While the market has fallen a bit from its recent high, there remain several stocks trading at stratospheric valuations. While these stocks have little in the way of earnings (two of them have lost money in the past twelve months), investors appear to be convinced of a very, very bright tomorrow (tomorrow typically being five years away). With any hiccup shares of these companies could easily decline 50+% (and in some cases much more). Here are my criteria:
- Market cap greater than $500 million
- P/E greater than 75x
- Unproven competitive position or questionable business model
- Insider selling
I will start with Yelp (YELP) which soared nearly 20% this week (and is up a whopping 318% in the past year). Investors are very excited about Yelp's rapid revenue growth and have awarded the company a $6 billion valuation (18x forward revenue) despite losing money in 2013. While Yelp is becoming ubiquitous, the company operates what I believe will prove to be an inherently low margin business model. Because the company deals with local businesses, it must hire an army of salespeople to solicit advertising dollars. This is an expensive proposition - Yelp saw its largest expense line, sales & marketing, grow 53% year over year during 2013. While this is below the company's 72% revenue growth rate, I expect that sales & marketing will continue to grow at a rapid clip - particularly given that local businesses have a higher rate of failure than larger companies implying that as the business matures, Yelp will have to run to stand still (attract new local businesses to replace those which have failed).
While I don't doubt that Yelp will continue to grow at a fast rate, even if the company grows five-fold by 2020 (26% CAGR) from it's current rate and eventually brings operating margins to 20% (4x the level of Groupon, which faces the same difficulty in leveraging it's expenses and earns just 3-5% operating margins), Yelp would be trading at roughly 30x 2020 operating profit. Even if we assume that the business is worth 30x 2020 operating profit, discounting back to today at 10% means that fair value is $56/share. In a less Rosy scenario, shares could be worth much less. In my view the biggest risk to the short thesis is that YELP is acquired by a large competitor like Google (GOOG) or Facebook (FB). While I am short shares of YELP, it is by far the smallest short position of companies mentioned in this article.
ServiceNow (NOW) shares have had an incredible run since the company's 2012 IPO - increasing 278%. At today's price and using the fully diluted share count, NOW has a market capitalization of $11 billion or 17x 2014 estimated revenue. Like Yelp, NOW has yet to earn a profit - while 2013 revenue advanced +74% vs. 2013, NOW's operating loss actually increased as total expenses grew 90% in 2013! This is particularly important as it relates to the story that NOW is telling investors. Management has consistently increased the estimated size of the markets in which NOW is competing in order to justify its share price.
The reality is that virtually all of NOW's revenue comes from the ITSM business which has an estimated market size of ~$2-$2.5 billion (of which 50-70% is likely to ultimately be served by SAAS providers). By showing such rapid revenue growth NOW management appears to have convinced many investors that the market is up to 10x the size of the ITSM market. However, with an unlimited budget (funded by buyers of shares/convertible debt), I believe that NOW has simply accelerated its penetration of the ITSM market. An unlimited sales budget essentially allows the company to accelerate notoriously lengthy sales-cycles as well as targeting companies across the globe. If NOW is truly limited to the ITSM market, its sales growth rate is likely to significantly decelerate - likely sooner rather than later (2015?). When this happens, look out below! Should investors start to perceive NOW as a company with a large share of a small market (earning no profit), shares could fall meaningfully. Assuming 2015 revenue of $800 million and P/Sales of 4-5x (reflecting a slowing growth outlook), NOW shares could fall as much 70% (to $20-24/share). Should the market start to question whether SAAS companies will ever generate acceptable margins, shares could fall even further (my fair value estimate is only $15). While being short has been painful, I recently added to my position and believe NOW represents virtually return-free risk at these levels (it is one of my largest short positions). Unlike YELP, I do not believe that NOW is a logical acquisition candidate for large software players like Oracle (ORCL), Microsoft (MSFT), or SAP (SAP) as it operates in an unattractive niche and offers limited strategic possibilities. Despite what management says, a quick look at their actions (such as massive insider selling) indicates that management agrees with me.
Exact Sciences (EXAS) sports a $900 million valuation despite having less than $5 million in trailing twelve month revenue. EXAS has somehow convinced investors that it is on the precipice of introducing Cologuard, a blockbuster new cancer detection test. Those with an appreciation for history will note that the company has captivated investors with this story before, only to see the test flop and shares fall by 90%. EXAS has been able to take a free ride on the biotech mini-bubble - its stock has risen +150% since mid-2010 despite an absence of tangible evidence that it's product will be a blockbuster. In fact, the product faces significant competitive headwinds from the incumbent FIT test which is cheaper and does a better job of detecting cancer. If Cologuard proves to be a flop, and I think it will, Exact Sciences has massive downside (90% +) as there are limited assets to fall back on (and no revenue).
While sell-side 'analysts' are eager to broker purchases of the aforementioned companies, such analysts are conflicted given the investment banking model (dare I say there is a hole in the Chinese wall). Cautious investing to all.
Additional disclosure: I am long SAP, MSFT, ORCL, GOOG