I'd Be Mad At Myself If I Didn't Short These 3 Stocks

Sep. 18, 2014 7:31 AM ETFRSH-OLD, GMCR, ULTA8 Comments
Weighing Machine profile picture
Weighing Machine
2.3K Followers

Summary

  • Market capitalization greater than $100 million.
  • Normalized P/E greater than 30x.
  • Expectations of slowing EPS growth (or EPS shrinkage in the case of Papa Murphy’s).

We are 5+ years into the current bull market. While cheap equities are becoming increasingly scarce, heavily overvalued stocks are abundant. Today I will identify 3 companies which I believe to be significantly overvalued. My criteria are as follows:

  1. Market capitalization greater than $100 million
  2. Normalized P/E greater than 30x
  3. Expectations of slowing EPS growth (or EPS shrinkage in the case of Papa Murphy's).

Papa Murphy's (FRSH) stock has been about flat since its May IPO. The company makes and sells pizzas that customers take home and bake in their ovens. This concept is similar to a Midwestern chain Homemade Pizza which went bust earlier this year. There are several reasons to short Papa Murphy's, including: 1) 30%+ of franchisees are in financial distress (losing money at the operating level) based on a relief plea franchisees made earlier this year (2) while Papa Murphy's sells at an apparent P/E multiple of about 18x, after factoring in the potential for lost royalties from troubled franchisees, Papa Murphy's sells for 45x earnings (3) the company has a weak balance sheet with over $100 million worth of debt. While the company has been able to service the debt thus far, if troubled franchisees halt royalty payments, Papa Murphy's could be in financial distress and (4) Papa Murphy's IPO lock up expires November 2. This means that millions of shares are likely to come to market. While the stock has been strong the past couple of weeks (likely due to a short squeeze), a flood of new shares is likely to hurt the share price. I think that normalized earnings for Papa Murphy's are somewhere around $0.30-0.35 per share (assuming ½ of troubled franchisees are forced to exit). Applying a 10x P/E multiple gets me to a share price of $3.00-$3.50, roughly 70% below today's levels.

Shares of cosmetics retailer Ulta (ULTA) have had a very strong run over the past 5 years, increasing 742% (and 23% year-to-date, most of this occurred in the past two weeks). While the company has done a great job of profitably expanding its store base over the past several years, this seems to be more than reflected in the stock price - Ulta sells at a whopping 31x forward earnings, about 2x the multiple of the S&P 500. While Ulta has a spectacular history, I think there are several reasons to be cautious. First the company faces significant competition - not only from department stores and direct competitors like Sally Beauty Supply (SBH) but also increased competition from online competitors. Online competition has dampened investor enthusiasm for most retailers and it is unclear why Ulta should be an exception. Bulls argue that customers like to try products at Ulta - while I agree, I think that after a customer tries and finds the product they want, that customer is then most interested in getting the best price. This could pressure volumes, prices and gross and operating margins. Second, the company already operates over 550 stores. While the market is not completely saturated, finding quality locations (without cannibalizing existing stores) will become increasingly difficult. I think that 18-20x P/E is a more appropriate valuation for Ulta, implying 30% downside.

Keurig Green Mountain (GMCR) have soared 80% year-to-date as investors are excited about 1) the company's tie up with Coke (KO) and think it is possible (likely?) that GMCR is eventually acquired and (2) GMCR recently introduced a second generation of coffee machines - investors had been concerned that consumable K-Cup sales (this represents the bulk of GMCR's profit) were vulnerable to 3rd parties seeking to sell consumable cups at lower prices. Will Coke buy GMCR? I suspect not. First, GMCR has a market cap of $22 billion at today's price. Coke is already facing pressure from activist investors like David Winters - I doubt these investors would be pleased to see Coke spend $25-30 billion (assumes a 15-35% premium) to buy GMCR. This would be particularly worrisome to value investors like Warren Buffet (value investors constitute a meaningful % of Coke's investor base) given that GMCR sells at 33x earnings (despite slowing growth) which is a 50% premium to Coke's 21x P/E. This implies that the deal would be earnings dilutive (unless Coke took on significant debt). Secondly, while GMCR thought that it's new machine would protect it from 3rd party consumables, it seems that creative entrepreneurs have already found a way around this, making GMCR susceptible to competition in its highly profitable K-Cup business. I think GMCR should fetch about 20x P/E, or roughly $80 per share implying that shares have 40% downside.

Over the next three years, I expect a short position in GMCR, ULTA, and FRSH to meaningfully outperform both the S&P 500 and the Russell 2000.

This article was written by

Weighing Machine profile picture
2.3K Followers
Former global buyside analyst/PM doing fundamental research for over a decade (2001-2012). Long term (5 year) time horizon when investing.

Disclosure: The author is short ULTA, GMCR, FRSH. 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.

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