"If past history was all there was to the game, the richest people would be librarians." --Warren Buffett
This is certainly true, but investors would be wise to understand what the end of a major bull market usually entails.
Currently, we are seeing an unwinding of high price to earnings multiples. Granted, we are in the midst of another global financial crisis, and a broad global equities sell-off. Regardless, the collapses in Netflix (NFLX), Groupon (GRPN), Green Mountain Coffee Roasters (GMCR), LinkedIn (LNKD), and to an extent, Salesforce (CRM) (which is sure to get much, much cheaper in the coming months) are part of a broader trend.
Keep in mind, we've had plenty of stock sell-offs earlier this year. After the Japanese crisis, our indicies lost all of their yearly gains up to that point. How about this summer, during the credit downgrade? The market tanked, but high P/E issues did not significantly underperform.
Now we're seeing the darlings of "hyper-growth" traders getting wiped out on a weekly basis. These sell-offs are not buying opportunities.
Netflix is clamoring for cash, and is selling shares in their business at a price that is $130 off what they could have gotten a couple of months ago. LinkedIn's insiders are selling most of their shares for huge profits, while the stock further approaches its IPO price of $45. GMCR's curious accounting has finally been publicized, and years of negative free cash flow are finally being questioned.
As our two and a half year bull market completes its unwinding, the stocks with the mightiest of expectations have begun to regress to the mean. These three stocks are sure to be the "next" GMCR, LNKD, and NFLX. While some of them already have high short interest, the fundamental cases for shorting them far outstrip any arguments that overwhelming negative sentiment is bullish.
Amazon (AMZN): Yes, I get it. "The haters have been saying short Amazon forever." Well the haters are right. As I wrote here, investors in Amazon's shares don't quite understand what they are paying for.
Wall Street expects 22% annual earnings growth for the next five years (down from the 27% expected only a few weeks ago). Amazon earned $1.04 billion in 2010, so assuming 22% yearly growth, this leaves us with about $2.808 billion in net income in 2015, or $6.10 in EPS. At current levels, Amazon would still be valued at more than 30 times earnings in 2015, after a decade's worth of 20% annual growth.
Let's also keep in mind that to achieve these earnings, assuming their current profit margin of 2.0%, Amazon needs to achieve $140 billion in revenues. Even Apple doesn't generate that much revenue.
Lastly, legislators have been pushing hard for tax reform regarding online companies like Amazon. With already razor thin margins, a new sales tax would remove Amazon's competitive advantage and could slash profits.
Of course, this is the absolute rosiest scenario, unless you believe Amazon can outpace 22% yearly growth. Amazon, in the intermediate-term, has nowhere to go but down. Given current market conditions, another poor earnings report should be the catalyst for a real unwinding.
Qlik Technologies (QLIK): Qlik is yet another high-flying, cloud-space stock trading at well over 100 times earnings.
Qlik does pretty much the same thing as Salesforce, Oracle (ORCL), SAP (SAP), Rightnow (RNOW), Microsoft (MSFT), and dozens of other companies. The company provides companies with business analytic software and related services.
The most important piece of my short thesis on QLIK is management's astonishingly shareholder-unfriendly dilution of their stock. According to Qlik's most recent (Q3) 10-Q, there were 68 million fully diluted shares at 3rd quarter's end in 2010. At that time this year, however, 87.6 million fully diluted shares were outstanding, good for a 29% year-over-year increase.
There are few instances where a 29% annual share dilution is alright, and no instances when a 29% dilution is ok for a stock trading at more than 300 times earnings. Share dilutions of this magnitude mean one, or some of the following:
- Excessive granting of stock options used for executive compensation, typically to avoid "cash" charges that bite into GAAP income
- Need for zero-risk capital
- An overvalued stock price that allows management to extract more value than they give up (by selling pieces of the business)
Sure enough, a look at the options segment QLIK's 10-Q shows that their are currently 9.2 million granted options outstanding, and another 3.3 million that are still available for issuance under their 2010 executive compensation plan (equity incentive plan).
Additionally, $760,000 of QLIK's income was derived from foreign exchange gains, or 33% of its total, after-tax net income. Yikes.
For QLIK to be trading at over 300 times earnings is insane, and it will be continually punished as the market becomes more risk-averse.
Dunkin' Brands Group (DNKN): There are rarely better short opportunities than closely watched IPOs. Recently issued stocks are generally supported by those who did the underwriting, and eventually fall victim to selling by management, underwriters, and other institutions who already made the quick buck. In some cases, like LinkedIn, the company will come back with a secondary shortly even after the market provides them with billions.
In Dunkin's case, a group of three private equity firms, none of which have shareholder's best interests in mind, still own 75% of the company. Of course, this can only mean one thing: there is plenty of dilution to come.
Sure enough, the owners announced a few weeks ago that 22 million more shares were going to be offered via a secondary. Furthermore, absolutely none of the proceeds will be reinvested into the company's operations. Before paying themselves a "special $500 million dividend" (which was then loaded onto the balance sheet as long-term debt), the investors were down a couple hundred million on their failed investment. All equity sales going forward will be simply to milk everything they can out of the market in order to line their pockets.
Investors should really be asking themselves why, if DNKN is such a great investment, did the private equity investors sell out at an operating loss? And, as is true with all IPOs, selling shares in a company is quite literally selling pieces of the business, and if you were really getting a good value by investing in them, isn't management pretty stupid to give up the shares at a price lower than their intrinsic value? In this case, the investors probably realized that competing with Starbucks (SBUX), McDonald's (MCD), and regional stores is not an easy business, and that expanding nationally would require years of excessive investment that would take years to (maybe) see a rate of return.
Throw in other facts such as that the company includes Baskin-Robbins, a struggling ice cream vendor, a debt to equity ratio of over 200, and dismal same stores sales growth, and seeing a price to earnings multiple of 42 is downright confusing...or just a sign of a good short opportunity.