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 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.

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.

This isn’t a great business. It isn’t even a good business. But it’s not a terrible one, and that’s what it is being priced as.

Reverse Corp is in the collect-calling business. It had its heyday, back before the age of mobile phones, but it’s been in steady decline ever since.

During its peak years, it expanded into all sorts of other terrible businesses. It opened new collect calling divisions in European countries and it expanded into payphones. Needless to say, these businesses were crushed after mobile phones came into the picture, and the stock fell from a peak of $6/share to less than a penny per share.

But the board took action. They began a restructuring in 2013 in which they divested all those loss-making divisions. This restructuring, combined with a shift of focus of the company to collect calls from pre-paid cellphones, turned the company around from huge losses to huge profits. They also started a new line of business, an online contact lens store called Ozcontacts.com.

1-800-REVERSE

The idea is, when pre-paid phones run out of minutes, the owner will have to use the company’s service, 1-800-REVERSE, to make a call to anyone. Up until recently, all calls from mobiles cost the user minutes – even calls to 1-800 numbers. However, Reverse Corp was able to negotiate exclusive contracts with the biggest Australian mobile phone companies, Telstra and Vodafone, such that calls to 1-800-Reverse would be the only free call a pre-paid wireless customer could make.

Needless to say, this monopoly on a niche market drove up profit margins. Unfortunately, the Australian government moved to make all 1-800 numbers free from cellphones by the end of 2014. It was expected this would have a huge negative impact on revenues, as the competitors, 1-800-MumDad and 1-800-PhoneHome, would now have access to the pre-paid wireless market, so Reverse Corp shares sold off.

Oddly, the results have been exactly the opposite. In the most recent fiscal year, revenues actually increased 3%, and EBITDA increased by 12%.

Perhaps there is some brand loyalty to 1-800-Reverse, or perhaps pre-paid wireless customers are simply not aware of the change in rules yet. Whatever the reason for this paradoxical increase in revenues, there is evidence that investors should not be discounting the cash flows from this business so heavily.

OzContacts.com

Most of the time, when managers start a new line of business in which they have absolutely no experience, it’s a complete failure. But Ozcontacts has been anything but. Over the course of the last 2 years, the company has grown organically from nothing to a business doing $1.8 million in revenue per year. Over the course of the last fiscal year, it broke even on cash flow, and management reported the business was actually cash flow positive in the last half of FY 2015.

Unfortunately, the business has hit up a wall as far as its growth; revenues are down year-over-year. Management attempted to restructure the business, and states the decrease in revenues is related to a new focus on customer retention and increasing sales per customer rather than increasing the number of customers. It appears the new strategy has at least driven cost improvements:

Management seems to strongly believe in this business. It was started as a JV in which Reverse Corp only owned 65%, however in the last quarter of FY 2015, they bought out their partner, for a current ownership of 95%.

Valuation – Sum of parts

The sum of parts method is probably the best method to value the company; there is a core business that is contributing all of the earnings, another that isn’t, plus a big wad of cash and a hidden tax asset. So first things first – let’s look at cash.

Part 1: Is the Cash worth Cash?

Management plans to use cash on hand to acquire stakes in profitable growing businesses. Normally, this would make me nervous. But the company has a good history of getting in to reasonably good businesses – first with the pre-paid mobile business, and then with the contact lens store. So I think it is most likely they won’t destroy value with any investment.

The cash could be discounted if earnings turn negative on one of the businesses and management doesn’t cut their losses – eating into the big cash pile. But here again, management has a history of divesting loss-making divisions, first with the overseas businesses, and then with the payphone business. If either OzContacts.com.au or 1-800-REVERSE turned unprofitable, I think it’s most likely that management would get rid of it quickly.

Finally, working capital requirements are probably pretty low for these businesses. Since its operations are either run by submitting bills to wireless customers and charging customers online, it doesn’t really need a lot of cash on hand for either of these businesses.

All of this makes me think that the cash is worth near full value, and deserves only a modest discount, if at all. Let’s say 90 cents on the dollar, so $6 million, or $.064 per share.

Part 2: OzContacts.com.au

The business just became profitable, but it is difficult to assess to what degree, because of the inclusion of the unprofitable months at the beginning of FY 2015. Even so, I’d imagine that a profitable online business is worth at least half of sales. It might be worth something more like 1-1.5X sales to a strategic acquirer, like one of the other contact lens stores. So we get to a range from $900,000 in the worst case to $2,700,000 in the best case, or $.01 to $.029, respectively, with a most likely valuation somewhere between that – maybe $.02 per share.

Part 3: 1-800-REVERSE

This is the big question: what is the core collect calling business worth?

Worst Case:

We could easily say that in the worst case, competition catches up, customers catch on, revenues drop off a cliff, and the company quickly becomes unprofitable and gets divested. In the scenario that revenues drop off by 50% in each of the next two years, 1-800-Reverse would only contribute free cash flow for 2016 and 2017, and become unprofitable in 2018, at which point it would likely be divested. This leads to a valuation for 1-800-Reverse of a little more than $750,000, or $.008 per share.

Most-likely:

Considering revenues have actually increased under the new rules, I think it’s likely that the rate of decline in 1-800-REVERSE will be far more modest than 50% per year, maybe something like a 10% decline in revenues per year. Under this assumption, we get to a valuation of $7.6 million, or about $.08 per share.

Best-Case:

Under the best case scenario, we assume flat revenues. Maybe the growth in the population and the market (pre-paid mobile) matches the entry of competition to the market. Maybe the company finds a way to capitalize on a new market (like expanding overseas, except this time, profitably). In either case, it is a possibility that management figures out how to keep up revenues at this pace, with similar kinds of margins. Under this scenario, we get to a valuation of $18.1 million, or $.194 per share – more than the whole company is worth today. (For terminal value, I assumed that after 10 years, the revenue begins to decline at 10% per year).

Part 4: Deferred Tax Assets – a hidden value

The company has about $150,000 in net deferred tax assets sitting on the balance sheet. In addition, they have $750,000 of deferred tax assets sitting off balance sheet in relation to a capital loss. The company can recognize the latter if it realizes a capital gain, if, for example, it sold off OzContacts. If this were to occur, the company could revalue these, and you’d get another cent per share of assets.

Sum of parts

All told, under worst-case-scenario pricing, we get to valuation of $.082 per share – a 34% downside. Keep in mind, this is under extremely aggressive assumptions for decline in 1-800-REVERSE. In the most-likely case, we get to $.164 per share, an upside of 32%. And under the best case scenario? A valuation of $.288, an upside of 130%.

A simplistic valuation check

Things can get hairy quickly doing DCF valuations. But even using a quick multiple check shows us that Reverse Corp is likely undervalued.

The company is trading for 12.5 cents a share and has 93.4 million shares outstanding. We already stated that the value of cash was about $.064 per share. That puts the valuation of the rest of the businesses at 6.1 cents a share, or about 5.7 million.

The company generated $2.8 million in EBIT during fiscal 2015, so that puts the company’s valuation at a measly EV/EBIT of 2 – certainly low enough to merit a deep value investment.

Summary

The company has undergone a turnaround, and even though its core business is undesirable, it is currently throwing off a lot of cash flow. The major determinants of value are

1) Whether 1-800-REVERSE declines in revenues as a result of the 2014 ruling to allow free 1-800 calls from all mobile phones, and whether fewer callers resort to collect calls over time

2) Whether the contact lens business can meaningfully contribute to cash flow or will be put up for sale

3) What businesses the management decides to buy with cash

If you buy the arguments for the best case scenario, then the company offers a pretty good risk/reward of 1 to 3. If not, then at worst it’s a toss-up – about a 1-1 risk/reward. I think it’s entirely possible the company continues to earn at its current rate, and therefore I’ve accumulated a position for myself.