While my background is as a long-only investor, I believe there are very few asymmetric opportunities for the risk-averse long investor in today's market. While this is a negative, the upshot is that there is no shortage of exciting opportunities to short (massively) overvalued stocks. Today, I will profile three stocks which I believe are significantly mispriced and are likely to fall more than 50% over a 24-month time horizon. My criteria are as follows:
- Market cap > $500 million
- P/E greater than 50x
- Limited competitive advantages or unproven business model
- Cyclicality which isn't being taken into account by the market
SolarCity (NASDAQ:SCTY) shares have increased nine-fold from their 2012 IPO price. Despite a litany of risk factors, speculators are captivated by the simple story of an Elon Musk-led company with a leading position in a growing market. While I don't debate any of the three aforementioned points (and betting against Musk causes me to think twice - ok more than twice), the company faces a litany of risk factors which are seemingly being ignored by investors. Firstly, the company has limited proprietary technology (outside of the software it uses to assess customer needs/options). The model has (and will continue to be) replicated by competitors' packaging equipment, financing, and installation services - this will drive down margins (we've already seen gross margins decline over 10% in two years).
Secondly, the company is dependent on financing partners (both equity and debt) in order to attract customers - SolarCity pitches its customers on being able to save on monthly electricity bills at no upfront cost. It is able to do this because it has financing partners who capture a portion of the monthly savings. If we learned anything from the last financial crisis, it is that financing is cyclical. Since virtually the entire business model (almost nobody pays cash upfront for the equipment) is dependent on cheap money, SolarCity is dependent on both low interest rates and a willingness to lend on attractive terms. Thirdly, there is a material reduction in federal subsidies from 2017. Federal subsidies (coupled with financing) are what allow SolarCity to make an attractive value proposition to customers. This is likely the best of times for the company - things can really only get worse, in my view. However, the market has priced in a blue sky environment through at least the end of the decade. When financing dries up (or the market focuses on the subsidy change in 2017), SolarCity's shares are likely to fall out of the stratosphere. The company trades at over 4x its estimate of cash flows to be received (generously calculated, as pointed out by SA contributor CDM Capital). Were the market to take into account a lower renewal rate and use a higher discount rate, while at the same time taking into account a less optimistic view of the future, I believe SolarCity shares could fall 50-60%.
Rackspace (NYSE:RAX) just reported another disappointing quarter, with operating income declining 45% year-over-year despite nearly 16% revenue growth. Rackspace's problem is a difficult pricing environment, as it competes with industry heavyweights Amazon (NASDAQ:AMZN), Google (NASDAQ:GOOG), and IBM (NYSE:IBM), among others. While demand for cloud services is likely to continue to increase for the foreseeable future, Rackspace is essentially offering its customer a commodity product. My problem isn't that Rackspace is offering a commodity product - rather that the stock is priced as if Rackspace is offering a highly differentiated product. In fact, Rackspace earns only commodity-type returns on capital (9% for 2013). Even if a commodity business is growing, if it is only deploying capital at (or below) its cost of capital, it does not deserve a premium multiple. Rackspace trades at 48x 2013 earnings (and a similar multiple of 2014 earnings, as margin compression is again expected to offset revenue growth). I think a more appropriate multiple for the stock is 13x, which is reflective of its commodity product offering, low returns on capital, and minimal free cash flow generation. At 13x 2014e EPS, Rackspace would trade at $10/share, or 72% below where it was trading after hours (even taking into account the 11% after-hours decline).
While 3D Systems (NYSE:DDD) has declined 31% from its recent all-time high, shares are still selling at an astounding 75x 2014 expected earnings. The market has priced 3D Systems as though it has a dominant position in a fast-growing industry which is resilient to cyclicality. I don't believe that any of these things are true. At this early stage of the 3D printing industry's growth, it is far from clear which competitors will ultimately be winners. While growing R&D spend will likely increase the company's chances of remaining relevant, all competitors are likely to take similar actions (many of whom are awash in capital from recent IPOs/secondary offerings). Similarly, 3D printing is primarily used by manufacturing customers for prototyping. Manufacturing is a highly cyclical industry, and DDD will not have the linear growth trajectory many investors seem to be forecasting (many are modeling 25-30% revenue CAGRs through 2020-2025). This downturn could come sooner rather than later, as manufacturing companies (in particular automakers) have been spending increasing capacity to meet emerging market demand. The instability we are seeing in emerging markets could curb their appetite for 3D printers. Thirdly, I think the idea of a rapid uptake of 3D printers among households is laughable. While many love to make the flawed argument that 3D printers will have the ubiquity of the PC, there are many reasons why this is unlikely to be true including: 1) completely different cost curve - PC functionality/cost was linked to Moore's law - there is no such dynamic at play in 3D printing, which is why 30 years after their introduction (yes 3D printing has been around that long) few people have 3D printers in their homes (2) no need for prototyping at home. When the market wakes up from its 3D dream, I expect 3D Systems to sell for 15-20x earnings. As such, I'd be interested in covering my short around $20.
Rosy projections about the future are fueling the valuations for the companies mentioned above. When reality proves disappointing, I expect share prices to decline materially. While most brokers rate the aforementioned companies 'buy,' there are a myriad of conflicts weighing on their advice. Thus, I urge investors to take the time to do their own work and come to their own conclusions.
Additional disclosure: I am long GOOG.