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For the past couple of years, Amazon has trialed last-mile delivery with individuals, in a program called Amazon Flex, and with small-courier companies using “white vans.” Both of these initiatives are designed to rival UPS and FedEx.
As Amazon prepares for the holiday season, these programs are ramping up to take on more of the load. But that’s not all. Amazon recently launched Amazon Relay, an app aimed at making it easier for truck drivers to make pickups from Amazon warehouses, and is soon to launch a trucking cargo app. All of these services are being trialed internally at Amazon and slowly being turned into platform businesses, specifically services marketplaces.
Amazon Flex: What Uber Rush Aspires To
Amazon Flex lets individuals with cars pick-up packages from an Amazon warehouse and deliver them to customers’ doorsteps. Amazon advertises that drivers can earn $18-25 per hour. The B2C delivery model has been tried before by platforms like Postmates, Deliv and UberRush. However, UberRush has been reported to be struggling after launching a couple years ago.
UberRush also focused on small businesses as its primary customer. These businesses, like restaurants, would use UberRush to deliver products to their customers. Postmates is different. The customer places the order through Postmates and pays Postmates the delivery fee.
Amazon Flex can subsidize the cost of the B2C delivery model to small businesses with its own package volume. As Amazon Flex gains a more public presence, it’s rumored that Amazon will let other small businesses use the program for their own needs. However, the cost structure is completely different if a driver is already on a scheduled route to deliver Amazon’s packages and is adding incremental volume from small businesses.
Amazon’s Trucking Apps
Amazon Relay is primarily for internal use and will likely not be opened up as a stand-alone platform. It helps trucker drivers coordinate their drop offs at Amazon warehouses. The app makes this tedious process more organized and efficient. However, the app also will prove to be a great learning experience for Amazon in advance of the rumored release of Amazon’s cargo delivery app for truckers.
Uber Freight launched in May of 2017 and began a national roll-out just a few months after launch. The service provides a seamless booking process for truck drivers to accept freight delivery jobs similar to the Uber process for passenger drivers. Uber Freight also provides driver benefits like payment within a few days of completing a job when the industry norm can be payment after a month or more. For this reason and others, Uber Freight seems to be making good progress.
Amazon’s competing app should be coming out soon and will probably follow a similar process of leveraging the existing demand from Amazon’s routes as we have seen with Amazon Flex.
Act as a Consumer
One of the hardest elements of building a successful platform is the chicken and egg problem. Existing businesses have an advantage in launch a platform because they can act as the producer or consumer at launch to seed the marketplace with liquidity. In Amazon’s case, it is acting as a consumer for both individual delivery drivers as well as truckers.
As Amazon builds a fluid network of producers (drivers), it can scale its network by opening the service up to other customers. If not opened up, this would still be considered a linear business; however, platforms like Amazon are masters at building new platform businesses on top of its core modern monopoly: the product marketplace.
Just like Google built platform moats around its modern monopoly in search. Google built Android, YouTube, Gmail and others which leverage Search’s advertising network and protect the business that drivers over 95% of Google’s profits.
As Amazon expands further into logistics, it seems to be heading down a similar path.
When does an LP not act like an LP? When it issues a 1099 at tax time, so you can avoid the complications of a K-1. KNOT Offshore Partners LP (KNOP) is one of a few LPs that has elected to be treated as a C-Corp, and issues 1099s to unit-holders at tax time. Thus, we are spared what some investors refer to as the “dreaded K-1.”
KNOT Offshore Partners LP owns and operates shuttle tankers under long-term charters in the North Sea and Brazil. The company provides crude oil loading, transportation, and storage services under time charters and bareboat charters. KNOT Offshore Partners GP LLC serves as the general partner of the company, and Knutsen NYK Offshore Tankers AS is their sponsor. The company was founded in 2013 and is headquartered in Aberdeen, UK.
To say that shuttle tankers are a niche industry would be putting it mildly – shuttle tankers comprise only around 1% of the world’s conventional tanker fleet, and are a vital key solution for oil companies looking to monetize their product. Since many ports don’t have the infrastructure to accommodate large tankers, producers charter shuttle tankers to get their oil into port. These are specialized vessels that take 2.5-3 years to build, so there isn’t a lot of speculative new-building going on in this industry.
Like many of the high-yield stocks and LPs we cover in our articles, KNOP works on long-term, fee-based contracts, with strong counter-parties such as Statoil (NYSE:STO), Exxon Mobil (NYSE:XOM), and Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B).
This serves to provide stable cash flow for KNOP’s distributions. The company now has an average of 4.4 years left on their fleet’s contracts, with an additional average of 4.5 years extension at the charters’ option.
Since their 2013 IPO, KNOP’s fleet has grown 230% to 14 vessels with a low average vessel age of about 4.5 years, compared to the rest of the industry average, which is much older – around 12 years.
(Source: KNOP site)
Our High Dividend Stocks By Sector Tables track KNOP’s price and current distribution yield (in the Services section).
KNOP pays their distributions in the usual Feb-May-Aug-Nov. cycle for LPs, but there’s a big difference at tax time: unlike most LPs, it’s elected to be treated as a C-Corporation for tax purposes, so investors receive the standard 1099 form and not a K-1 form. (Tell your accountant he owes you a beer.)
Management has held the quarterly distribution steady, at $.52, since October 2015 – it’s ~39% above their targeted minimum distribution of $.375. Since their 2013 IPO, KNOP has paid common unit distributions of $8.74.
When asked about future distribution hikes on the Q3 earnings call, management replied, “The MLP has an elevated yield compared to most MLPs, and we therefore are focused on first rebuilding coverage and then deleveraging when not making accretive investments. There is little benefit to the MLP in the short term (in) paying much more than the current yield.”
KNOP achieved record distribution coverage in the past two quarters, at 1.46x in Q3 ’17 and 1.43X in Q2 ’17:
KNOP has options, which we feature in our premium service, and didn’t list here. But you can see details for over 25 other income-producing trades in both our Covered Calls Table and also in our Cash Secured Puts Table.
After a sub-par Q1 ’17, KNOP has bounced back strongly in Q2 and Q3 ’17. Q3 ’17 saw 34% growth in Revenue, 29% EBITDA growth and 18% DCF growth.
KNOP hit record amounts for revenue, EBITDA, DCF, and net income in Q3 ’17, due to their new vessels contributing to earnings.
In the last 12 months, the MLP has acquired the Raquel Knutsen in 2016 Q4, Tordis in Q1 2017, Vigdis in Q2 2017 and Lena Knutsen in Q3. “The fleet achieved strong performance with 99.7% utilization for scheduled operations and 99.3% utilization, taking into account the scheduled drydocking and repair of Carmen Knutsen. We completed the acquisition of Lena Knutsen, which is a five-year charter to Shell.” (Source: Q3 ’17 earnings call)
Even with the unit count growing by 9%, distribution coverage has grown from an already strong 1.24x factor to 1.28x, over the past four quarters:
This table compares the low end of KNOP’s 2017 guidance, pro-rated for three quarters, to their actual figures for Q1-3 ’17. So far, they’ve exceeded their net income and EBITDA guidance, and narrowly missed their DCF, distributions and coverage ratio guidance:
Dilution/Coverage: Since LPs pay out the lion’s share of their cash flow, they must periodically go to the debt and equity markets to raise more capital for further expansion. (See the Financials and Debt and Liquidity sections at the bottom of the article for more information about current debt levels.)
On 11/6/17, management announced a secondary public offering of 3,000,000 common units, representing limited partner interests in the Partnership. This 10% dilution caused their price to fall well over 12%, to around $20.00.
But therein lies the opportunity – with KNOP’s ample distribution coverage, that $.52 quarterly distribution isn’t going away. Even with a 10% higher unit base, they should still achieve good coverage.
3M more units at $.52/unit = $1.56M in additional payouts/quarter. In Q3, they paid out $17.39M in total distributions, so this would rise to ~$18.95M. If DCF is flat, coverage would still be ~1.26x, with plenty of leeway.
Management did warn on the earnings release that in Q4 ’17, “the Partnership’s earnings for the fourth quarter of 2017 will be affected by the planned drydocking and repair of the Carmen Knutsen, which is expected to be offhire for 73-75 days until mid-December 2017. Offsetting this offhire will be the Lena Knutsen, which is expected to operate for the entire fourth quarter. There is no further expected offhire for the fleet during the fourth quarter of 2017″ (Source: Q3 ’17 earnings release).
So we could see DCF fall, with the Carmen Knutsen being out for ~2.5 months, unless the new vessel, the Lena Knutsen is able to pick up the entire slack. Either way, we see KNOP maintaining good distribution coverage for the long term, which is why we bought more units on the dip.
Contract Expirations – Management has been working on renewing/extending contracts for some of their vessels which had contracts expiring in late 2017 (Windsor Knutsen) and in 2018 (Hilda and Torill Knutsen). So far, it’s gotten the Windsor extended to October 2018.
The company addressed this on the Q2 earnings call:
The Windsor Knutsen has been on a two-year contract from 13th of October 2015 with Brazil Shipping, a subsidiary of Royal Dutch Shell with a further six years of extension options. In July ’17, the first option is listed taken charter codes reaching October 2018.”
The company still has plenty of time to re-contract the Hilda Knutsen and Torill Knutsen, whose contracts expire at the end of Q3 ’18 and Q4 ’18, respectively. Also in their favor is the fact that these are highly specialized vessels, which would take 2.5 to 3 years to replace.
Privately held Preferred Units: Management sold a total of 4.1M preferred units in two private placements in February and May.
These 8% (~$2/unit annually) preferred distributions will take seniority over common units in any liquidation scenario, in addition to lessening the amount of DCF available to pay common unit distributions, by around $1-2M/quarter.
However, as we detailed above, KNOP’s distribution coverage hit records in Q2 and Q3 ’17, even after accounting for the preferred payouts.
Management elaborated about current trends and developments concerning their sub-industry and their sponsor Knutsen NYK on the Q3 earnings call.
As our production moves further offshore, these tankers operate in a space which will see substantial growth in the coming years. Some of the largest discovered oil reserves in the southern hemisphere are in pre-salt layer, 130 kilometers off the coast of Brazil. And Petrobras, for the month of September, oil and natural gas output on those proportions of 1.68 million barrels of oil equivalent average daily production, a 6.6% increase from the previous months and higher than last year’s average.”
Petrobras Transpetro have requested tenders for shore tankers and whilst have not been specific about numbers, we believe their requirement will be for at least 4 vessels initially. Although our MLP is young, our sponsor is a very experienced operator, having been involved in the design and construction of these type of vessels for over 30 years.”
Concerning future dropdowns, they said, “We will see when we get this Torill financing out of the way and perhaps, we’ll see how the equity market looks. I think probably early next year, first quarter next year, we might send that ship dropping to the MLP. But that’s subject to the factors on equity we can raise and what kind of financings we do. So it can be longer than that. But after that, we’d probably take a bit of a breather.”
Analysts’ Price Targets:
At $20.25, KNOP is over 16% below the average price target of $23.57, and 23.5% below the high price target of $25.00.
Estimates are mixed – with average EPS estimates rising over the past seven days for Q1 ’18, 2017, and 2018, but a mix of upward and downward EPS revisions for those same periods, and two downward revisions for next quarter:
KNOP was outperforming the market and the Guggenheim Shipping ETF (NYSEARCA:SEA) over the past year, until the November pullback. At $20.25, the stock is only 2% above its 52-week low.
Although KNOP isn’t an LNG tanker company, we’ve added them this LNG shipping company valuations table to compare the company to other tanker companies we cover in our articles, such GasLog Partners LP (GLOP), Golar LNG Partners LP (GMLP), and Dynagas LNG Partners LP (DLNG). The table also includes Teekay Offshore Partners L.P. (NYSE:TOO), the closest comparative company we could find, and Hoegh LNG Partners LP (HMLP).
KNOP is in the lowest tier of this small group, for price/DCF, price/book, and price/sales. Their 10.27% distribution yield is above average also:
Like most LPs, KNOP’s debt levels wax and wane over time as the company takes on debt to finance new vessels, and those vessels begin to contribute to earnings. The company ended Q3 ’17 at a net debt/EBITDA level of 6.11x, up substantially from Q3 ’16, but also much lower than their peak of 7.15x. Their ROE ratio has improved over the past two quarters, while their ROA is lower than it was in Q3-4 ’16, due to a higher asset base and higher depreciation and amortization charges:
KNOP is in a lower margin business than these LNG carriers, but their financial metrics are certainly much better than Teekay’s, the other shuttle company in the group:
Debt and Liquidity:
In the year-to-date, to finance the growth of acquisitions, we have raised both $145 million of new equity and $100 million of long-term debt, and $25 million of credit facilities, all on attractive terms.”
At the end of Q3, we had a very solid liquidity position with cash and cash equivalents of $38.1 million and undrawn credit facility of $12 million. And the credit facilities are available until mid-2019.”
The Partnership announced that its subsidiary, KNOT Shuttle Tankers 15 AS, which owns the vessel Torill Knutsen, has entered into a term sheet for a new $100 million senior secured term loan facility with The Bank of Tokyo-Mitsubishi UFJ, which will act as agent. The New Torill Facility is expected to be repayable in 24 consecutive quarterly installments with a balloon payment of $60.0 million due at maturity. The New Torill Facility is expected to bear interest at a rate per annum equal to LIBOR plus a margin of 2.1%. The facility is expected to mature in 2023 and be guaranteed by the Partnership. The new Torill Facility would refinance a $74.4 million loan facility associated with the Torill Knutsen that bears interest at a rate of LIBOR plus 2.5% and is due to be paid in full in November 2018. Closing of the New Torill Facility is anticipated to occur by the end of 2017.” (Source: KNOP Q3 ’17 release)
With the new Torill Facility, KNOP’s first maturity is in 2019:
(Source: KNOP Q3 ’17 release)
We rate KNOP a long-term buy, based on their very attractive yield, their distribution coverage, and their secure position, via long-term contracts within their niche industry.
All tables furnished by DoubleDividendStocks.com, unless otherwise noted.
Disclaimer: This article was written for informational purposes only, and is not intended as personal investment advice. Articles posted on SA aren’t meant to be all-inclusive white papers by any means. Please practice due diligence before investing in any investment vehicle mentioned in this article.
Disclosure:I am/we are long KNOP, GLOP, GMLP.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
HAWTHORNE, Calif. (Reuters) – Tesla Inc (TSLA.O) on Thursday unveiled a prototype electric big-rig truck that it will start producing in 2019, throwing itself into a new market even as it struggles to roll out an affordable sedan on which the company’s future depends.
Tesla’s new electric semi truck is unveiled during a presentation in Hawthorn, California, U.S., November 16, 2017. REUTERS/Alexandria Sage
Chief Executive Elon Musk unveiled the big rig, dubbed the Tesla Semi, by riding the truck into an airport hangar near Los Angeles in front of a crowd of Tesla car owners and potential buyers.
Later the semi truck opened its trailer, and a new Roadster drove out. The car is an updated version of Tesla’s first production vehicle. It can seat four and travel 620 miles (1,000 km) on a single charge, a new record for an electric vehicle, Musk said. It can go from 0 to 60 miles per hour (100 km per hour) in 1.9 seconds.
Musk has described electric trucks as Tesla’s next effort to move the economy away from fossil fuels through projects including electric cars, solar roofs and power storage.
Some analysts fear the truck will be an expensive distraction for Tesla, which is burning cash, has never posted an annual profit, and is in self-described “manufacturing hell” starting up production of the $35,000 Model 3 sedan.
Musk did not give a price for the truck.
Tesla also has to convince the trucking community that it can build an affordable electric big rig with the range and cargo capacity to compete with relatively low-cost, time-tested diesel trucks. The heavy batteries eat into the weight of cargo an electric truck can haul.
The truck can go up to 500 miles (800 km) at maximum weight at highway speed, Musk said.
Diesel trucks are capable of traveling up to 1,000 miles (1,600 km) on a single tank of fuel. Musk said diesel trucks were 20 percent more expensive per mile to operate than his electric truck.
The Tesla Semi can also go from 0 to 60 mph in five seconds without cargo or reach 60 mph in 20 seconds at the maximum weight allowed on U.S. highways of 80,000 pounds (36,300 kg).
“I can drive this thing and I have no idea how to drive a semi,” Musk joked.
Ahead of the unveiling, Tesla executives showed off the Class 8 truck to journalists, describing it as “trailer agnostic,” or capable of hauling any type of freight. Class 8 is the heaviest weight classification on trucks.
Tesla’s new electric semi truck is unveiled during a presentation in Hawthorn, California, U.S., November 16, 2017. REUTERS/Alexandria Sage
The day cab – which is not a sleeper – has a less prominent nose than on a classic truck, and the battery is built into the chassis. It has four motors, one for each rear wheel. Tesla designed the cab with a roomy feel and a center seat for better visibility, executives said. Two touch screens flank the driver.
The truck has Tesla’s latest semi-autonomous driving system, designed to keep a vehicle in its lane without drifting, change lanes on command, and transition from one freeway to another with no human intervention. Reuters reported in August that Tesla was discussing self-driving trucks with regulators in Nevada and California, but the company did not mention full autonomy in a release on the new vehicle.
Tesla will guarantee the truck’s drivetrain, which delivers power to the wheels, for 1 million miles.
Old Dominion Freight Line Inc (ODFL.O), the fourth-largest U.S. less-than-truckload carrier, which consolidates smaller freight loads onto a single truck, said it would not use the Tesla truck.
Slideshow (9 Images)
“We met with Tesla and at this time we do not see a fit with their product and our fleet,” Dave Bates, senior vice president of operations, said in an email, without elaborating.
Earlier this week Musk tweeted that the truck would “blow your mind clear out of your skull,” joking, “It can transform into a robot, fight aliens and make one hell of a latte.”
Tesla faces a much more crowded field for electric trucks than it did when it introduced its electric cars.
Manufacturers such as Daimler AG (DAIGn.DE), Navistar International Corp (NAV.N) and Volkswagen AG (VOWG_p.DE) are joining a host of start-ups racing to overcome the challenges of substituting batteries for diesel engines as regulators crack down on carbon dioxide and soot pollution.
Still, manufacturers are mostly focused on medium-duty trucks, not the heavy big rig market Tesla is after.
Tesla would need to invest substantially to create a factory for those trucks. The company is currently spending about $1 billion per quarter, largely to set up the Model 3 factory, and is contemplating a factory in China to build cars.
Charging and maintaining electric trucks that crisscross the country could be expensive and complex.
Tesla said the truck can charge 30 minutes and then travel 400 miles.
Shares of Tesla have risen 46 percent this year to make the company the No. 2 U.S. automaker by market value.
Reporting by Alexandria Sage; Editing by Peter Henderson and Lisa Shumaker
Musing on the future of the economy earlier this year, Bill Gates warned of smart machines replacing human workers and suggested a tax on robots. A new study of how technology is changing American jobs suggests workers are most immediately challenged by more common technology that Gates himself bears much responsibility for, such as Microsoft Office.
The new study from the Brookings Institution used government data on work tasks to track how use of digital tools changed in a wide range of occupations between 2002 and 2016. Use of digital technology, such as computers and spreadsheets, became more important to occupations of all kinds. But the most dramatic changes were felt in jobs traditionally least reliant on technology skills—think of home health aides and truck mechanics using computers to diagnose problems or record their work.
The Brookings’ study created a “digitalization” score for 545 occupations covering 90 percent of the economy, using government survey data that asks workers about their knowledge of computers, and how much they use them. In 2002, 56 percent of jobs scored low on Brookings’ digitalization scale; by 2016, only 30 percent did. Nearly two-thirds of new jobs created since 2010 required high or medium digital skills, the report says. That shift is problematic given America’s long-established deficit in basic digital skills, such as familiarity with spreadsheets or other workplace software, where US workers score well below other those from other advanced economies.
Overall, the Brookings report suggests the window of opportunity for workers without basic digital skills or a college degree is closing. “With the availability of jobs that require no to very low digital skills dwindling, economic inclusion is now contingent on digital readiness among workers,” says Mark Muro, a senior fellow at Brookings who led the study. “While tech empowers it also polarizes.” He recommends that companies, government officials, and educational groups invest in programs that train workers in basic digital workplace tools.
That diagnosis and proposed remedy stand in contrast to two common prescriptions for how to help the US economy adapt to technological change. Gates and many other tech executives suggest new government programs to support workers displaced by a coming generation of smart robots. In recent years there has been a swell of support, including from the Obama administration, for programs that teach people to code.
The new Brookings data suggests the US faces a more immediate, and perhaps less glamorous task. “Coding for all is not quite the right model,” says Muro. “It’s less sexy, but we need much broader exposure and mastery of humbler, everyday software.” Maybe not everyone needs to be a code slinger, but word processing and enterprise packages like Salesforce are hard to avoid.
Google CEO Sundar Pichai made a similar argument last month, when he launched a $1 billion educational program focused on helping workers skill up in workplace technology. Google employees will offer training in cities around the US. Naturally, they’ll highlight products such as GSuite, Google’s competitor to Microsoft office.
The digital-skills crunch has been a long time brewing. Erik Brynjolfsson, director of the MIT Initiative on the Digital Economy, says that IT’s impact on US businesses surged in the mid-to-late ’90s—not coincidentally around the same time US median wages began to stagnate. In 1996, President Clinton announced a “national mission” to make all US children technologically literate by 21st Century. The Brookings report shows there is still a way to go. “We could have done a lot better,” says Brynjolfsson.
Brynjolfsson echoes Muro’s call for better educational efforts to widen the pool of workers with basic digital skills. He also says society’s poor track record at adjusting to the digital age shows we should be starting now to prepare workers for the next big shift, in which machines become capable of many tasks now done by humans. He recommends that, in addition to productivity software and coding skills, workers should be encouraged to develop their creativity and emotional intelligence—faculties believed to be among the toughest for software to acquire.
Jason Kloth, CEO of Ascend Indiana, an industry-led group that tries to improve workforce skills, generally agrees with Brynjolfsson’s long-term predictions that advanced automation will challenge workers of all kinds. But his organization has more immediate concerns. “We need to close the gap between demand and supply in the labor market today,” he says.
Ascend has collaborated with Brookings on research on workplace skills. The Indianapolis group’s initiative includes programs that help companies identify or create educational programs for workers. Kloth says he feels there’s more at stake than just the fortunes of local companies and workers. “I think that growing income inequality manifests in social and political unrest,” Kloth says. Spreadsheet training could—maybe should—be a political issue.
NEW DELHI (Reuters) – Uber’s [UBER.UL] chief of policy for India and South Asia has quit, two sources familiar with the matter said on Monday, in the latest high-level departure at the online taxi company.
The Uber logo is seen on mobile telephone in London, Britain, September 25, 2017. REUTERS/Hannah McKay
Shweta Rajpal Kohli, a former Indian journalist who joined Uber last year, would join cloud-based software maker Salesforce.com Inc next month, the sources told Reuters.
Uber, in a statement to Reuters on Tuesday, confirmed Kohli had quit.
Kohli was mostly tasked with building Uber’s relations with regulators and government officials in India, a market where the firm has faced several regulatory and reputational hurdles.
One source said Kohli “was leading government engagements in the influential circles, so her exit is a step back for Uber.”
Uber was briefly banned in New Delhi after one of its drivers raped a woman passenger in 2014.
Uber hired a law firm this year to investigate how the firm managed to obtain the medical records of the rape victim, an incident that led to criticism of the culture at the U.S. firm, sources told Reuters in June. Uber declined to comment.
Kohli is the latest senior executive to leave Uber. The firm’s European policy chief quit in October, shortly after the departure of Uber’s top boss in Britain.
Uber has suffered a tumultuous few months which has seen former CEO and co-founder Travis Kalanick forced out after a series of boardroom controversies and other regulatory battles in multiple U.S. states and around the world.
Uber counts India as its second-biggest market after the United States. It operates in about 30 Indian cities and competes with Ola, a ride hailing service backed by Japan’s Softbank.
Uber said on Monday it had agreed with a consortium led by SoftBank and Dragoneer Investment Group on a potential investment.
During the past several months, some prominent Wall Street players have questioned the enduring legacy of value investing or have outright declared its imminent death. And why not as we are enjoying a bull market for the ages where non-dividend paying growth stocks (FANGs), momentum trading, trend following, and high yield dividend equity (HYDiS) among other speculative portfolio strategies, are outperforming the more risk averse value approach.
But we think that investing in quality, dividend-paying companies at reasonable prices — whether from a growth or value perspective — endures well beyond the scrap heap where this market may ultimately dump the portfolios of investors that are chasing fast money in the euphoria of a post-Great Recession boom.
Thus, we believe value investing will survive as the superior investing strategy along with dividend growth investing not called HYDiS. Value investing is not dead. It is just camouflaged, with die-hard practitioners waiting in the bushes ready to pounce on the falling stock prices of otherwise enduring enterprises.
Here is Main Street Value Investor’s argument that value matters in all markets.
From Bust to Boom
American writer and humorist Mark Twain (C. Stovall for Pixabay)
Remember the junk bond-fueled 80’s that led to the 1987 stock market crash? How about the dot-com craze of the late 1990’s that ended with the tech crash and subsequent bear market at the turn of this century? Perhaps we are all young enough to recall the housing boom that led to the capitulation of the stock market in 2008 and the ensuing Great Recession, the worse economic downturn since the Great Depression of the 1930’s.
If Benjamin Graham, the father of value investing, and Mark Twain, the legendary writer and humorist spoke from their graves with words of wisdom on today’s bull market, Graham would be screaming “where’s the margin of safety” as Twain reminds us that history does not necessarily repeat but certainly rhymes.
Well, high yield junk equity rhymes with high yield junk bonds, expensive internet growth stocks rhyme with dot-coms, central bank quantitative easing rhymes with savings and loan deregulation, and forever ascending stock prices rhyme with perpetually climbing home prices.
Trends are just that, trends which, by definition, always come to an end.
Nobody knows precisely when, but this end cycle will leave a secondary, more palatable heap of quality enterprises on sale for a limited time with a wide margin of safety or discount to perceived intrinsic value.
Grantham On Investors’ Preference for Extreme Comfort
Jeremy Grantham, the famed deep value co-founder of the Boston-based investment firm, Grantham, Mayo, & van Otterloo [GMO] started the latest debate on the virtues of value investing in GMO’s Q2 2017 letter to shareholders. Grantham’s argument was not about predicting the death of value investing as much as a narrative on why current stock market prices are trading beyond a reasonable margin of safety.
Investors’ extreme preference for comfort, like human nature, has never changed (tested back to 1925.) This is unlike financial and economic conditions, which have very substantially changed in the last 20 years.
The ebb and flow of these variables explain previous market peaks and troughs. These comfort factors, for example, have been at an extremely high average level for 20 years (as have P/Es) and remain so today. Thus today’s high priced market is the completely usual response from investors.
Any shift back to a lower P/E regime must therefore be accompanied by a major sustained fall in margins or a sustained rise in inflation (or both).
And, yes, I do believe these comfort variables will move to be less favorable. But probably not quickly.
Grantham correctly called and positioned his portfolios for the dot-com and housing bubbles, but has seen a negative outflow of GMO funds from clients as his bearish view of the current bull market is challenged daily by ever-rising indices.
Nonetheless, we believe that neither GMO clients’ performance chasing nor Grantham’s penchant for predicting market crashes is a sustainable investment strategy.
On a long enough timeline the survival rate for everyone drops to zero.
-Chuck Palahniuk from his best-selling satirical novel and movie, Fight Club
We agree with investment site, Zero Hedge that Fight Club’s sarcastic, although eerily truthful anthem also applies to the markets. As such, life expectancy, whether human or markets, is mostly unpredictable in the context of exact time frames.
Goldman Sachs: there isn’t much value in investing these days
At about the same time as Grantham’s narrative, Wall Street staple Goldman Sachs Group (GS), in a widely-covered report, argued that buying stocks with the lowest valuations and selling those with highest is not working in this bull market. According to Goldman, the pure play value strategy, known as Fama-French, has resulted in a cumulative loss of 15% over the last decade following a 70-year cumulative positive return for the same investment approach. We argue that investing solely on value is as speculative as trading non-dividend growth FANGs, i.e., Facebook (FB), Amazon (AMZN), Netflix (NFLX) and Google parent, Alphabet (GOOG) (GOOGL), among others. As is an over-reliance on HYDiS to leverage a retirement portfolio (read my article: High Yield Dividend Stocks Are Equity Junk Bonds); or the reemerging craze of trend following to quench an insatiable investor thirst for fast money.
At Main Street Value Investor (MSVI), we define value investing as a commitment to both price and quality. Our investment objective:
Buy and hold U.S. exchange-traded, dividend-paying, well managed, financially sound businesses, or funds of companies that produce easy to understand products or services, have enduring competitive advantages from wide economic moats, enjoy steady free cash flow, and are trading at a discount to our perceived intrinsic value at the time of purchase. Then, of utmost importance and perhaps the biggest challenge, practice patience in waiting for our investment thesis to play out as projected over a long-term horizon.
MSVI’s investment objective enthusiastically follows the rational wisdom of legendary value investor, Warren Buffett. As reiterated in the excellent HBO documentary, Becoming Warren Buffett, he endured a transformation from buying cheap companies, regardless of quality, and unlocking value through corporate events, i.e., dump the stock when the price increased to a profitable level; to buying and holding wonderful companies at fair prices and taking advantage of the magic of compounding.
Buffett acknowledges that it was under the tutelage of his partner Charlie Munger that he made this career makeover from a stock trader to a company investor.
As influenced by Buffett and Munger, we prefer investing in quality, enduring companies as opposed to trading in speculative, faceless stocks.
David Einhorn: FANGs are killing value investing
Another household name from Wall Street, famed long and short value investor and founder of hedge fund Greenlight Capital, David Einhorn, thinks the popularity of non-dividend paying, ultra-growth FANG stocks, are redefining how shares are valued. In October, Einhorn wrote the following passage in an investment letter to Greenlight clients:
Given the performance of certain stocks, we wonder if the market has adopted an alternative paradigm for calculating equity value.
We think Einhorn’s banter is relevant in the current trend of ever-rising stock prices without regard to valuation multiples and underlying fundamentals. But we also believe that his presumption of the death of value investing as we know it is a trend in of itself.
Such a vogue paradigm will likely fade as most trends do, and the argument will revert to the mean that all things bought and sold are valued based on the correlation between quality and price. This fundamental economic reality may vary in reasonable or unreasonable ways but will never change because theoretically, valuation cannot deviate from the buyer and seller’s independent perceptions of the actual price relative to perceived worth.
Perhaps a return to the basic tenets of value investing is in order.
Value Investing 101
Value investing is a simple strategy in an otherwise superfluously complex financial services industry.
At Main Street Value Investor, our definition of value investing is steadfast to the word value as it applies to all aspects of our consuming lives, including investments.
Something that can be bought for a low or fair price.
Usefulness or importance of something.
Our research and analysis of stocks and funds are quite similar to the purchase considerations in other aspects of our lives:
What is the product or service worth to us? What is the quoted price? What is the difference and will it be available for a lower or fairer price at some point in the future? Put another way, is it mispriced based on the inherent value we place on the product or service? And, just as important, why buy an attractively priced product or service unless we see usefulness or importance in owning the product or service?
Now substitute “stock and fund investment” for “product or service” and re-read the same paragraph based on our formal definition of value:
What is the company or fund of businesses worth to us? What is the quoted price? What is the difference and will it be available for a lower or fairer price at some point in the future? Put another way, is it mispriced based on the inherent worth we place on the company or fund? And, just as important, why buy an attractively priced stock or fund unless we see usefulness or importance in owning a slice of the business or fund?
Next, we apply the above formal definition of value to our investment philosophy repeated for reader convenience.
Investment Objective: Buy and hold U.S. exchange-traded, dividend-paying, well managed, financially sound businesses, or funds of companies that produce easy to understand products or services, have enduring competitive advantages from wide economic moats, enjoy steady free cash flow, and are trading at a discount to our perceived intrinsic value at the time of purchase. Then, of utmost importance and perhaps the biggest challenge, practice patience in waiting for our investment thesis to play out as projected over a long-term horizon.
The above mission statement or investment philosophy is short, to the point, and focused on quality products and services with built-in barriers to competition that are produced and sold by financially sound companies or funds of those companies. The representative securities are purchased at fair, reasonable, or cheap prices, and held for as long as our conviction remains intact or improves as demonstrated by the overall performance of the company stock or stock fund.
So how do we measure the quality of a company’s product or services, its competitive advantages, financial strength, and intrinsic value or perceived enduring value relative to current price?
First, we give our portfolio a K.I.S.S., i.e., Keep Investing Super Simple, by limiting our measurement and analysis to a handful of essential metrics in each key area of the company or fund. Our due diligence involves profile, value proposition, fundamentals, valuation, and margin of safety; with a counter understanding and acceptance of the downside risk, should our thesis or perception of intrinsic value misfire.
Modern methods of measurement utilized by momentum investors and day traders such as technical analysis, or the in-depth study of past price behavior, are avoided.
The legendary value investor, money manager, and author, Howard Marks, writes in his must-read book, The Most Important Thing (New York: Columbia University Press, 2011):
Moving away from Ouija boards, along with all other forms of investing that eschew intelligent analysis, we are left with two approaches, both driven by fundamentals: value investing and growth investing.
As does Howard Marks, we focus on value investing in our fundamentals driven analysis of equities.
In essence, we research the company and then tell a story of why or why not the stock is worthy of ownership. Intelligent investors own risk-averse slices of wonderful companies. We leave the trading of stocks to risk-defying speculators.
Instead, the MSVI model portfolio invests in companies producing worthwhile and profitable products or services that assist consumers worldwide in solving personal and business problems, wants, or needs. The portfolio represents a collection of owned slices of companies producing high quality, in-demand products and services with enduring competitive advantages.
We leave the crystal ball to market speculators as ours cracked years ago.
Trying to Predict Market Events is a Fool’s Game
Value investors buy financially stable companies with strong fundamentals when macroeconomic events produce attractive valuations. Then sell or reduce the holding on weaker fundamentals or inflated valuations when microeconomic events erode the company’s financial strength or the demand for its products and services.
In his bestselling nonfiction book, The Black Swan: The Impact of the Highly Improbable (New York: Random House, 2007), Nassim Nicholas Taleb presents his black swan theory or the extreme impact from certain kinds of rare and unpredictable events or outliers. He explores the human tendency to find simplistic explanations for the occurrence in retrospect. This rationalization is in spite of the individual or group taking a beating as a result of the surprise episode.
From an investment perspective, the timing of the book was profound as the Black Swan event that became known as the sub-prime mortgage crisis that led to the Great Recession occurred one year after the publishing of Taleb’s book.
However, Taleb writes that he does not attempt to predict Black Swan events. To the contrary, he proposes that being aptly prepared for these surprise macro events, should one occur, is more prudent than attempting to forecast the anomaly. He illustrates by suggesting a Black Swan event is a “surprise for the turkey but not the butcher.”
An obvious translation of his theory is the typical Wall Street philosophy of trying to predict market fluctuations, i.e., the market timer as the turkey, versus manipulating the market’s ebb and flow to your advantage after they unexpectedly occur, i.e., the value investor as the butcher.
If the Wall Street market timer is wrong in predicting a Black Swan event, granted incorrectness is often the more likely outcome, he or she may lose substantial assets from being too long or too short.
On the other side of the trade, the value investor is already prepared to take advantage of any surprise Black Swan macroeconomic event by allocating planned cash reserves to take new or increased positions in the stocks or funds of fundamentally strong companies. He or she takes advantage of indiscriminately depressed prices from the macro event. These incidents, any tragedies notwithstanding, are the value investor’s white swan.
For example, investors that held, added, or initiated quality positions immediately following the market crash of 1987, during the dot-com bear market of 2000-2002, or in the early run-up after the Great Recession of 2007-08 invariably profited from subsequent booming portfolios.
To be sure, a few lucky speculators predicted these events and perhaps benefited from them, but many investors reacted after the fact by foolishly selling-off already depressed securities. I imagine more than a few of these Black Swan victimized portfolios have yet to recover.
I have observed that investors who successfully predict a Black Swan event often become intoxicated by the lucky call and begin to base his or her investing philosophy on the sudden perceived ability to predict future events. Such inebriation of financial intellect induces proverbial gazing into the crystal ball that magically filters a false state of being. What is predictable is that the luck soon runs out as does the principal on his or her investments.
Unless, of course, you have the seemingly magical instincts of Warren Buffett.
Fear and Greed are Pricing Mechanisms for Value Investors
Warren Buffett (Reuters)
The value investment theory of buy when the Black Swan flies, a surprise event affecting an entire economy or sector; and sell when the swan comes home to roost, a surprise event affecting only a company or industry also appears in a metaphor from the most famous value investor of all time.
I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful. -Warren Buffett
What Nassim Taleb wrote so eloquently in a 400-page book, Buffett independently coined in a brief passage. The lessons of Howard Marks, Taleb, and Buffett for value investors are to stop market timing or stock trading and start investing or divesting as actual macro and microeconomic conditions dictate. In most cases, that means being contradictory to the crowd.
As such, the value investor sticks to the tried and true approach of researching a company’s fundamentals to determine the level of ownership worthiness; then, if warranted, measures the stock’s valuation multiples to decide whether to buy, add, maintain, reduce, or sell the holding.
Value investors are steadfastly patient in waiting for Taleb’s random Black Swan macroeconomic event, or Buffett’s fearful retreat from stocks on Wall Street. As prices drop to attractive valuations, we will sift our watchlist for superb, fundamentally sound companies trading at appealing valuations that offer what we perceive as reasonable margins of safety.
Alternatively, we may just add to our current positions, as our first, seventh, and twelve ideas are probably better values than the 20th opportunity presented by the Mr. Market.
And whenever the swan comes home to roost, and Wall Street traders get greedy, thereby negatively affecting the fundamentals, valuation, or margin of safety of a single holding, we will consider reducing or eliminating our ownership in that position. Conversely, if trader reaction to the micro event renders attractive valuations with wide margins of safety, we will purchase a new stake or add to the position.
Another reminder that value investors are contrarian by nature.
Is There Further Downside to Value in this Bull Market?
The inherent risk to the value investing model is the non-value investors that permeate this and most market cycles.
Chasing the dragon has been a cornerstone of investing for Wall Street professionals and Main Street do-it-yourselfers since, well, market trading began. Human nature dictates that once we outsmart Mr. Market and successfully predict this swing or that trend, or go beautifully long or short on a stock or sector, it is “off to the races” as they say at the horse track. We begin the hamster roll of predicting and trading with abandon because we are self-convinced that we have this thing figured out.
As validation, there is always a perceived reputable assist to our sudden crystal ball accuracy. Lately, that has been in the form of the current U.S. president — who despite claiming he is not invested in the stock market, although apparently he is — takes credit for igniting it to its present record levels as well as fueling speculation of more upside from deregulation, trade renegotiation, and tax reform.
Of course, before November 2016, there was an assist from the Federal Reserve in keeping interests rates artificially low. Before that the hand-off came from government deregulation of the housing market allowing most anyone to buy a home and for unscrupulous investment banks to package the mortgages into marketable securities, thus creating more mortgage dollars.
Before the highly rated — despite no doc and no income — mortgages, there was an assist from the capital markets of free-flowing investment into dot-com ideas that were just that, ideas. And before that, there was the contribution from junk bonds that creatively financed otherwise impossible mergers and acquisitions.
Yes, the most significant threat to a value investor is the market itself. But Mr. Market is also our friend as he can be counted on to deliver individual company or entire market value opportunities. Dedicated value investors stay self-disciplined and patient as we do not know when or how those opportunities will present themselves. Nevertheless, make an appearance they will and when least expected.
We prepare for the pending downside with dry powder in the form of FDIC-insured cash to ride the ensuing upside in the stocks of quality companies that are temporarily value-priced by the sudden extreme preference for discomfort among investors.
Because as value investors, the market or targeted company’s downturn is our workday while the upturn is our payday.
Jeremy Grantham’s note to clients on the extreme preference for comfort by the market’s likely future victims, aka the perma bulls and market timers, reminds us that the day of reckoning is inevitable, although not pinpoint predictable.
Instead of chasing the dragon, value investors prefer the long-term benefit of partnering with a company that supports its customers with in-demand, useful products or services, rewards its employees with sustainable career opportunities, and compensates its shareholders with positive returns protected by world-class internal financial controls.
As individual value investors, we never stress over failed short positions, diminishing assets under management from departing performance chasers, or useless self-doubt fueled by the 20/20 hindsight of missing out on the FANGs and HYDiS when they were trending upwards. We remind ourselves that for every speculative winner, there are several Enrons, Blockbusters, and Valeants (VRX).
Ultimately, we take extreme comfort in knowing that as long as there are financial markets or farmers markets, value investing will prevail.
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Comments are strongly encouraged and always welcomed. Please read the important accompanying disclosures.
Main Street Value Investor is a trademark, and Main Street Value Investor Model Portfolio(MSVI) and Main Street 20 Watchlist are service marks of David J. Waldron.
Data Sources: Seeking Alpha, Goldman Sachs, and YCharts.
Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Data is for illustrative purposes only. The accuracy of the data cannot be guaranteed. Narrative and analytics are impersonal, i.e., not tailored to individual needs or intended for portfolio construction beyond the contributor’s model portfolio which is presented solely for educational purposes. David J. Waldron is an individual investor and author, not an investment adviser. Readers should always engage in further research and consider (as appropriate) consulting a fee-only certified financial planner, licensed discount broker/dealer, flat fee registered investment adviser, certified public accountant, or qualified attorney before making any investment, income tax, or estate planning decisions.
Why Valeant may have been treading water for months
As a bear on Seeking Alpha about Valeant (VRX) since October 2015, when the stock was around $100, I modified my views some months ago subsequent to the stock falling below $10, after which several positives emerged. These positives included:
Removal of the Ackman overhang,
pending or actual launch of Siliq,
expectations that Vyzulta would finally launch, and
rescheduling of the debt.
The modified trading views were to expect VRX to trade in a range rather than collapse immediately. After all, a 95% bear market since the Q3 2015 highs is plenty. Furthermore, the psychology of speculators gets very interesting when a stock with about a $5 B market cap has $25 B of net debt. In this situation, the enterprise value may be viewed as the $5 B value of shares outstanding X price, plus $25 B or $30 B. This is the amount the company needs to earn to pay back the debt and earn the value of the stated market cap. Thus, if the company can earn not just $30 B but $35 B, subtracting the same $25 B debt means that the equity is suddenly worth $10 B. This implies that the stock price doubles. From there, one can imagine an “up, up and away” move as Bausch & Lomb strengthens and new products succeed, one after the other. Meanwhile, interest costs decline as debt gets paid down, etc. So then one can think of a triple to, say, $40. All this upside, and the worst is that the stock can go to zero – but the usual speculator psychology is that one can limit one’s loss by selling at some predetermined point, such as $10.
Thus there is a pool of buying power that likes the reward:risk ratio. At the same time, there is a large pool of stockholders that is down on the stock and is perhaps grimly determined to wait for better times.
So the combination of the company offering hope from new products and receiving breathing space from its creditors led me to think of a range-bound stock price, but within a bearish big picture setting where I believed and said the major trend for the stock was probably still down, possibly to or near zero.
However, with VRX having rallied post-earnings to close the week at $15.38, this article explains why the earnings release, slide presentation, and conference call continue to support a bearish long term view
A personal note: I’ve never been long or short VRX, and am a long-only investor. I am not working with or in any other way aligned with a short seller, put buyer, etc.
As far as analysis of companies that have lots of debt and little cash, and which emphasize non-GAAP “earnings,” I look at them two ways to see if they correlate. If they point in the same direction, both bearish, then I can think about them bearishly and explain it both ways in an article. The two ways that cover the bases with VRX are GAAP EPS and balance sheet/cash flow analysis. It is the latter that allows me to join the bulls and ignore amortization charges, goodwill writedowns, etc. But because stock prices basically rise with earnings, I will begin first with earnings and ask if the core of VRX is, or is not, profitable, using generally accepted accounting principles that prevail in the United States of America.
Another complicated quarter for VRX, but at the core, VRX is unprofitable (and this may worsen)
As VRX’s CFO explained in his prepared remarks in the conference call, VRX showed a GAAP profit due to a very large tax benefit. There were also significant one-time events, which I will try to exclude. I will just try to get to a recurring core of the P&L. Thus I am excluding negatives that some other perma-bears on VRX mention, such as writedowns goodwill/intangibles/in-process R&D, and legal risk (I have never worried much about legal risk for VRX, though the legal fees are significant). I do this to try to accurately uncover the true story.
Now to my P&L analysis.
From the first table in the earnings release, we learn of $2.2 B in revenues for Q3. Here are the expenses I list as reasonably recurring, in millions of USD:
659 = cost of goods and revenues
623 = SG&A
81 = R&D
657 = amortization of intangibles
456 = net interest expense.
Total recurring expenses: $2.48 B.
Loss from continuing operations, excluding tax expenses or benefits, about $300 MM.
So, VRX is unprofitable even after excluding writedowns and the like, and excluding one-time tax benefits.
The next question is whether this will change in future years. Only time will tell, of course. I discuss this later and explain why I have a point of view that is negative for VRX’s chances.
Why amortization charges are included in measuring profitability (or, “a false construct”)
Some VRX bulls dispute amortization as a continuing cost when doing a profit and loss analysis. I disagree: it is a real cost when doing P&L analysis. In addition, unlike writedowns, amortization charges are recurring; they end on schedule, or when changing conditions change or eliminate the amortization charges. All the amortization does is measure money previously spent that never entered the P&L as the loss that it was. This accounting convention was done to benefit shareholders. Then it got misused by aggressive managements and their allies/enablers in the financial community. The reasoning in a little more detail:
A purchase costs money, with the operative word being “costs.” That cost has to either be put in the P&L line when the money is spent (cash basis) or spread out over time (amortized). This basic insight led me to correctly diagnose VRX going back to my first article, written when VRX was around $100:
Basic Problems With Valeant’s Valuation, With Comments On Recent News
One of the overlooked aspects of the stock is a conventional analysis of its operations based on generally accepted accounting principles…
The conclusion is that VRX was grossly overpriced simply based on GAAP EPS and a very weak balance sheet.
That article also correctly estimated that VRX was probably worth $10 per share or less (at least a 90% haircut) even if the allegations then hitting the news from short sellers such as Andrew Left were false.
This helps to show the value of paying attention to GAAP profits or losses. The media was propounding the idea that VRX was highly profitable (even the previously conservative Value Line joined in), but that was using fake non-GAAP “earnings.” These numbers omitted such key points as bringing the cost of the acquisitions into the ongoing P&L statements via amortization charges. There were other evasions in the non-GAAP numbers, but ignoring amortization was the largest. Because VRX’s tens of billions of dollars expended on acquisition was funded entirely, or almost entirely, with debt, the importance of thinking through underlying profitability was much more important than with a company that spent its own cash in the bank on a deal. In that case, GAAP continues to be the right way to measure whether the deal is working out, but the company’s solvency is not at stake as it is when the deals bring in mounds and mounds of debt.
As it happened, within mere months of my article, VRX was on the brink of having to default on its debt, which I think would probably have destroyed the share price, until lenders saved it. Undoubtedly saving it was to benefit the lenders, not shareholders, and this led to the lenders coming into control of the company’s goals. Debt repayment rather than growth and gambling suddenly took priority.
The theme of the importance of GAAP was just then coming into public consciousness. About a week after my article was published, the New York Times achieved much greater awareness of the same issue I was pointing to in a Sunday article by the well-known realist on financial affairs, Gretchen Morgenson. The title of her piece was clear: Valeant Shows the Perils of Fantasy Numbers. Two paragraphs from her article show the validity of our arguments:
Valeant is among a growing number of companies that regularly present two types of financial results: those that adhere to generally accepted accounting principles, and those that help executives put the best spin on their operations.
In accounting parlance, such adjusted figures — which exclude certain costs from calculations of a company’s earnings — are known as pro forma or non-GAAP numbers. But let’s call them what they really are: a false construct.
In case you still disagree, just look at all the pharma roll-ups that have emphasized non-GAAP numbers always trying to get investors to ignore those pesky amortization charges. These worthies include Teva (TEVA), Mallinckrodt (MNK), Endo (ENDP), etc. All of them are huge losers in one of America’s great bull markets. Even Allergan (AGN), a stronger contender, has done as well as it has done only because it made a huge capital gain by dumping its large rolled-up generic division (Actavis) to TEVA. But as I have pointed out in my AGN articles, I have always resolutely refused to turn fundamentally bullish on AGN even when the stock was down, because using GAAP, profitability remained absent despite the stronger assets and strong management.
Moving on, the next section discusses a cash flow method, not the P&L method, of looking at VRX. This is the proper way to ignore amortization charges.
This method allows us to think about whether VRX is ultimately solvent based on free cash flows: is it generating more than enough cash to meet its ongoing interest and, beginning in 2020, its debt repayment obligations? What are the trends for cash flow from operations going forward?
Cash flow is not good enough now, and it looks worse for next year
The trend in cash flows this year is poor, mostly but not exclusively reflecting ongoing problems in VRX’s dermatology division, the sale of FCF-positive assets, and ongoing losses of exclusivity. From the CFO’s prepared remarks (see Slide 16):
We generated $490 million of cash from operations in the quarter, and year to date we generated more than $1.7 billion.
This sentence calls for analysis. Cash flow from operations, or CFFO, for nine months was $1.71 B. Subtract $0.49 B for Q3’s contribution and you see that H1 had CFFO of $1.22 B, which is $0.61 B on average per quarter. Thus:
CFFO in Q3 saw a drop of about 20% from the H1 average.
How is that a justification for this debt-ridden company’s stock to have surged? Just because, just maybe, the bear market in generic pricing is winding down (no guarantees)? VRX has only a small generic division, which has low profitability. VRX is a combination of B&L and specialty branded pharma, with a small generic business as well.
Now let’s look at the debt set-up to see if likely forward CFFO run rates are adequate to meet the upcoming obligations. I think this shows that there is no reason for any fundamentally-based investor to go long this stock anywhere near the current price.
As shown on slide 16 of the presentation linked to above, VRX must repay about $20 B by 2023 to meet its debt obligations. Clearly, $2 B per year X 6 years is only $12 B, so it’s $8 B short by that quick calculation. (Perhaps $20 B shrank to $19 B or so after the quarter ended, due to debt repayments the company made, so maybe it would be $7 B short using this simple calculation).
This multi-billion-dollar shortfall is much more than VRX’s entire market cap, so good luck getting the money from the sale of equity.
But it looks worse than that to yours truly just looking forward to next year.
There are at least two ongoing problems with attaining that number, discussed next.
Ongoing losses of exclusivity (slides 31-32)
From Slide 32, we see that two ophtho drugs, Lotemax and Istalol, are anticipated both to go generic this quarter. Their estimated 2017 sales apparently will be around $111 MM. Critically, the pre-tax profit from these sales is $106 MM (Not all sales are equal. B&L has much lower gross margins than these old cash cows).
That point is important in assessing VRX. Old drugs getting near end of life lose marketing support and thus represent almost pure profit. Whereas, new drugs are expensive to introduce to the market and tend to be cash flow negative for some time.
Two other drugs, Mephyton and Syprine, likely both lose exclusivity in Q4. Finally, Isuprel has lost exclusivity in Q3, and unless that occurred early in July, the full impact of that was not seen in CFFO last quarter.
The 2016 Annual Report shows that Mephyton and Syprine together achieved $144 MM in sales. Isuprel did $188 MM in 2016 sales. Per slide 40, Mephyton and Syprine together had $32 MM in Q3 sales. I assume that translated to around $120 MM annualized in FCF for these two brands. Isuprel did $30 MM in Q3 2016, $30 MM in Q2 2017, and $23 MM in Q3 2017.
The five drugs discussed above may cost VRX $300 MM annualized as soon as next year, according to my calculations.
Thus CFFO at VRX has a serious structural problem: it looks ready to get worse.
Also, based on p. 148 of the annual report which shows the decline in annual amortization for several years hence, significant additional losses of exclusivity are likely in 2018 and beyond. As one example, Apriso, with sales annualizing around $160 MM, may go generic in April next year. Others, possibly a relatively major product called Uceris, are anticipated to go generic in the next several years. Again, many of these are not being promoted much, so that their pre-tax profit margins can easily exceed 90%. Thus if their sales drop to near-zero, the hit to profits is proportionally greater than the sales that remain, which generally have much lower all-in pre-tax margins.
All this creates continuing headwinds. In addition…
Recent divestitures hurt CFFO
Per slide 33, the sale of iNova at the end of Q3 did not materially affect cash flow, but beginning this quarter, its annualized $100 MM EBITDA will be gone. Then, this quarter, Obagi, with EBITDA around $20 MM will have flown out the door.
The divestiture of two divisions alone will cost around $120 MM in FCCO next year.
Putting things together, VRX looks to me to likely run about $400 MM less in CFFO annualized next year versus this. So, instead of CFFO annualizing at $2 B per year, I propose $1.6 B. Multiply that by the six years from 2018 to 2023, inclusive, and you get $9.6 B in cumulative CFFO.
This is inadequate compared to $19-20 B in debt maturities by 2023. I doubt that anything that VRX is launching, or anything arising from its shrunken pipeline, can make up the approximate $9 B gap.
In addition, remember the $5-6 B in long-term debt due after 2023. Even if Xifaxan retains patent protection for a long time, eventually it too will go generic.
So, the cash flow method of looking at VRX makes it mandatory for massive profits and free cash flows to be generated from new products, plus hoped-for growth of Xifaxan and other products such as Relistor, and from B&L. Everybody is, of course, free to be as optimistic as they want on the above. To keep this article from becoming a whale, I will focus on three new or expected products, where perhaps the Street does not have as clear a view of what they may achieve than for the known quantities of Xifaxan et al and B&L.
Brief analysis Of Siliq, Vyzulta and IDP-118
Sales were nominal in Q3. Competition is fierce in psoriasis. Even the leading oral entry, Otezla from Celgene (CELG) faced both pricing and volume pressure in Q3. Siliq is thus a “show me” story, because of its black box warning and because of newer, also highly effective antibodies that lack that black box warning. Also, the innovator, AstraZeneca (AZN), is VRX’s partner, splitting profits, if any, and also in line for another lump sum payout if sales reach a certain level. Right now and perhaps permanently, Siliq uses cash.
It is difficult for me to be optimistic about Siliq’s cash generation ability for VRX knowing that before Siliq is prescribed, patients must be advised that this drug may make them suddenly want to kill themselves. The black box warning may be removed at some point, but A) the clock is ticking and B) competition is tough and growing in the psoriasis space. So I am very cautious about Siliq.
This is an eyedrop for glaucoma. The active ingredient is related to the heavily genericized glaucoma drug Xalatan, the dominant force in the market. The leading brand of this type of glaucoma treated is Travatan Z, is an improved formulation of Travatan. The active ingredient is the same in both Travatan and Travatan Z, but the latter is easier on the eyes.
Travatan Z’s marketer is Alcon, the powerful eye care division of the giant Novartis (NVS).
Comparing the Vyzulta P.I. to the P.I. of Travatan Z, similar levels of therapeutic effect were demonstrated, even though the VRX drug, Vyzulta, may work by two mechanisms within the eye whereas Travatan Z may work by one mechanism. The P.I. of Travatan Z also mentions results of its effects as monotherapy as well as its use as add-on therapy to a beta-blocker eye drop. However, the following is the entirety of the clinical results listed for Vyzulta:
14 CLINICAL STUDIES
In clinical studies up to 12 months duration, patients with open-angle glaucoma or ocular hypertension with average baseline intraocular pressures (IOPs) of 26.7 mmHg, the IOP-lowering effect of VYZULTA™ (latanoprostene bunod ophthalmic solution) 0.024% once daily (in the evening) was up to 7 to 9 mmHg.
This FDA-approved language stands in contrast to all the studies listed in VRX’s press release announcing FDA approval of Vyzulta, which mention other clinical trials results. These may have been Phase 2 results that the FDA did not consider scientifically strong enough to allow mention of them in the label.
There is also competition in the branded space from Lumigan, an Allergan (AGN) product; AGN is also very strong in ophtho.
So, this again is a “show me” story. The incumbent brands will fight hard for every percentage point of market share (and fractions of points). They may be able to bundle products, and they will likely do what it takes on price as well to withstand Vyzulta. For VRX to make a lot of profit from this eyedrop is not going to be easy, in my humble opinion.
This pipeline candidate is a combination of two generic topical agents for psoriasis. An NDA was submitted in September. Assuming FDA approval, which I expect next year, there are obvious problems with the prospects for this. Psoriasis topicals comprise a crowded field with numerous generics. The two drugs in IDP-118 are each available generically. In the press release linked to above, VRX makes this statement on that topic:
Both [drugs] approved to treat plaque psoriasis, halobetasol propionate and tazarotene, when used separately, are limited to a four-week or less duration of use. Based on existing data from clinical studies, the combination of these ingredients in IDP-118 with a dual mechanism of action, potentially allows for expanded duration of use, with reduced adverse events.
The first point within this first problem is that four weeks of treatment are often enough.
A second problem is that once the combination is approved for a longer period, then it may be logical for the doctor to try each drug individually, and if treatment needs to go longer than four weeks, continue them individually.
The basic question on sales is why insurers will not create major financial incentives for each drug to be dispensed individually if a prescription for the combo is written.
In the linked press release, VRX references a Phase 2 study that it says shows that IDP-118 was superior to each drug given separately. Let us see if that sort of language is included in the P.I. I am skeptical at this point of this.
Finally, there are the twin questions of what intellectual property VRX will have to protect this combination, and the related question that if this idea is so good, and VRX has been talking about it for some time, how much similar competition from other combinations will also come to market?
Putting it together, I look at IDP-118 the way I look at Siliq and Vyzulta, namely a “show me” product with uncertain commercial prospects.
VRX does have some other projects, including several “IDP-” type dermatologics. It is implausible in my view that all of them collectively will move the needle given the massive scale of VRX’s net debt load. VRX spends about 4% of revenues on R&D, which is on the downswing. With no platform technology or discovery engine, structurally VRX is not much of a drug company in my eyes. Rather, it is primarily a bunch of old brands, in-licensed products such as Siliq, and B&L.
Since I have disclosed no confidential information in writing this article, the information I have analyzed can be known by all. So, whether for technical reasons or because I am missing something, VRX can rise, perhaps leaving its lows behind permanently.
If all the above new products do well, and if B&L can break out in Asia and elsewhere, then the leverage inherent in VRX shares may work for shareholders.
As usual, I write this article from the neutral standpoint of myself or other investor who has cash and is looking to invest it.
My view remains that VRX is de facto under the control of its creditors. I think it has been that way ever since it avoided a forced liquidation about 1 1/2 years ago. Looked at through this prism, the company’s behavior and comments in the conference call make sense. The lenders want the company to repay debt as the priority. In the meantime, cutting R&D and other costs and generating CFFO allow interest payments to be paid easily. Eventually, if some of the principal cannot be repaid, creditors are maximizing their recovery.
Joseph Papa, the new CEO, is not a magician. His history and that of the VRX team suggests there will not be the sort of magic that Steve Jobs accomplished when he rejoined a trouble Apple (AAPL) in 1997. It would appear doubtful that there would even be the turnaround of the sort that Howard Schultz led when he stepped back into the CEO role at Starbucks (SBUX) several years ago. Mr. Papa tried to relaunch Addyi, the “female Viagra,” but now the Sprout deal that brought Addyi to VRX with some fanfare has been acknowledged as a near-total failure.
If my fundamental analysis is mostly correct, then while I do not short stocks and provide no advice, I will comment that this may be a reasonable set-up for traders who do short stocks to think that VRX may be set for a more sustainable drop once again. Reasons that come to mind include:
Rally to a difficult level (near recent highs of the prior rally),
Siliq Rx data will be rolling in and may disappoint,
rotation to pharma/biotechs that have dropped recently while VRX has surged, such as Merck (MRK) and Regeneron (REGN), and
debt-heavy companies tend to falter when the Fed is tightening.
While it would be nice to see VRX succeed, producing wealth rather than disclosing all the wealth that prior management failed to crease, I continue to doubt that the stock ultimately has much if any value given the massive debt load.
Thanks for reading and sharing any comments you wish to contribute.
Disclosure:I am/we are long CELG, REGN, AAPL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser.
What if mom-and-pop businesses had the same advertising capabilities as billion-dollar corporations with Madison Avenue media agencies at their beck and call? That’s the idea behind Facebook’s Blueprint “e-learning platform.” The company announced on Tuesday that the service is used by more than one million small businesses worldwide.
“We originally built Blueprint for the really sophisticated advertisers,” according to Dan Levy, Facebook’s VP of small business, told Inc. But the company noticed that ad agencies and other specialists weren’t the only users attracted to educational materials. “It’s a pretty big endorsement to us that this is valuable for them,” Levy said. Facebook still conducts in-depth and in-person trainings, but Levy said that Blueprint allows the company to scale its outreach to many more people.
The top five courses that small businesses flock to are “Welcome to Marketing on Facebook,” “Ad Policies for Content Creative and Targeting,” “Brand Best Practices,” “Extend Your Campaign’s Reach with Audience Network,” and “Targeting: Core Audiences.” There’s worldwide appeal: The countries in which Blueprint is most popular are the United States, Brazil, India, Great Britain, Mexico, Indonesia, Canada, Australia, Germany, and the Philippines.
Blueprint is not a philanthropic endeavor for Facebook, of course. In teaching businesss to use the company’s products more effectively, it not-so-tacitly encourages them to increase their advertising spend.
Not that they need much convincing. Facebook may have become a political hot potato, but it’s still a darn good tool for reaching potential customers.
For marketers, Facebook and Instagram “are the stuff of fantasy — grand bazaars on a scale never seen before,” as Burt Helm put it in The New York Times. Helm, who also writes for Inc., showed how Facebook advertising is increasingly the fuel that startups rely on to get their initial customers. “The leaders of more than half a dozen new online retailers all told me they spent the greatest portion of their ad money on Facebook and Instagram,” he added.
During its recent earnings call, Facebook reported that more than 6 million advertisers use the platform, a 20 percent jump since April. The majority of those advertisers are small businesses, a spokesperson said.
Part of what makes Facebook advertising so successful, and thereby makes the company so profitable, is the low barrier to entry. “If you know how to use Facebook, you can use Facebook for business,” Levy said. While the advent of so-called self-service ads allowed Facebook and Google to become the dominant duopoly of digital advertising, a significant portion of those 6 million advertisers need at least a little support. Blueprint is around to provide that extra handholding.
Four years ago, almost to the day, it was obvious that Snapchat should have taken the money: $3 billion Facebook offered to acquire it. But, no, the company’s founders insisted that it would be a bad move. Co-founder and CEO Evan Spiegel and, presumably, others were sure it was worth more. Not according to the earnings release today by parent Snap Inc.
Snap’s 2017 third quarter results were egregious. It was like watching the Coyote in a Road Runner Cartoon stop off the edge of a cliff and keep moving for a bit until, looking down, it realized the situation.
Revenue was up by 62%, which is wonderful. Only, analysts expected nearly $237 million in revenue instead of the $207.9 million the company had. There was little change in the number of users, and when you depend on advertising revenue to grow the business, that’s really bad. The quarter’s net loss of $443,159,000 was more than 3.5 times larger than the same period last year.
The company uses the non-standard measure of “adjusted EBITDA” to measure its, uh, success. Net income or loss excluding interest income and expense, other income or expense, depreciation, amortization, stock-based compensation and the related payroll tax expense, and “certain other non-cash or non-recurring items impacting” the bottom line. Even with that twisting, there was a $178,901,000 loss, which tells you just how many contortions it takes to massage the real loss.
If only Snap were an aberration on the West Coast tech scene. But it’s not. There’s billions of investment money in Uber, which is in the red a couple of billion dollars a year at this point. Juciero and its crazy-expensive juicers and juice packs finally packed it in a couple of months ago when it was clear few people were crazy enough to spend many hundreds on a machine and then $140 to $200 a month on juice. Heck, you could invest the cash and start your own small juice bar at that rate. And Juciero had only $118.5 million in venture money.
There’s an old saying: owe the bank $100 dollars and it owns you; owe it $100 million and you own the bank. This is what Silicon Valley and U.S.-style tech investing has come to. Forget a Microsoft of Apple or even a Facebook, where the companies went public after they were making real money. They build businesses that understand the profit concept, not almost eternal indebtedness that was supposed to turn the corner one day.
Here’s the difference: Snap’s founders lost a lot in paper worth on a company that, if you took away all the venture money, would be out of business. Microsoft launched Bill Gates who, back in 1986 when he was 30, was “probably one of the 100 richest Americans,” according to Fortune. Now he’s the richest man in the world.
Investors have been entranced by companies that seem like they should be worth billions and billions because they have scalable architecture and, doggonit, people like them. But it’s not enough to have a likeable business. Attention isn’t enough. Do VCs and money people not know the history of the dot com bubble? “Eyeballs,” a former crazy measure of success, don’t count for squat unless you have a solid business model that can create revenue and, eventually, profit.
Entrepreneurs would be better off to forget the nonsense that has passed for business acumen all too often and instead focus on the three basic questions: What needs to people have, what can you do to solve them, and how will you get paid? If you can’t answer all three, better keep working on the idea.
But, too many investors will keep hoping for the magical company that will make their fortunes, and too many entrepreneurs will want to be the mighty captain of industry. Things won’t change until a couple of these unicorns go spiraling into the desert floor so hard and fast that it makes a Coyote landing look like a short drop to a fluffy mattress.
(Reuters) – U.S. cable operator Altice USA will sell mobile service on wireless carrier Sprint Corp’s network under a new multi-year agreement announced on Sunday, becoming the latest firm to enter the wireless market in a bid to retain customers.
FILE PHOTO: A Sprint store logo is pictured on a building in Boca Raton, Florida, U.S. on March 19, 2016. REUTERS/Carlo Allegri/File Photo
The companies announced the agreement a day after Sprint and T-Mobile US Inc ended merger talks.
Under the terms of the agreement, Altice, the fourth-largest U.S. cable operator, will use Sprint’s network to provide voice and data services in the United States. It gave no time line on when it will introduce such services.
The deal will allow Sprint to use Altice’s cable infrastructure to transmit cellular data and develop a next-generation network, or 5G.
Sprint and T-Mobile on Saturday called off merger talks to create a bigger U.S. wireless company to rival market leaders. That has left Sprint, the No. 4 U.S. wireless carrier, to engineer a turnaround on its own.
Japan’s SoftBank Group Corp, Sprint’s majority owner, said in a separate announcement on Sunday that it intended to increase its stake in Sprint but that it would keep ownership of outstanding common stock under 85 percent, a move that avoids triggering a tender offer for the remaining shares. SoftBank currently owns roughly 82 percent of Sprint.
U.S. cable companies have begun venturing into the wireless market as a way to bundle more services to reduce churn, or customer defections, at a time when more consumers are canceling cable subscriptions.
Comcast Corp started selling wireless service this year on Verizon Communications Inc’s network, and Charter Communications Inc plans to launch service next year.
Reporting by Parikshit Mishra in Bengaluru and Anjali Athavaley in New York; Editing by Paul Simao and Peter Cooney
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