3 Red Flags In Otherwise Attractive Stocks
Seeking Alpha Analyst Since 2020
GreenDot Stocks looks for companies that are sustainably growing revenue and generating free cash flow - a powerful combination for investing success. We aim to highlight stocks for long-term (3+ year) investments and "multi-bagger" returns.
Summary
- Bulk of growth from acquisitions.
- Customer concentration.
- Too much share dilution.
- Article gives examples and explanations of each.
Rising, recurring revenues, and a moat. Hold for years.
Rising, recurring revenues, and a moat. Hold for years.
That is the entire recipe for success with "green dot" stocks!
I've been investing for nearly 25 years, and gone through each of the stages. Quantitative, Ben Graham-style value investing. Peter Lynch-style "buy what you know" investing. I've studied the masters of the craft and read all the systematic books from guys like Ken Fisher and Pat Dorsey. Like many investors, Buffett has been a big influence. I've even delved into the basics of technical analysis.
There is so much information and so many tips to take in.
Ultimately, though, as the quote goes: "simplicity is the ultimate sophistication"! Rising, recurring revenue, and a moat. Hold for years. That is about as simple and effective an investing strategy as I've ever found, and it is one that ANY investor, beginner or 30 year veteran, can follow.
Simple is best, but like anything simple, there is always depth that goes understated, small details that can make a seemingly good stock be less attractive then it seems.
In this article, we're going to look at 3 "red flags" that occur frequently enough in what look like otherwise "green dot" stocks. These "red flags" are details that some investors may miss. Be on the lookout for them!
Red Flag #1: Bulk of Growth From Acquisitions
This one is a detail under the "rising revenues" category.
Most companies grow organically. This means that they expand their existing business to more customers, get existing customers to buy more of their products/services, create new products/services, are able to push through price increases, etc. Basically, the company is investing its cash flow internally to increase its revenue.
Organic growth is what you want to see!
Sometimes, though, what looks like a really good revenue growth rate is generated on the back of numerous large-scale acquisitions of competitors or "complimentary" businesses.
Take a stock like SS&C Technologies. Its growth rate looks pretty darn impressive: 46% 3-year annual rate, 43% 5-year, and 33% 10-year. In 2019, its revenue rose from $3.4 billion to $4.6 billion, a 35% increase. This looks like a really fast growing company.
Looking closer though, the story changes a bit.
SS&C has been a very acquisitive company, buying Advent Software in 2015 for $2.6 billion, and really playing the big spender with a $5.4 billion purchase of DST Systems in 2018. When you run through the revenue numbers, you can see that these 2 acquisitions account for close to 38% of that 3-year growth figure, meaning SS&C grew organically by less than 10% during that period. That makes the stock far less attractive from a growth perspective.
Bulk of growth by acquisition is a turn off, for a few reasons. For one, it is event-driven and not a repeatable trend - we cannot rely on it continuing at a predictable rate. Second, it is expensive and adds a lot of debt to the balance sheet. Third, it is highly risky. Integrating the people, systems, and cultures of a large organization into your own has historically proven to be value destroying in most cases. Even SS&C, a stellar acquirer, has seen client losses at DST since buying them.
The bottom line here - make sure that impressive 3-year revenue growth figure is mostly an ORGANIC one, and not created on the back of a few large acquisitions that juiced sales figures.
Red Flag #2: Revenue Concentration
Revenue concentration is another red flag that can slip through the cracks.
This one is pretty simple. When a company relies on just a single customer for a meaningful portion of revenue (say, 20% or more), or just a handful of customers for half of revenue or more, we have a red flag.
The reason why is obvious. If one of these key customers decides to reduce its business with the supplier, or decides to change suppliers altogether, suddenly a very significant portion of sales disappear overnight. Guess what else happens? You got it - the stock tanks overnight in unison.
A stark example of revenue concentration is in Skyworks Solutions (SWKS), a supplier of components for use in electronic devices. Although it has moderated sharply in recent years, Skyworks delivered great revenue growth through much of last decade, riding the smartphone boom to 20%+ annual revenue increases. It looked like a great growth play on the phone and "Internet of things" trends.
Dig deeper, though, and we find a big, fat red flag.
Skyworks (in its 10-K) reports that Apple (AAPL) accounted for 39%, 47%, and 51% of its revenue in the years 2017-19 (respectively). Apple, Samsung, and Huawei together accounted for close to 75% of total revenues in 2019!
When you consider that Apple just dumped microprocessor giant Intel to make its own Mac CPUs, it is pretty clear that Skyworks is skating on some thin ice. Apple already has substantial power over how much Skyworks can charge for its components (e.g. whatever Apple is willing to pay!). Should Apple decide to replace Skyworks components' with its own, that could mean a sharp revenue decline almost overnight. The stock would certainly follow suit.
Large customer concentrations are necessary to disclose in 10-K filings, so be sure to check for it in any stock that interests you. It is never a good thing and can often be a ticking time bomb.
Red Flag #3: Excessive Share Dilution
It is fairly common for stocks that fall into the "green dot" category to have share dilution. Many of these firms are in the rapid growth stage of the business life cycle, and are spending above their means in marketing and development to grab customers before competitors can. One way to finance this is by selling shares of their own stock.
Equity compensation is also an enticing carrot to offer employee talent. Many talented workers are looking to get into a promising company early, gather a lot of shares through compensation, and become quite wealthy when the stock takes off.
So, share dilution is not necessarily unexpected, or even a bad thing.
As long as it is kept within reason.
Too much share dilution eats into our piece of the pie as common shareholders. Even worse, it is also frequently a sign of a management team that is undisciplined and disrespectful of the common shareholder. Both of these are bad news for future returns on the stock.
How much dilution is too much? Each investor will likely develop his or her own threshold, but here any dilution sustained above 5% for several (3+) years is considered a red flag. Also, I'm more forgiving of share dilution shortly after (1-2 years) an IPO than in a more established public company.
A good example of a dilution violator for many years was Twitter (TWTR). For a full 6 years after its 2013 IPO, its share count grew at an annual compound rate of about 5.5%. IPO investors, at the end of 2019, had seen their stake in Twitter decline by 30% through dilution alone! Thankfully, the company seems to have addressed this issue, as 2019 share count was up only 1.5% from 2018. Still, it illustrates how share dilution act as a handicap against out-sized investment returns for common shareholders.
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