Thoughts on the Twitter IPO

I confess; when Twitter (TWTR) launched I thought it was stupid. When every single television commercial and print advertisement started saying "like us on Facebook, follow us on Twitter, etc I felt like it was social media overload. Now I can hardly watch any TV program without having random hashtag phrases pop up on the screen. Like enough people are really dying to tweet about the Survivor episode they are watching. #redemption island? Please. Stop. And no, I don't care what most celebrities have to say in 140 characters. And how many times do we need to hear about a professional athlete who tweeted something insensitive and then had to issue a public apology? We have better things to do with our time. As a result, I never thought I would really "get" Twitter.

But I am slowly coming around. Not because I find Paris Hilton interesting, but because I have actually found myself searching twitter several times lately for other reasons in my daily life. I was traveling on the day of the Potbelly (PBPB) IPO but one of my clients was interested in the shares, if the price was right after it came public (it wasn't). So I am sitting in an airport terminal waiting for my flight and wanted to know how PBPB opened. Since IPOs typically don't open until an hour or so after the opening bell in New York, I had no idea when that first trade would print. But a quick search on Twitter provided that information. I no longer had to be in front of a TV tuned to CNBC to find out.

Not only that, but I also wanted to know at what price it opened. Many stock quote apps are 15-20 minutes delayed and it would take 30-60 minutes for major news outlets to write and publish a story about it. Once again, Twitter was the only way I could find out the opening price in real-time. Within minutes after that I was boarding my flight and powered down my phone. But I knew that the price was above what I felt was reasonable and I could forget about it for the rest of the day.

It turns out Twitter is very useful for non-investing information as well. Now that I have lived in the Pacific Northwest for almost 18 months, I have grown to be a huge fan of food trucks. They were everywhere in Portland (part of the culture really) and here in Seattle there aren't as many but still quite a few. In fact, there are two that serve the parking lot outside my office a few times a month. The schedules can be variable and sporadic (the food truck business is tough from a proprietor standpoint so unless you have a "can't miss" location reserved, you are likely to mix it up day-to-day or week-to-week to try and get by financially). It turns out the only way to really find out where and when a particular truck will be in a given location is through Twitter. Web site listings become quickly out of date given how much these trucks relocate and how little advance notice is typically given.

So, I am warming up to Twitter. I don't actively tweet (although links to each of my blog posts are set up to automatically go out to followers of @peridotcapital) and I don't plan to, but the service clearly has value. And as I have found, not only to celebrity junkies or tech heads. Now, does the fact that I can get Potbelly quotes and food truck location updates mean that Twitter is a sure-fire business that is worthy of your consideration at a $20 per share IPO price/$14 billion initial valuation (and likely to go higher than that even before it begins trading)? Maybe, maybe not.

I don't think there is any way to know that without a crystal ball. After all, the company will bring in about $700 million in revenue this year so investors who buy the stock are buying it for future revenue and profits, not what they are earning today (which is only about $3 per year for each of the 230 million monthly active users they have right now).

It is entirely possible the stock opens at $40 next month (I would not be surprised if the IPO price gets bumped up to $25-$28 before it is all said and done as well) and comes with a nearly $30 billion valuation. It is hard to justify that, but I am beginning to see that Twitter could play a large role in social media going forward with a larger slice of the population than I would have guessed and is likely to figure out a way to make several billion dollars monetizing the platform over time. Whether investors are willing to pay $10 billion, $20 billion, or $30 billion for that business remains to be seen.

Full Disclosure: No positions in any of the companies mentioned at the time of writing, but positions may change at any time.

Part Time Workers, Consumer Spending, And The Affordable Care Act

Don't worry, no political arguments will be made here. That is not worth the effort for the author or the readers of this blog. However, since we are focused on stock picking as investors, it is a valuable exercise to dig into the data and determine if there will be a material impact on U.S. corporate profits because of the Affordable Care Act. After all, if consumers' pockets are squeezed from fewer hours worked each week and/or the need to start buying health insurance for the first time, that would definitely impact the sales and earnings of the companies we are invested in. And that could hurt our portfolios.

Since the September jobs report came out this week I decided to take a look and see if the trend than many people fear as a result of the new healthcare law -- employers shifting full-time workers to part-time status in order to be exempt from being required to provide them with health insurance -- has actually started to take hold. Many people have already argued one way or the other, but most of them have political motivations and rely on a small subset of anecdotal reporting without actually looking at the numbers and reporting the truth.

The good news for our investment portfolio is that this trend has yet to materialize. It certainly could in the future, so we should continue to monitor the situation, but so far so good. Last month there were 27, 335,000 part-time workers, out of a total employed pool of 144,303,000. That comes out to 18.6% of all employed people working part-time (defined as less than 35 hours per week). That compares with 26,893,000 part-time employees during the same month last year, which equated to 19.1% of the 142,974,000 employed persons. Interestingly, part-time workers are actually going down in both absolute terms and relative to full-time workers. These numbers will fluctuate month-to-month, but it clearly has not happened as of yet.

The other potential problem with the Affordable Care Act, and more specifically the requirement that everyone buy health insurance, is that discretionary consumer spending could fall as more of one's after-tax income goes towards insurance and is not spent on discretionary items. We should remember of course that consumer spending counts the same in the GDP calculation regardless of whether or not we buy insurance or other things, so there is no overall economic impact. But, we should expect to see consumers allocate their funds differently, which could impact specific areas of the economy (vacationing, for instance).

But just how much of an impact will this have? Will it be large enough to materially hurt the earnings of many public companies? To gauge the overall potential for that we need to dig into more numbers.

About 15% of the U.S. population does not have health insurance. Let's assume 100% compliance with the Affordable Care Act (either via the purchase of insurance or the payment of the penalty for not doing so). Let's further assume that the net negative financial impact of such compliance comes to 5% of one's income (not an unfair assumption based on insurance premiums). That means that approximately 0.75% of consumer spending (5% x 15%) would be reallocated to healthcare and away from other areas. While that is not a big shift, it would be real.

However, the analysis can't end there. We can't simply conclude that approximately 1% of non-healthcare consumer spending will be lost due to the new law. Why not? Because that would assume that every American earns the same income. In reality, those impacted by the Affordable Care Act (the uninsured), are skewed towards lower and middle income folks. Most wealthier people get health insurance through their full-time jobs and will continue to do so.

Now, the bottom 50% of Americans only make 15% of the income earned nationwide. If we factor that point into the equation, then the overall impact on consumer spending goes from quite small (0.75% per year) to fairly immaterial. In fact, it comes out to something around 0.2% of overall consumer spending per year if we assume that the average uninsured person falls into the 25th percentile of total income.

So what is my conclusion from all of this? Well, I own a lot of shares in consumer-related companies both personally and for my clients, and I am not concerned about the Affordable Care Act taking a meaningful bite out of the profits that those companies are going to generate in the future.

Netflix Management: Our Stock Is Overvalued

It won't get much attention since Netflix (NFLX) stock has been on fire this year and investors today are loving the company's third quarter earnings report released last night, but Netflix's CEO and CFO have actually come out and publicly warned investors that the stock price performance in 2013 (started the year at $92, opened today's session at $388) is likely overdone to the upside. In their quarterly letter to investors published yesterday this is what they wrote:

"In calendar year 2003 we were the highest performing stock on Nasdaq. We had solid results compounded by momentum-investor-fueled euphoria. Some of the euphoria today feels like 2003."

Let's see what they are referring to. As you can see below, Netflix stock went from $5 to $30 in 2003:

And then in 2004 it peaked at $40 and fell all the way down to $10:

Netflix started 2013 at $92 and opened today's trading session at $388: 

In this case the company is executing very well but the stock price does not really make any sense. Shareholders beware.

UPDATE (11:55am ET): Netflix is currently trading at $328, down $60 per share from its opening price this morning. Maybe the company has actually called the top in its stock for now. Interesting.

Full Disclosure: No position in NFLX at the time of writing, but positions may change at any time.

Yahoo Stock No Longer Cheap After Doubling In A Year

We are less than two weeks from the one-year anniversary of my blog post entitled "Does Marissa Mayer Make Yahoo Stock A Worthwhile Bet?"that highlighted how cheap the shares were at $16 each and the answer has been a resounding "yes." Yahoo (YHOO) has now doubled in price and I think the easy money has been made. Take a look at my sum-of-the-parts valuation on the company: 

As you can see, the majority of the value in Yahoo is their 20% stake in Alibaba (slated to go public soon at a valuation of around $100 billion) and the company's core operations that Marissa Mayer is in the process of trying to turn around. The stock right now is trading right at this $32-$33 valuation. While there is additional upside if Alibaba marches even higher post-IPO and/or if Yahoo can start to grow its core business, both of those are far from assured. As a result, the stock looks fully priced based on what we know today.

Full Disclosure: Long Yahoo at the time of writing but positions may change at any time

Sears Holdings Transformation Picks Up Steam, But Will Still Take Years

It's been nearly ten years since Sears Holdings (SHLD) CEO and majority shareholder Eddie Lampert pulled off the Kmart/Sears merger that had investors salivating over the potential for enormous realization of the company's real estate value. Since then however, real estate monetizations have been meager and Lampert has instead attempted the impossible task of turning around the retailing operations of Kmart and Sears. Predictably, he has failed. Take negative free cash flow and no real hope for a reversal, and throw in a few billion in debt as well as an underfunded pension plan (to the tune of about $1.5 billion), and you have a stock market disaster. Why then has the stock perked up strongly in recent weeks, as the chart below shows? 

Well, a little-known firm based in California called Baker Street Capital Management recently put out a 100+ page presentation making the case for why it believes Sears Holdings shares are dramatically undervalued (the midpoint of its estimated sum-of-the parts valuation range is $13.9 billion or $131 per share, more than double the current stock price of $58). The slide deck provides detailed research showing that the Sears asset monetization plan that investors have been clamoring for since 2005 may very well be starting to take shape. Most interesting are bits of information regarding the company's real estate portfolio, which is where the majority of the asset value within Sears lies.

First, store closings have accelerated in recent quarters. This could very well signal that Lampert is getting fed up with his unsuccessful attempt to make Sears and Kmart stores more profitable (or profitable at all). I decided to look at the historical data on Sears and Kmart store closings and it does appear that the company is shutting down money-losing stores at a faster pace lately. However, as you can see from the chart I put together below, the acceleration in that trend is both noticeable and relatively small compared with what many investors would prefer.

Second, Lampert has actually taken more than 200 properties and placed them into a newly formed wholly-owned entity called Seritage Realty Trust. Not only that, but a seasoned real estate executive has been brought in to run Seritage and the company is publicizing its plan to redevelop a property in downtown St Paul, Minnesota. An artist rendering for the mixed-use project (taken from the Seritage web site -- yes, this subsidiary even has its own web site with no mention of its relationship to Sears) is below:

Okay, so as a former believer in Sears Holdings as an investment, you might be thinking that I am getting into the stock once again. Well, not exactly. I still have some huge issues with the equity right now (though I do hold a position in the bonds). First, although nobody can refute that there is tons of value within Sears' real estate portfolio (billions of dollars), we can not ignore the fact that the retail operations are still bleeding cash. And as you can see from the pace of store closing shown above, there are still more than 2,000 of these stores open. Each day that passes brings with it more red ink. Even if Eddie Lampert decided to eventually shut down the retail stores completely, that process would take years. It could take a decade to transform Sears Holdings, in an orderly fashion, into a pure-play real estate company.

The reason that is a problem for would-be equity investors is that the time value of money shrinks how much that real estate is worth today. Let's take Baker Street Capital's estimate of Sears' real estate portfolio; $8.6 billion. Even if this number is in the ballpark (given that they own the stock we can assume this figure is on the high side), if it takes 10 years for Sears to unlock this value through property closings, divestitures, redevelopments, etc. then the present value of these properties is actually a fraction of $8.6 billion. It's not like they could just sell them all to somebody tomorrow.

The second problem I have with the stock is the supposed value ascribed to the company's other assets. About half of the value of the company is outside of the real estate portfolio, according to Baker Street. The bulk of those assets include the Kenmore, Craftsman, and Die Hard brands, Lands End, the Sears online business, and the Sears home services and extended warranty businesses. Baker Street contends these assets taken together are worth another $6.8 billion. Keep in mind that the stock market values the entire Sears company at $6.2 billion today.

The core issue here is that Kenmore, Craftsman, Die Hard, Lands End, Sears Home Services, and Sears Extended Warranties all derive the vast majority of their revenue from Sears and Kmart stores. But what happens to these stores if Eddie Lampert decides to monetize the real estate by closing down stores, selling others, subleasing others, and redeveloping others? The value of all of these others brands declines dramatically. Good luck selling Lands End for a good price if you are in the midst of closing down Sears stores. Same goes for Kenmore, Craftsman, and Die Hard. Sure, those brands could be sold in other retail stores if they were independently owned, but the revenue gained would just be offset from the fact that Sears and Kmart stores were disappearing. In my view, Sears can either become a real estate company and shut down its money-losing stores, or it can continue to operate as a retailer with multiple owned brands. What it can't do is realize the full value of both at the same time, and yet that is exactly what Baker Street Capital (and other bulls on the stock) claim.

If you ask me, Sears should go the real estate route. It may take a long time, but shareholders should see some tangible benefits over time. Consider Seritage Realty Trust, the new company within Sears that holds 200 properties (or about 10% of the total). According to the Seritage web site, those properties control about 18 million square feet of space. Let's assume they are redeveloped and can generate $30 per square foot, on average. That equates to $540 million of annual net operating income. If Seritage was IPO'd it could be worth about $8 billion (at a 7% cap rate). That is why Sears shareholders have a margin of safety in the stock and why it is not going bankrupt. However, since that process would take so long to implement, it is also the reason why Sears stock today is not anywhere near the $100+ per-share valuations the bulls claim it is worth in a break-up scenario.

Full Disclosure: No position in Sears stock and long Sears bonds at the time of writing, though positions may change at any time.

Dow Jones Industrial Index: Worst Financial Services Stock Picker Ever?

This week we learned that the components of Dow Jones Industrial Average (DJIA) will be changing again later this month. As former blue chip companies become less relevant over time, those who oversee the index seek to modernize it by replacing former darlings with new age companies that are more dominant in the current economy. Not surprisingly, such actions offer an interesting lesson on contrarian investing. To get booted from the Dow 30 a company must really be struggling. Conversely, if you are chosen as a replacement, chances are good that things have been going well lately.

Back in 2005 I talked about this and showed that the stocks that are removed from the Dow have actually outperformed their replacements after the changes were made. So yes, making these changes to the index has actually hurt its long-term performance, even though the motivation is exactly the opposite. While my piece is nearly a decade old, it remains relevant as the trend has not abated in any way. Here is the link: Examining Changes to the Dow 30 Components.

Looking back over the last 15 years shows that the Dow 30 index has been an especially bad timer of financial stocks. Bank of America (BAC) is one of three stocks that is being removed from the index this time around (Alcoa and Hewlett Packard are the others). Amazingly, BAC has only been part of the Dow 30 for five years. Since it was added in February 2008, the stock has collapsed from $42.70 all the way down to its current quote of around $14.50 per share. That 66% decline is quite astounding, as the chart below shows.

Now you might think that Bank of America is an isolated case, because it was added to the index at the peak of the last banking cycle, right before the financial crisis began (great timing Dow Jones!). In fact, mistiming financial stocks is a trick the index keepers have been perfecting for a long time!

Prior to Bank of America, the last large banking-related stock added to the Dow 30 index was.... drumroll please..... AIG! American International Group (AIG) was added to the Dow in April 2004 when it was trading at $76.25 per share. If you thought BAC made a quick exit after five and a half years, AIG lasted only four and a half years. It was removed from the index in September 2008 at the plump price of $3.85 per share, for a loss of about 95%.

I won't belabor the point much longer, other than to mention that before AIG, Citigroup (C) was added to the Dow in 1997 and was then removed in June 2009 at $3.46 per share (you can guess how brilliant of a move that was).

Not only has the timing of financial stock removals from the Dow 30 been so lousy, but they also epitomize the contrarian investment strategy inherent in these psychologically-motivated index changes. AIG and Citigroup shares have been roaring higher over the last two years. If you had to buy just one of the three stocks being removed from the Dow this time around, Bank of America looks like the obvious choice.

Full Disclosure: Clients of Peridot Capital Management were long shares of BAC and AIG at the time of writing, but positions may change at any time.

Hedge Funds Move In As Ackman Sells, But JC Penney Still Far From Running At Break-Even

For some reason Pershing Square's Bill Ackman decided to bail on his near-20% stake in struggling retailer JC Penney (NYSE: JCP) at a 50% loss after being instrumental in the company's recent troubles. Classic buying high and selling low (when the pain becomes too great) case here. As has been the trend lately, hedge funds are coming in and buying what Ackman is selling (Herbalife being the most recent example). Glenview Capital and Hayman Capital have announced large stakes in recent days and now a handful of hedge funds (adding in Soros Fund Management and Perry Capital) own about a third of the company's common stock. At $14 per share, JCP's equity is worth about $3 billion, excluding net debt of more than $4 billion.

I have written quite a bit about JC Penney over the last year or two, since Ron Johnson was hired as CEO and then fired after implementing a disastrous plan, and I am baffled as to why these hedge funds are so bullish on JCP at this point in time. The seeds for a turnaround have certainly been planted with Mike Ullman's return as CEO, but from what I can tell from the numbers, it is going to take a while before they really start to grow. Perhaps these funds are playing JCP for a quick trade to the upside, which would make sense given that Ackman's sale represents capitulation at its best (or worst, depending on your perspective), but it appears premature to bet on a sure-thing turnaround at JCP longer term. Let's look at the numbers.

Thanks to Ron Johnson's blunders, JCP's sales this year should come in around $12 billion, down from $17 billion a few years ago. Operating costs (SG&A) for the prior four quarters came in at $4.4 billion, and have been slashed lately to preserve cash. Although the company's gross margins are nowhere near their historical average of 37% today, CEO Mike Ullman is making the right moves to reach those levels again, in 2014 if you are optimistic.

Retail companies are not that hard to analyze and from these few figures we can figure out what level of sales JCP needs to reach cash break-even again, a crucial goal post if you are going to see a prolonged turnaround in the company's share price performance. With 37% gross margins and $4.4 billion in annual SG&A costs, JCP's operating break-even point is $12 billion at first glance, but the company is losing lots of money right now due to elevated capital expenditures and a huge debt load, which has only risen as the company's sales have plummeted. Throw in $300 million of annual capital expenditures going forward (guidance from management) and $500 million of annual interest costs, and JCP actual cash break-even level is $14 billion of annual revenue. That means sales would have to rise 15% from here just to reach break-even. Could that happen in 2014? It could, but that seems quite optimistic. 2015 is probably more likely.

But even if you assume that sales rebound and the company stops bleeding cash, I don't think JCP shares are that exciting at today's $14 price. Macy's and Kohl's are very good department store comps for JCP. Both trade at about 6 times cash flow. Let's assume JCP's sales continue climbing and reach $15 billion by 2016. Assuming margins hold steady, JCP will have annual cash flow of about $1.1 billion. Multiply that number by 6 times and net out $4.3 billion of net debt and the equity would be worth about $2.3 billion, or $10 per share. In order for JCP stock to zoom back into the 20's and stay there, the company has to be cash flow positive and begin paying down some debt (every $100 million of debt repayment would boost that $10 fair value price by 50 cents). Given that it will take a year or two for JCP to reach break-even, it looks to me like these hedge funds might be too early to the JCP stock turnaround party.

Full Disclosure: Long JCP senior notes maturing in 2018 at the time of writing, but positions may change at any time

Fossil Stock Momentum Could Falter If "Smart" Watches Are Successful In Coming Years

Shares of accessory maker Fossil Group (FOSL) have been on fire lately, capped by an 18% jump on Tuesday after a better-than-expected second quarter earnings report:

While Fossil's business is unlikely to be impacted in the next few quarters, I have to wonder what happens to this stock if the category of "smart" watches takes off in coming years. After all, during the first half of 2013 more than 75% of Fossil's revenue came from watches. We know that tech giants like Apple and Microsoft are developing smart watch products to be used as phone extension accessories. Smaller firms focused on wearable computing are also jumping into this space.

While it is too early to declare the product category a success (development could go south, or the products could bomb upon release), given that the younger generation does not really wear watches at all (they simply use their cell phone to tell time) and plenty of companies believe they can add functionality for the traditional watch wearer, it stands to reason that Fossil would suffer materially if a certain percentage of regular watches were replaced over the next few years by a wearable electronic device.

If these new product developments continue to progress, Fossil shares could be a very attractive short candidate. Given how focused Wall Street is on short term results, it does not appear that many investors have this potential catalyst on their radar. In my view it is definitely something to monitor, especially if Fossil shares continue to march higher short term even as the demographic and technology trends are moving against them in many respects over the intermediate and long term.

Full Disclosure: No position in Fossil at the time of writing, but positions may change at any time.

After Doubling, Groupon Shares Now Appear Fully Valued

After two very accurate calls on Groupon (GRPN) stock on this blog; bearish on the company's $20 per share IPO in 2011 (Numbers Behind Groupon's Business Warrant Caution), and bullish last year as the stock was being priced like trash at $4.50 (Isn't Groupon Worth Something), I should probably quit while I am ahead. But what the heck, let's try to go 3-for-3.

In the year since my last Groupon post the stock has doubled to $9 per share, giving the company an equity market value of $6 billion. At this point I believe the market has appropriately priced it, understanding that while the company's growth has come to a screeching halt, it has a sustainable business (which I argued was not the consensus view at a $3 billion market cap). The company is profitable, proving the naysayers who raised solvency concerns last year wrong, and should book about $2.5 billion in revenue this year.

It is hard to argue that the stock is worth materially more than the current price, in my view. While I still believe that high fixed-cost businesses, such as hotels and movie theaters, will continue to use Groupon to draw customers to fill unbooked rooms and empty seats, many small businesses will realize that repeated Groupon promotions aren't likely to pay off meaningfully for them. While new businesses should still consider Groupon for an awareness campaign (again, my personal view), growth from new vendors is not going to move the needle very much now that Groupon has become a multi-billion dollar company.

Today, Groupon's daily deals business is likely to succeed with only a subset of small businesses nationwide, and their Groupon Goods overstock retail offerings can certainly move volume, albeit at very low, Amazon-like profit margins. So while Groupon stock has done well lately as the doomsayers quiet down, I don't see how one arrives at a valuation much higher than $6 billion/$9 per share, and there are risks to the business longer term from a competitive perspective. A year from now, I'll try and revisit the stock again and see if I was able to go 3-for-3.

Full Disclosure: No position in GRPN at the time of writing, but positions may change at any time

Does Sales Growth Really Matter That Much?

"Sure, earnings are going to be fine this quarter, but sales growth has been tepid."

I am hearing this line a lot in the financial media lately and frankly, it is a theme that is being given way too much airtime. All else equal, would earnings grow faster if sales were also growing faster? Sure. But that does not mean that earnings growth this quarter (tracking at 5-6%) is somehow bad news for investors. All too often it seems that people forget that stock prices are based on earnings, not sales. Why? Because shareholders in public companies are entitled to a proportional share of the firm's free cash flow. Sales have nothing to do with it.

Don't buy that argument? Think about the dot-com bubble. Why did the internet stocks tank beginning in March 2000? Because the companies were not making any money and after a while investors refused to pay 20 time sales when they were used to paying 20 times earnings. I could set up a web site that sells dollar bills for 95 cents and it would be hugely popular. Think of how fast I could grow the site's sales! But an investor would never give me any money because the business model does not work. Stock investing is all about placing a value today on profits to be earned in the future. Sales growth is irrelevant in that context.

Consider a real world example. IBM has doubled its stock price from $100 to $200 since 2009. IBM is expected to book sales of $102 billion this year, versus $96 billion in 2009. If sales growth really mattered, IBM's stock would not have doubled in four years because it only grew sales by 1.5% annually. Earnings per share, on the other hand, have risen by 70% during that time. That fact, along with some P/E multiple expansion, explains the stock's performance. Don't get caught up in the revenue growth debate. Earnings are what matter.