- An SA article uses momentum-based price-to-sales valuation to predict 9-bagger.
- 66 months into a bull market, the valuation game is likely to change.
- A more traditional earnings-based model gives vastly different results.
"Maintaining difference of opinion is a thing commendable, but not at the cost of the respect you extend to whom you differ with."
- Rana Junaid Mustafa Gohar
This morning I read Gerald Klein's Seeking Alpha article titled "The Case For Valuing Kandi". I have followed Kandi (NASDAQ:KNDI) with some interest over the course of this year and watched it deliver outstanding growth of revenue in its earnings reports, as well watching the meteoric rise in its stock price since the beginning of the year. The stock price has been volatile, probably an investor's nightmare but a trader's dream. I presently have no position in the stock, but I had seen the headlines about its sales growth and had previously penned an article that focused on what appeared at the time of writing to be a bubble in KNDI's stock price. I was intrigued to read an article that would attempt to value the stock. I wanted to know if the huge increase in revenues would now justify the current stock price, and more importantly, show a clear path to more gains in the near future.
In his article, Mr. Klein begins by invoking a comparison of KNDI to TSLA - "It's my belief KNDI is to personal intracity transportation what Tesla Motors, Inc. (NASDAQ:TSLA) is to the open road. And like TSLA, KNDI is led by a visionary leader pursuing an exceptional, elegant strategy that gives KNDI an edge over its competitors. Unlike TSLA, KNDI's market cap hovers near $800 million, while TSLA boasts a market cap of $32 billion, over 40 times greater than KNDI as of today." He then moves on to cover the market for EVs in China and proceeds to establish the case for demand for cars that do less damage to the environment, and points out that KNDI's electronic vehicles and carshare program are a convincing part of the needed solution.
Mr. Klein finally concludes a price per share range of $117-$205, depending on which of his assumptions about what number of shares outstanding you expect to have in 2016 and what revenue at that time will be. Taking the mid-point of his broad range, $161, implies roughly a 9-bagger from here. Keep in mind that today's stock price is up over 4 times in the last 12 months.
His methodology is quite simple: he takes a price-to-sales multiplier and applies them to an assumed 2016 revenue. His multiplier is 6x, derived from a multiplier an analyst he has quoted used to value TSLA on 2016 revenue. The analyst in question used a 4 multiple on TSLA, and Mr. Klein does not give reason for his jump to 6. While I personally do not agree with Mr. Klein's methodology, I want to point out, quite clearly, that I do not think his methodology is wrong. Since Mr. Klein treats us to a few pithy quotes in his article, let me return the favor by providing another one here:
"... But I'm annoying you to no purpose with my arguments. A person whose house is only open on the west can't see the sun rise at dawn; it's only seen when the sun sets at dusk. If one tries to compare the color and appearance of the two, one will go on arguing forever... The fault lies not with the vision but with the closed windows. If you look out of only one opening till the day you die, you'll ever see anything new."
- Sarat Chandra Chattopadhyay
An Alternative Method to Determine Value
My purpose in this article is to provide an alternative methodology to value KNDI, one that takes a different approach and, consequently, results in a dramatically different outcome. That does not make my approach "right", and it certainly does not make Klein's approach "wrong". KNDI is a momentum stock, within a momentum industry, in a momentum market. Momentum players look for those companies demonstrating the greatest momentum in revenue growth, they extend the line and apply a price/sales multiple to that assumed future revenue to come up with a valuation. Had you used Mr. Klein's methodology a year ago, the valuation you would have come up with would be much closer to today's current stock price than the one I am about to use.
We are now 66 months into a bull market. That is very long by historical standards. Bullish markets are not the permanent state of affairs; they are followed by bear markets, just as certainly as bear markets are inevitably followed by bull markets. During a bear market, a momentum valuation will no longer be applicable and an earnings-based model will become more appropriate. My approach to valuing KNDI is to use an earnings-based model. This late in the cycle, I think changing methodologies is appropriate, just as it was when the last tech cycle approached its end in 2000.
In order to be of the most service to readers, I will try to use some of the parameters that Mr. Klein has used, so that readers can contrast the two valuations to determine which one best suits their beliefs. The first variable to then consider is 2016 revenue, the basis for Klein's valuation. Klein assumes 2016 revenue will come in at a range of $1-$1.5 billion. In his article, he does not provide any reasoning or back-up for that number. Predicting revenues 2 years out is not an easy task, particularly with a young, rapidly growing company. But Mr. Klein does cite the Q2 revenue increase, Q over Q, of 171%. Perhaps that is his basis for reaching the revenue range he uses for 2016. What he fails to note is that Q over Q revenue gain on an annual basis is actually a revenue decline from the two previous quarters ($33 million in Q2 vs. $40 million in Q1 and $50 million in Q4/13):
View: Annual Data | Quarterly Data
All numbers in thousands
(Source: Yahoo Finance)
Trailing twelve-month revenue stands at $140 million. The upper end of his revenue range implies at a 10-fold increase by 2016, the midpoint is a 9-fold increase. I would be very interested to see further justification for such an astonishing increase, given two quarters of sequential revenue declines.
KNDI is most certainly in a rapidly growing market, as Mr. Klein's article points out. But I find him less convincing as to KNDI's ability to grow its own revenues at the level of the market's growth, given the recent slide in sales compared to the previous two quarters. Given that the company has not provided any revenue guidance in its most recent press release, the job falls then to past achievements. Looking at the annual results, we see roughly 50% revenue increases:
View: Annual Data | Quarterly Data
All numbers in thousands
(Source: Yahoo Finance)
However, I am persuaded by Mr. Klein's arguments for growth in the China EV market in the coming years, which I believe could accelerate KNDI's revenue growth from previous years. Annual revenues have been increasing at 50%, could it up that to 75% or even 100%? At this point, it becomes pure guesswork. 100% annual revenue growth from 2013 would put 2016 revenues at $752 million. 75% annual revenue growth puts 2016 revenue at $504 million. While these numbers are well below Mr. Klein's forecasted growth rates, they are substantially above the growth rates for EVs of 14.9% to 2018, as described in a recent report published by Ireland-based Research and Markets.
Next, I want to look at gross profit margin, which was 22.8% in 2011, 18.8% in 2012 and 22.9% in 2013. In the most recent quarter, GPM was 21.8%, and for the first half of the year, it was 16.5%. Looking at the company's history, and in the absence of any company guidance, I will model a 22% GPM.
Operating expenses, which include an extraordinarily light R&D load for a company touted to have such enormous growth prospects from developing cutting-edge alternative energy vehicles, was $4.6 million and $12.3 million for the most recent three- and six-month periods. As a percentage of sales, those numbers were 13.9% and 16.8% respectively, indicating a favorable, declining trend in operating expenses. As further economies of scale are achieved through growth in revenues, I would suspect this ratio to have declined even further by the time the 2016 numbers are in, perhaps to as low as 10%, a very enviable ratio by any standard.
Mr. Klein points out, through referring to another Seeking Alpha article, that KNDI has the capacity to produce 300,000 EVs annually. That other article provides no substantiation for that proposition. One must seriously question that, given KNDI's balance sheet shows less than $30 million of plant and equipment. Further, sales of EVs in 2014 throughout North America, Europe and Asia-Pacific are only estimated to be 352,000 vehicles. The most generous assumption would then to be to accept this proposition, which, if correct, would imply that depreciation would not change and nor would there be any need for substantial capital investment to get to the 2016 numbers. A brief model of 2016 EBITDA can then be created from these assumptions and used to roughly calculate a value for KNDI.
Value per share
I have chosen a multiplier of 2016 pre-tax income of 10 times. I have based that on looking at several of the more successful automobile manufacturers, Tata, Fiat, Ford, Toyota, who generally trade at 10 times after-tax net income. I feel that these are much more relevant comparables than Facebook, LinkedIn, SolarCity and Netflix. Tesla is a reasonable comparable, but does not yet have a PE ratio. No adjustment needs to be made to Enterprise Value, as cash and debt roughly cancel each other out. I have used Mr. Klein's greater number of 54 million shares, an increase of 10 million from present, as I cannot envision an as-yet unprofitable company making multiple increases in revenue without some additional capital.
By 2016, KNDI will be a very profitable company if it achieves anything like the potential that Mr. Klein has ascribed for it and for the EV market. At that time, it will surely be valued on its earnings, not its revenues.
I know that for several years, this momentum-driven market has placed price-to-sales valuations on companies that do not have earnings. They have resulted in multi-billion valuations for relatively new companies. But ultimately, every company has to generate earnings in order to survive. As we are in the late innings of this bull market, I think investors need to consider how companies will be valued if a return to traditional earnings and cash flow-based multiples become applied to their high-growth companies. A return to such forms of valuation would not only see KNDI not reach the multi-bagger potential Mr. Klein has described, but would in fact see a decline in KNDI's stock price from current levels.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.