Under Armour – Closing the Short, Taking a Victory Lap

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

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

My original rationale

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

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

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

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

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

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

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

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

But there were signs things might work out after all

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

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

Pushback often helps clarify your thesis

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

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


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

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

A first victory

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

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

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

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

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

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

Sleuthing pays off

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

Watching Under Armour investments – the new headquarters

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

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

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

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

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

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

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

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

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

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

The latest developments

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

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

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

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

The long run view for Under Armour

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

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

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

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

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

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

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


Under Armour (UA)

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

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

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

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

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

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

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

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

Advanced Drainage, Discover, and Under Armour

Advanced Drainage Systems (WMS)

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

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

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

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


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

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

Brexit and Shorts

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

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

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

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

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


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.


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.


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

MBLY – Mobileye

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

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


Another look at Reverse Corp

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

The Cash

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

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

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

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

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

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

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

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

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


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

Reverse Corp Worst CaseReverse Corp Most Likely CaseReverse Corp Best Case

Values per share

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

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

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

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


Disclosure: I own shares of Reverse Corp

Context matters

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

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

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

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

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

Current Ideas and Framework

Currently I am considering some of the following ideas:


I followed this for a while back in 2013. At that time I made money on the long side, the short side, then the long side again, by identifying a reflexive trend – using stock sales to fund acquisitions. It was a classic reflexive boom-bust, as outlined in chapter 1 of Alchemy of Finance. I lost money in the 2nd half of 2013 when I called the top of the bubble too early. I was squeezed out with a number of other shorts, and the stock chart turned parabolic until it peaked in Jan 2014. After that, it has fallen for over two years from the mid $90’s to current prices under $10. I learned some lessons –

  1.  to wait until you see the “whites of their eyes” when you are shorting – wait until the chart sets up perfectly to short, or
  2. to size appropriately in order to have staying power.

I am not the best reader of charts, so #1 seems difficult. #2 seems more within my grasp, although it involves a lot of discomfort as you “fight the market”. Whitney Tilson entered the DDD short at about the same time I did, however he had the staying power to make a lot of money on it. This demonstrates that I have a lot to learn still.

I am more interested in the long side now. I think that it’s margins could normalize  because of its cost cutting efforts (it acquired lots of unnecessary workers as part of its acquisition spree), an exit from the consumer space (which has always had lower margins), and a new metal printer (I haven’t confirmed the technical merit of this new metal printer). Such a turnaround would give it an EBIT somewhere in the neighborhood of 70-80 mm. At an 8X EV/EBIT, it would justify the current share price. That is not good enough to warrant an investment however. After a reflexive bust, the stock ought to become a true value, with an adequate margin of safety.

I have been trying to build a financial model that would allow me to test my assumptions, however it is taking me far longer than I expected. In the meantime, the stock has rallied so much that even if it was a bargain, it may not be by the time I finish. This seems to be why George Soros adopts a principle of “invest first, invesigate later”. The only problem with that approach is that you have to remember to do the investigation after you have invested and not complacency set in. This is especially difficult if the trade goes your way – you tend to do minimal work to prove the thesis without assessing the risks adequately because things are working.


This is an idea I first read on Value Investor’s Club. I would have been better off if I’d invested then, but I decided to wait out the global turmoil, attempting to be smart and time the markets. So much for that.

The thesis is that

  1. Macri, the new president of Argentina, has eliminated export taxes on many of Adecoagro’s products, which will give it somewhere in the neighborhood of $50 mm of FCF per year.
  2. years of capex in its sugarcane business are winding down, which also ought to contribute $50-60 mm of FCF per year.
  3. a 50% devaluation in the Argentinian peso has occurred, which ought to contribute $60 mm of FCF,
  4. Export subsidies of Argentina’s competitor countries have been eliminated under the Doha round of the WTO. I am not sure what the end impact of this will be, but it will assuredly be positive. India is a big competitor in the sugar markets, however it has massively subsidized sugar cane for years. At current sugar prices, few of its domestic sugar cane operations will be profitable. Also, The E.U. is a competitor in the dairy market (an area where AGRO plans to invest its new cash flows) and it had massive dairy subsidies.
  5. An agriculture inventory that has been building for several quarters. Management of AGRO anticipated Macri’s victory and the elimination of export taxes, and waited to sell certain inventories for several quarters. This depressed cash flow for prior quarters and will increase it in future quarters.

Risks include

  1. The Brazilian real has fallen. This affects the price of ethanol that AGRO sells directly into the Brazilian market. However, the dollar has risen, and the vast majority of its revenues are in dollars. I can’t really tell if the dollar bull market is a positive or not, for reasons of #2 below:
  2. The prices of commodities have been falling. This is largely due to the dollar. So the effect of the rising dollar doesn’t really benefit AGRO as much as you’d think – though it receives revenues in dollars, it is receiving less dollars per unit of product because the price of the commodities is falling.
    So far, I’ve been chalking currency changes to a positive, because many of its costs are in the peso which devalued much faster than the dollar. However, I may be totally wrong on this – there many forced pointing in different directions and its all a little confusing. The other thing is the Fed is likely going to abandon a strategy of multiple interest rate hikes this year, which ought to weaken the dollar.
    Will this increase commodity prices? So far it looks like the answer is yes. The commodity index is up today on news that the Fed is turning dovish. Perhaps the best tack is to just keep doing a bottom up analysis of this and if the value is there, whichever of the conflicting macro forces wins out will not hurt the thesis too much.
  3. El Nino. This is another possible risk, possible benefit. The yield of sugar from sugar cane decreases with increased rainfall, and half of its cash flows come from sugar. However, other crops have increased yields with the increased rainfall. Overall, it might be a slight negative.
  4. Dollar denominated debt. The company has some dollar denominated debt, and its borrowing costs have been increasing because of the rise in the dollar. The amount of debt is $580 mm, which is 4X EBITDA before all the aforementioned increases in profitability, which will come to something like 1.5-2 X EBITDA after those changes. Furthermore, the rise in the dollar could halt or reverse, and I think the company will be able to aggressively pay this down over the next couple of years, so I don’t think this risk is all that bad.

Maybe some of the risks pull the cash flow numbers a little lower for 2016. Either way, you are still going from a situation where cash flows were flat to slightly negative for the first part of 2015, suddenly turning at least $100 mm of positive FCF and possibly as much as $200 mm of FCF in 2016. The stock has rallied by about 40%, but I think this is far too small of a rally. The EV is currently about 2 billion, so the price isn’t that low, but once the debt starts getting paid off and new investments (like the dairy investments mentioned) start working, the stock will probably seem underpriced.

Now that I’ve gone through the value argument, I think the main reason why I’m so interested is that perceptions ought to dramatically change after the company starts reporting massively profitable quarters. So the time horizon on this isn’t as long as a typical value investment – I’m looking for this to work out in the next 6 months or so or I’ve made some wrong assumptions here.


This is an idea I saw on IBD talking about how investors turn to REIT’s during times of market turmoil. What I saw that got me excited was another possible reflexive boom-bust – the company is issuing a ton of shares and using them to acquire real estate. The company did several hundred million dollars in acquisitions last year, and management states they want to do over a billion this year. They just completed a share issuance for $320 million, and the stock rallied. I haven’t done a lot of work on this, but these seems like a prime “invest first and investigate later” type of investment – the stock has a perfect technical setup, so I dont want to miss it.

The stock has an inverted head and shoulders with a neck line of $16. After breaking through, it dropped, tested $16, and the level held. This indicates that it won’t likely fall through $16 again. As such, I can pretty clearly define the risk on this trade – if it falls through $16, I’m wrong. If it doesn’t, it ought to keep rising. The one thing I don’t expect, is that the price will stay where it is for the next year.

I would have to monitor this position closely, and I really must remember not to get complacent on this – that’s how you lose tons of money on these things.

Japanese stocks

I really don’t know which ones I like yet, but I’m putting this down as a theme I’m watching for now. The BOJ seems determined to make inflation happen, in an environment where one their key metrics of inflation, oil prices, keeps falling. This puts them in the struggle of printing more and more money by buying assets. The trouble is, those assets they are buying are JGB’s, which are now incredibly scarce. So they have turned to buying stocks outright through purchasing ETFs. They want the investment banks to make a custom ETF for them with Japanese companies that investing in Japan. Who the investment banks pick remains to be determined, but Mizuho put out a list of four possible candidates recently. After scouring those companies, I could only find one that I actually liked, Colopl, a mobile phone video game developer, now investing in VR games. It was cheap (7 X EV/EBIT), but not terribly cheap for a Japanese company – there are a ton of net-nets in Japan right now.

So far I have three possible strategies:

  1. Buy up net-nets. These are proven to outperform the market over a longer time period. But if Japan is devaluing the yen, then the value of holding cash decreases, and maybe this isn’t the best environment to do net-net investing.
    On the other hand, maybe Japan isn’t successful in further devaluations. Nearly everyone in Japan thinks the yen will devalue further, so this is a very against-consensus idea, but the yen might appreciate a lot if the risk-off dynamic persists.
    So then the yen might be a buy right? Well why not buy yen at a discount? If you buy up a bunch of net-nets, you can essentially buy cash at a 50-75% discount. Then, if the yen appreciates, the true value of your holdings has appreciated. If the yen continues to depreciate the core businesses and earnings improve, and the stock ought to go up. These might be a win/win
  2. Buy companies with lots of debt. These ought to be more volatile and their borrowing costs are decreasing, so they may go up more than net-nets in this environment
  3. Buy the companies I think will be included in an Abenomics ETF. Maybe this works, maybe it doesn’t. I don’t have a lot of confidence – after analyzing the candidates Mizuho put out there, they don’t look like great values.

GPRO – GoPro

Okay, the TTM EV/EBIT is 3.6X. Okay, sure, I know trailing numbers include this huge fad trend, and Gopro might never regain that kind of popularity again. But 3.6X!

I’ve generally observed that EVERY time that I’ve ever seen a fad stock crash to this kind of crazy level, it rebounds. I’m not saying it’s never happened that a stock falls and doesn’t recover, but I think there is usually at least a “dead-cat bounce”.

I think there’s a lot of potential for upside surprise here. What if the drone product takes off? What if people have a Gopro replacement cycle every 3 years and sales start picking up? What if other countries really start digging the Gopro thing? There’s a lot of ways it could go right.

Of course there are a lot of ways it could go wrong also, but I get a feeling that its all priced in.

I still have work to do, but I just get a hunch that there is value there. The last thing that makes me bullish is this article I saw at Motley Fool. When long term bulls are throwing in the towel, it’s usually a sign of the bottom.

The way I’d play upside surprise would usually be a simple call option, but the calls are so darned expensive. I’m thinking about buying a call spread – long a call at $10 or so, short a $20 call. This ought to lock in a 300% gain to 100% risk ratio, which seems about right for the probabilities here.


Kearny Financial Corp – an old-fashioned thrift conversion

Here’s an interesting idea I came across on Barron’s. After I read Klarman’s Margin of Safety and re-reading some of Peter Lynch’s old books, I did a recent search for thrift conversions, and there are still a few occurring. Kearny converted earlier this year, and is already up quite a bit. However, there is probably still a lot further to go – the Equity to Assets ratio is above 25, and non-performing assets are below 1%, meaning the bank could take a ton more leverage on and boost earnings. Ultimately that will lead to a higher price to book more in line with peers (currently 1.1, peers are 1.5).

An issue with regional banks in general is knowing the regional environment. This one is mostly in New York/New Jersey area. I’m not aware of major dynamics either way (bullish or bearish) that will affect the financial sector. If stocks in general take a bath, or the fallout in bonds wreaks havoc on Wall Street, there could be implications for Kearny. Furthermore, The bank has a team that is working on getting more commercial lending done, so they are going to be taking on quite a bit more risk, but of course that will come with higher earnings in the meantime.

Disclosure: I own no KRNY, may buy shares in the reasonable future. 

Reverse Corp – Not as Bad as It Looks – 130% upside, 34% downside

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.


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.


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.


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.


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.


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.

Energy One: a fast grower in the Australian electricity market.

This is an example of the kind of research I do when I’m investigating an idea. Right now I’m looking at foreign micro-cap stocks for ideas. Here is one I found. It seemed like a good value, but didn’t meet my level of risk tolerance due to its reliance on a few high-value contracts and some temporary work that is boosting results. I have gotten burned too many times on small companies receiving a few big contracts that later dry up, leaving a much less profitable business behind.

Energy One (ASX:EOL)

Market cap: $5.80 mm AUD

Cash: $1.73 mm AUD

No debt, total provisions of $180,000

Enterprise Value: $3.89 mm AUD

Overview of Business

Energy One  provides software and services to wholesale electricity, gas, and carbon trading markets in Australia.

The business model is based on selling one software system to a customer at a time, then upselling to further systems as the relationship develops. To further these plans, the company plans to make acquisitions of complementary businesses, so it can continue to bundle software packages into its product suite. This results in operating leverage, because the same staff can be used for maintenance of the old package and installation of the new package, resulting in higher profit margins.

In the early part of 2014, Energy One secured two major contracts with Australian energy utilities, Alinta Energy, and one other unnamed entity. Alinta has already purchased the entire Wholesale Energy Trading Suite.

The other utility purchased the Energy One Trading platform in July of 2014. So these revenues were not recognized until the half ended December 31,2014.

Finally, a third utility company has expressed interest in upgrading its systems from a previous version of Energy One’s software to a newer one in the near future. Currently, it is trialing this new version, so there are no guarantees, but a new contract would probably allow for continued profitability for at least another year or so.

Much of Energy One’s  revenue may have been derived from one-time revenues occurring on installation of its products at two major customers. From its December 18,2014 release:

“Energy One has been proceeding with the implementation of its products at two major customers and completed the implementation at another. Revenues from these projects will continue to be realized over the remaining installation period and from license fees and on-going support.”

The company receives revenues that are recurring (Licenses, support and maintenance, IT services, ongoing enhancements and engagements), and one-off (labour services for project-based implementations). These project based implementations generally last for 12-24 months from commencement.

Thus, the major projects announced H2 2014 and H1 2015 (calendar year 2014) will reach the closing implementation stages during H1 2016 (calendar year 2015).

Review of Operations

Because of all of its recent work, EOL published really good numbers for the half ended December 2014. The stock quadrupled from $.10 to $.40 on the news. It had the highest revenues for any half-year going back to 2011:

Revenues from Operations

Furthermore, as EOL has grown, it has been able to leverage its employees. It’s employee expense as a % of revenues is down to 58%, from greater than 100% 4 years ago.

Employee Expense

Other, more fixed expenses are coming down as a percentage of revenues too, showing the power of EOL’s business model to leverage fixed expenses. I regard Rental Expense, Accounting Fees, and Insurance Expense as more fixed expenses. These fixed expenses are smaller than employee expenses to begin with however, so leveraging these fixed costs will have a smaller impact on the bottom line.

Rental Expense

Accounting Fees


The one expense that is not decreasing as a percentage of revenues is the consulting expense.

Consulting Expense

The uptick in consulting expenses this last half is related to its recent major contracts. The company increased the numbers of both regular employees and consultants to deal with the new work. The outside consultants are mostly helping in software installation at the two major Energy utilities that signed on in 2014. Per the CEO, “As the projects revert to long-term support, these project costs will reduce as a proportion of revenue”.

R+D Tax Incentive

As of the last half-year, ended December 31, 2015, EOL received about 16% of its revenue from a R+D tax incentive. This down from 21% for the year ended June 30, 2014, signaling decreased reliance on government support for profitability.

Still, its tax incentive in H1 2016 was about $380,000, almost equal to its overall profits before income tax of about $390,000. So if these R+D tax incentives are wiped out, then EOL’s profitability could evaporate overnight.

According to the Australian Taxation Office, a refundable tax credit is issued to eligible entities with revenues less than $20 million AUD, whereas a non-refundable credit is issued to all other eligible entities.

How does one qualify for the Research and Development credit? It actually operates on the honor system, with random verification. From the ATO: ” We assume that you have completed your tax return in good faith… However, even though we may initially accept the claims in your tax return, we can later ask you to provide the records and information you used to complete your tax return.”

So, if EOL has made a mistake in assessing its eligibility for the tax incentive, the ATO could ask for a lot of money to be refunded.

Here are the R+D Tax Incentive Criteria:

  1. Did you incur the amount (or pay the amount if your expenditure is to an associate)?
  2. Is this amount eligible to be claimed under the R&D tax incentive?
  3. Is the amount incurred on R&D activities that are registered with AusIndustry (who act on behalf of Innovation Australia)?
  4. Have you apportioned your expenditure so that you are only claiming amounts to the extent they are incurred on R&D activities?
  5. Do you receive the major benefit from the R&D activities on which you incurred expenditure?
  6. Have you kept, or can you access, sufficient records to support your claims?

To the best of my knowledge, Energy One’s activities do seem to account for the kind of innovation that would qualify for the credits. However, I have no insight into whether the amounts claimed by Energy One are all eligible or not. I will assume the company has properly assessed the amount of the credit, but I will keep an eye on this as a risk to look out for.

Every year, EOL receives the incentives related to the previous year’s R+D activities. For the year ended June 30 2014, it received $720,247, which was the total amount spent on R+D in 2013. This is substantially higher than the $549,432 recognized on the income statement – one of the major reasons that cash flow was higher than net income for FY2014.

The reason for the discrepancy between the income statement and cash flow recognition of the credit relates to portions of the companies R&D that relate to employee expenses and those that relate to capital expenditures. Whereas in the U.S., R+D expenses are included on the income statement, in Australia, these tend to be recognized on the cash flow statement, if the R+D expense is not an employee salary cost. For EOL, $549,432 of its employee costs were related to R+D, so this amount of the credit is recognized on the income statement. However, the total R+D credit is recognized on the cash flow statement, because all R+D costs are included on the cash flow statement.

For fiscal 2015, EOL has already received $709,326, which was exactly equal to what the company stated it would receive in the annual statement from June 30, 2014.

Death and Taxes

Energy One has had an easy time with taxes so far because of a large build up of accrued tax losses. However, this stash of tax assets is about to run out. The amount left as of December 31, 2014 was only $92,790, down from $611,877 on June 30,2014. This means that pretty soon, likely in the next half, EOL will be forced to start paying taxes. And this will certainly decrease profitability and cash flow.

This means we will have to use theoretical after-tax numbers to value Energy One. If Energy One had had to pay taxes in the last half, it would have generated a net income of $273,964 for the six months ended December 31, 2014. This figure is much less tantalizing than the $513,060 it reported, which was boosted by an income tax benefit of $121,683.

For the half ended June 30,2014, it reported a net income before tax of $540,478, which would be $378,334 after Australia’s 30% business tax. Together, this yields a TTM net income after tax of $652,298.

Compared to an enterprise value of $4.274 million, that looks pretty good, giving it an EV/net income of 6.5.


In the Chairman’s Report, Energy One Chairman Ottmar Weiss mentions that many of Energy One’s customers are operating in “depressed wholesale market conditions”, particularly in the electricity sector. This is worrisome, since the other customer segments, like energy, are not faring particularly well either.

I don’t see much reason for weakness in the domestic electricity market other than the general economic weakness in the Australian economy. This generally depressed state relates to the poor environment for commodities globally. In the meantime, Energy One seems able to grow even in depressed conditions, leaving it in a prime position to benefit if there is an uptick in the general economy.

Ideally, customers would recognize that improved IT systems may lead to decreased costs in the long run, but in a cash crunch, companies usually don’t splurge on big capital expenditures, even if they may be cost-saving measures. So this is definitely a risk to EOL’s business model.

One of the long term trends that the managing director mentions as a potential headwind is the growth of domestic solar power. This decreases the need for consumers to tap into the energy grid. However, in my opinion, this risk is far from materializing. Due to the general downturn in oil and gas prices, electricity in Australia is only getting cheaper, reducing the impetus to switch to solar.

Looking Forward

There are two main questions that will determine Energy One’s future:

  1. How much of revenues are made up of license fees and on-going product support? During the installation period, the company receives installation fees, but after this period (i.e. beginning H2 2016) license fees and product support may become the main source of revenues.
  2. At what margins will the company be able to operate on a license fees and product support model? Will they be able to pull comparable profit margins to what they have been making in the past half, when installations were underway?

The CEO stated, “Notwithstanding that the company’s revenue base is still comprised of one-off project incomes (and those projects can be subject to delays and elements outside of the Company’s control), it is our intention and goal to seek to produce a second half performance that is comparable with the profit before income tax achieved in the first half of the year.”

This statement bothers me for two reasons. 1) the CEO referred to the revenue base as comprised of one-off project incomes. Rather than use the wording, “partially comprised”, he simply used “comprised”, which makes me think the breakdown between project implementation revenues and recurring revenues is heavily skewed to the former. This is bad news, because unless the company can sell new systems, it will likely sink back into the red again, under the weight of all the new employees that were hired for implementing these new system installations. Even if the consultants are let go, permanent employee expenses more than doubled over the course of H2 2014 and H1 2015, so if revenues go down to the levels of FY 2013, the company would quickly turn from a net profit to the biggest net loss in its operating history.

I don’t think this scenario is likely, due to the new recurring revenues and the fact that another major utility expressed interest in upgrading, but I think the risk of this scenario is too great to warrant an investment at this time. I am going to have to pass on Energy One until I see a new contract signed, or we get more information about how large the recurring revenue figure will be.