Homebuilders ready to run

I wrote the following in my trading journal a couple of weeks back. Since then, the homebuilders have run a little bit, but I think they have a lot of room to go. I am looking for feedback on this idea, so please comment below!

I am wildly bullish on the housing market, and I can’t quite figure out why the market isn’t repricing the homebuilders to higher multiples. It seems to me that market participants are awarding end of cycle PE multiples (high single digit) to the homebuilders when we are much more likely to be mid cycle.

I won’t rehash the arguments in full about housing supply – there are analysts who have done a much better job of this than I will. But the basic thesis is that the housing bust in 2008-2011 created an overhang of inventory, that has gradually been sopped up by the marketplace, and there is now little available housing inventory on the market. At the same time, millennials are reaching peak household formation age and there is a rush out of the cities amid a renewed focus on “home” during the pandemic.

I would also add some less discussed bullish points. Household debt to GDP has declined steadily since the great financial crisis (and I would wager this deleveraging of the household sector is a prime contributor to the low economic growth we experienced in the last decade). Household debt service as a percentage of disposable personal income, pre-pandemic, was at the lowest level since the government started collecting records in the 1940’s. Since the pandemic, this measure has broken to new lows. The average U.S. household could afford to take on a lot more debt, particularly at these interest rate levels.

The market seems to also trade down the homebuilders when mortgage rates rise, but we are still at such absurdly low levels, with the 30-year fixed mortgage at 2.8%, that I don’t think a rise of 20 basis points in the mortgage rate is going to make a difference. In the meantime, stimulus payments ought to strengthen the consumer balance sheets faster than they increase the treasury rate, so I don’t think an increase in rates is a valid concern for the homebuilder group.

The homebuilders as group are much stronger companies than they were pre-2008. They have consolidated further, with the larger homebuilders taking increasing share from the more fragmented small homebuilder group. As Michael Porter pointed out in his analysis of the homebuilders back in 2003, the large homebuilders have a lot of advantages over smaller homebuilders – like lower cost of capital since they can issue bonds rather than rely on bank debt, and lower costs per home due to better negotiating power versus suppliers. In the pandemic, I would also add better technological capabilities, allowing things like virtual tours, which may be more difficult for smaller homebuilders to set up.

In addition to consolidating the industry, the homebuilders have worked to reduce the capital intensity of their land developments. The pioneer of reduced land holdings is NVR, which has been an incredible stock, returning 100X the initial investment over the past 20 years, due to its capital light strategy and return of cash to shareholders via buybacks. NVR doesn’t buy land outright, but controls the land via options. It then pre-sells the home to a buyer, and only buys the land when it is ready to build the home. This process produces industry leading return on capital and reduces the capital intensity of the business. NVR is awarded a premium multiple typically in the high-teens, currently at 20X earnings.

Other homebuilders have seen NVR’s success, and all are in the process of reducing land holdings and transitioning to an option-controlled business model, which is freeing up a ton of cash flow at the major homebuilders. They are using this cash flow to reduce debt and strengthen the balance sheet, as well as for opportunistic buybacks. As a group, this change in business model should mean they command higher multiples, closer to NVR’s 20X, rather than the measly 10X earnings that they are trading at currently.

Lennar (LEN) is the homebuilder I’ve researched the most, but I am also open to exploring investments in the other homebuilders, provided I can get a grasp on the unique characteristics of each one. Lennar has grown via acquisition into the largest homebuilder in the U.S., and has focused on cost-control and improving margins over the past several years, achieving its highest homebuilding gross margin ever in Q4 2020 of 25.0%. Lennar is in the process of reducing land holdings and switching to a 50/50 mix of owned land and option-controlled land, which is freeing up a ton of cash flow – the company generated over $4 billion in cash in the last 12 months, on a $27 billion market cap. The company used a lot of this cash to reduce debt, and achieved an investment grade credit rating in 2020. There aren’t many homebuilders with an investment grade rating, and a higher credit rating lowers the cost of capital for the company. The ultimate return to shareholders over the longer term depends on the return on invested capital (ROIC) – weighted average cost of capital (WACC), and this spread seems to be in the process of widening. A widening of this spread also ought to lead to an increase in the multiple.

There’s an added kicker for Lennar that comes from its 4% stake in OpenDoor (OPEN). OpenDoor depleted its inventory during the pandemic, and is looking to rebuild housing inventory to pre-pandemic levels, which would entail net additions of about $1.2 billion of houses to its balance sheet. Zillow also depleted inventories in its iBuyer segment and is looking to rebuild inventories on the same order of magnitude. As the only homebuilder with a stake in an iBuyer (to my knowledge), I’d guess that Lennar would have a special ability to sell homes into OpenDoor’s inventory build.

Other relevant tickers are D.R Horton (DHI), KB Homes (KBH), Pulte (PHM), Toll Brothers (TOL), LGI Homes (LGIH).


Mitek – Massive Margins, Huge Moat, and Multiple Growth Levers

Mitek is a company that licenses image recognition software for mobile check deposits (67% of revenue) and digital identity verification software (33% of revenue). The stock rose from a penny stock in 2009 to a peak of $12 per share in 2011 and 2012 as it signed licensing agreements with the 4 big U.S. banks, and revenue has grown rapidly since then as signed licensing agreements for the Mobile Deposit product with more and more of the large U.S. financial institutions. In more recent years, the company has focused on expanding its offerings to include identity verification services for banks, which help banks comply with “Know your customer” (KYC) regulations.

Over time, the revenue composition for the company has transitioned from an enterprise software model, whereby the company sells a license for the software and a certain amount of check transactions for use in Mobile Deposit, to a model with some SaaS-like characteristics of recurring revenue from maintenance and services fees and more usage-based transaction fees with its Identity Verification product.  In 2019, services revenue increased to $37.7 million, or 44.5% of overall revenue, driven to a large extent by a 63% growth in the transaction SaaS revenue. Transaction SaaS revenue came in at $13.2 million in 2019, or 15.5% of overall revenue.

In recent quarters, the growth rate has slowed down and investors appear to be less willing to put a high EV/Sales multiple on the company due to the deceleration in growth. Most of the slowdown in growth is coming from slowing license sales for the Mobile Deposit product, as the company has likely saturated the natural market of financial institutions. The CEO estimates that Mitek now has a 98% market share of mobile deposit among U.S. financial institutions, with only 1-2% of the market represented by USAA, which developed its own mobile check deposit software. The number of physical checks in use is also in decline, with a consistent decline of 3-4% every year in check volume. I think this natural market decline along with saturation of the end customer has led the market to discount future growth rates for the company.

However, the CEO cited in early 2020 that only 18% of checks are deposited via mobile deposit, with the vast majority being deposited in bank branches, leaving plenty of room to grow check volume. Since the banks purchase a certain quantity of check deposits each year from Mitek, these deposit numbers might continue to increase for some time to come. There is a tremendous cost-savings to the bank from mobile deposit – mobile deposit only costs the bank a few cents per deposit, whereas in-branch deposits, when taking into account personnel costs, real estate costs, and processing, can cost up to several dollars per check. As the Mitek CEO has pointed out on numerous occasions, “There is no alternative to this technology” and “We have never lost a customer”. This means that Mitek has tremendous pricing power, which I believe it has not yet exercised in a meaningful way. Mitek already generates an 86% gross profit margin, but it could continue to expand this with pricing increases, with all price increases dropping straight to the bottom line.

I would also guess the amount of mobile deposits utilized by bank customers has increased dramatically during the COVID pandemic. I think many of these changes will be permanent changes in consumer behavior. I know I personally deposited my first check via mobile deposit during the month of April because I didn’t want to bother with masking up for the bank run, and I probably won’t ever deposit in person again because it was so easy. I would guess the banks have used up all the checks that they bought earlier this year, and will be returning to Mitek in Q2, Q3 and Q4 for further mobile deposit purchases, leading to an unexpected acceleration in revenue growth.

The company has been growing its identity verification products, which now make up 33% of revenue. This business is growing much faster, however has more competition than Mitek’s mobile deposit business. The Mitek CEO estimated the company has a 20-25% market share in this business, mostly composed of the same financial institutions that use its Mobile Deposit product. As I mentioned earlier, the company has been growing its transaction based revenues, which is describes as “Transaction SaaS” revenue, at a rapid clip. Most recently, these revenues made up 16% of overall sales, and are growing at over 50% per year. As these revenues increase, they will cause the overall revenue growth rate to accelerate as well. Management estimated the Identity Verificaiton business overall ought to grow at about 30% this year pre-COVID. I would guess this business has also received a tailwind during the COVID pandemic, particularly as home-buying has ramped up with many consumers viewing homes and getting mortgages entirely online. The identity verification business does sell to the hospitality industry, and these sales suffered in Q1 and will likely continue to suffer for the rest of the year. But in coming quarters, these effects will be swamped by the larger revenues from financial institution customers. Furthermore, upon the rebound in hospitality in 2021, Mitek should enjoy a return to higher revenues among the hospitality customers as well.

I’d mentioned the company has likely saturated its core market of U.S. financial institutions. However, recently it made two acquisitions, ICAR and A2iA, located in Spain and France, respectively. Management now appears to be pivoting for growth to European financial institutions. The acquisitions have taken a toll on gross margins, adding significantly to COGS. However, in fiscal Q1 2020, the company announced it was restructuring the Paris operations of A2iA, and, concurrently, the COGS dropped from 16% of revenue to 13% of revenue year over year. Prior to the acquisitions, the company typically had a 90% gross margin, and I’d expect margins to creep back to this level as the company continues to rationalize its European operations. Furthermore, the European operations provide a platform for growth among European financial institutions, provided the company can navigate the more complex regulatory structure in the European Union.

These acquisitions have also obscured the operating profit and free cash flow picture. Additional payouts from the acquisitions, restructuring costs, and amortization of goodwill associated with the acquisitions have added up to about $10.1 million in the TTM period. This is actually a positive as it has reduced the tax burden (the company typically realizes an income tax benefit rather than expense), but has little use for calculating the long term profitability of the business.

Though the Mobile Deposit business is still growing (management estimated growth at 10-13% pre-COVID), it is highly profitable. Margins may actually have some upside as check volumes increase and the company exerts its pricing power. The Identity Verification business is actually losing money, but the company estimates it will get to profitability at some point within the next year or two. Currently, the company has a non-GAAP operating margin of about 20-22%. Keeping in mind this figure adds back stock-based compensation, which I regard as a real cost, it still reveals a company which will be highly profitable at scale, once the Identity Verification business begins to contribute to the bottom line rather than subtract.

I’d guess the operating margin for this company at scale is somewhere in the 25-30% range, meaning its an incredible business with a very high return on capital. It’s got an asset light business model, and ought to throw off tons of free cash flow at scale.

I’d also figure that the many growth levers mentioned above will get revenue growth to accelerate from 16% in the most recent quarter, to above 20% by year end. A software company with huge margins and a 20% growth rate probably should not be valued at an EV/Sales ratio of 3.9X. The transition to a more SaaS-like business model might also get investors to place the company alongside some of the high-flying SaaS names, which might cause the stock to re-rate. I would guess a more appropriate EV/Sales multiple might be closer to 8X, indicating about 100% upside to current prices.

Technically, the stock price has shown a strong predilection to round numbers, and is sitting just above $9 which has proved to be a strong support and resistance in the past. I’ve got a big position on just above this level and am intending to ride this out for Q2 and Q3 results. I’m looking for a target price in the $18-20 per share range.

Verra Mobility: An overlooked high-margin, wide-moat business

Verra Mobility (VRRM) is an incredible business with a wide moat that is being overlooked due to its opaque financials and unglamorous entrance to public markets via a Special Purpose Acquisition Company (SPAC). The company was formed via multiple acquisitions in the traffic management space, incurring numerous transaction and transformation charges, as well as large goodwill amortization expenses. In addition, the company incurred sponsor fees via the process of going public using a SPAC. The depreciation and amortization charges on the income statement add up to a whopping $80 million per year, yet capital expenditures have stayed below $20 million per year for multiple years in row. When depreciation and amortization, transaction and transformation expenses, and nonrecurring sponsor fees are backed out of the income statement, and maintenance capital expenditures are assumed to be $20 million going forward, one can unearth a company with normalized operating margins north of 40% per year, which is on par with some of the greatest businesses of all time.  

The large operating margins reflect the wide moat of the business. Verra has a virtual monopoly on managing red-light cameras and school zone speed enforcement cameras in the United States. It is also the leading provider of toll management, violation management, and title and registration services for fleet vehicles and rental car companies in the United States. The company offers parking management solutions in Europe and is looking to expand its toll management operations in Europe, with a pilot program in France ongoing and a recent acquisition of Pagatelia, a small toll management company based in Spain. The continued adoption of school zone speed enforcement cameras, continued growth in the number of toll roads, and conversion of toll roads to cashless payments should add tailwinds for growth for years to come, and additional opportunities for expansion in Europe and potential adoption of congestion charges by municipalities provide upside optionality.  

The closest public comparator is Fleetcor, which offers fuel payment, lodging payment, and toll payment solutions to fleet vehicle companies. Fleetcor has an operating margin of 52% and is similarly levered with a debt to EBITDA of 3.15X. Fleetcor has been an incredible stock, with over a 1000% gain since going public in 2011, and it trades at 35X FCF. I believe the normalized free cash flow figure for Verra (assuming adequate working capital management) is around $100-120 million currently, with runway for growth in the low teens for many years to come. At the current stock price of $15.25 per share, and 163.7 fully diluted shares outstanding, Verra trades for 20-25X FCF, and is levered with a Debt-normalized EBITDA of 3.5X. This may seem like a lofty multiple, but companies with stable recurring revenue streams (like Verra’s long-term contracts with municipalities, rental car companies, and fleet vehicle companies) and high margins are trading at multiples in the 30X-40X range in the current environment. Assuming a similar multiple to Fleetcor of 35X FCF, Verra would trade at $22-26 per share, for upside of 44-72%. More importantly, the company has the prospect to continue to compound for many years at a 10-20% rate of return as it reinvests at a high rate of return and continues to gain operating leverage. As it delevers its balance sheet, the company may pursue additional acquisitions to realize further synergies (management appears to have a proven track record of integrating acquisitions prior to coming public) or buy back stock for additional returns.  

As the company laps its 1-year anniversary as a public company, the incredible financial strength should become more and more apparent as investors buy in to the story and analysts deepen their understanding of the business. Moreover, a recent contract with New York city to install an additional 720 school zone speed enforcement cameras (on top of the 300 existing cameras) should add at least $32 million of high margin recurring revenue going forward (720 cameras * $3800 per camera per month * 12 months). Recent New York State legislation on school bus cameras may result in further upside if Verra can get the contract – a high probability given its level of involvement with New York City. Additional contracts are under negotiation in Georgia, and multiple municipalities are mulling the prospect of congestion pricing. Finally, investors will get a litmus test on pilot programs in France in 2020 as the company seeks to expand its toll management solutions throughout Southern Europe.  

Risks include the prospect for public backlash against red light cameras and school zone speed enforcement cameras. Seven states have banned red light cameras, and Verra lost $11 million in annual recurring revenue when Texas banned red light cameras in 2019. I’d anticipate New Yorkers may take some umbrage when school zone speeding tickets begin to arrive in the mail throughout 2020. New York City has asked the company to target 60 school zone camera installations per month in 2020, a significant increase from its 40/month pace in 2019, and even management has expressed doubts they can hit that figure, so there are certainly execution risks in this program. 

Competition from Fleetcor or new entrants may eat into the toll management business. One might argue the rental car business is in terminal decline, which will eat into growth rates in toll management. There are significant execution risks with the rollout of toll management in Europe, as Europe is a much more fragmented market than the United States and management has limited experience working with municipalities and toll operators in Europe.  

It is worthwhile to note that working capital management has been lax in the first few quarters, with accounts receivable growing faster than revenue, and receivables will be a key figure to watch to ensure the company hits the normalized FCF figures above. It is also worth noting the complete flop of “Peasy”, Verra’s iPhone app designed to provide electronic, RFID-free toll-management to retail customers.  The company has struggled to get adoption, and management has no experience marketing an app to the wider public. Lastly, I’d note that the private equity sponsor, PE Greenlight Holdings, has been selling out of the companyIt offered shares at $12.50 in June, and recently reduced its stake from 25% to 15% of the company in another secondary offering in November at $14.25 per share. The offering price has acted as a congestion point for the stock, with the price consolidating in the $14-15 range for the last 6-7 months. The recent breakout from this range may be a good sign for the stock, but also note that the PE firm may seek to sell out the rest of its stake as the stock rises, adding overhead pressure.  

JD.com: little downside, big upside

JD trades at the low end of its valuation on a price to sales basis since its IPO. It has rarely traded below a P/S of 1, and currently can be bought for a P/S below 0.9. Even the most pessimistic analysts forecast average revenue growth of at least 20% for the next two years, and consensus pegs revenue growth at 30% for 2018 and 25% for 2019.

I have difficulty envisioning a scenario where sales growth turns negative in the near future. I also have difficulty envisioning a scenario where the P/S declines even further to 0.7 or 0.6, yielding maybe a 30-35% downside. However, I think it’s fairly probable that JD delivers at least 20% top-line growth for the next couple of years, and that the P/S normalizes to something like 1.2-1.3, yielding an upside around 100% for the next two years.

The Price to trailing free cash flow is only 17.9, but I would argue the cash flow is imperfectly calculated at JD because of the impact of JD Finance’s credit products. I don’t think the P/E ratio is an appropriate valuation measure for JD.

The stock has been punished for its inability to execute on profit margins, slowing sales growth, the threat of a trade war between the U.S. and China, a general environment of China slowing in early 2018, and general weakness in financials globally.

It hasn’t grown profit margins as much as it said it would, and the company has maintained this is because they are continuing to invest in the logistics network. In mid-2017, it appeared that JD would be largely done with its logistics investments by the end of the year, and the profit margins would widen out as a result. However, the company has chosen to continue logistics investments, probably in preparation for a spin-off of the logistics business. Management claimed that these investments will pay out by the middle of 2018, and that the operating leverage that investors were expecting by 2017 YE should become apparent then. Credit Suisse slashed margin expectations for the full year 2018, and I don’t blame analysts for not trusting management’s guidance anymore.

But I do think these investments are prudent. Logistics in China are a nightmare, and I think JD has built a sustainable competitive advantage with its heavy investments. The need for same day delivery in China is even greater than in the U.S. I remember buying a wifi router in Beijing. I looked up the nearest electronics superstore, which was 20 minutes away without traffic, but over an hour away during rush hour. It was nearly impossible to get a quality product at any sort of reasonable price in local stores. JD was the most efficient option, and at that time they were only offering 2-day delivery services.

The third-party services should also allow management to the company to fetch a higher price in any spin-off. I would say the investments were validated by the success of the recent JD Logistics fundraising, which valued the logistics arm at $13.5 billion, or close to a third of its $42.8 billion market cap. Such a spin-off might reveal the profitability of the commerce operations.

Slowing sales growth mostly relates to a slowdown in apparel. While growth in JD’s core appliance and electronics market has remained steady, apparel sales have dropped and management expects continued weakness for the next several quarters.

Alibaba has likely pressured numerous major clothing brands to quit JD and sign on exclusively with Alibaba. Over 100 major brands left JD’s platform in late 2017. JD has filed formal complaints, however I do not expect the Chinese government to do anything about it.

“Unfair competition still exists,” Wang Bingnan, a deputy director at China’s Ministry of Commerce, said in a June speech about China’s e-commerce market. “Behaviors like forced ‘choose one of two,'” he added, “are hard for regulators to define, prove or deal with accurately.”

This is a sign that the competition between the two is becoming increasingly nasty. Unfortunately, I think it means margins will remain under pressure for some time. I believe JD’s recent increase in logistics investments is a bid to attract a bigger third-party business over time and to provide some additional value over Alibaba’s T-mall. I think it will be some time before Alibaba is able to offer a logistics solutions that will be able to get goods to the customer same-day. The question is whether the strategy will work.

I think that U.S. companies are less likely to play ball with Alibaba’s tactics. A more recent story details an American clothing company’s battles with Alibaba after refusing to sign an exclusive contract with Alibaba. Alibaba then down-listed the company’s listings on the T-mall site.

The recent trade negotiations between the U.S. and China have centered on abusive practices in China towards U.S. corporations. If this doesn’t constitute an abusive practice, I don’t know what does.  While I don’t expect China to take action, I think U.S. exporters might voluntarily choose to list on JD rather than Alibaba as a result.

JD has proven to be much more friendly to U.S. exporters. The company maintains that, despite signing some exclusive deals, it doesn’t strategically push for such deals:

“We support fair and open competition because greater choice is always better for brands and users,” JD.com said in a statement. “We are winning over customers by providing a superior shopping experience, rather than by limiting the options of brands or consumers.”

I think that the likely outcome of the “trade wars” of recent weeks is a rebalancing of the U.S.-China trade relationship, however I believe this will be achieved through an increase in U.S. exports rather than a decrease in Chinese exports to the U.S. Steve Mnuchin has said this was the Trump Administration’s goal, and this would fit within Xi Jinpeng’s goal of growing the Chinese consumer economy. If U.S. players view JD as a more friendly partner than Alibaba, this may disproportionately benefit JD over Alibaba.

Chinese exports have been slowing so far in 2018, and this has worried many China watchers. I would guess this has a lot to do with the recent strength in the Chinese yuan. However, China’s expectations for GDP growth have not come down dramatically, and the authorities are expecting strong consumer spending to help them achieve their GDP growth goals. The banking sector has been pushing consumer credit products, and recently the household debt-to-GDP has been expanding rapidly in China. The PBOC recently reduced reserve requirements, which should provide fresh liquidity for the banks to continue lending, and should mitigate some of the upward pressure on the currency. If the consumer economy is as strong as the authorities expect, I’d guess this would be a very positive macroeconomic tailwind for both Alibaba and JD.

The JD Finance unit is a big wildcard for me. I don’t understand the unit as well as the retail or logistics units. My best understanding is that it provides credit to companies in the supply chain, and obtains the capital by packaging these into credit obligations and selling an asset-backed security. Revenue in the unit is up in the triple digits, so it is a strong growth driver, but the business appears to have a number of risks, with some outsized risk in a potential Chinese credit crunch. I think part of the pressure on the share price has been related to the generally weak environment for financials this year, which I believe is related to the unexpected spike in LIBOR over the fed funds rate. This pressure may not let up any time soon.

However, the JD Finance reorganization appears to move these risks outside of the company. My understanding of the reorganization plan is that JD receives a little over $2 billion to sell off its current equity stake, and will retain the right to receive 40% of profits of JD Finance when profit is positive. It also has an option to receive a payment equal to 40% of the equity interest in the event of a JD Finance IPO. This exposes it to the upside of the business, but not the downside.

It doesn’t completely remove the risks from JD Finance however. If there is some unforeseen blowup, I could imagine the entire supply chain freezes up and sales tank. However, in such an environment, I would imagine we would see macroeconomic implications for all of China, since I would expect similar issues simultaneously at Ant Financial and because JD and Alibaba now make up a huge percentage of Chinese commerce. I’d imagine I could figure out a way to hedge such risks. Moreover, the PBOC moved last week to quell such risks in the finance sector, by reducing reserve requirements. I think the authorities are aware of the risks and are actively managing the situation. Whether they are successful or not remains to be seen.

A generally unacknowledged risk comes from JD’s increasingly intertwined relationship with Tencent. I think Tencent bears the risk of being too successful. Pony Ma is probably the second most powerful man in China after Xi Jinpeng, and I don’t think this has gone unnoticed in the communist party. Though Pony Ma has done his best to remain obsequious to Xi, I’d imagine there will be an impending reckoning, possibly through increased regulation of Tencent. How this might impact JD I can only imagine, but I wonder if Tencent may become pressured at some time in the future to lighten up on its 18% stake in JD.

This tie-up is a double-edged sword. WeChat is an integral piece of Chinese life. It is the most important app on one’s phone, and in many ways is like an OS within an OS. Tencent has become increasingly focused on driving its payment system, WeChat Pay, and JD is the dominant retailer that accepts WeChat Pay. As the battle plays out between WeChat Pay and AliPay (Alibaba’s payment system), JD has some upside if WeChat “wins”.

I think JD is well positioned to grow in Southeast Asia. It has more experience in complicated logistics than any other e-commerce company, and the infrastructure in Southeast Asia is much worse than China, so the region will require complex solutions. I am not aware of homegrown competition of size (I am sure there are some), but I don’t think other international players like Alibaba or Amazon will be able to enter Southeast Asia as easily as JD.

As an aside, I think it is interesting that the investor base in JD appears to care much more about net profit margin than Amazon’s does. While JD fetches a P/S well below 1, Amazon trades at a P/S above 3. I think a general anti-China bias is part of the problem. I saw a recent WSJ article that China has been pushing to have more of their successful internet companies open a second listing at home, as the tremendous growth in these companies has benefited only foreign investors and not Chinese investors. I wonder if Chinese retail investors would value JD the same way that a largely western investor base does.

Stocks and the Economy in 2018

Despite IHS reports of West Texas shale’s economic viability, I am very skeptical of the capacity for additional production out of Texas unless we get higher oil prices, mainly due to the cost of rising land. Land prices now are many multiples what they were a few years ago when oil prices were double today’s levels.

Global demand and a falling dollar have been responsible for an oil rally into the year end. We have synchronized global growth for the first time in two decades, and I think oil demand will continue to grow.  

The oil and gas majors have been reluctant to add deepwater capacity, and large capital-intensive projects are being placed on hold as investors become uneasy about the impact of electric vehicles. I think this should add up to a supply shortage over the next couple of years.  

The key will be American oil production. Operators are now experimenting with enhanced oil recovery (EOR) in shale, but the techniques are largely untested outside conventional reservoirs. EOR will be a key area to watch, and I am keeping a close eye on the Core Labs earnings conference calls for updates on the industry. There is a possibility that reservoir challenges, like “frac hits”, and challenges with adding additional stages (horizontal drilling has hit upon natural limits to length of wells due to the loss of pressure in the latter stages) will increase the cost of drilling to make marginal shale plays uneconomic.  

In addition, the oil operators have benefited from a long period of deflation by the oil service providers – overcapacity in the oil service companies led to falling prices and margins for these companies. As an example, C&J Energy Services, a pure-play on-shore U.S. energy service company, was running razor thin gross margins throughout 2016 (2.5%) and the first few quarters of 2017. However, in the latest quarter, gross margins hit a respectable 23%. I would guess that oil service companies will finally start to price higher in 2018, which will constrain production growth from the E&Ps. Even if you are bullish on American shale, it makes more sense to me to be long the service providers, on the theory that demand will finally allow them to price higher, than the American shale E&P’s themselves, which have production risks.  

I am tentatively bullish on non-shale sources of oil. There are some cheap Canadian producers, and, if Trump opens the Pacific to offshore, some of the specialized offshore service companies may be an interesting buy. Computer Modelling Group, for example, has a massive ROIC, and, though it trades at 34X earnings, it’s earnings have been depressed by years of low demand for offshore services.

I think higher oil prices will finally push inflation higher in 2018. Inflation has been subdued for many years. Part of the problem is that, despite falling unemployment, labor force participation has fallen from a pre-crisis 66-67% to, more recently 62-63%. Though the Phillips curve would predict falling unemployment would cause inflation to rise, it does not account for a drop in participation. However, labor force participation has trended higher ever since bottoming out in late 2015 and early 2016. I would also argue that the labor force participation rate is not picking up data about the “gig economy” – Uber drivers, Airbnb renters, etc – which now make up a substantial number of people.  

Another component of low inflation has been the low level of consumer spending. However, in recent months, consumer spending has increased, and the personal savings rate declined from 6% to 3% in the past year. There has been an inventory overhang ever since 2015, with the inventory to sales ratio spiking in 2016 to levels not seen in an economic expansion since the late 1990’s. High inventory levels reduce prices across the economy. However, the inventory to sales ratio has declined throughout 2017. For example, after Hurricane Harvey, the auto inventory to sales completely normalized, as the demand for new cars in affected areas sopped up all the excess used car supply on the market. Excess housing inventory has also been nearly completely consumed, causing new home construction to pick up. Millennials are finally moving out of their parents’ houses and forming new households, and this demand ought to drive home construction activity for some time. House prices have finally recovered to long term averages, and the wealth effect on U.S. households ought to contribute to further consumer spending.  

The falling inventories and rising home construction have contributed to commodity demand, and since late 2016, nearly all commodities have been on a tear. Capacity reduction in Chinese metals has caused iron ore to recover from a 5-year bear market, and driven a bull market in the metals. Global growth in Southeast Asia, India, and Europe has caused created a perfect backdrop for a roaring commodity bull market. 

The U.S. dollar has remained under pressure. One of the most vocal FOMC members, Lael Brainard, was speaking just last year about the necessity for rate hikes, despite weak inflation, to curb rising asset prices. However, her latest speech indicates that she has come around to Ben Bernanke’s argument that a prolonged period under the 2% target rate necessitates a prolonged period over 2% as a “catch up” period. This change in Fed mentality has curved expectations for interest rates downwards. We have limited data thus far on Jerome Powell’s thinking on the matter, but the market consensus is that he is more dovish than Yellen.  

On a PPP basis, the dollar is still overvalued versus the euro. Parity remains significantly higher at a EUR/USD level of 1.35. Since the formation of the euro, the dollar-euro pair has touched the PPP level every 2 or 3 years. The dollar rocketed higher in 2014-2015 on the back of monetary policy divergence, however I’d view the dollar’s weakening in 2016-2017 as a correction of this move back towards PPP levels. Higher inflation in the U.S. and lower inflation in the Euro area should continue to drive the PPP towards a stronger euro.  

Immediately post-election, I went long the dollar on a thesis that a rising budget deficit and monetary tightening would lead to a strong currency. There are good test cases in the U.S. in the early 1980’s and in Germany in the early 1990’s. In both cases, the currency appreciated wildly beyond levels that would be predicted by PPP. However, I am starting to revise this thesis. Despite increasing rates, I don’t think we can characterize what is currently occurring as a tightening process. We are still in an abnormally loose monetary policy environment. The Taylor rule would predict a “natural rate” of interest at about 4% currently, while the Fed Funds rate is at 1.5%. Excess reserves, as measured by the St. Louis Fed, are still at $2.2 trillion, compared to a nearly zero pre-crisis level. Because banks usually lever at least 10-1, these $2.2 trillion in reserves represent a potentially massive amount of excess liquidity. In an environment where money supply is still relatively large, fiscal expansion should be inflationary and negative for the currency. The Trump administration has passed increases in defense expenditures and a tax cut, which should both cause the deficit to widen next year.  

While the Fed’s favorite measure of inflation, PCE ex-food and energy, has still been tracking slightly under 2%, another measure I track, the Dallas Fed’s trimmed mean PCE, has already popped above 2% and now sits at 2.2%. I think the Fed will raise rates next year, but will remain relatively loose because their preferred index remains weak, which ought to allow the dollar to continue to fall and inflation to rise significantly. 

Despite prospects for increased inflation in the near future, treasuries have rallied into year end. I know some market participants are taking the view that inflation will remain weak and further rate hikes will invert the curve, cause a recession, and we will see even lower yields on long term bonds. Furthermore, when the curve is flat or inverted, banks cannot make money by borrowing short and lending long. This means with a flat curve, the $2.2 trillion in excess reserves are “impounded” in the banks, and won’t be released into the real economy.  

I also think part of the demand for treasuries has come from fund managers seeking protection from a sell-off in equities. Many funds take on leveraged exposure to treasuries, which gives income and has provided a negatively correlated return in times of falling equity prices. This holds true in most environments, except when asset prices fall because of rising inflation. In the 1970’s, the last high inflation era, stocks and bonds had correlated sell-offs due to the pernicious effects of inflation.  

However, I have no strong convictions on U.S. equities. I see good arguments for continued easy money and economic growth to push multiples to all-time highs, and economic strength and tax cuts to push earnings higher. At the same time, I get the sense that many of the funds who were holding high cash balances in 2016 and early 2017 are now fully invested, which leads me to question, who will be the marginal buyer at these prices? I have also noted that the latest data out of the BEA shows that foreign capital has moved from inflows (throughout the period of 2009-2016) to outflows this year, which means that any increases in equity prices will have to come from domestic investors. If I am right that equity fund managers are fully allocated to stocks now, the only way we can get excess gains in the stock market is if new liquidity is created by bank lending, or liquidity is transferred from the bond market to equities. I could also see a scenario where we get a sharp correction in stocks because of a drying up of liquidity, but no slowdown in real economic growth, as occurred in 1987.  

I would guess large consumer staples companies continue to underperform, as fund managers transition to “growthier” names. In addition, the latest tax reform limits deductibility of interest to 30% of EBITDA, reducing the potential for large 3G-style leveraged buyouts. Finally, with relatively low tax rates to begin with, I think these companies will benefit least from the tax reform. I remain negative on all consumer staples, especially center-aisle food processors, like General Mills and Kellogg. The only risk I see is that a falling dollar boosts international sales. However, I would also argue these companies will have to contend with home-grown competition in these international markets in the near future.  

I also am negative on junk bonds. They will likely suffer the most from the reduced deductibility of interest. They will also suffer in a rising inflation environment. I am short the JNK ETF. It recently broke down through the 200-day moving average after the breakup of two major telecom deals, and has not been able to recover above this mark, though it is testing it currently. Coming back to my views on energy earlier, I think that some weakness in the sector in 2018 may worsen the outlook for junk.  

Regarding the UK, I am exceedingly negative on the economy. I cannot see a good way out of Brexit. Food prices ought to spike next year, which will continue to place upward pressure on inflation. However, the central bank will be constrained from raising rates due to the pressure it would place on consumers. Wages have not grown as fast as prices, and the majority of UK homeowners have variable rate mortgages, rather than fixed-rate. Any rate hikes will increase mortgage payments and hurt consumer spending, which is already weak.  

However, positioning of fund managers is already extremely bearish, especially on UK stocks. There are a number of UK companies that are not correlated to the general economy that should stand to benefit. For example, AA plc looks relatively cheap, and also benefits from the “private equity math”, where paydowns of debt increase the value of the equity. It has a high debt load, stable cash flows, and is entering a new business, insurance underwriting, where it has decades of experience as a broker for 3rd parties. The stock sold off after the previous CEO was abruptly fired for punching a coworker in a barfight, but I think the new CEO is much more stable. Another example is Renishaw, a rapidly growing 3D printing company focused on metal printing, with over 90% of revenues derived from outside the UK. These companies suffer from the general negative UK bias.  

I am positive on European equities, particularly heavily levered companies with strong cash flow. A couple of small examples would be Greiffenberger, a German auto parts maker that trades at a 9% FCF yield and has a massive debt load, and Ambra, a Polish wine importer with a much smaller debt load, but also trading at a 9% FCF yield. These companies can benefit from the absurdly low rates in Europe. They also benefit from the sort of “private equity math” I mentioned earlier. The falling dollar has pushed the Euro higher, which gives the ECB an excuse to push out the wind down of QE later and later. All the excess liquidity being added to Europe and suppressing bond yields makes European equities, which trade at markedly lower multiples than in the U.S., relatively attractive. I don’t know what will happen as QE winds down in the latter part of this year, but in the U.S. the rally continued for a significant period of time after QE was reduced to zero.  

I am also positive on certain Asian equities. Particularly, I am long Japan and Thailand. I have a theory that Japanese fund managers are investing domestically for the first time in nearly 30 years, which is why the correlation between the yen and Nikkei has broken down. The BOJ’s direct equity purchases essentially make Japanese equities a one-way bet. Japanese fund managers, as recently as summer of 2017, were running massive exposure to U.S. assets, and as they pull money out of the U.S. and invest domestically, it should push the dollar down, the yen up, and stocks higher. This should cause Japanese GDP to pick up, due to the two-way connection between the stock market and real economy. In addition, Japan’s huge advances in fields like robotics and artificial intelligence ought to benefit the economy going forward. I would rather own Japanese stocks in yen, via a vehicle like the EWJ ETF, rather than currency-hedged positions.  

Thailand has a strong currency, high current account surplus, low inflation, high real GDP growth, a high savings rate, and a new government plan consisting of investments in infrastructure, research and development, and education. I think the “Thailand 4.0” plan is about the smartest government plan for growth I have ever seen. Though the investment community remains relatively skeptical about the Thai government’s ability to pull this off, and indeed about the stability of Thai politics, I think the economic growth ought to empower officials to continue to execute on their plans. At a 40% debt-to-GDP and 2% government bond rates, the government can easily run a deficit to finance its growth plans. The BOT also has ample room to loosen policy. If they BOJ doesn’t loosen, the current account surplus will drive the currency higher. If they do, the loose policy will drive equities higher. Either way, investing in a fund like the THD ETF, which owns Thai stocks in Thai currency, ought to be a winner for 2018. One risk would be the negative demographics of an aging population, which signals weak consumption, however the economy is heavily geared towards exports, which benefit from “synchronized global growth”. Another risk would be the heavy reliance on the auto industry. However, exports to China have actually outstripped exports to the U.S., and the auto industry in China looks much healthier than that of the U.S.  

A weak dollar is generally positive for Southeast Asian countries. Many of these countries never really recovered after the currencies were smashed in the late 1990’s. Thailand and Taiwan are breaking out for the first time in two decades, and Japan is breaking out for the first time in three decades. If the prospects for the dollar remain weak, I’d imagine the rally will continue.  

One Belt, One Road ought to create a massive boom in Southeast Asia. As far as I can understand, China will build out the infrastructure for the region, and leave the countries with large liabilities to China, denominated in yuan. While it saddles the countries with debt, these countries have underinvested in infrastructure for years, mainly because of lack of capital. The years of underinvestment mean that the initial infrastructure investments ought to have outsized returns for the real economy. The resulting boom in growth will make the countries more able to pay down their liabilities. The growth in foreign assets ought to help balance the large debt loads in China. The infrastructure buildout should create an export market for the previously-troubled Chinese steelmakers. And, eventually, as these countries develop a middle class, China creates an export market for its consumer goods as well.  

This should relieve pressure on the Chinese exporting companies, and, in turn, relieve pressure on the Chinese currency. It should also smooth the transition from an export-led economy to a consumer-led economy. In addition to directly investing in Southeast Asian countries, investing in Chinese consumer names may be an interesting play. I am invested in JD, Tencent, and considering plays in Ctrip or other companies levered to Chinese tourism, both because of the massive growth in the individual companies, and potential for continued growth from the rise of consumerism in China.  

I’d expect OBOR to create a boom-bust process in Southeast Asia similar to the 1990’s wave of investment, but on a much larger scale. Eventually, the liabilities will grow too large, and growth will not be sufficient to repay the liabilities. At that point the process will reverse. China will be left in a precarious position of either devaluing its currency to bail out the Southeast Asian countries, which would harm the domestic consumer, or letting Southeast Asia crater. I’d imagine it would elect to do the former. I think we are years away from such a turning point.  

I am on the sidelines with regards to India. Investing in the SCIF ETF was one of my most profitable trades in 2017. I viewed demonetization as a net positive, because it would take cash out from under mattresses and inject it into the banking system, creating an extraordinary amount of new liquidity. However, most market participants viewed it as a negative as it disrupted consumer spending in the short term. I sized the position very large after the fall from the demonetization scare, and I was well rewarded. I think the valuations have run considerably and India will need a “catch-up period” for earnings to grow into implied valuations. Modi has announced a plan to recapitalize the banks to deal with the problem of large non-performing loans, but I am wary that this is similar to China’s propping up of “zombie companies” after the collapse in metal companies in 2011.  

One interesting theme I will watch is Indian defense. India cannot stand idly by as China makes alliances on all sides, and it does not want to play ball and become a Chinese subsidiary with One Belt, One Road. I’d imagine they have quite a bit of posturing to do to reassert themselves against China’s growing shadow over the region.  

Pakistan is looking attractive as it has sold off quite hard after a corruption probe into the former Prime Minister. The key question will be whether this leads to further political instability. I think 2018 might start bringing some benefits from the China Pakistan Economic Corridor, and some of the initial infrastructure gets completed. Moreover, Pakistan’s economy tends to follow India’s economy with a slight lag. I haven’t invested yet, but I am monitoring the situation closely, and may pick up shares in the Pakistan ETF.  

In South America, I have been monitoring Argentina closely. Victories for Macri’s party in October mean he now has a mandate to implement reforms. From my conversations with locals, companies are receiving bids from foreign investors for the first time in years. This opening up of markets to foreign capital ought to create a boom in the economy. However, the stock market is still relatively small compared to the rest of the economy – around 9-10% of GDP. Very few firms are actually listed, which means international investors looking to get a piece of the turnaround are pushing valuations to very high levels. I am still bullish on the market, but I am wary that the boom can peter out as more and more companies list and valuations come back to earth.

Cannabis is an interesting area to watch in 2018. I have been investing throughout the rally in 2017, but I sold all my holdings on December 30th as all the stocks swooned in the afternoon. The fact that the stocks have recovered most of the losses after Jeff Sessions’ scare tactics shows me that the rally still has strength. I’ll look to get back in as I believe the rally should continue until Canada goes legal for recreational purposes in June 2018. After that, I have no insight as to where the companies will trade. It is interesting to me that the stocks have made such dramatic moves, and the companies have raised billions, with almost entirely retail investor involvement. Large institutional investors have stayed on the sidelines, but I think they will get involved in 2018, and this should push valuations even higher. I don’t think the boom will end soon.  

I think the best approach would be to invest across the spectrum, with some capital going to large companies likely to be institutional favorites, like Canopy Growth, and some capital to small companies with some positive economics, like Cronos Group, for example. Valuations are very stretched, but prices have become dislocated from fundamentals. Eventually valuations will matter, and we will get a large correction in the stocks, at which point only the “real” companies will survive. I think private market valuations are much more attractive right now across the space, and I would look there to achieve less speculative long-term returns.  

Despite a positive outlook for commodities, I would not be involved in gold at the current time, because of the continued run in cryptocurrencies. They could take significant market share from gold as a store of long term value. Gold is approximately a $10 trillion asset class, so with significant penetration it is conceivable cryptocurrencies can become a trillion-dollar asset class. With a world economy of approximately $80 trillion, gold currently sits at 12.5% of the global economy, but at times, the size of the gold asset class has gotten significantly bigger. It is conceivable that any additional gains for the “store of value” asset class go to new cryptocurrencies instead of gold. However, the rapid rise in cryptocurrencies, the substantial volatility, and the involvement of insiders who understand the market much better than most retail traders, makes for a dangerous market to play in, especially if you don’t know what you’re doing (and I’ll freely admit I don’t). The only insight I can derive from the matter is that I would not invest in gold at the current time, and I believe the market price of gold could have significant downside if cryptocurrencies continue to gain in value.  

If you want a hedge against inflation, it makes more sense to me to invest in real estate. As I am mostly concentrated on liquid financial markets, I have been searching for good stock ideas where real estate held might be worth considerably more than the market capitalization. A couple of small examples might be Maui Land and Pineapple, which holds vast tracts of Hawaiian real estate, and Amrep, which holds huge tracts of land in New Mexico.  

Short Treasuries: Natural disasters should cause rates to rise, not fall


Can Hurricane Harvey trigger a financial crisis? Probably not. But it may spark some unexpected inflation.  

I came back to Houston last Sunday after vacationing in Montevideo for 2 weeks. Houston seems unchanged in many parts, but certain highways were still under water and many traffic lights aren’t working. Traffic is terrible. Many are still living in temporary shelters in the stadiums and it will take a long time for life to come back to normal for them.  

Moody’s puts Harvey losses at about $80 billion, Warren Buffett threw out a rough estimate at $150 billion, and Governor About announced damages were expected to be $180 billion. These figures are about 0.4%, 0.8%, and 1% of GDP, respectively. For scale, the San Francisco Earthquake of 1906, which set off a chain of events leading to the Panic of 1907, resulted in damage estimated at 1.3-1.8% of GNP at that time. The losses from Hurricane Irma have yet to be tallied.  

Losses from a natural disaster don’t always lead to financial panic. Hurricane Andrew in 1992 led to losses around 1% of GDP, but no crisis followed – in fact, the economy began to recover from a recession immediately after the hurricane struck.  

But the hurricanes are still big enough to tighten money. Affected areas will need loans to rebuild, and this ought to drive interest rates higher.  

Inflation ought to go up as well. Affected areas will demand more materials to rebuild, and this demand ought to drive prices higher.

The majority of losses in Houston are estimated to be uninsured, so a lot of the rebuilding will have to be funded by the Federal Government. FEMA is running low on funds and the Trump Administration has authorized more funds on an emergency basis. All of these funds will come from issuing more treasuries.  

The Fed is likely to start shrinking its balance sheet this fall. This also will directly increase the supply of treasuries in the market.  

I think treasuries are setting up to be a good short. And yet, treasuries have rallied after the hurricane, on the logic that Harvey and Irma have reduced the odds for the Fed to hike rates or shrink its balance sheet.  

Consider the Fed’s response to Hurricane Katrina. Immediately after the hurricane, the market expected the Fed to “pause” its rate hiking cycle to make funds available for the rebuilding effort. However, the Fed continued with its 11th consecutive rate hike in September 2005 

This is appropriate. The standard Taylor rule response to a natural disaster is to increase rates. This is because with a Taylor framework, inflation is more important than output in determining the appropriate rate. And inflation ought to go up.  

If anything, the odds that the Fed will hike this year have gone up since the hurricane, not down. The treasury market is getting this wrong. I went short a treasury position at about 30% of my account equity. I’ll keep adding to this position until the yield breaches its 2016 low, at which point I would cut my losses. I’ll also add to the position if the yield exceeds the post-election high.

Staying the Course with a Core Labs Short

One of my ongoing shorts has been Core Labs. I took on the position after reading David Einhorn’s thesis. One of the blogs I like to read is csinvesting, by “John Chew”, a treasure trove of value investing knowledge. John posted the Einhorn thesis for discussion back in May. I initially disagreed with Einhorn but after researching some of the points Einhorn brought up, I came around to his idea and went short the stock. I discussed the Core labs presentation in a comment on that blog, so I’ll repost my thoughts here:

I did my own work on this, and came to an analysis that it wasn’t an easy short because it could be trough earnings, and that reinvestment at its high ROIC would make the upside scenario too dangerous.

I did analyze the two business segments, but mistakenly thought that Production Enhancement was the area that would suffer going forward, because, like many analysts, I thought the Reservoir Description business would benefit from secular growth. I thought that this would provide a floor for earnings going forward, and that any upside from Production Enhancement revenues might make the earnings meet analyst guidance.

Einhorn did a fantastic job here of highlighting the precarious nature of their core business, Reservoir Description, because of its dependence on international offshore revenues. Furthermore, he made a great point that these complicated projects are planned out years ahead, so the revenues in Reservoir Description would not show any decline from the drop-off in Offshore until a few years after the drop in oil prices. This is particularly deceptive if you look at numbers from the 2008-2009 oil price drop, or even the drop-off in revenues 2014-2015, because it takes a while for all the pre-existing offshore projects to roll off.

It pains me a bit to say it, because I was a shareholder in Core Labs in the early 2010’s – I talked to David Demshur before and he was a great guy, and I really believed in the bull argument for this stock – but I do happen to agree with Einhorn after reading through his presentation. If the crown jewel of Reservoir Description is truly correlated to international and offshore, it might be more vulnerable than most analysts expect. Since the growth path forward will be dependent on Production Enhancement, which ought to have a lower ROIC than Reservoir Description, the upside risk may not be as high as I originally thought.

On a side note, I disagree a bit on his characterization of Demshur – while he may be promotional at times, I don’t think he intentionally was seeking to mislead investors.

As PW noted, one of the important things I learned is that ROIC is only as good as your reinvestment opportunities. After all the Buffett quote is that the best business is one that employs LARGE AMOUNTS of incremental capital at very high rates of return, not one that uses all of its incremental capital (and then some) to pay a dividend.

I shorted at $102. Since then, Core Labs has declined significantly in price, but I’m still holding the short position.

I believe Core Labs is priced as if earnings were about to accelerate back to 2012-2014 levels. Earnings are running in the $60-70 million range, with FCF in the $100 million range. The stock currently has a P/E multiple of 55 (minimal net debt, so P/E is probably fine to use). Even if you believe Core Labs is an incredible business with a high ROIC, if the company cannot reinvest and cannot grow, an appropriate multiple is probably around 30.

I think Core Labs will have trouble growing earnings because the major shale basins are running into production problems. They are reaching natural limits on lateral length and suffering from a phenomenon called “frac hits” which is dropping production and impacting the economics of infill drilling in shale wells. Core Labs is pivoting to Enhanced Oil Recovery techniques, but these techniques have really only been tested in the Eagle Ford reservoir, so it will take some time to prove this technology in the Permian. In the meantime, E&P’s still aren’t investing in major offshore projects, so the Reservoir Description segment ought to continue to suffer or remain stagnant.

Rig count growth is moderating and may actually decline in the latter half of this year, especially if E&P’s continue to suffer from frac hits in infill wells. This ought to keep Production Enhancement revenues steady at best, or declining at worst. Unless there is rapid adoption of EOR in the Permian and other basins, I don’t think Core Labs can increase earnings.

If earnings don’t increase quickly, then the stock will have to reprice. At 30X earnings, the stock should trade in the low $50’s. I will continue to hold until I see signs of rapid adoption of Enhanced Oil Recovery techniques, a pickup in deepwater drilling, or the stock hits my target.

Retail Woes

Impinj -a Boom-Bust Process in the Making

I have been wrong on many fronts with regards to the retail sector. I got it wrong with my short of Impinj, which appreciated over 50% since my article. I tend to invest first and investigate later, so as I was doing due diligence, I realized my argument was for a short on Impinj was weak for the precise reason that commenters had mentioned on my article: strained apparel retailers were willing to invest in a technology that could optimize their inventory. The commenters were right and I was wrong.

I do think in the longer run, Impinj might have to come to earth in regards to its valuation, and its continuing rise in inventory is worrisome. The company currently trades for 8X revenue and makes continuous losses. Inventory turnover has gone from 3.59 in 2015 to 1.96, draining cash. However, as I should have seen from my prior experience with boom-bust cycles, the company is able to fund its cash losses by issuing stock at inflated prices. This sets it up to be a reflexive boom-bust process that is capable of running for a long time.

Value bets on Retailers were Misguided

At the same time, my bet on retailers that were optimizing their inventory has also failed. I invested in Express (EXPR) and Buckle (BKE). The entire sector sold off massively on a bad report from Macy’s (M). This is not what I would expect to see at a bottom. In a bottoming sector, I would expect minor sell-offs on negative news and rallies on any news that’s mildly positive. I sold EXPR on the break below $8, and in hindsight, the move was fortuitous. BKE is showing more share price strength so I’m holding for now.

Bottom Fishing is a Dangerous Hobby

On a separate note, I have been reviewing my results, and I noticed a distressing tendency. I tend to invest in companies that I believe are bottoming well before they bottom. I tried many times to catch the bottom in 3D Systems (DDD), a stock which I got right on the long and short side, but I caught a falling knife multiple times, and missed the eventual bottom at around $6 a share (it now trades above $20).

Again I got caught in the oil patch, investing far too early in an oil turnaround, however when it eventually came, I was able to hold out long enough to make a profit.

So the lesson I take away from all this is that I ought to wait a lot longer than I feel like waiting for a turnaround in a sector. As Larry Livingston from Reminiscences of a Stock Operator might say, “If a man never made mistakes, he would own the world in a month. If he never learned from his mistakes, he wouldn’t own a blessed thing”.

The Path Forward for Retail

Retail should prove no different. If I feel that I should invest now, when multiples seem absurdly compressed, there are probably at least 2-3 more big moves downward that ought to come before the bottom.

This is a sector that is littered with the corpses of companies that failed to adapt. I was looking at the quarterly letters from Kerrisdale Capital in 2011 (the year they made 200% while the market was flat), and the following struck me:

It is clear that we need to be more careful investing in struggling retailers with same-store declines and deteriorating margins. Sometimes they turn around, but usually they don’t. The hidden leverage of operating leases continually catches us unaware.

Kerrisdale lost on two separate retailers that unexpectedly went BK. I would note that the most recent Kerrisdale letters, during the current retail crisis, have neglected to mention any retail investments.

Changes to FASB Will Mean Re-ratings of Several Retailers

The “hidden leverage” of operating leases is not going to stay hidden any longer. Changes to lease accounting are coming. This will mean all the leverage implicit in an operating lease is about to be made explicit. The explicit statement of the operating lease liability on the balance sheet is bound to end up with winners and losers. Retailers that have the worst terms (i.e. long term leases that were signed > 2 years ago when leasing rates were much stronger) will suffer when these liabilities are made explicit. Many of the retailers will go from showing net cash to showing net debt. Companies have until January 2018 to comply. I would imagine those with the worst positions will delay filing until the last minute.

Short Retail REITs – Federal Realty Trust (FRT)

Federal Realty Trust is a REIT focused on retail properties – generally strip malls in relatively affluent areas. It trades at 21X FFO, while commercial REIT peers trade at 16X FFO. While it has a low payout ratio (dividends are only 61% of FFO) and a low MCX ($16-17 million), it does have a need to refinance in the next twelve months because of rising interest costs and principal repayments. There are $210 million in principal due in the next 12 months, $280 million of dividends to be paid, $17-18 million in MCX, and only $434 million in FFO.

The CEO is very confident the company can refinance at a property level, and I think this is true, but I think the company ought to get worse interest rates going forward, given multiple hikes at the Fed, and the levered nature of the company. Moreover, I think lease rates will go down as all the retailers race to shut down stores. Finally, I think the growth engine of a REIT that has been powered entirely by retail sector strength will stall out, which ought to cause the company to trade in line with peers. Multiple re-rating would imply 20-25% downside from here, and any further weakness in leasing rates going forward ought to mean a further 10% or so decline. My target is $90-95 per share. I have momentum in my favor, and I will seek to limit losses if the stock spikes.

I am actively looking through all the REITs with real estate exposure that I can get my hands on. I think these are some of the best shorts in the current environment where bond proxies ought to suffer and a secular decline in retail ought to hurt renewal rates on the underlying leases.


A change of heart on apparel retailers

Lately, I have been putting 80+ hours per week at the hospital, so it has been difficult to get time to write. However, I have managed to stay abreast of my positions and current events more or less.

I closed the Impinj position last week. One piece of evidence for closing the short was simply the fact that the stock rose above $30. I wrote in my article that the technicals looked “awful”, and wrote the following, ” …the stock fell through $30, tried to break back above and failed to push through.” Well, it did end up pushing through. And then some. This rendered one support for my thesis invalid.

I generally use some kind of loss-limiting mechanism on my shorts. Usually it’s a system of halving my short if it goes the wrong way and I don’t know why. I also think of the process as thesis invalidation, which is a broad term that encompasses both price stops and discovering new arguments that might weaken the thesis.

As part of my due diligence on Impinj, I started reading conference calls of apparel retailers (Impinj’s largest customer base), and I was surprised to find myself liking what a lot of these management teams were saying. Many of them mentioned improving inventory management as an initiative. Furthermore, several mentioned initiatives to ship from store and buy online and pick up in store. Such moves ought to increase the turnover of inventory by turning mall stores into miniature distribution centers.

Such inventory focused initiatives ought to be tailwinds for Impinj, both by improving the health of the retail sector and by increased sales to more inventory focused businesses. There may be a lagging effect of 2016’s retail weakness that shows up in Impinj’s next quarter or two, but I bet it will probably guide a little higher and bounce after the next quarter.

I managed to close my short with minimal losses by concentrating on the key price level at $30. I closed around $31, and the stock took off afterward. I still wouldn’t go long the stock as I find it far too expensive and I can buy growth more cheaply elsewhere. And I may go short again if the valuation starts to get really ridiculous.

I am instead turning around and calling a bottom in the mall retailers. These stocks trade at absurdly low valuations. I can pick up some of the fast fashion brands, like Express, for nearly 5X free cash flow (EV/FCF).

Express has had a tough time competing with Zara and H+M, however has worked over the past year to speed up their time to design and now stands on better ground to compete. They are working on ship from store and buy online, pick up in store initiatives. They have 25% of sales online and are working actively to increase this. They have tons of cash and are buying back stock aggressively. They think there is still room to cut down on costs to minimize losses from same store sales declines. 50% of stores are up for lease within the next 2-3 years, giving management an opportunity to close loss-making stores and boost earnings.

Express has a track record of pretty conservative guidance. The best scenario management presents is a flat to low single-digit same-store sales environment. I can envision scenarios (like a broad based recovery in consumer spending) where Express has positive same store sales. Even if they hit guidance, the stock will still be cheap.

There are macro drivers for the mall-based retailers too. Nearly all of these companies pay the absolute highest corporate rate and would be direct beneficiaries of tax reform. While there may or may not be an eventual tariff placed on importers, one thing I know for sure is that the dollar is higher since the election, especially against the yuan, and the president is no longer committed to calling China a currency manipulator. Currency moves are mitigating any eventual tariffs that the new administration might place on imports from Asia.

I put on a very large position in Express, and it is now the largest single equity position I hold. I obviously have a lot of additional research to do in the name, but Thursday’s 7% move in high volume (for a really insignificant piece of news) indicates to me that a big move might be about to start in retail, and that I’m not the only one looking at this.

I also think there are perhaps better retailers out there that I don’t know yet. The entire sector might be due for a turnaround. It is the one sector out of all U.S. stocks that seems to be universally trashed, and the thesis behind the short is obvious and well-known: malls are dying and Amazon is taking over the world. But a new thesis is emerging – A malls will survive, C malls will die. As the market shifts from the idea that all malls will die to some malls may survive I think there will be a revaluation of PE multiples across the sector.

I’ll probably spend a lot of my precious free time digging in the retail sector for the next few weeks to see if I can invalidate this thesis.

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.