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Aerospace engineer who is seeking to learn as much about investing as possible in hopes of one day managing more than just my own money.
  • Baffled By The Bifurcated Market 5 comments
    Mar 10, 2014 5:42 PM | about stocks: AAPL, AMZN, CMG, CRM, F, FB, GM, GOOG, IBM, MCD, MSFT, ORCL, TSLA

    I haven't written an article in a while, and honestly the main reason is I've been befuddled by the market lately. I'm already leery of putting new money to work in a bull market that has done pretty much nothing but go up for five straight years, and the recent divergent behavior of certain stocks makes me even more nervous that we could be approaching a momentum driven bubble where certain stocks, and perhaps by association the entire market, has become divorced from reality.

    The poster child for this lately has been Tesla (NASDAQ:TSLA), which has accelerated faster than one of its high performance electric sedans, more than doubling from $120 to over $250 in just the last three months. Some of this gain has come from the company recovering from an overreaction to news reports of some of its cars catching fire in extremely rare circumstances, bouncing back to deliver a record number of cars in the most recent quarter. However, most of Tesla's valuation is based on future expectations like the continued buildout of their Supercharger network, now in Europe as well as the US, and the latest preposterously prefixed project, the Gigafactory.

    This $5 billion factory aims to bring down the cost of the most expensive component in their cars, the lithium-ion battery packs. By expanding their production capacity while bringing down costs by as much as 30% through economies of scale, this presumably paves the way for the company to release a much anticipated next generation car with a lower price tag for the mass market. For them to be able to reach their stated goal of being able to deliver 500,000 vehicles once the factory is up and running in 2020, up from the 35,000 that they are expected to sell this year, we should probably expect some margin compression from the lower prices likely to be realized by a car aimed at the 99%.

    Even if Tesla is able to leverage the expected cost savings from the lower priced battery and maintain their 25% gross profit margins, nearly double that of Ford (NYSE:F) or GM (NYSE:GM), this would result in a maximum gross profit of $6.25 billion if they are able to realize an average sale price of $50,000 per vehicle. Assuming R&D and other selling and administrative costs merely double by 2020, this could result in after tax income of maybe $4 billion. While this seems like a lot, if we apply a discount rate of 10% this equates to a present value of about $2 billion. At Tesla's current market cap of $31 billion, this is equivalent to a P/E of 15.5, well above where both Ford and GM are trading.

    Alternatively, you could extrapolate the recent 10% annual growth in Tesla's share count forward to 2020 to obtain approximately 175 million shares outstanding, or diluted earnings per share of about $23. At the same P/E ratio of 15.5, this would result in a share price of $350, which again seems pretty good, but in reality is only a compounded annual return of 6% over today's $250 share price. At this price and share count, Tesla's market cap would be $62 billion, approximately what Ford's is right now. Even if you assume Ford is so devoid of innovation that both its earnings and market cap would remain exactly the same, Tesla would still trade at a valuation almost double that of Ford. We can basically buy Ford's practically worst case future earnings for half the price as we'd have to pay for Tesla's best case scenario, which seems preposterous to me.

    Another egregious example of overvaluation is demonstrated by cloud computing juggernaut (NYSE:CRM). Despite a slight dip after another spectacularly unprofitable quarter, the stock is up 15% year to date after gaining 28% last year. With GAAP losses approaching half a billion dollars over this timeframe, the stock clearly trades based on something else, namely phenomenal revenue growth. To achieve this remarkably consistent revenue growth, the company has had to continuously make acquisitions, as well as increase sales and marketing expenses at an even faster rate than revenue growth, somewhat ironic for a company that supposedly makes sales and marketing tools more efficient and cost effective.

    The company continuously boasts that its analytics tools will eventually allow people to manage their sales accounts or even entire companies on a smartphone running the Salesforce1 platform. This narrative is so compelling that's overly promotional CEO Marc Benioff apparently felt the need to relate an anecdote, about him being able to run the company on his iPhone while at dinner, three separate times after the company reported earnings, once on the conference call, again during the question and answer session, and once more on his obligatory appearance on chief cheerleader Jim Cramer's Mad Money show.

    Despite this tantalizing prospect of enterprise cloud computing nirvana, which you would think would be so much in demand that it would sell itself, the company still relies heavily on paying commissions and stock options to salespeople and management. The company ignored half a billion dollars worth of stock based compensation in the non-GAAP earnings it reported last year, but even if you stripped out all of's ballooning SG&A expenses, the company would have only earned about $2.5 billion over the past 12 months, good enough to get their P/E ratio down to 15. Incredibly, this totally unrealistic elimination of almost all of their expenses still results in the company being more expensive than most of their competition, like Oracle (NASDAQ:ORCL) at 13.5 times earnings, Microsoft (NASDAQ:MSFT) at 14 times, and IBM (NYSE:IBM) at 10.5.

    These old tech companies aren't the only ones languishing as they are perceived as revenue growth deprived and innovationless. Apple (NASDAQ:AAPL) is trading at barely 3 times cash and less than 8 times earnings after backing out said cash stash. Contrast this with Google (NASDAQ:GOOG), which is trading at 24 times earnings even assuming earnings grow 17% over last year's results. This would be a remarkable achievement for such a large company to achieve for even one year, much less 5 straight like Google has. As we saw with Apple, it becomes increasingly difficult to grow the larger you get, and Google would have to continue to grow earnings at 17% for another 7 years before passing Apple's annual income. Despite this lofty hurdle, Google is already nipping at Apple's heels in terms of total market cap, at a valuation of $410 billion versus just $475 billion for Apple, and if you factor in net cash positions, Google is actually already the larger company by enterprise value.

    Clearly investors are ready to pay up on the hopes that Google can start to better monetize their popular Android operating system, something Apple already has achieved, with iOS garnering over half of all profits from mobile devices. There are also moon-shot expectations baked into the stock, such as gaining widespread popularity for wearable devices like Google Glass, not to mention innovations like driverless cars, but so far there hasn't been much tangible evidence that Google can move away from deriving over 90% of their revenues from their dominant online advertising platforms like search and YouTube. This market is also expected to get more competitive as other titans like Facebook (NASDAQ:FB) and Amazon (NASDAQ:AMZN) vie for the larger share of advertising dollars implied by their own overextended stock prices.

    At the risk of belaboring the point, I would also point out another disconnect with a company I've been wrong on so far, Chipotle Mexican Grill (NYSE:CMG). I'm skeptical that they can keep up the incredible same store sales growth they've shown lately, which clocked in at an astounding 9.3% last quarter and 5.6% for the full year. Chipotle management has repeatedly warned that they are unlikely to keep this up forever, forecasting only "low to mid-single-digit" comps growth for the current year. This is even after raising it from the "low single-digits" due to the momentum shown at the end of last year, but any additional sales growth is counting on them being able to raise menu prices in order to pass through cost increases in the high quality organic ingredients Chipotle prides itself on serving.

    However, in part because of these impressive results, Chipotle's stock price is now pushing $600, good for a trailing P/E ratio of well over 50 based on last year's earnings of $10.47. The forward P/E ratios based on this year and next year's expected earnings are also at the lofty levels of 46 and 37, respectively. Even with the latter value, this would result in a PEG ratio of about 1.7 based on expected 5 year earnings growth of 22%. When you have to use forward PEG ratios to justify buying a stock at these levels, I remain skeptical that there's much value left in Chipotle at these prices, even if they do continue to put up good operating results for awhile longer.

    In contrast, the company that Chipotle was actually spun out of back in the day, McDonald's (NYSE:MCD), looks downright cheap by comparison. The company is trading at 17 times last year's earnings and 16 and 15 times the earnings expected this year and next. McDonald's $94 billion market capitalization implies that each of their over 35,000 restaurants is valued at about $2.65 million each. Compare this with Chipotle, whose over $18 billion market cap values each of the approximately 1600 locations they had at the end of last year at over $11.5M each, over 4 times higher than each McDonald's.

    Moreover, McDonald's actually owns much of the valuable real estate under their restaurants, reporting about $20 billion worth of owned land and buildings on this owned land, out of the $40 billion in total property and equipment that are held on the balance sheet at cost. This means that the value of most of these properties are probably understated since many of them have been held for years or even decades. Compared to Chipotle's strategy of leasing most of their land, I would personally much rather buy a restaurant that generated $150,000 in annual profits for $2.65 million and own some of the land and property outright as well, instead of having to pay $11.5 million for one generating $200,000 and getting less value in leasehold improvements, no matter how enticing the growth prospects appear to be.

    These are just several examples of what I view to be pricing discrepancies between older, boring, more profitable companies and newer, exciting ones that exhibit the kind of revenue growth that investors seem to be infatuated with. There are legitimate reasons why you might want to focus on revenue growth, notably that profit margins are at all time highs, meaning stagnating companies might have difficulty squeezing profit growth from spending cuts. However, you have to be careful not to pay an absurdly high price for earnings that might never materialize, so I would avoid the stocks that have these overly optimistic assumptions baked into the current share price and instead choose the reasonably valued companies that people currently don't seem to think will be able to compete with the flashier upstarts.

    Disclosure: I am long AAPL, F, MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Comments (5)
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  • RonK2
    , contributor
    Comments (114) | Send Message
    This disconnect between relatively similar stocks is certainly baffling to me.
    13 Mar 2014, 12:26 AM Reply Like
  • brp15
    , contributor
    Comments (29) | Send Message
    Completely agree, particularly regarding CRM. Their sketchy accounting disclosures and further clouding of numbers via acquisitions, on top of an overly promotional CEO (always a red flag for me and Benioff definitely reminds me of others in the past who set off the same spidey sense), among many other reasons that you cited, make it a LT decliner in my mind.


    The game of musical chairs may not end tomorrow or even this year, but when it does, things will be ugly.
    5 Apr 2014, 03:53 AM Reply Like
  • Illuminati Investments
    , contributor
    Comments (9609) | Send Message
    Author’s reply » Yeah, Benioff gives me the creeps, shares so many traits with the people you always see on "American Greed", and when coupled with CRM's aggressive accounting seems to make it a ticking time bomb, only problem is it's so difficult to short when all people seem to care about is revenue growth.


    However, CRM and some of the similar momentum names that rely heavily on this seem to be breaking down lately. Too bad I couldn't get this article published because it "wasn't original enough", since the pair trades I suggested have performed very well so far:


    TSLA-F = 15%
    CRM-ORCL = 10%
    GOOG-AAPL = 10%
    CMG-MCD = 8%
    7 Apr 2014, 02:04 PM Reply Like
  • Illuminati Investments
    , contributor
    Comments (9609) | Send Message
    Author’s reply » Less than a year later, the scoreboard for these short/long pair trades is:


    TSLA-F = 20%
    CRM-ORCL = 15%
    GOOG-AAPL = 60%
    CMG-MCD = -20%


    Not too shabby, looks like the market can't stay bifurcated forever.
    12 Feb 2015, 02:02 PM Reply Like
  • Illuminati Investments
    , contributor
    Comments (9609) | Send Message
    Author’s reply » Wow, just ran across this and still consider it to be the finest article I've ever written, but apparently the market really can stay bifurcated for a long time:


    TSLA-F = -12%
    CRM-ORCL = -28%
    GOOG-AAPL = +14%
    CMG-MCD = +51%


    Thank god for that last one; comps finally did collapse, but in an even more spectacular fashion than I ever could have imagined.


    So to mix a couple Yogi Berra metaphors, even though I'm pretty sure no one will come here to read this because it's too crowded; it's tough to make predictions, especially about the future...
    25 Aug, 06:24 PM Reply Like
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