% for 2016-17 and 50% for 2018.
That gives overall revenue growth of about 18-19% for the next two years. If UA gets back to its historic high of 11% operating margin, at current interest and tax rates, we get $1.10 in EPS.
Is UA really worth 35X 2018 earnings? I don’t think so. I don’t actually think margins can get back to 11% and there is a substantial risk of operational missteps that give a lot of downside potential and limited upside.

The above was my rationale on valuation. I built out my own messy excel model, and came to maximum reasonable EPS of 87 cents, based on more reasonable international growth figures (50% slowing to 40%), North America growth around 10%, and operating margins coming down figures closer to the more recent 8-9%. At 30X earnings, I figured a price target of $26 was a good target for the short.

A first victory

Under Armour dropped big in early November 2016. The inventory issue I had focused on started to become difficult to ignore, as inventory started piling up faster and faster. Connected fitness continued to pressure operating margins. Management dropped the forecast for operating margins. I put together some of my thoughts at the time:

“My downside target based on a 30 PE of 2018 earnings gave me a stock price of $25-26. The upside was $50-51 based on a 40 PE of 2018 earnings if margins ever come back to historic highs. Is the short still worth it?

One thing I’m working on is holding my winners. I’ve noticed a consistent pattern of getting out of my positions months before the trend ends. I think there is a realistic possibility that Under Armour overshoots to the downside. After all, the company still has write-offs of inventory and accounts receivable that will pressure margins for the foreseeable future.

I recently went to an Academy near my apartment, and half of the (nearly empty) floor was covered in Under Armour merchandise. The channels are full. The company says it can expand the number of channels, but I have doubts regarding the potential sales of these channels. Kohl’s (NYSE:KSS) isn’t going to sell as much Under Armour as Macy’s (NYSE:M).

UA is constrained until international and DTC grow big enough to overcome the relatively weaker North America sales.”

I closed part of my short immediately after the fall, and I regretted it. However, I might do the same thing again in a similar situation. Right after a big fall it may be prudent to take some off the table. The problem is, the more times you “take some off the table”, you are left with nothing on the table when the big win comes. Luckily, I had already noticed my tendency to close my positions too early. I was re-reading one of the Market Wizards books at the time and I noticed one of the consistent themes was getting comfortable holding winners and cutting losers. The ability to hold winners as long as your thesis stands is another trait of great investors, and will be another take-away from this experience.

Sleuthing pays off

I did a bit of sleuthing in October, visiting sporting goods stores. I was inspired by a book called the Sleuth Investor, recommended by a friend, Nick Bodnar. I was really surprised by a visit to Academy, where half the floor was Under Armour. There were entire walls of $30 Under Armour baseball caps. Who the heck buys this stuff? Moreover, who buys this stuff from Academy? The visit made a huge impression on me.

Watching Under Armour investments – the new headquarters

I also found a new reason to short Under Armour in the fall of 2016. I started developing a new theory on shorting. A stock’s earnings multiple ought to be related to the amount of capital it can easily reinvest into its business and the kind of return it can get on that reinvested capital. A choice Warren Buffett quote:”The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.

If a company is worth more if it is employing a lot of capital at high rates of return, the reverse should also be true: a company is worth less if it employs a lot of capital at a low rate of return. Moreover, if a company changes from a high rate of return on capital to a lower one, the multiple ought to change as well.

Under Armour has been reinvesting a lot of its capital. In the early years, it was reinvesting capital directly into making more t-shirts, shoes, socks, and other high margin products. These investments had a very high return on capital. In 2016, the reinvestment rate started to go up dramatically. What were these investments for? They were massive investments into Under Armour’s new headquarters in Baltimore.

Now, my brother lives in Baltimore, and Kevin Plank is a demi-god in that town. I’ve heard a lot of hoopla about the things Kevin Plank is doing in Port Covington. I have a ton of respect for the man. His plans for the development and rebuilding of old parts of Baltimore are wonderful, and the fact that he’s using tons of his own money in the project makes me pretty hopeful that Baltimore may be revitalized from the huge investment.

But I heard a story that made me wince. From the Washington Post:

Under Amour was taking in well over $1 billion in annual revenue when Plank went to the board of directors in 2012 and said that, in addition to building a new headquarters to accommodate the company’s growth, he wanted to buy and develop a much larger section of Baltimore.

The answer was: Under Armour isn’t a real estate developer, stick to shirts and shoes.

The fact that Plank would go to the board to develop real estate, for what is essentially a charitable endeavor, makes me question a lot of things. I think he may be conflating his personal desires with the business at this point. I think he has been taking his eye off the ball if he is not sticking to “shirts and shoes”. It is clear that he has been spending a ton of time on the Port Covington developments, lobbying politicians and selling it to investors. How much time has he devoted to the future direction of Under Armour in America? Has he noticed the accounting changes over the past several quarters?

Moreover, what is he really hoping to gain from the new HQ? Is it really being built to maximize profits for Under Armour? Or to maximize employment in Baltimore?

In any case, an investment in a new building for the company’s headquarters is likely going to have a lower rate of return than investing in a new factory to make clothes, Under Armour’s primary business.

The latest developments

The departure of the CFO Chip Mallow confirms my suspicions that there was something funky going on with the inventory management system that the company was touting in mid-2016.

Inventory write downs tanked gross margins this quarter, dropping to 44.8% from 48% a year earlier. Kevin Plank had this official statement: “We are incredibly proud that in 2016, we once again posted record revenue and earnings, however, numerous challenges and disruptions in North American retail tempered our fourth quarter results”.

The disruptions in North American retail did not start in the 4th quarter. On the contrary, the 4th quarter has been much stronger down the channel. What Under Armour is experiencing now is the delayed effect of the pseudo-recession that occurred in Q1 2016.

Revenue growth slowed down – approximately 12% growth, close to my calculations of about 13%. I think this is a rate that is more sustainable long term. With a good margin and reinvestment at a decent rate, the company could support a 30-40 multiple in this market.

The long run view for Under Armour

I think the bulls and bears for Under Armour both make a lot of good points. While I have obviously been a bear, I think a lot of it comes down to time frame. In the future, International is only going to be a growing slice of the pie. The great thing about a fast growing division is that the division starts to affect the overall revenue growth exponentially as it becomes a bigger and bigger share of revenues. International revenue came in at a strong 55% year on year growth, but they are still only 16% of revenues. In a couple of years, we will hit an inflection point where international is more important to overall growth than North America, and at that point, the overall revenue growth rate should pick up.

If management is willing to take the hit on inventory in one quick and painful write-off, and discounts at the retailers can clear the channel, the company will have a lot of productive growth ahead of it.

The HQ, while perhaps of dubious return to shareholders, will eventually be finished, freeing up the free cash flow to go to more productive uses. Given the timeline of large construction projects, this should probably happen about the same time that overall growth hits an inflection point.

The investments in connected fitness will likely help differentiate Under Armour from the pack of knock-offs and competitors. Smart clothing is an upcoming trend, but we are still at least a few years away from widespread use. The investment in MyFitnessPal has probably helped establish the brand, and increased the mindshare of Under Armour. They now have a platform to easily integrate smart clothing if and when this becomes a viable business line.

In a time when few companies are actually reinvesting, and most are simply focused on buying back shares and cutting costs, a company that is willing to invest in its brand and future products stands out. But valuation has to come to terms with the fact that North American growth is slowing.

The price has surpassed my original target of $25-26 a share, closing at $21.44 per A share today. Like I said in November, I think stocks often overshoot to the downside. There is no telling how far the stock can go to the downside, because even a 30 multiple, close to the overall market multiple, puts the stock price at $13-14 a share.

I am closing because I don’t think the stock is grossly overvalued at this point. I am still not willing to turn around and go long, because I demand a lot of margin of safety on my longs, and I’d need to see a lower valuation to get comfortable with owning Under Armour. But I think long investors can be reasonably hopeful in the longer term. I am certainly no longer a stolid bear on the company. More like an inconstant bull.

Under Armour (UA)

I thought I’d put together a quick overview on my thoughts at this point. The short has worked out pretty nicely.  I covered a small part of the position immediately after the earnings call, but now I’m regretting it. I didn’t believe the weakness in the price would be this pronounced.

The inventory buildup was extraordinarily bad this quarter. Accounts receivable continue to build – write off is looking more and more likely. Connected fitness continues to suck money out of profitable businesses for an uncertain payoff. And perhaps worst of all, the capex is going through the roof as UA builds out its massive new HQ. I respect Kevin Plank for what he’s doing for Baltimore in Port Covington, but I have to wonder if he isn’t taking his eye off the ball a bit.

My downside target based on a 30 PE of 2018 earnings gave me a stock price of $25-26. The upside was $50-51 based on a 40 PE of 2018 earnings if margins ever come back to historic highs. Is the short still worth it?

One thing I’m working on is holding my winners. I’ve noticed a consistent pattern of getting out of my positions months before the trend ends. I think there is a realistic possibility that Under Armour overshoots to the downside. After all, the company still has write-offs of inventory and accounts receivable that will pressure margins for the foreseeable future.

I recently went to an Academy near my apartment, and half of the (nearly empty) floor was covered in Under Armour merchandise. The channels are full. The company says it can expand the number of channels, but I have doubts regarding the potential sales of these channels. Kohl’s isn’t going to sell as much Under Armour as Macy’s.

UA is constrained until international and DTC grow big enough to overcome the relatively weaker North America sales.

As for the buyout rumors, I am pretty confident these are floated by traders with long positions looking to offload. 1) I really really don’t think Kevin Plank would ever want to sell. He has a specific vision and almost certainly wouldn’t trust someone else to execute this. 2) Who would buy? I really doubt Nike would be interested, especially at these prices. No one else is big enough. Maybe a PE firm would be crazy enough to do it, but again, I think Kevin Plank would fight like hell before being subjected to the oversight of a PE manager.

I think there’s a good chance that UA breaks technical resistance at $30, and then who knows where it stops? So I’m holding, although at a slightly smaller position.

Advanced Drainage, Discover, and Under Armour

Advanced Drainage Systems (WMS)

As I wrote about before, I think WMS represents an excellent short. Jeremy Raper on SA and utah1009 on VIC wrote some great, detailed write ups on it, and I’d recommend you read those. Basically, it is fundamentally overvalued, has significant accounting issues, and a large amount of convertible bonds that can add 38% to the market cap that many analysts miss. Analysts are projecting huge margin gains on the back of drops to the material cost.
In addition, the CEO Joe Chlapaty owns a significant amount of stock (13%) and probably drew some margin to get that much, so it is one of those stocks that could run into a CEO-margin-call issue if it starts falling very fast.
If you take out some of the more absurd add-backs to EBITDA, add in the extra convertible shares, and value the company based on its comparables, you get a price ~ $12.
The drop in material costs has been boosting the gross margin significantly, and macro tailwinds in construction have been holding up revenues enough to keep the stock moving higher the last several months, putting me well underwater on my short position. However, after negative earnings announcements by U.S. Concrete, Martin Marietta, and others in the construction industry, all the stocks have taken a bath. I added a bit to my short in the mid-20’s after reading USCR’s conference call.
U.S. Concrete is particularly relevant to WMS because WMS makes plastic pipes used to replaced concrete ones. The price of concrete has been soaring, which boosts demand for WMS’s plastic pipes. This is coming at the same time that the price of polyethylene has been dropping, which boosts WMS gross margin.
The construction industry in general was pretty hot Q4 2015 – Q1 2016. The BEA data from Q1 showed that the biggest gains in GDP came from the construction industry. I think its slowing down as the latest housing starts from Q2 2016 show. USCR and Martin Marietta maintain that the slowdown in construction is a temporary blip related to weather. Maybe it is, maybe it isn’t. Either way, WMS ought to announce pretty crumby earnings tomorrow, which should be a nice time to take some profits.
Discover Financial Services (DFS)

Discover is an interesting idea. It trades at a discount to AXP, 2.25X Book vs AXP’s 2.91 X Book, despite being essentially the same business model*. AXP has an E/A ratio of 12.9% and DFS has an E/A of 13.1%.
It originates the credit card loans and holds them, unlike V and MA, which originate and sell off the loans. But the great thing about Discover’s business is they generally go after very credit-worthy customers.
The stock has taken a hit, in my opinion, over two issues – the recent loss of exclusivity with Sam’s Club, and an expectation that the lower than average loan losses will reverse in the next credit cycle. Both are reasonable concerns, but the even if the company takes a pretty big hit on these, say 20-30% of earnings wiped out, it is still going to be trading at a PE in the low teens, and a cash flow yield in the 8-10% range. I am perfectly happy to take the possibility of a drawdown of 20% over the next year for the chance to own a security that is essentially yielding 10+% a year for the foreseeable future, and with a substantial possibility of a re-rating to a 7-8% yield.
I think the business is good enough to trade at a higher multiple, a P/E something like 15X and a cash flow yield around 7-8%, or a 12-13X P/FCF, compared to its current P/E of 11 and its current P/FCF of 8.65. It could probably rise to AXP’s price to book, though I think even AXP could go a little higher on that ratio.
On top of that, technically, the chart looks great. It’s made a nearly perfect inverted head and shoulders over the past year, with a neckline around $56. It just broke through the neck line over the past couple of weeks. This is generally a pretty positive sign, and it gives you a natural stop, so it is an easy stock to set up a large size in – you know exactly at what point the thesis is invalidated and you need to get out.
Let’s say you couldn’t get out, or you hate using technicals. In a downside scenario, an upcoming recession, if you take it for granted we don’t have a 2008-09 style recession in our near future, I don’t think DFS would trade for less than 1.5X book, even if earnings collapse and loan losses go up a lot, which gives you $40 a share. In an upside scenario, 3X book, you get exactly $80 a share. This upside target at 3X book also roughly corresponds to a 15X earnings multiple.
3X book may seem high for a company that is essentially a bank. But consider this: banks with 10% ROEs and a high E/A ratio routinely trade for 1.5X book. Discover has a 20% ROE and a very high E/A so a 3X book doesn’t seem unreasonable.
The odds then appear roughly 50/50. Then look at the macro. The BEA released real consumer spending numbers that were surprisingly positive for the second quarter, and I think consumer spending was a key driver of the latest rise in the stock market. This actually bodes well for another upturn in the cycle, despite narrowly missing a recession earlier this year.

So you get a mildly positive macro tailwind, a positive technical indicator, and good fundamentals, with a worst-case downside about equal to the best-case upside. DFS makes for a good bet.

* So okay, AXP might be a little better business. The ROE at AXP is 25%, so maybe it deserves a higher P/Book than DFS. But AXP probably has upside too – it is trading at a discount to its own historical multiples on P/Book and P/E.

UA

UA is starting to stress me out. The latest quarterly earnigns really bore out core points of my short thesis – the accounts receivable continue to rise, and inventories continue to climb, with management making a mountain of excuses. But I was troubled by one comment they made on the call. Management compared the amount of distribution outlets UA has to the amount that Nike has, with the argument they still had substantial room to expand distribution.
A big chunk of my thesis was that UA had benefitted for years from growth in distribution channels. But I figured that it was running out of new channels to grow into, and would start to suffer lower growth. I also postulated that the recent Sports Authority’s bankruptcy and weak same-store sales from the department stores were contributing to the bigger charge-offs and inventory build-up, and I thought that management was trying to obfuscate this by announcing they were changing their inventory management system.
The problem with this thesis is that if UA can still expand distribution – like they just announced with Kohl’s – there may be a while left before the negative fundamentals start to catch up.

I also made a cardinal mistake when I thought about UA earlier this year. I made the assertion that industry growth in athleisure was about 10%, and UA had been growing for 25-30% for years because of its market share growth and distribution channel expansion. Eventually, if the latter was coming to an end, and the former was being challenged by new entrants, then UA revenue growth would ultimately slow to 10%. As such, it did not deserve a premium P/E multiple to NKE and definitely did not deserve a premium multiple to LULU. Moreover, as LULU took back market share after its latest turnaround strategies set in, UA would suffer. This was the basis of my short position, and where I was figuring my profit targets for the trade.
The fault was that I didn’t consider that instead of UA’s P/E multiple falling, the P/E multiple of LULU and NKE could RISE to match that of UA. And that is essentially what happened, the returns of LULU and NKE have been exceptional, while UA just stayed flat. In retrospect, the smarter play would have been a pair trade, short UA and long LULU. I just have difficulty paying 40X earnings for any company, even fast growing ones with positive underlying market dynamics.
One last thing that’s making me nervous is David Einhorn’s Q2 letter. I noticed he just wrote that Greenlight closed out their UA short. I don’t think he has a crystal ball any more than the rest of us, but Greenlight is a bunch of incredibly smart people who have a long history of shorting successfully, and if they think the risk/reward is gone from the trade in the high 30’s, who am I to say that there is more potential for this thing to fall? The last time I held on to a trade after Einhorn closed out his short was Mobileye, and I got crushed by the subsequent rally.
Here are the parts of the thesis that are still intact. Lululemon is still taking back market share. I don’t think the Stephen Curry line will be as profitable as the Jordan line, despite expectations of analysts to the contrary.
But the most important component is this: 5-6 years ago, Under Armour had a unique proprietary product that no one had ever seen before and that everyone wanted. Now that sweat-wicking material is being copied everywhere for dirt cheap prices, and UA has to compete by making incremental improvements that really won’t move the needle on consumer preference. Even it’s biggest customer, Dick’s Sporting Goods, is moving aggressively with their own athleisure line. This is a substantial change in the business model – it’s never good for business to compete with your customers.
It’s the classic problem of an innovator – eventually, everyone catches on to the basic innovation, and the company is now left spending tons on R+D for small gains while competitors take market share. UA is betting hard on “connected fitness”, taking on debt to buy MyFitnessPal, but it will be a long time before these initiatives are a contributor to revenues, and in the meantime it’s a drag on the bottom line, while the top-line is under attack.
The technicals on this one are interesting. The stock is stuck in a wedge. Being at the bottom of the wedge, its prudent to at least take some off the table – it’s more likely to bounce back up into the wedge than it is to break lower.  But as the wedge narrows, there is an increasing probability of a large price move in either direction.

Brexit and Shorts

So I turned very negative on U.S. stocks during May. Part of it was seeing the apocalyptic presentation by Stan Druckenmiller at Sohn, and reading the piece in the WSJ about Soros coming back to fund management after an 8 year hiatus, but it also arose from an inherent belief that stocks are expensive, we are in a bear market, and earnings have gone lower for 3 quarters in a row.

The liquidity situation is hard to read. The Fed is the big question mark and biggest decider. Capex and inventories are rising, which suck liquidity out of markets. Earnings are falling, which obviously leaves less cash available for pouring back into markets.

But on the other side of the equation, buybacks and M&A are continuing at a torrid pace, often funded by the excess cash on balance sheets and corporate debt. So there remains a positive force to buoy the markets. If this stops, the market will tank.

Brexit clearly wasn’t anticipated by the market. I don’t think the actual event is all that significant, but I think it provided a catalyst for a market that was looking for a reason to fall. I didn’t have any currency positions, because I didn’t have any conviction as to how the vote would end up. I’m going to use the weekend to rethink my views on currencies and see if I can come up with a thesis.

I wasn’t positioned perfectly for the shock, but my portfolio was up about 3% Friday because of my large SPY short. I also have a number of individual shorts, my two biggest being SHAK and UA.

SHAK

Shack Shack is a short I’ve held ever since the borrow rate came down to reasonable levels. I think even at these prices it’s still way too expensive. I used their own forecast – 14 new shacks a year, average AUV of $2.8-3.2 million for new shacks, Shack-level operating profit margin of 18-22%, projected total of 450 shacks. Even if you use the high end of their internal forecasts, then apply a very generous 7.3% discount rate, you get a $26 share price. Keep in mind this doesn’t include execution risks, and also my projection was that average AUV would still remain very high because of the higher AUV of the New York and East Coast Shacks. Insiders have been selling since lockup and are still selling in droves. I’m still short and won’t cover til it hits $30.

UA

Under Armour is running into issues with its distribution channels, and I think its trying to cover it up. They announced a new inventory management system – I think the channels are stuffed and they can’t move the inventory. Inventories and Accounts Receivable are both rising faster than revenues – a huge red flag. Sports Authority went BK, a sign of the troubles at its distributors. It’s biggest customer is Dick’s Sporting Goods, which hasn’t run into trouble yet, but Dick’s is also launching its own athletic wear line to compete with UA. Oh yeah, and the Steph Curry’s are probably the worst reviewed shoe of all time, plus the Warriors lost.

The company has been growing revenues at 30% a year for the past 3 years, and forecasts 25% growth this year, so the market gives it a high multiple, about 70X trailing earnings. Compare this to Lululemon, which had posted an average 10% growth for 3 years, but just accelerated last quarter to 17% revenue growth, and trades at 37 times trailing earnings. UA may be worth more than Lululemon but not twice as much.

WMS

Okay, maybe I should stop shorting this thing. I read the write up by utah1009 on Value Investor’s Club, and it made a lot of sense, so I shorted. But you can’t fight a promotional management, a promotional Wall Street, AND macro tailwinds. It’s done nothing but lose money for me since I shorted $21. I think it should be worth something in the low teens eventually, but the question is how long can I wait? Luckily the position size was small, so the losses haven’t been huge. But the lesson here is pay attention to the macro – if there is a fundamental reason for this thing to do well, you shouldn’t be short.

MBLY – Mobileye

I read a really good thesis on Mobileye by Suhail Capital on Seeking Alpha, it made sense, and I shorted. The company has shown impressive revenue growth and has huge margins and little competition at the moment. But there is no patent protection, and there are a ton of companies entering the space, including the auto manufacturers themselves. I think, looking two years out, growth will have flatlined and margins will have come down, leading to 2017 earnings that are about the same as those of the last twelve months. Currently it’s trading at a P/E of 124, and if you buy the thesis, then it’s a forward P/E of about the same. I’m short a small position.

I’m still looking for great short ideas. I think Friday’s drop was just the beginning of another market rout, like January-February, like last August. Hopefully, third time’s a charm.

 

Another look at Reverse Corp

Reverse Corp (ASX: REF) came out with an announcement on the Half-Year ended Dec 31, 2015. I’ve updated my sum-of-parts analysis below.

The Cash

An interesting development in the cash picture has evolved. The company still has net cash of $5.56 million, but has also purchased shares in another Australian company, Onthehouse Holdings, an Australian real estate software company. It initially bought 1.75 million shares at an average price of 57 cents a share, then Onthehouse received a takeout offer. for 75.5 cents a share. The share price rose to 70 cents a share, and Reverse Corp bought another 1.39 million shares, betting the merger would occur. As luck would have it, Onthehouse rejected the initial takeover offer, and the buyers offered to increase the bid to 85 cents a share this morning.

Shares are currently trading at 79.5 cents a share, for a 26% gain from Reverse Corp’s buy-in price. Reverse Corp’s stake now stands at $2.50 million, from an initial investment of $1.98 million. If the deal goes through, the stake will be worth $2.67 million.

That puts cash and marketable securities at $8.06 million, or 8.6 cents per share. For reference, the whole company is trading for 11 cents per share.

Last post, I said the cash probably deserved a 10% discount, as management was looking to make acquisitions, and we have no assurance of the success of these acquisitions. The latest development seems to show that they are at least looking in the right places. I’ll keep the 10% discount, and say cash is $7.25 million or 7.8 cents a share.
OzContacts

OzContacts is positive on EBITDA, but the EBITDA is still miniscule at $35,593. This was probably because of a lower revenue this HY than the previous. It might be consumer weakness in Australia, or it might be weakness in the business. I’m not sure which is the case, and it is worth keeping an eye on. I’ll take my cue if on the next earnings announcement the inventories have built up – that would be a sign that the business has serious problems.

The company wants to make acquisitions in this business, achieve scale, and boost margins through synergies. I would normally say I don’t trust management to be do things like this, but the company has proven itself to be a shrewd capital allocator.

The company divested its loss-making divisions immediately when they stopped contributing to the bottom line, cost-cut their core business to start generating tons of cash flow, started a new business in an area they have no expertise, successfully got the business to profitability, and has been even investing in the stock market with success (more success than I have had lately). Some of these might be luck, but after enough successes in a row, I have to think management must be doing something right.

So I think it’s reasonable that management might succeed at acquiring another contact lens business and cost-cut to realize synergies.

The business is profitable and growing EBITDA (despite the decline in revenues), and probably is still worth at least 1-2 cents a share.

1-800-Reverse

The revenue at Reverse declined 16%, rather than the 50% decline in my worst case, and the 10% decline in my most likely case. So it’s doing a little worse than I thought was likely. I’m now assuming 30% yearly decline in the worst case, a 15% yearly decline in the most-likely, and 5% decline from here on in the best case.

Reverse Corp Worst CaseReverse Corp Most Likely CaseReverse Corp Best Case

Values per share

So in the worst case, I won’t lose much (in fact, might even make a little), and in the best case, I might make a lot.

There is room for additional upside. If management deploys capital in an effective way, and is able to realize synergies from a contact lens acquisition, we could see more value in the OzContacts business.

On the 1-800-Reverse side, I think the pre-paid calling business is counter-cyclical and should benefit from the current macro picture. The pre-paid cellphone business grew in the U.S. during the 2009-2010 recession. With Australia in a slump from a decline in the mining sector, and now oil and gas weakness, the pre-paid calling business ought to benefit from tailwinds of a cash-strapped consumer. There is a real possibility that revenues at Reverse Corp actually increase, rather than continue to decline, as consumers shift to pre-paid mobiles.

Finally, the strength of the 1-800-Reverse brand shouldn’t be underestimated. Though there are two competitors in the space, Reverse Corp spent years on advertising to develop recognition among consumers. It can now reap the dividends of those years of investment without need for further advertising. The collect calling industry isn’t big enough to justify large advertising budgets anymore, which essentially locks in the consumer “mind-share” at old 1990’s levels. The competitors can try to buy their way in, but they can’t afford to do the kind of advertising necessary to displace 1-800-Reverse. This mind-share ought to allow keep at least a small moat against the competitors as the industry continues to decline.

 

Disclosure: I own shares of Reverse Corp

Context matters

I was watching one of Joel Greenblatt’s MBA classes at Columbia the other day where they analyzed some investment writeups of Charlie479 on VIC. When Greenblatt asked the class for their thoughts on the write-up, many classmembers pointed out the more obvious points to the investment thesis (buying back shares, cheap on some metric, etc), however one thing that he brought up that his students were missing was the psychology of each investment – what was the difference between market perception and reality?

NVR was misunderstood – everyone thought it was a homebuilder, in a capital-intensive, cyclical business, and therefore deserved the same multiples as the other homebuilders. However, they missed its capital-light model, negative working capital, and its business practice of pre-selling.

NII Holdings was disregarded as a post-bankruptcy stock, and its earnings were difficult to compute, because the filings were so complicated. The fact that it took Charlie479 significant effort to come up with the 2.8 EV/EBITDA figure was something that stood out to Greenblatt that the students brushed over. Greenblatt realized that if it was that difficult to discern its earnings, NII Holdings must be misunderstood. (As an aside, this stock eventually went bankrupt again – a so-called “chapter 22” filing – and has again emerged from bankruptcy. It ought to be worth a look again this time.)

Finally, Sportsman’s Guide was regarded as a catalog business, however, what the market didn’t see was the potential to cut costs dramatically from internet sales. The students did concentrate on this as a salient point, but what differentiates Greenblatt’s approach is a concentration on what the market doesn’t see.

There is a plethora of new value investors on the scene (myself included) who probably spend too much time on simple metrics – EV/EBIT, ROIC, P/E, P/FCF, etc. However, what Greenblatt emphasized continually in his MBA classes is that context matters.