Vistry: Constructing a Capital-Light Future
Summary
- Vistry has transitioned from a traditional housebuilding to a partnership only model positioning itself as the UK leader in affordable housing.
- Labour’s ambitious housing goals and policies, such as mandatory housing targets, fiscal stimulus and green/brown belt reallocation, align directly with vistry’s expertise.
- Recent cost overruns tied to the legacy housebuilding division have impacted near term financials. However, these issues are isolated, and the partnership business remains unaffected.
- In-house timber frame production, bulk material purchasing, and economies of scale further enhance cost efficiency, supporting long term profitability and competitive advantages.
Business
Vistry is a UK housebuilder which has historically operated in two primary business models: traditional housebuilding and partnerships. However, approximately a year ago, the company began phasing out its legacy housebuilding division to focus entirely on its partnership business. This transition is still underway, and Vistry has stopped reporting the two segments separately.
While other companies also employ the partnership model, Vistry is the clear leader in the sector now. In 2024, the company expects to deliver circa 17,500 homes. In contrast, Lovell and Keepmoat delivered 3,000 and 4,100 homes respectively in 2023.
Vistry’s scale and focus on the partnership model position it as a dominant player in the affordable housing space.
A fitting comparison for Vistry’s new model is the US-based homebuilder $NVR, a pioneer of the capital-light approach. A quick glance at NVR’s stock chart and outstanding shares since inception highlights its success in value creation. A former board member of NVR is now on Vistry’s board to help them with this strategic shift.
Additionally, the capital freed up by this transition would let the company return £1 billion in excess cash to shareholders, with another £300 million going to reduce the debt. £200 million of this buyback target has already been completed.
Moreover, beyond an initial buyback, management anticipates capital returns to amount to 50% of the operating income. With a near-term target of £800 million operating income, Vistry could return a significant amount back to shareholders via NVR-style buybacks.
Historical Timeline
Vistry, as it is known today, was officially formed in 2019 through the merger of Bovis Homes and Galliford Try’s housing division. Greg Fitzgerald, the current CEO, was previously the CEO of Galliford Try between 2005 and 2015, during which time the company grew substantially, including a significant expansion of its partnership business. After briefly serving as a chairman, he retired in 2016.
By 2017, Bovis Homes faced serious challenges. Fitzgerald, with his strong track record at Galliford Try, was brought out of retirement to rescue the struggling company. Under his leadership, Bovis recovered and was back on track in two years, and shortly thereafter, they acquired Galliford Try’s housing business.
However, it was the 2022 merger with Countryside Partnerships that truly shaped the Vistry we see today.
Before the pandemic, Countryside Partnerships was a shining example of the partnership model. By 2019, they were delivering 4,400 homes annually. Their partnership division, which accounted for roughly half of their profits, boasted a remarkable ROCE of 78%, far exceeding the typical 15-25% range for UK housebuilders. Despite these achievements, the market undervalued Countryside, granting it a P/E multiple of 10—lower than many peers. This reflected the market’s emphasis on valuing housebuilders by book value rather than earnings, penalizing those with higher returns on equity.
In response, then-CEO Ian Sutcliffe announced plans to split Countryside into two entities to unlock shareholder value. Unfortunately, the CEO had to step down due to personal reasons, and the new management scrapped the plans of a split, which left shareholders frustrated, attracting activist investor Brown West, which acquired a 10% stake and secured a board seat. Over the next year, the board and top executives resigned, and the board committed to a pure-play partnership business. Later, the company decided to sell, and in September 2022, Countryside agreed to a stock-for-stock merger with Vistry, creating the entity we recognize today.
The merger was largely successful. Management exceeded initial estimates for cost savings, and the stock price more than doubled following the merger. By September 2023, Vistry announced its decision to focus solely on partnerships, signaling a definitive shift in strategy.
Since then, the company has been winding down its non-partnership business, completing existing projects, reallocating suitable plots to the partnership division, and selling off the rest. This process is expected to free up approximately £1 billion in capital, of which £200 million has already been returned through buybacks and dividends.
However, challenges emerged in October 2023 when Vistry disclosed cost understatements amounting to £115 million on several sites. This revelation caused the stock price to plummet from £13 to £9.5. A month later, an additional £50 million in losses were identified, and the profit outlook was reduced from £350 million to £300 million, allocating 50% of the reduction to these one-time losses and the remaining to a slowing economy. This took the share price down to the present level of £6.3.
Despite these setbacks, there are reasons to believe that the market may be misinterpreting the implications of the issues, a topic we’ll explore in detail.
Partnership
Vistry’s partnership approach differs significantly from the traditional model used by most housebuilders. It involves collaborating with housing associations, local authorities, and private rental sector (PRS) investors to deliver a mix of affordable, PRS, and privately sold homes.
The structure of these partnerships varies by project. In some cases, the developer provides the land and allocates the units to partners. In others, partners such as housing associations might own the land and bring in Vistry to develop it. In either case, partners usually prepay for the units before the construction begins.
The traditional housebuilding process is well understood: developers identify a site, secure necessary approvals, and either purchase the land outright or via an option contract. Construction of individual homes typically takes 5 to 7 months. However, the partnerships model is a fundamentally different approach, emphasizing collaboration between homebuilders and public or private entities such as local governments or housing authorities.
In the partnership model, the developer forms a joint venture (JV) or enters into a contractual agreement with the public entity. These collaborations leverage resources and align objectives to deliver housing that meets both social and commercial needs. For example, Vistry may develop on donated land without forming a separate entity while still operating under principles of shared responsibility and benefits.
The partnership model enables efficient development by distributing risk, leveraging resources, and aligning incentives. It represents a shift from the speculative approach of traditional housebuilding to a collaborative framework designed to meet the needs of diverse stakeholders, including local communities.
Below are common structures of partnership JVs:
Development-Led Joint Venture
In this model, a local authority partners with a developer to purchase land, often receiving a cash payment upfront. The agreement specifies a timeline for the developer to complete construction on the site. Once the project is finished, the local authority receives a share of the profit.
Investor-Led Joint Venture
Here, a long-term investor such as a pension fund or real estate trust provides forward funding for a development and shares in the project’s financial risks. The local authority assumes the long-term operational risk for the completed development. Typically, the investor leases the land from the local authority and finances the construction with a homebuilder. Upon completion, the local authority leases back the homes from the investor for an agreed term. At the end of the lease, ownership of the asset reverts to the local authority, often for a nominal payment.
Limited Liability Joint Venture
This type of JV is established on a project-by-project basis. Local authorities may also secure strategic partnerships with developers to ensure continuity across multiple projects. Upon completion, the council and its partner may either retain or sell the completed assets. Retained properties may be transferred to the council’s housing company, an investor, or a new JV formed for long-term management.
Return on Capital and Moat
The partnership model stands out for being capital efficient offering significant advantages to traditional housebuilding. A developer traditionally spends years acquiring land, navigating planning waiting for sequential sales and then building. Even with a strong margin ROIC is very low.
In partnership model homes are often presold 1-2 years in advance. Pre-selling eliminates the need to delay construction for market timings. The land is often provided by the partners with planning permissions already in place.
In 2023 Vistry achieved a 21% return on capital which was dragged down by their former housebuilding business. Their partnerships business was delivering ROCE around 40%.
Management aim for 40% ROCE overall by 2028, driven by wind down of traditional housebuilding business and further synergies from merger with countryside.
Unlike the private housing market, which is highly sensitive to the economic factors like interest rates and consumer confidence, partnerships are far more stable. This is because the buyers are housing associations and PRS investor which have long term objectives. This causes contractors to prefer working with vistry and bulk purchasing of materials causing economies of scale.
By 2026, Vistry’s in-house timber frame manufacturing will support 12,000 units annually further driving cost efficiencies.
Vistry has a very strong reputation with the local authorities particularly through its countryside brand which has established itself as the most reliable partner in the industry. Bellway as an example has exited the London partnership market owing to the market pressures, unable to match vistry’s capabilities.
Overall Vistry’s partnership model combines capital efficiency, resilience to economic cycles and unmatched track record. These strengths supported by economies of scale and strong institutional relationships, position vistry as the clear leader with a possible moat in the growing partnership market.
UK Housing Economics
Looking at the demand side the previous government estimated in January 2024 that 300,000 new homes are required each year. However, some suggest that this number could be higher. One report in 2019 from National Housing Federation estimated around 340,000 new homes needed while Financial Times analysis from earlier this year estimated 421,000 new homes or even as high as 529,000 new homes if current migration levels hold.
Now onto the supply side, we see a report from the govt. earlier this year where they report a total of 234,000 net new dwellings in 2022-2023, which were 6% lower than the 2019-2020 peak.
These figures suggest a severe shortage of houses, even more for the affordable houses where the demand is estimated to be 145,000 houses and supply stands at around 60,000 per year. One estimate from last year states that Britain today has a backlog of 4.3 million new homes that are missing from the national housing market as they were never built. This housing backlog is increasing each year with the mismatch in demand/supply metrics. It can take decades to fill even if the current target to build 300,000 new homes a year is reached.
The newly elected labour government has set an ambitious target of delivering 1.5 million new homes over the next five years. Skepticism around this target is understandable particularly given the conservative governments failure to meet their promise of delivering 300,000 homes annually by 2024. Building more housing was unpopular in many conservative strongholds which led them to drop the target of delivering 300,000 new homes.
Labour, however, enjoys a strong electoral mandate and is less constrained from voters resistant to new development in local areas and the party’s majority in the parliament makes it easier to implement necessary reforms.
Early signs of progress
Labour has already introduced several policy changes aimed at kickstarting housing developments, including
Mandatory local housing targets: Replacing advisory targets with mandatory ones. Local Planning Authorities (LPA’s) are now required to meet the targets or risk intervention by the government.
Revised target calculations: Adjusting the calculation methodology for housing targets which should increase them by roughly 21%.
Selective green belt reallocation: Allowing development provided that at least 50% of the units are affordable housing.
Expanding Definition of Brownfield Lands: Broadening what qualifies as previously developed land to make more areas available for housing
Additional Funding: Allocating an extra GBP 500 million to the Affordable Homes Program (AHP)
Greg Fitzgerald, Vistry’s CEO commented on Labour’s commitment during the recent earnings call:
“So, Labour in the run-up to the election talked a lot about housing. They could have said that after winning the election, only joking, it's business as usual. What they haven't done is they have absolutely -- and I've never seen, and I've been doing this for 43 years, nothing like it, whether it's meetings, letters to local authorities, to housing associations, to us, they mean business.”
While Greg’s optimism can be viewed skeptically, Labour’s actions so far have aligned with their stated intentions, signaling a strong push toward their housing goals.
The private housing market is unlikely to derive significant growth. Unlike affordable and PRS developments which are constrained by planning and funding, the primary limitation in the private market is demand.
The real opportunity lies in affordable housing and the PRS. Even if private sales grow by 25%, affordable and PRS housing would still need to double to meet Labour’s targets. This presents a major medium term or even long-term growth opportunity for Vistry if the funding remains consistent, particularly given its leadership in affordable housing projects and large scale developments.
Cost Overruns
On October 8, 2024, Vistry revealed that the full life cycle cost on nine of its approximately 300 developments had been understated by about 10%, leading to a £115m impact, spread over the next three years. This issue was isolated to the south division of the legacy business and the management responsible has been replaced. Despite these actions the market reacted sharply. Stock fell from £13 to approximately £9.6.
Vistry then engaged an external auditor to conduct a comprehensive forensic review of all 300 sites. The audit uncovered additional cost issues in a few more developments, also within the south division, adding £50m to the total impact. Stock declined further dipping below £7.
Contrary to many reports that suggested these issues could point deeper flaws in vistry’s partnership model and that the costs overruns might be much more, the auditors report confirmed that these issues were only isolated to vistry’s legacy business and were confined in the south division. However, market’s reaction didn’t significantly change even after this clarification was made public.
One of the other important news released with this was the sales/trading statement in which vistry lowered the outlook of operating profit from £350 to £300m, half of this was because of these one-time cost adjustments and the other half was because of the slowing economy. The number of homes completions were previously expected to be more than 18,000, they were cut to around 17,500. Company also explained that the timeline of the return targets set will also increase. Exact timeline is not announced yet.
This cut in outlook increased the pessimism on the already beaten down stock of vistry. Market seems to be waiting for the next years outlook and timeframe of the returns.
The independent review attributed the problems to insufficient management capability, non-compliant forecasting processes and poor divisional culture. This boils down to the mid-level management in the south division whose leadership came exclusively from vistry’s legacy business, which is being wind down anyways.
The independent review confirmed that no similar issues - financial, cultural or procedural exist in other divisions.
Insider buying following the stock dump has been noticeable. On the day of the first disclosure CEO Greg Fitzgerald purchased gbp200k in shares and two independent directors who had never previously invested bought 75k and 45k. Browing west, Vistry Largest shareholder and controlled by Usman Nabi, who also hold a board seat increased their stake by £7.5m worth of shares and a further £3.65m following the second announcement.
The financial impact is significant but not catastrophic. Most of the cost adjustments will affect FY24, reducing pre-tax profits by £105m, FY25 by £50m, and FY26 by £10m.
Valuation
We have employed a discounted cash flow model for the valuation purposes. In this free cash flow model we have tried to remain as conservative as possible and not to rely on the managements guidance for growth and margins. As the Labour government has promised to deliver growth in the housing sector and has already taken steps to deliver on their promise so we have used a 5 years’ time frame to reflect the labour governments tenure. We could use a longer time frame as the shortage of houses will take longer than a decade to resolve but we are not sure of the future governments policies, so we decided to only look at the near future where we have clear stimulus from the government.
In that regard Vistry is guiding for a 5-8% near term growth but we have used only 2% growth which is not just conservative, it also doesn’t align with our whole discussion but the point of the DCF is to find how company performs on very stressed assumptions.
Ignoring the long term deficit of houses and vistry’s prime position to capture that market I have used only 1% terminal growth. The operating margins are expected to be lower in the partnership business and given the economic outlook, increasing mortgage rates, and decreasing consumer affordability, company might have to spend more on marketing. Although going forward in the partnership model just 25% roughly will be sold to the private market so the deteriorating economic conditions will not have much impact on the margins and marketing needs will be lower. The straight-line EBITDA assumption we have used is 11.5% but this doesn’t account for the cost over runs. Adjusting for this result in EBITDA ranging from 8.7% to 11.5%.
Vistry has had negative working capital requirements ever since the countryside acquisition because of the partnership model. Going forward as vistry goes full partnership mode the working capital will be even more in the negative territory. Last two years Vistry had -9% and -10% working capital requirement as a percentage of sales. This is a huge positive for the valuation but in our DCF we will only use -2%. Capex requirements here are minimal, the average we have used is in line with the historical average but higher than the consensus. Same goes for the depreciation where we have used a historical average lower which is lower than the consensus.
The cost of capital was calculated based on the traditional framework using CAPM for the cost of equity. We used Professor Damodaran’s current month ERP of 4.29%-, and 10-years UK GILT of 4.43% for the risk-free rate. Using the market beta of 2.22% we arrive at 13.95% cost of equity. Pre-tax Cost of debt based on the weighted average was found to be 6.88%. Based on these two figures and the respective weights for debt and equity we arrive at a cost of capital of 11.93%.
With these inputs as our base, we reach at a valuation of £10.60 which represents a 70% upside from the current levels.
It is very important to reiterate the fact the management is guiding for more aggressive numbers. Given the housing shortage and the stimulus from the government we believe those numbers will eventually be achieved but here in our valuation we have tried to find the most conservative valuation to have a sense of the margin of safety if everything doesn’t go according to the plan.
Detailed Cost of Capital
Discounted Cash Flow
Sensitivity Analysis
To aid all those with a different potential input than ours, we have performed a sensitivity analysis on the main value drivers.
In the table below, Sensitivity analysis highlights the potential valuation based on different operating margins and cost of capital as we believe both have room to improve.
Considering our use of below guided terminal growth and higher WACC, table below is useful to understand the impact different inputs can have on the valuation.
Conclusion
In summary, Vistry group is under transition to focus solely on its partnership business, abandoning its traditional housebuilding division to become a leader in the affordable housing sector. This capital light model, inspired by US based NVR offers significant advantages including higher ROIC, enhanced cashflow stability, and resilience to macro volatility. Despite recent setbacks, including cost overruns tied to its legacy business, a reduced profit outlook, these issues are isolated and do not reflect its core partnership model strengths. With growing demand for affordable housing, bolstered by the Labour government’s ambitious housing policies and vistry’s proven expertise and scale, the company is well positioned for long term growth. Insider buying and managements proactive steps to address challenges reinforce confidence in vistry’s strategy, which combines operational efficiency, government alignment, and a commitment to a substantial shareholder returns.
Vistry’ current valuation appears to offer a significant margin of safety, with the stock trading at a steep discount to its estimated intrinsic value. Risks remain particularly around the governments promises slowing economy increased taxes and the management, but the business fundamentals strong partnership model and planned shareholder returns present a compelling investment opportunity.
Stellantis: A Strong Buy Amidst Industry Turbulence and Undervaluation
Brief Summary
- Market Position and Challenges: Stellantis struggles with innovation in the electric vehicle sector, lagging behind leaders like Tesla and BYD. High interest rates further strain the automotive market, complicating consumer financing and impacting vehicle sales.
- Brand Perception and Quality Issues: Significant brand perception challenges, especially in the American market, are exacerbated by multiple recalls affecting key models like the Jeep Grand Cherokees and Citroen, DS, Opel, and Peugeot brands, leading to potential safety concerns and eroding consumer trust.
- Financial Performance: Stellantis has experienced a notable decline in revenue, with a reported 12% drop in net revenues year-over-year in the Q1 2024 and an inventory buildup indicating ongoing sales difficulties despite modest gains in electric and low-emission vehicle segments.
- Investment Potential and Valuation: Despite current challenges, a deeper financial analysis reveals potential undervaluation. Stellantis maintains strong financial resilience with $19.5 billion in net positive cash and a sustainable dividend yield of 7.5%, suggesting investment potential under a conservative valuation approach.
- Value Investing Perspective: Stellantis presents a compelling buy for value investors due to its undervaluation relative to intrinsic metrics, bolstered by substantial cash reserves and a robust dividend yield. Applying conservative value investing principles, including Greenwald’s EPV model, suggests a potential for significant upside despite the broader market's pessimism and operational challenges. This aligns with a value investment strategy, emphasizing potential gains from a recovery or normalization in market conditions.
Market Dynamics and Industry Challenges
The auto sector is notorious for its competitive margins, and with the evolution towards electric vehicles (EVs), companies lagging in innovation are finding it particularly tough. Stellantis, despite its efforts, is among those caught behind, which is especially evident in the struggle to compete with industry leaders like Tesla and BYD. This struggle is compounded by high interest rates, which depress the automotive market further since most consumers rely on financing to purchase vehicles.
Currently, Stellantis is facing significant brand perception issues, particularly outside of Europe, in the American market, where the quality of its cars is frequently questioned. This sentiment is reflected in several recalls, which have not only impacted sales but also the brand's reputation:
- Plug-in Hybrid Electric Vehicles (PHEVs) Recall: Stellantis has recalled over 90,000 vehicles across brands like Citroen, DS, Opel, and Peugeot due to fire risks associated with the drive battery support potentially leading to water damage and rust.
- Jeep Grand Cherokees Recall: This recall involves more than 354,000 vehicles globally due to improperly installed rear coil springs that could detach while driving, posing serious crash risks.
- Chrysler-Fiat Airbag Issue: In Canada, over 10,000 Chrysler 300 and Dodge Charger models from 2018 to 2021 have been recalled due to a defect in the side curtain airbag inflators, which could unexpectedly rupture and send metal fragments towards occupants.
These safety issues necessitate urgent attention and action from Stellantis, affecting consumer trust and potentially future sales.
Recent Performance and Market Reaction
The inventory levels reflect ongoing struggles, with unsold cars accumulating:
- Share Price Drop: Stellantis' stock has plummeted by more than 24% in just over a month.
- Quarterly Financial Report: The Q1 report showed a 12% drop in net revenues year-over-year, shipments decreased by 10% to 1.3 million units, and a total new vehicle inventory rising to 1.39 million units.
- BEV and LEV Sales: There has been some positive movement, with battery electric vehicles (BEVs) and low-emission vehicles (LEVs) sales up by 8% and 13%, respectively., but not enough to spark any optimism.
Valuation and Investment Potential
As a value investor, my focus is on areas the majority might overlook, especially when they abandon quantitative evaluations. I aim to delve into the numbers to gauge the market's level of pessimism and to determine if the prevailing nervousness has led to unrealistically low valuations. This could signal a potential buying opportunity for me. I'm aware that I'm not investing in a top-tier business; rather, I'm betting on a mediocre business priced too low to ignore, despite the challenges it faces
Despite the pervasive pessimism, which has led many traders and funds to steer clear of the sector, a deeper dive into Stellantis' numbers suggests potential undervaluation:
- Financial Resilience: Stellantis boasts $19.5 billion in net positive cash and has increased its dividend to $1.65, yielding about 7.5% at the current stock price. This dividend is sustainable, supported by a robust balance sheet valuing the company at $65 billion with earnings of $20.5 billion.
- Investment Strategy: The company's commitment to reinvestment is evident from its billions of capital expenditure in the past three years, aiming for a return to be competitive.
A value investor might argue that this is not growth capex but essential spending, because not investing in EVs means falling behind. I can agree with this viewpoint, which is why I do not include the growth capex. Historically, this company achieved an ROIC of nearly 20% and, by reinvesting 50%, should theoretically generate 10% growth. This is evidenced by their new acquisitions and the 25 new models coming this year, so ignoring the impact of this substantial capex is still quite a conservative stance, to say the least."
Valuation and Financial Analysis
I've put together a rough valuation model, somewhat similar to the one I use for Meta, acknowledging that Stellantis doesn't match the same quality level of business. I've assumed a revenue decline of roughly 15% from the last year levels and a margin contraction to 9%, although the CFO recently reiterated that they expect to maintain double digit margins. But, for a conservative approach, let’s stick with the more pessimistic margin.
Earning Power Value (EPV) Assessment
The EPV model, developed by Professor Bruce Greenwald at Columbia University, is a staple in my value investing toolkit. It's designed to calculate sustainable earnings without growth. As per book I should add to the sustainable earnings calculation to the side the money spent on growth that are not maintenance, because on the long-term those capex will eventually stop however in a twist to adopt a very conservative stance, I hypothesized that all growth capex, which is significant, is completely lost—like throwing money in the bin.
Despite such a severe assumption that the reinvestment rate at 20% ROIC would generally suggest a 10% EBIT growth, the market doesn't see this as feasible, and neither do I. I prefer to err on the side of market wisdom and stay pessimistic. Using a leveraged beta of 1.41, I've calculated an equity premium of 7.8% over a WACC of 12%. Given the risks involved I have added an extra layer of 3% discount over my cost of capital, bringing the total to 15%. Even with these conservative figures, I still see over a 50% upside potential.
An Intrinsic Valuation Perspective
As a value investor, I typically avoid using DCF models because the number of assumptions required could create a false sense of security with seemingly complex outputs. However, it's useful to understand the potential numbers that could appear in a DCF analysis, especially with assumptions that align with those used in Earning Power Value (EPV) models, and to identify the drivers that could influence the valuation.
Market analysis indicates a clear reduction in EBIT and an absolute lack of growth. Initially, I thought the WACC might have been inaccurately calculated. As Stellantis operates internationally, it's crucial to consider the risks associated with global operations, sometimes even if the cost of capital isn't a predominant consideration for some investors.
In past analyses, I have discerned how different assumptions about the WACC can significantly alter stock valuations, impacting the attributed equity premium or beta. This is not the case, but it is why I wanted to have a thorough analysis of the beta and WACC and, therefore, I have written a session only for approach these elements which you will find below in the report.
So far, the WACC is not the issue, I believe the market is currently overstating the impact of growth reduction on the stock; only a 14% loss would justify the current market valuation.
I am presenting the first DCF model in which I've maintained some assumptions similar to those in my EPV analysis. These include management projections up to 2028, after which I've aligned with the consensus for the terminal margin. I've considered a minimal growth of 1.5% up to 2028 and no growth beyond that date. For both cases, the WACC used is 12%. Please refer to my paragraph discussion on WACC for more details.
We are again very close to the Earning Power Value (EPV) and also to the stock value before the last earnings call. However, the current market price implies a substantial 14% drop in revenue, which seems at odds with the company's high reinvestment rate. Stellantis's strategy involves reinvesting heavily—more than 11 billion annually, representing a 50% reinvestment rate. Such a significant commitment to reinvestment typically does not align with the narrative of a steep decline in growth prospects. If this revenue drop persists, it may compel the company to reassess its reinvestment strategy. They might either reallocate these funds more effectively or adopt new measures to enhance value distribution to shareholders and implement cost-cutting strategies to improve long-term EBIT. Under the leadership of Carlos Tavares, an expert manager, Stellantis is equipped with top-tier, highly reliable management that is well-prepared to navigate these challenges
Weighted Average Cost of Capital at 12%
Value investors traditionally dislike using beta and calculating the WACC. I understand their perspective but also think that when performing an intrinsic valuation of a stock, it's crucial to carefully reflect on the value of risk to accurately assess the premium. Using an equity premium that might distort the intrinsic valuation of the stock is risky; it could be too high or too low for the specific stock, potentially rendering the intrinsic valuation impractical. Additionally, when deriving an Earning Power Value (EPV) by capitalizing the cost of capital, it's essential to have a defendable, objective cost of capital; otherwise, the EPV lacks credibility.
You might disagree with defining risk as volatility based on standard deviation from historical movements, in that case you could use other approaches, like bottom up beta or others that allows for a baseline beta valuation or alternative methods.
I aim not to bore the reader with different WACC calculations and their methodologies in this research, but rather to present the information I've collected. We start with the assumption that the 10-year Treasury rate is not risk free and depurated the embedded default risk, that’s why we have used 4% rather than the actual rate of the 10-year. We then compile the revenue information and assign a weighted average premium to each region. This step is crucial, especially for a company operating globally including potentially volatile and emerging markets, where a lower WACC could significantly impact the valuation. Historical discrepancies in risk perception have sometimes caused dramatic drops in stock prices when the market adjusts.
For the unleveraged beta, I've used the industry average, and then adjusted for Stellantis's debt-to-equity ratio. You can find the formula below for reference.
WACC calculation using Damoran model
Liquidation Value Considerations:
Rather than tediously examining each asset, I opted for a quicker, yet quite realistic approach to estimate the liquidation value. If Stellantis were to liquidate today, here’s how the numbers would look:
- Tangible Book Value: $15.76 per share.
- Goodwill and Intangible Assets: I looked into the $30 billion of goodwill and intangible assets and identified that only $15 billion is directly related to the brand value. These brands would hold value even if Stellantis were to liquidate; other automotive manufacturers could potentially purchase these brands.
- Inventory Valuation: With $22 billion in inventory, applying a 30% discount for quick sales gives us a rough current market value.
Therefore, I don't see Stellantis facing bankruptcy within the next three years. To justify the current valuation at 3.74 times earnings, revenues would have to significantly decline over 30% annually, which seems unlikely. Even at the existing capex levels, which would no longer make sense if growth stalls, Stellantis could still generate 50% of the current market cap in free cash flow in the next 3 years and maintain a residual liquidation value at today's prices.
Market Sentiment and Investment Perspective
I'm not counting on Stellantis to suddenly turn around and fulfill its ambitious plans for 2030 under CEO Carlos Tavares. If it does, the stock might hit $60, but that’s not where I’m placing my bets. I’m interested in the company's real worth, which seems overlooked. I am going to use a simple value formula to derive the value.
Rate of Return
Formula = R t,t+1 = Dt/Vt + gt,t+1 + (1+gt,t+1) * ht,t+1
Where
Dt = share repurchase + Dividend + Net debt repayment + Interest rate
Gt,t+1 = Marginal ROIC * Reinvestment rate
Reinvestment rate = Growth Capex / Adj. NOPAT
ht,t+1 = Multiples Expansion/Compression
For this instance I am going to assume a zero growth and not debt repayment
• Dividend Yield: 7.5%
• Buyback Yield: 3.5%
• Growth (gt): 0% (assumption of no growth)
• Initial P/E Ratio: 3.3
• Target P/E Ratio: 5.0
Where
• Dt (Total returns from dividends and buybacks): 7.5% + 3.5% = 11%
• Gt,t+1 (Growth rate): 0%
• ℎ+1ht,t+1 (Multiples expansion): (53.3−1)=51.52%(3.35−1)=51.52%
Plugging these into the formula, the expected rate of return, considering the multiple expansion, is approximately 62.52%.
To calculate the annualized return:
Annualized Return=(1+Total Return)(Number of Years1)−1
The annualized return over a 3-year period, based on the initial single-year return estimate of approximately 62.52%, is about 17.57% per year.
In understanding this valuation, it's important to note that it includes an assumption of multiple expansion, which might seem too optimistic. However, we're in a high-interest rate environment, and it's reasonable to expect rates to drop over the next three years. If you set aside the multiple expansion, the stock could still offer an annual return of 11%. This is not bad, considering it also gives you a free shot at additional gains if CEO Carlos Tavares even partially achieves his goals. It’s a situation where if things go well, you win; and if they don’t, you don’t really lose much — tail you win, head you don't lose that much."
Conclusion
Stellantis, despite its current challenges, presents a value buy opportunity. The potential for significant upside and a robust dividend yield makes it a compelling investment in a market that may be undervaluing its fundamentals.
I then rate Stellantis a Strong Buy.
Risks
The prevailing high-interest rate environment is elevating financing costs for consumers, potentially suppressing automotive sales. Should interest rates persist at these elevated levels, or if anticipated rate reductions fail to materialize, Stellantis could see a significant impact on both sales volume and stock performance. Particularly, if the so-called 'Fed put'—an expectation of Federal Reserve intervention during economic downturns—does not provide the anticipated market support, there could be further downside risks. If sales decline exceeds our projected 15% and profit margins deteriorate beyond current forecasts, Stellantis' stock may experience substantial valuation pressures.
Capitalizing on Anticipated Rate Cuts in an Overpriced Market: The Risk-Reward Sweet Spot with Treasury Bonds
As the Federal Reserve hints at a more dovish stance and the likelihood of further rate hikes diminishes, we recognize the potential for the financial landscape to change. With inflation seemingly on a trajectory towards normalcy and stock valuations creeping back towards potentially overvalued levels, we believe an attractive risk-reward opportunity is presenting itself within the U.S. Treasury market.
The central focus of this opportunity is the U.S. 10-Year Treasury bond (Gov10). Currently priced at 95.25 with a yield-to-maturity (YTM) of 3.96%, we see potential for significant upside under the right circumstances
In assessing the potential returns of investing in Gov10, our central thesis hinges on the direction of inflation and, subsequently, its impact on the Gov10's YTM. The Federal Reserve has reiterated its commitment to a long-term inflation target of 2%. Their unwavering stance suggests that they are likely to utilize monetary policy tools to steer inflation towards this target over the medium to long term.
Nevertheless, in our calculations, we have opted for a more conservative approach. Instead of assuming a reversion of the Gov10's YTM towards the 2% inflation target, we assume that it falls to 2.6% in the next 24 months. This approach allows for some persistence in above-target inflation, which is plausible given recent trends.
Given this assumption, we believe there is room for the YTM of the Gov10 to decrease, which would lead to an increase in its price.
Using the formula for calculating bond prices:
Price = [C / (YTM / 2)] * [1 - (1 + YTM / 2) ^ -2n] + [F / (1 + YTM / 2) ^ 2n]
where:
- C is the annual coupon payment ($3.38),
- YTM is the yield to maturity (2.6%),
- n is the number of years to maturity (10), and
- F is the face value of the bond ($100)
we estimate that if the Gov10's YTM declines to 2.6% over the next 24 months, the price of the bond would increase to approximately $107.29. This potential change represents a total gain of about 19.94% over the two-year period, including the bond's coupon payments.
To calculate this total gain: Total Gain = [(New Price - Old Price) + 2Coupon] / Old Price Total Gain = [(107.29 - 95.29) + 23.38] / 95.29 ≈ 19.94%
Annualizing this total gain, we derive an Internal Rate of Return (IRR) of approximately 9.39% per annum. This annualized return is attractive, especially when juxtaposed with the current yield of the 2-year Treasury bond at 5.4%.
Moreover, should this yield contraction occur more rapidly than anticipated – say, over 18 months – the annualized return would improve further to approximately 12.64%.
Additionally, it's crucial to consider the positioning of this trade within a broader portfolio context. The proposed strategy could act as a hedge against adverse market scenarios.
For instance, let's consider a scenario where market conditions deteriorate and a recession emerges. Currently, the markets do not fully account for this possibility in their valuations. The materialization of a recession would likely prompt a market sell-off. However, such an environment would also likely lead to a 'Fed Put', a situation where the Federal Reserve steps in to support the economy by cutting rates. Consequently, the value of the Gov10 Treasury bond would likely increase, given its inverse relationship with interest rates
Finally, while historical data suggests that bonds do not necessarily provide accurate long-term inflation predictions, they do reflect the market’s inflation expectations. If these expectations normalize and align more closely with the Federal Reserve’s targets, we could expect the Gov10 YTM to decline by 100 to 150 basis points.
In conclusion, investing in the Gov10, considering the current market dynamics and potential inflation trajectory, offers an appealing risk-reward balance. Not only does it provide a meaningful return potential, but it also serves as a plausible hedge against negative market scenarios, thereby reinforcing the defensive stance of a diversified portfolio.
An Examination of EDUC: An Unconventional Value Proposition
SPECIAL SITUATION
Amid the ever-evolving investment landscape, identifying opportunities often requires digging beneath the surface, seeking out undervalued entities whose latent potential has been overlooked by the market. In the realm of small-caps, Educational Development Corporation (EDUC) stands out as a compelling case for closer examination.
Overview of EDUC
Educational Development Corporation operates within the domain of children's literature, publishing and distributing a rich array of educational materials. It operates via two primary business units: EDC Publishing, responsible for publishing children's books, and Usborne Books & More, which operates as a multi-level marketing organization to sell these books.
A Deeper Look into EDUC's Challenges and Opportunities
Not long ago, EDUC faced profound adversity. Mounting fears of bankruptcy led to a steep decline in its share price. On July 14, 2023, the stock closed at a price of $1.21 per share, a drop of over 40% since May. To put this into perspective, EDUC's book value per share at the end of May 2023 stood at a substantial $5.12. When adjusted for the fair value of property, plant, and equipment, the value per share escalates to over $7.00, signaling a stark disconnect between the intrinsic value and the prevailing market price.
The primary catalyst for this decline was the market's perception that EDUC was on the precipice of filing for Chapter 11 bankruptcy protection. However, recently disclosed information from the company's SEC filings and the latest quarterly report indicates a contrary outlook.
As of May 31, 2023, EDUC had an outstanding debt of $10,959,200 on its Line of Credit (LoC) with the Bank of Oklahoma, well within its $14 million credit commitment. This commitment, which is slated to fall to $13.5 million, is expected to stay afloat throughout the subsequent month.
The company's management, particularly Mr. Craig White, expressed confidence in its ability to successfully negotiate an extension of its revolving loan maturity date with the Bank of Oklahoma. If successful, this extension will significantly mitigate the looming risk of bankruptcy.
The Market's Response and Future Trajectory
Over the past two weeks, the market has started to align with this revised outlook. The stock price has experienced a substantial upward swing, surging 62.8% to $1.97. However, it's crucial to note that Mr. White and CFO Dan O'Keefe are likely still in negotiation for a third amendment to the credit agreement with the Bank of Oklahoma. Should this amendment be agreed upon, there's a potential for the stock to reach or surpass the $3.00 mark.
Risks: The Usborne Contract and Inventory Write-Downs
While the near-term prognosis for EDUC appears favorable, certain risks persist. Notably, the potential termination of the Usborne contract remains a significant concern. Although the risk of this occurring in the near term appears to have reduced considerably, it cannot be entirely ruled out.
Additionally, there is an issue regarding inventory classification. Presently, EDUC categorizes 90% of its $63.3 million (gross) of inventory as "current," despite the company's Cost of Goods Sold (COGS) for the latest fiscal quarter being only $5.2 million. It implies that it would take approximately 3 years to sell its entire inventory at the current run rate. Therefore, while the company could potentially write down its inventory, it is unlikely to do so given its optimistic future sales expectations.
Conclusion
Investing in EDUC presents an unconventional value proposition. While the potential risks associated with the Usborne contract and inventory write-downs warrant careful consideration, the company's improved debt management, along with its positive operational cash flows, points towards a potential recovery. However, investors must conduct thorough due diligence, focusing on EDUC's strategic initiatives and risk mitigation strategies before making a decision. As always, investment decisions should be guided by individual financial goals, risk tolerance, and investment horizon.
To wrap it up, it's important to note that EDUC is indeed a small-cap stock, characterized by significant volatility and risk. Therefore, for prudent portfolio management, it should constitute only a small percentage of an investor's portfolio. As always, diversification is key, and individual investment decisions should reflect one's personal risk tolerance and financial objectives.
The Sea Change in Finance: Navigating Interest Rates, Volatility, and Credit in a Sticky Inflation Era
In an era where the term austerity seems to have faded into the archives of economic history, the specter of sticky inflation is rising to the fore. We are witnessing a world where fiscal spending and global expenditure are increasing at an unprecedented rate, bringing us into a new economic phase that demands our attention.
As the Federal Reserve and European Central Bank (ECB) grapple with sticky inflation, interest rates are set to rise. Both institutions will need to continue their hikes, possibly even exceeding 6%, to keep inflation in check. With consumption and restaurants booming in the Eurozone, the UK stands in contrast, struggling with unique challenges of its own.
The real concern is that the swift, generous monetary policies in response to the current economic situation may set the stage for future crises. It's only a matter of time. Short-term interest rates alone aren't enough to create tighter financial conditions. Most old mortgages have locked in favorable rates. This environment may even facilitate a carry trade, with short-term interest rates higher than long-term ones, creating a "reverse yield curve."
The key to navigating this shift lies in understanding Quantitative Tightening. Central banks are trying to "break the system" slowly with gradual rate hikes, avoiding the need for early market rescues. Unless things break down entirely, no immediate rate cuts are expected.
Fast forward to a future with a potential 5% interest rate in the next few years. This scenario would necessitate a major repricing of many financial assets, a shift that hasn't occurred yet. Caution is warranted.
Now, if we imagine a trajectory where the 10-year yield heads towards 4-4.5%, we can foresee a surge in market volatility. This increase would impact various sectors, especially those heavily reliant on favorable interest rates for funding, REITs, and Tech companies. If the market refuses to revert to the mean, existing policies and business models will likely need an overhaul to survive.
Credit is another arena requiring keen scrutiny. While it's been relatively stable, I predict an increase in default rates in the coming months. While I don't foresee a double-digit rise, some pressure is undeniable. In such an environment, government bonds don't offer a compelling spread, making them less attractive.
In terms of investment opportunities, certain areas within the credit sector show promise. For instance, defensive high-yield sectors in Europe could offer value, though one must act quickly as opportunities can be fleeting. Banks too present an intriguing prospect. However, I advocate for caution and recommend positioning against certain REITs and tech SPVs, which may struggle in this changing environment.
Preserving a healthy cash reserve is advisable. Treasury and high-grade financial bonds are potentially good choices, offering an added layer of protection against volatility. If we experience an increase in volatility, well-diversified portfolios are expected to fare better.
Our current global financial situation is shifting from a low-inflation environment to a persistently higher one. In such a landscape, private bonds may find support from governmental bodies. However, with soaring inflation, the freedom to cut interest rates as liberally as in the past is dwindling. It's crucial not to overleverage, to stay invested, and to make sound, careful decisions in these challenging times.
In summary, while the market environment is undoubtedly tough, it's filled with opportunities for those who can navigate the storm. This era demands prudence, adaptability, and a keen eye for shifting trends. Protecting against volatility and unfavorable valuations is key while uncovering potential growth areas. This changing tide may be challenging, but it is also a time for growth and evolution for savvy investors.
In light of these market conditions and potential risks, as an investment professional, I'd like to outline four primary strategies I would consider for a well-balanced portfolio. Each position is aimed to mitigate risks and capture potential opportunities in this changing economic landscape.
- Defensive High-Yield Sectors in Europe: There may be pockets of opportunities in these sectors. These are expected to provide yield in an uncertain environment.
- Government Bonds and High-Grade Financials for Protection: These are primarily seen as defensive measures against potential instability and volatility. They are not expected to provide significant returns but rather to offer safety and stability to the portfolio.
- Short Positions in REITs and Unstable Tech Business Models: There's an expectation of an industry shake-up due to rising interest rates. Short positions in both real estate investment trusts (REITs) and tech businesses, particularly those with unsustainable models and questionable long-term free cash flow projections, could serve as a hedge against potential downturns in these sectors.
- Maintaining Cash Reserves: Cash reserves are critical for flexibility, enabling quick responses to market changes. They also provide a safety net in case of unforeseen market turbulence.
Remember, in this volatile environment, it's key not to overextend positions. While there are potential opportunities, it's crucial to have the means to stay invested without risking excessive exposure.
Originally published on Medium
Unveiling a Spin-off Opportunity: Sphere Entertainment Co. (SPHR)
In the fast-paced today’s world of investing, it is always exciting to discover a compelling opportunity that holds favorable upside potential. As a discerning value investor, my relentless pursuit is to uncover opportunities where the market may be overlooking a company's true worth, leading to an undervaluation. Today, we shift our focus to an intriguing investment occasion: Sphere Entertainment Co. (SPHR); a spin-off from the renowned Madison Square Garden Entertainment Corp. (MSGE).
SPHERE
SPHERE is an innovative entertainment venue under construction in Las Vegas. It promises to be quite a spectacle with a slated opening in September. Although Las Vegas is accustomed to grand entertainment venues, SPHERE is set to redefine expectations.
Located in the heart of the Las Vegas Strip, adjacent to the esteemed Venetian Hotel, the MSG Sphere (as it is also known) has the potential to become a long-standing central attraction for the city. With a seating capacity of approximately 17,000 to 18,000 and a standing capacity of about 20,000, the venue incorporates cutting-edge technology, including a 190,000-resolution screen enveloping the entire building, spanning an impressive 160,000 square feet.
The SPHERE’s sound system will incorporate more than 165,000 speakers, and its 600,000 LED lights promise to create stunning visual experiences. It is designed to host a variety of events, including concerts, boxing, MMA fights, and esports tournaments. SPHERE promises to be one of the most iconic venues and tourist attractions in Las Vegas and will be even seen from flights landing in the city.
Analysis
To understand the calculations, we first need to understand the structure of the company before and after the spinoff. The original company MSG had broadly four types of assets/businesses,
- Maddison Square Garden
- Sphere Construction project
- Maddison Square Garden Networks
- TAO Group.
As a result of the spin-off, Sphere Entertainment Co. (SPHR) is composed of three assets: SPHERE, MSG Networks, and TAO GROUP. As well as a 33% interest in Madison Square Garden Entertainment Corp. (MSGE).
One development worth noting is the sale of TAO Group a post-spinoff where SPHR is expected to receive a net of $300 million.
Given the complexities surrounding the spin-off, an asset valuation presents a buying opportunity: acquiring the Sphere asset (built at a cost of $2.3 billion) for less than $500 million. This might seem improbable, yet market dynamics can occasionally create such scenarios.
Our calculation methodology takes into account that Sphere holds a 33% stake in MSGE worth north of $636 million at current prices.
To determine the adjusted price of Sphere, we subtract this holding from its overall market capitalization. Additionally, we incorporate a conservative estimate by adding $104 million in cash, considering that approximately $100 million is projected for further construction expenses. Furthermore, we consider the anticipated net cash from the sale of Tao and deduct the outstanding term loan as part of our calculation. We get a price of around $556m which translates into a per share price of $16.02. I must stress the fact that even the initial forecasted cost of sphere was $1.66b provides us with a remarkable discount at current prices.
In the subsequent analysis, we will thoroughly examine the valuation of these assets. It's essential to remember that an asset's inherent value is tied to its capacity for generating sustainable earnings and free cash flow. While estimating the revenue potential of a unique asset like SPHERE is a complex task that requires careful consideration of assumptions, even with conservative estimates, the asset's current valuation suggests an attractive investment proposition.
Advertising
It is important to highlight the uniqueness of Sphere as an asset and its tremendous potential in the advertising sector. The exceptional design of SPHERE grants it a distinct advantage, making it valuable for large corporations seeking branding and naming rights opportunities. Based on media reports, we can see that the Dolan family is actively seeking $50 million in naming rights for Sphere. However, in our analysis, we will adopt a conservative approach and account for only $3 million in potential revenue from naming rights.
SPHERE is not just an entertainment venue but a colossal billboard with 580k square feet of fully programmable LED panels. The magnitude of this structure far surpasses anything currently available. This guarantees superior visibility, making it an unavoidable spectacle for local pedestrians, passers-by on adjacent roads, and passengers in planes flying into Las Vegas.
The advertising strategy revolves around the use of digital billboards, with a display time of 10 seconds. This duration allows for a more conservative approach, ensuring advertisers are comfortable with the length of their ads while maintaining competitive CPM rates. It is worth noting that the 10-second duration aligns closely with the standards set by major billboards in prominent locations like New York City and Los Angeles.
To calculate potential revenue, Sphere Entertainment Co. employs a CPM rate of $8, which is deemed reasonable given the company's capabilities. With an estimated impression count of 12,500, the daily revenue estimation is around $100,000. Considering 300 days of advertisement in a year we get an annual revenue of $30 million and applying a 45% operating margin, the projected EBIT (earnings before interest and taxes) from the advertising business alone amounts to $13.5 million.
When combined, the estimated EBIT from the total advertising business, including naming rights, amounts to $16.5 million.
Events
Let's move on to ticketing revenue from concerts, shows, and movies. We could postulate numerous assumptions, but we will maintain a conservative approach to both ticket prices and occupancy rates. An average price of $140 for a concert, considering the anticipated high-profile acts and the Sphere's unique experience, seems reasonable. Assuming 40 concerts per year and a 60% occupancy rate for the 17,000 seats, and a profit margin of 10%, we could calculate the gross revenue as follows:
The gross revenue for one event: 10,200 seats (17,000*60%) * $140 per seat = $ 1,428,000
Gross revenue for 40 events: 40 events * $1,428,000 per event = $57,120,000
Finally, applying the 10% profit margin: $57,120,000 * 10% = $5,712,000 EBIT.
Sphere will also be hosting Movie screenings. The company's plan includes organizing 400-500 screenings per year, with a potential ticket price of $50 per screening.
Conservatively if we assume only 350 screenings in a year with a price of just $35 per seat, an occupancy of just 35%, and a margin of 22.5%, we can calculate the EBIT as shown below:
Gross revenue for one screening: 5,950 seats (17,000*35%) * $35 per seat = 208,250
Gross annual revenue for total screenings: 208,250 * 350 = 72,887,500
10% Profit Margin: 22.5% * 72,887,500 = 16,399,688.
From the Sphere managed events we get an estimated total EBIT of $22,111,688.
Third-party events
The Sphere is also set to host an assortment of third-party events, from concerts to award ceremonies, corporate product launches, and combat sports events. The success and attractiveness of these events depend on the Sphere's performance and its ability to garner external interest. If we consider an annual rate of 10 events with a venue licensing fee of $200,000 and an assumed profit margin of 60%, we can calculate the potential revenue:
Total Revenue: 10 events * $200,000/event = $2,000,000
EBIT: $2,000,000 * 60% = $1,200,000
As explained in the above calculation, we could estimate that third-party-hosted events would generate at least $1,200,000.
Food & Beverages
Regarding food and beverage revenue, we should consider a conservative assumption. Let's assume that 74% of attendees (approximately 7,548 out of 10,200) will purchase food and beverages at each event, with an average spend of $39.50 per person, and a total of 50 events annually:
Per Event F&B Revenue: 7,548 attendees * $39.50 = $298,142
Total Annual F&B Revenue: $298,142 * 50 events = $14,907,100
EBIT: $14,907,100 * 50% = $7,453,550
Revenue breakdown and EBIT estimations
Below is the breakdown of our revenue and EBIT estimations for different sources of revenue.
- Sphere-Hosted Events:
- Revenue: $130million
- EBIT: $22.11million
- Third-Party Events:
- Revenue: $2million
- EBIT: $1.2million
- Food & Beverage Sales:
- Revenue: $14.91million
- EBIT: $7.45 million
- Advertising:
- Revenue: $30 million
- EBIT: $16.5million
Total Revenue: $130 million (Sphere-hosted events) + $2 million (third-party events) + $14.91 million (F&B sales) + $ 30 million (advertising rights) = $176.91 million
Total EBIT: $22.11 million (Sphere-hosted events) + $1.2 million (third-party events) + $7.45 million (F&B sales) + $16.5 million (advertising) = $47.26 million
So, with these estimates, the Sphere's total annual revenue would be approximately $176.91 million and its total EBIT would be approximately $47.26 million.
In this case, the value of Sphere could be $47mil EBIT x 15 multiple equal to $709 million.
Indeed, the initial EBIT assumption of $47 million might seem rather conservative, especially when considering the scale and potential of the Sphere project. Given the Sphere's substantial initial budget of $1.66 billion, one would expect a target yield of at least 5 to 6% to justify such an investment, which translates to an EBIT in the ballpark of $83 to $99 million.
Therefore, estimating an EBIT of $75 million appears more realistic and aligns more closely with the expected return on investment. At a multiple of 15x EBIT, this would suggest a valuation for the Sphere alone of $1.125 billion, translating into a share price of $51.68..
This analysis, of course, rests on the assumptions that the SPHR will be able to generate such an EBIT, that a 15x EBIT multiple is appropriate, and that market conditions will be conducive for such performance. It also depends on the successful completion and operation of the Sphere. Remember, while we strive to be as precise as possible in our projections, the actual outcome may differ due to unforeseen market factors and operational challenges.
However, it's worth noting that even at a valuation of $1.125 billion, SPHR is significantly undervalued compared to its initial forecasted cost of $1.66 billion. The discount becomes even more pronounced when considering the revised construction cost of $2.3 billion. These discrepancies underline the potential value opportunity at hand, given successful execution and favorable market conditions.
Sensitivity Analysis
The table below highlights the valuation of SPHR at different EBIT assumptions.
Considering the above a value of $50 to $55 should be indicated for the stock.
Identified Risks & Conclusion
Understanding the forces at play behind the scenes requires an examination of the Dolan family and MSGE. The Dolans have long held controlling interests in numerous companies, including MSGE, which owns iconic properties such as Madison Square Garden. Family patriarch Charles Dolan founded Cablevision, which was later sold to Altice, as well as HBO. His son, James Dolan, has played a significant role in managing Cablevision, MSGE, and sports franchises such as the New York Knicks and the New York Rangers
For us, one of the potential risks associated with investing in SPHR relates to the ownership and management of the Dolan family. The Dolan family has demonstrated a historical tendency to prioritize their own interests over those of minority shareholders.
Recently, the Dolan family reached a settlement amounting to $85 million for a case dating back to 2021 involving the merger of MSG with MSGN. The lawsuit accused the family of orchestrating the merger, overpaying for MSGN, diluting the value of MSGE's public stockholders, and advancing their own interests by enhancing their voting rights.
In fiscal year 2019, Dolan received a total compensation of $54.1 million, earning him the highest CEO salary in the media sector for that year, according to an analysis conducted by S&P Global Market Intelligence. The majority of his compensation was comprised of stock and option awards totaling $49.9 million. In March 2019, a lawsuit was filed in the Delaware Court of Chancery, alleging that the MSG board had violated their fiduciary duties to stockholders by approving Dolan's compensation.
In June 2020, the company reached a settlement with a shareholder, and Dolan agreed to relinquish additional one-time stock awards in MSG Sports and MSG Entertainment.
Another aspect to consider is Sphere Entertainment Co. anticipated project in London. As value investors, we prioritize the return of capital to shareholders through means such as buybacks and dividends, which is one of the reasons we favor $OXY. However, with this company, there is a risk that the cash flow generated from the Vegas project may be allocated toward the development of SPHERE in London. Not only is this an inherently risky capital allocation decision for growth purposes, but it is also, in our view, an unfavorable business decision due to the vast cultural differences between London and Las Vegas.
London serves as a prominent global business hub with a distinct professional atmosphere, where evenings tend to be quieter. Concerns have already been raised by British individuals regarding the potential night-time illumination of SPHERE. Consequently, we firmly believe that utilizing cash flow to pursue the development of SPHERE in London poses a significant risk.
Moreover, given the Dolan family's past actions, we consider it highly likely that they may repeat a similar pattern in the present circumstances. It is worth noting that the Dolan family faced lawsuits in the past when they merged MSGN, with allegations suggesting that the merger was driven by the need to fund their Sphere project. These legal disputes further reinforce our concern regarding their potential utilization of cash flow for the development of SPHERE in London.
Another risk to consider is the situation concerning MSGN. It is important to note that the loan associated with MSGN is non-recourse, which is the primary reason why we have assigned a conservative valuation of zero to it. Our concern lies in the possibility that the Dolan family may be reluctant to relinquish control of MSGN, even if the company encounters difficulties in repaying its loan. Their actions might not align with the best interests of the overall group if it comes to safeguarding the legacy network company.
It is also important to highlight the significant increase in SPHERE's construction costs, which currently surpassed $2.3 billion, exceeding the initial forecast of $1.66 billion. It remains uncertain as to how much further the costs for this construction project might escalate, and whether the newly scheduled opening in September can be adhered to, or if it will need to be postponed again, as has occurred in the past.
However, when evaluating the risk-reward profile associated with investing in SPHR, we find it to be generally aligned with our risk appetite. That being said, considering the theoretical nature of the EBIT calculation, the lack of a sustained earnings history, the risks associated with the Dolan family, and the potential long-term operations, we would limit our exposure to no more than 3% of the total portfolio. This precautionary approach provides a balanced way to participate in Sphere's potential upside while mitigating downside risk.
In conclusion, it is important to reiterate that this investment is primarily focused on the potential value of the underlying asset, with uncertain earnings at present.
Lumen Technologies: A Risky But Potentially Rewarding Turnaround Story
Lumen Technologies, formerly known as CenturyLink, is a global communications company that offers cloud infrastructure and managed services to businesses, governments, and consumers. With a commitment to innovation and a focus on customer satisfaction, Lumen is positioning itself as a leader in the digital landscape by investing in its network and expanding its portfolio of solutions. However, the company's recent suspension of its dividend and high level of debt has led to selling pressure, making it a risky but potentially rewarding investment.
Introduction to Lumen Technologies Lumen Technologies is a global communications company that was founded in 1968 and is headquartered in Monroe, Louisiana. The company offers a wide range of services, including network connectivity, data centers, cloud computing, managed IT services, cybersecurity, and communication solutions. Lumen operates under three brands: Lumen, Quantum Fiber, and CenturyLink. With 190,000 on-net buildings and 500,000 route miles of fiber optic cable globally, Lumen is one of the largest providers of communications services to domestic and global enterprise customers.
Challenges Facing Lumen Technologies Lumen's inability to grow meaningfully has been a major factor in its recent struggles. Over the past nine years, the company's revenue growth has been a disappointing 7%. Additionally, the proportion of debt to equity is alarmingly high, with debt roughly five times the market cap. This high level of debt makes traditional measures of valuation, such as EPV and DCF, unreliable.
Lumen's Transformation Efforts Lumen is in the process of transforming its business model from a telecommunications company to a technology company. The company is entering new sectors such as hybrid IT, cloud, and edge computing to keep pace with technological advancements. The recent appointment of a new CEO, Kate Johnson, is a positive sign in this regard. Johnson, who previously served as the president of Microsoft for US operations, brings valuable expertise to Lumen in addressing its two main challenges: growth and transformation.
The Suspension of the Dividend and Sale of Non-Core Assets Historically, Lumen's strategy has been to return capital to shareholders in the form of dividends and share buybacks, returning roughly $19 billion to shareholders. However, this strategy has hindered the company's growth potential. The recent suspension of the dividend and sale of non-core assets highlights Lumen's eagerness to turn things around. The company has announced the sale of three businesses, including its Latin America operations for $2.7 billion, its ILEC business for $7.5 billion, and some of its operations in Europe, the Middle East, and Africa for $1.8 billion.
Future Outlook for Lumen Technologies Lumen has several options for how it can use the incoming funds from the divestiture of non-core assets. The company could use the funds to repay debt, which would be a welcome relief given its overleveraged capital structure. Alternatively, Lumen could use the funds for share repurchases, as the company has a $1.5 billion plan in place. Finally, the riskiest option would be to use the funds for growth initiatives.
Conclusion Lumen Technologies is a risky but potentially rewarding investment opportunity. The company's recent divestiture of non-core assets, combined with the appointment of a new CEO with a strong background, presents a unique opportunity for growth. However, due to the high level of risk involved, we recommend taking a cautious approach and limiting any investment to a 1% position until we have more clarity on the future of the company.
META - A Value Opportunity In The Tech Environment
The accounting representation of Tech companies is key to understanding their value. Only if you dig deep enough can you appreciate their fair value, and being a conservative Tech investor is not easy. Value investors are usually unwilling to pay for growth, and finding a tech stock where growth is not priced in is a rare beast or a value trap.
Asset protection is hard to assess because Tech companies are asset-light and intangible, and Goodwill represents most of their assets. One needs to be skillful in recreating an adjusted asset valuation to understand the true essence of the balance sheet.
Why would any analyst be worried about recreating an adjusted balance sheet of a tech company? That’s what a fundamental value investor should do, and in this article, we discuss why while applying this concept to this very debated company.
In this article, we are going to:
- Recreate a conservative Asset value for META (META) to compare it to its EPV (Earning Power Value).
- Compute EPV calculation.
- Explain why META is undervalued even when considering all the investment in reality labs as lost with zero growth priced in the valuation
- Conclude that from its current price, there is a limited downside possibility, and multiple are so compressed that any easing of the micro conditions or small improvements of margins or revenue could drive META to outperform the market.
Why EPV?
Earnings Power Value is a measure of sustainable earnings used often by Proof. Greenwald at Columbia University is a proxy for putting in perpetuity at WACC a company’s sustainable earnings, smoothing out revenue and margin that are not considered within the norm, mostly averaging them after understanding the firm's typical cycle.
We have previously employed the value investing framework in assessing companies like Silvana or Menzies, and for both, we exit at more than 100% gain, but publicly until now, we haven't analyzed a tech company using a value approach; we intend to try now with META (META) since among the FAANG it seems the one where the market is discounting the worse possible scenario.
Only once we have assessed that a company is able to produce superior returns, meaning that having capitalized sustainable earnings which are superior to its asset value, we can dig further to verify that the company enjoys barriers to entry. Therefore we can analyze what is called franchisee value, which is the ability to generate higher returns on invested capital over its cost of capital.
That’s what Munger calls a "great business for a fair price" When he refers to the importance of a business having a MOAT and the ability to compound returns at a rate higher than WACC. How much to pay for its growth is a key metric in buying a great business without losing sight of a realistic valuation.
Asset Value of META
Starting with asset valuation, some of you might think that asset valuation does not have any meaning for tech companies, but it does provide the opportunity to verify the essence of the moat when compared with their sustainable earnings.
Let’s take a glance at the balance sheet. It’s not a surprise to see how low leveraged META is, with an asset value, according to the last available statement, of $179b and an equity value of $124b, with only $55b in liabilities, including $16b of accrued expenses. If we look at the goodwill amount, it is about $20b, which includes amounts related to the acquisition of Instagram, WhatsApp, Oculus, and other smaller firms.
So, meta reports its revenues into two segments: Family of Apps and Reality Labs. With the latter, the main issue is $10b “lost” in 2021, and only last quarter loss of $3.6b, and Zuckerberg does not seem to be interested in stopping this, which some value investors are calling a bloodbath.
The Reality Labs' issue is the key to understanding META's stock price crises. Realty Labs' cost is dramatically increasing, the operative cost was 3.95 billion, and its trend has been up north of 50% in the last year, and it shows no sign of coming down. The table below highlights the breakdown of revenue and operating income between the family of apps and Reality Labs.
This investment is, as we know, far from becoming profitable. All of you that came across the famous Christensen book “The Innovation Dilemma” perfectly understand META's current stage and the main problem of its founder.
A company at this stage could become a cash cow, in which the management could concentrate on returning shareholder value through buyback and improving cost efficiency. However, this does not come as a free lunch. Indeed, it comes at the expense of the company's future growth, which would no longer be there. Instead, investing in growth and new opportunities for new markets would allow the company to try not to get disrupted by other companies in the future. Money spent on growth would eventually come back as a new stream of free cash flow. At least in theory, and only if the company can produce and sell a meaningful, useful product.
In META's reported intangibles, the most important part, the internally generated ones, are missing. The internal product portfolio, software, internal technologies, and platform that METAS has. And the customer portfolio, the billions of people participating in the network that every day log into those platforms to interact. Also, the workforce, engineers, marketing staff, and executives who generate value for the company.
We believe that the valuation of intangibles is the only way to assess the profitability of the company and the possibility that this company can convert investments in research and development into streams of future cash flow.
Assessing Asset Value
To assess those missing internal intangibles, we will proceed as follows.
First, we are going to use a perpetual inventory model to assess the product portfolio, then we will assess the customer portfolio by using the reproduction cost framework, and lastly, we will assess the cost of rehiring the workforce and capitalize on it.
For the workforce, we take the general administrative expenses for the year of $9.9 billion and divide them by 76,000 employees (after firing 11k just a few weeks ago). At this point, the average salary for employees would be 130,000, and we would assume 15% of the headhunting fee in general, which would be a value of roughly $2.5 Billion for the workforce.
The capitalization of the R&D in the product portfolio is not reported, and we want to be conservative and assume that all the money of realty labs would be lost. So, let’s assume that a depreciation of 20% starts from 2014. We are going to use the perpetual inventory method. So, looking at this, we will cut by much the reported R&D and only use the one without realty labs cost.
Research and development expenses are the costs spent on developing new products and keeping old products up to date. The classical or maintenance CAPEX is included in these expenses, which is a very important distinction to assess to separate the maintenance costs from the Growth CAPEX.
25% of those costs in R&D are based on stock compensation, which is typical of some tech companies, so dilution does happen all the time to pay for this compensation. However, Meta has been buying back, as we know, many shares, but it’s important to assess the real net value of the buying, also considering the dilution in place, to understand if the buyback is a way for the executives to sell their stocks or it would be a way to drive shareholder value.
Sometimes, people tend to jump quickly to conclusions on buybacks. Yes, they could be a great way to create shareholder value if the company does not keep diluting from the other side to compensate its team.
For reference, the table below highlights the cost related to share-based compensation for the past three years.
The second most important factor is the customer portfolio. We will be highlighting both of our models to calculate it for the understanding of our audience.
Traditionally the model we use is based on some assumptions.
The number of customers acquired during the fiscal year is linear based on the money spent on sales and marketing expenses.
The rate of customers acquired per dollar spent on sales and marketing decreases over time (it cost more to acquire the last client than the first one).
Starting from the formula of the customer:
C(T) = (1-a) * C(t-1) + B(T) * i(T)
The customer today C(T) is just the customer of yesterday C(t-1) less the churn rate (1-a) plus the money spent on marketing i(T) multiplied by how much spent in dollars terms convert into customers B(T).
We are assuming a churn rate of 5%, which is the rate at which Meta loses customers every year. For a number of customers, we are using the daily active users (DAU) that Meta reports in their annual reports.
From this, we rearrange to get the B(T) value:
B(T) = (C(T) - ((1-a)*C(t-1))) / i(T)
As we can see, the number of customers obtained for each dollar spent is the customers today minus those who are left after one year, divided by the money spent on sales and marketing.
So, the goal is to find how much a customer costs to be acquired B-1(T), which is the inverse of B(T), and then multiply that by the number of customers to get the customer portfolio, which obviously is not contemplated in the balance sheet.
From the above methodology, the value of the customer base would be m$153,696. Calculations are highlighted in the table below.
Since we are being very conservative with META's valuation, it only makes sense to use a conservative model for the customer base too.
In that model, we first calculate the sum of how much the company invests each period to increase the customer base (IC) for several years and then add that amount to some base period to get the value of the customer base (VCB).
Our conservative estimation of the customer portfolio is shown in the table below, which gives us a value of $58,871m.
So, let’s readjust the asset value to include the missing intangibles we have calculated above. There is one more adjustment that we will make, which is to adjust Goodwill to avoid double counting.
We only want to keep the Goodwill of the brands that still have a separate brand identity, like WhatsApp or Instagram. Since Oculus is now fully integrated with the Meta brand, we would remove the part of Goodwill which was acquired due to Oculus’s acquisition.
Asset Value Calculation
The adjusted asset value we get is $235,078b. We will next calculate the earnings power value (EPV) and compare it with the asset value to identify whether Meta has an economic moat or not.
Earnings Power Value Assessment
We have a revenue estimate, which is lower than the last financial year, so not only are we not accounting for the growth of revenue, we are conservatively reducing the revenue to $105 Billion, which is lower by roughly 11% YoY.
We also use a very conservative margin of 27%, which is much lower than the historical one, close to 40%, also accounting for the huge R&D expenses in realty labs and reels and AI which the company is facing, and they might persist longer.
At this point, we must consider the growth CAPEX related to product and customer portfolios.
If we use the same amortization rate of 20% for a product portfolio worth 50 billion, that will be 10 billion depreciation, intended to be the amount we need for the maintenance CAPEX of the software. To find the growth part, we will deduct the maintenance expense from the total expense of RnD ex Realty labs of $19.4 billion, the total growth part would be around $9.4 Billion.
This is an assumption; of course, we need to believe the 9.4 billion spent on reels, AI, etc., would eventually not be lost. However, at this stage, we do find that to be the case.
In order to understand the growth part related to the customer portfolio we have to calculate the maintenance CAPEX, so it will be the cost of acquiring a client B-1(T) of 100$, multiplied by the 5% churn rate multiply the number of customers of 1.9 bill, so total = 9.6Billion, I need to subtract the latter from the total sales and marketing expenses of 14 billion and from that the remaining growth will be $4.4 billion.
We have also made a more reasonable assumption with higher revenue using the latest one and by adjusting our conservative estimate of the margins for the latest announced layoffs and a lower WACC close to the current one.
Earnings Power Value Calculation
As we can see, there is a huge difference between the asset value of $86.75 and the Average EPV of $162.29. This indicates that META may have a competitive advantage (MOAT), so paying for growth might be justified. But we want to be conservatives and don’t want to pay for growth. Even at current levels, there is enough margin of safety for an investor to feel comfortable.
Conclusion
In this valuation, we could argue that we have adopted a doomsday scenario, in which we have compressed operative margin, being quite severe with WACC, and have included not only zero growth but in scenario 1, we also assumed a contraction of revenue, assuming that all the Metaverse investment would be completely lost, referring not only yo the previous but also to the future investment, since in the EPV we have assumed that Zuck will keep investing 12 billion yearly and receive not benefit from it.
Even in such circumstances, Meta is a great buy. We recommend buying at this level and holding at least up to $165 to $180.
If we start to receive a breath of fresh air on the metaverse front or growth starts to pick up again due to WhatsApp and/or Reels, META (META) should be worth north of $250.
telegram crypto: 13 Best Crypto Telegram Groups to Join in 2025 ✓
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Free thoughts on my wrong investment in ATER
In life and business, consistency is essential. The ability to show steadiness with your thoughts gives you leverage in the form of moral authority. One of the main characteristics that leaders share is stability and commitment to their previous thoughts and ideas. Many “lazy” thinkers (sheep) want to follow somebody they can trust, that does not change their mind. In equity investment, not changing your mind can be fatal – for your capital and the capital you manage on behalf of others.
An equity story cannot be a life commitment, neither can you show devotion to them as a religion or your favorite football team. Things change, executives make mistakes, new technologies come, macro scenarios change, and more than anything else, you could realize you were WRONG. That happens as well, and there is nothing wrong with it unless you persist in the error. Many money managers and equity analysts want to avoid admitting mistakes and stay with their thesis. After years, not only do they look stupid, but they also affect their capital and/or the capital they manage.
I made a mistake with ATER. In the last few years, thanks to God, I did not make many, but ATER was one of the worst I made for sure.
When you sell a stock at a loss, you can use that amount to buy another, and if that new investment goes up, you make money back (with less risk sometimes). So, you don’t have to wait until you recover your losses with the same stock when you can redirect that money into a better strategy. I know it’s obvious, but some people get stuck for years in a losing position without realizing or admitting that it was a mistake when they should have shaken it off and move forward.
In the last few months, from October 2020 to February 2021, we have lived a very hectic stock market period where we had no time to sleep, primarily due to momentum stocks going higher every day. During that kind of pre-bubble time, in which it is impossible to cover all those stocks profoundly, you always have a few that you leave more to your team, rely on third parties, or you go over them by yourself but not with the needed level of in-depth analysis.
ATER was one of those companies I quickly looked at and therefore didn’t pay too much attention to some details that I left in my analysts’ hands. I checked up the models but didn’t have the time to dig deeper into the story, which at the moment seemed a straightforward, growth story.
I have come to believe that DCF for growth stories is something that doesn’t make much sense. Most of it has so many assumptions that it becomes a very risky bet. That’s why I usually prefer Sustainable Earnings (EPV) valuation, which allows us to analyze what the company has achieved in recent years and therefore provides a “feet-on-the-ground” idea of what it can deliver in the future.
I like some small growth stories on which I have small positions on my portfolio, between 1% and 2%, which gives me the ability to spend less time studying the stock because of the implied risk for my overall performance. Of course, I spent much more time analyzing the companies where I have more significant positions and still follow and study them closely.
I would have taken more prominent positions. However, time management is an essential skill, especially in high-volatility environments where opportunity cost is outrageous. You must spend more time on the significant convictions of your portfolio rather than trying to make the impossible and cover all the “promising-looking” stories.
The lack of proper due diligence is behind any mistake
Many FinTwit gurus only push the stories and never go into valuation assumptions or perform a proper strategic analysis of the stocks. They overlook the matter by throwing some multiples (usually P/S and EV/S); those multiples are a hazardous way to value a company. Especially in a period of bullish market in which relative multiples are very high and even more when you choose the wrong peer and compare “apples with oranges.” Different companies usually have distinct growth and risk implications, and this can bring two companies of the same space to have unrelated multiples justifiably by their intrinsic and individual characteristics. So, executing a valuation by simply looking at multiples can be extremely harmful because it might lead you to believe that a company is cheap when it is overly expensive.
Revenue Growth is meaningless to value a company unless it is not aimed to produce future free cash flow. Don’t forget that! Most Tech companies, especially SaaS, are based on a subscription model, and most of their revenue can be converted into EBITDA and then eventually free cash flow. When you buy software companies, 80% to 90% of that revenue can be converted into free EBITDA. Once you consider the cost of customer acquisition and the churn rate, most of the income would be cash, so multiples like EV/S may make some sense.
Because of the above argument, some gurus in the FinTwit community take for granted that EV/S is a useful metric for all Tech companies in general when it is bloody not!
Look at the kind of people we need to answer to on Twitter:
Stock pumping on Twitter is creating virtual boiler rooms
Stock pumpers manipulate followers and leverage their lack of knowledge. FinTwit traders have a dangerous behavior that fraudsters can exploit. When you learn about something, understand the terms and have some experience but don’t comprehend the subject deeply, you could be in danger. Because you are at a stage where you think you can handle a conversation, you can put your head around it, so you feel you don’t have to say, “I know nothing about it,” but deep inside, you know you don’t master that topic. That degree of knowledge is dangerous because it is not enough to address the issue accurately and not too little to let you walk away so that you can get played!
Wrong valuation input leads to big mistakes!
When you do a DCF on a growth story, you rely on multiple extremely difficult assumptions to hit correctly. Terminal growth could be responsible for 60% or more of your final equity value, and the model would be susceptible to the hurdle rate you use and the assumed growth. When you don’t know how value drivers move (Free cash flows either to the equity or to the firm, hurdle rate, and terminal growth), you are not safely investing. For some companies, DCF just doesn’t make sense.
As an example, let’s dig into ATER’s valuation technicals, and let’s try to explain what the issue with ATER is.
Look at what happens to ATER’s DCF model if you change some of the realities of the company to reflect new evidence:
- Raising Hurdle rate from 14% to 16%
- Reducing terminal growth rate from 3,5% to 1%
- Increasing the share count from 23.2 mil now to 26.2 (however, we could also use 30 to incorporate options and higher strike price warrants, but to avoid critics to this methodology, we use the share count on a weighted average basis)
One could argue that 16% as a discount factor is too high? Well, think about it again: if debt holders are getting 8% on a cash basis with an option to avail warrants, the real cost of debt is north of 12%. Wouldn’t the equity holder be compensated a few extra percentage points of risk premium?
The growth dilemma leads to other big mistakes!
That said, let’s now try tweaking the revenue CAGR growth rate. Growth can slow down if the share prices remain depressed. This is because one of the major investment theses of this company revolved around accretive M&A deals. To remain prudent, here we are assuming that the company’s organic growth does not decline, instead remains stable and grows slowly – which is also a big “if” and risky assumption. We will decode this argument later. If you tried to capture this scenario, valuation again drops significantly.
The fallacy of such a method to value this company is that we are missing the whole point by purely basing the valuation on growth assumptions from now to 10 years ahead. Trying to foresee the growth for a company like this is misleading. Revenue doesn’t mean anything; EBITDA is what matters, or, if we dig deeper, how much EBITDA you can convert into free cash flow. This is especially true when the company is externally buying growth at a high cost of capital.
While I was busy, my team prepared a DCF on ATER; sometimes, busy analysts do that quickly by using consensus and maybe adjusting for a higher hurdle rate if they smell implied growth might be high. By inputting consensus numbers and calculating a reasonable hurdle rate, you most likely will understand what the market thinks about the company.
When the initial model was constructed, the M&A activity of the company was done in an accretive way because the market cap was more than two times what it is today. So it was easy for the company to grow by giving shares in exchange. This narrative has now changed, as ATER is down more than 60% from its ATH, and buying assets in exchange for shares is highly dilutive for ATER. Think about it this way: if you are worth USD 1bln and buy an asset worth USD 40 mln, your share base dilution would be 4%. After a 60% share price drop as in the case of ATER, the same deal would lead to a a 10% share base dilution.
If we look at the products ATER bought, they are pure Chinese garbage. Objectively, they are cheap goods that sell well online. How much the company can grow is NOT the most crucial factor here.
A company can grow its sales CAGR at a factor of infinity. Still, the most crucial element is that whatever they sell makes enough money to pay for the debt and gain a reasonable amount of money. Think about it, plain a simple, they can keep buying all the companies they want and become a 100 billion turnover, but they are buying with a capital that needs to be reimbursed after the debt is paid, and that is the key.
So, the parameter you have to adjust in the DCF model is not only growth, but the most critical part is the EBITDA conversion to Free Cash Flow and EBITDA Margin.
Look below:
Getting back to company valuation, the most crucial element to analyze a company is its free cash flow. We all know that valuation is just trying to figure out the future cash flow of a company and bring it back discounted of the hurdle rate to today’s value. Still, some of these genius stock pumpers don’t even know what a hurdle rate is.
When you work on ATER’s model, you take for granted that the EBITDA margin will grow towards 15%, as indicated by the management. Only focusing on the growth will tend to overvalue the company. This is very easy to understand. ATER is buying growth. They are buying companies financing growth north of 12% (8% + warrant), so revenue increase is not an issue that is relatively easy to achieve. It would be best to make sure the company you buy will generate enough money to pay for the debt and remunerate the capital accordingly to satisfy the risk incurred.
Growth is not a helpful metric because ATER is buying it; ROIC is what we have to analyze because if your return on capital is not adequate, you can grow, destroying value. ATER sells stupid cheap Chinese goods, and they have to increase the sales of those products to justify their investment. If they can grow their sales and make a good spread between the money they borrow and what they make, then the business can succeed. However, if these products will go out of favor, or they won’t be able to sell them for a higher price, this company can easily go bankrupt. YES, it can be worth ZERO.
AIMEE is not a competitive advantage
ATER claims AIMEE to be the key to its business model. Well, AIMEE is just a data software that works with data inputs, and it has a code that would analyze data in a certain way. This doesn’t seem to be an advantage or a moat. What should be monitored closely is what kind of advantage AIMEE can offer. In my opinion, it was just one of those gimmicks where a company tried to take up SaaS valuation by selling an investor story involving this tech.
Look at this scary situation, one of the crucial revenue segments is going down dramatically:
Source: 10Q
This is what we need to look for as investors. Can they grow sales of the companies they are acquiring? Their rebuttal was:
Source: 10Q
What happened to AIMEE? They are selling 37% less because of “sell-outs inventory”? So, all this competitive advantage due to AIMEE technology that is supposed to optimize the process does not exist?
A company could hide their organic growth slowing down but keep growing revenue by buying companies at high prices and higher multiples if you don’t have a breakdown of the different companies. These companies could be running a Ponzi scheme, and it would not be easy to spot them if their financials don’t share segment by segment details.
Another FinTwit myth that needs to be clarified: Don’t get fooled by the story that a new high growth story does not have to be profitable. Some companies could not be profitable initially but will be investing heavily in Research and Development (R&D). Think about Amazon, Apple, or any other company that has spent years developing technologies that represent an actual moat. So, if you look at the P&L, you will see hundreds of millions or even billions spent during years to develop a technology.
You will see this cost deducted from the profit. But when the technology is eventually developed, all those R&D will ultimately manifest itself in a growing cash flow stream. In the case of ATER, their R&D is negligible – in 2020, they spend less than 4% of their revenues in R&D.
Conclusions
You should invest in ATER only if you believe that AIMEE provides a substantial competitive advantage. Their organic sales will grow steadily, and their products won’t get out of favor. It would help if you also trusted that they would be able to get better debt conditions. But how would you know that?
Moreover, let’s address two quick issues; in valuation, there are parameters to check for accounting manipulation called Benish Score and Z score. Although the explanation of these tests is beyond this article’s scope, I am not suggesting they are manipulating their books, but the possibility remains.
Nonetheless, a company like this could do this easily because of the setup of the business model. If they don’t show the breakdown of organic growth for each company they buy, they can show a higher EBITDA. Still, we wouldn’t know if EBITDA growth is fueled by a new acquisition (from expensive debt) or was fueled organically. Only the insiders like the CFO know that. ATER, former CFO left after the short report (according to the report, he had previously bankrupted a company).
So, back to the main issue, if the EBITDA growth cannot be assessed accurately, we will never know if it is a company with a stable future. Sometimes you can also define a stock by analyzing who is primarily investing in it. Feel free to go on the Twitter feed and check the kind of people pushing ATER, their financial background, as well as their motives. I was not impressed.
So, if you are a momentum trader and want to ride this, there is nothing wrong with it. If the growth story keeps going up again, ATER could get pumped back to $30 or $40 once again. But remember that price and value remain two different things.
I don’t know, and I don’t care where ATER will go. I don’t want to be seen like somebody who promotes this stock because I don’t feel safe and made a mistake the first time I bought it.
Because I changed my mind about ATER and made some tweets expressing my concerns, I was bullied and even received death threats and all sorts of insults from several Twitter accounts that are bullish on the stock. I have initiated legal procedures, and my lawyer already informed the police that they are constantly monitoring Twitter and taking things very seriously.
This is my last post on ATER, and I don’t want to talk or tweet anymore about it. I am not short yet; I would only take a short position eventually if there is further strong evidence of organic growth slowing and price momentum gaining traction. That said, I will pursue legal actions if I receive insults or threats because of my view and opinions.
About Antonio Velardo
Antonio Velardo is an experienced Italian Venture Capitalist and options trader. He is an early Bitcoin and Ethereum adopter and evangelist who has grown his passion and knowledge after pursuing the Blockchain Strategy Programme at Oxford University and a Master’s degree in Digital Currency at Nicosia University.
Velardo manages an 8-figure portfolio of his investment company with a team of analysts; he is a sort of FinTweet mentor, people interact with him online, and he has more than 40,000 followers after his tweets. He has built a fortune in the great tech years and put together a tail strategy during the pandemic that allowed him to take advantage of the market drop. “I did not time the market, and I did not think this was even a black sworn,” he says.
On the side of the financial markets, Velardo has a unique combination. He was a real estate entrepreneur that developed several projects in Tunisia, Miami, Italy, the UK, and many other countries and cities. But he has always been passionate about options trading. Still, contrary to the volatility player and quant trading, he always had a value investing touch in his blood. Antonio studied Value Investing at Buffet’s famous business school at Columbia University. Even though the central concepts of value investing are antagonists to the venture capital pillars, Antonio’s approach tries to bridge elements of both worlds in order to seek alpha. Velardo has learned the importance of spotting pure growth stories and taking advantage of their S-Curve position. This is an essential element of Velardo’s approach as he looks forward to embracing great tech stories at the right time of the adoption cycle. This applies to stocks but also to blockchain projects.