Research Notes: Big Earnings Movers

With earnings season near an end, a look at some intriguing stories

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Earnings season is nearing an end with only smaller retailers left. Here’s a look at four stocks that have moved big this earnings season:

Zoom Video Communications (ZM)

I wrote about ZM following the company’s after-close fiscal Q2 earnings report on Monday. The thesis was relatively simple: if you look at Zoom’s enterprise business alone, Zoom stock starts to get interesting. Enterprise is growing low- to mid-20s this year, and new products (Zoom Phone, Zoom Contact Center, etc.) have only just begun. Gross margins presumably are roughly the same as for the rest of the business (mid-70s on a GAAP basis), and investments behind that side of the business should be leveraged over time, suggesting the potential for solid long-term operating margins¹.

ZM closed Monday’s after-hours session down 8%-plus — but I actually thought the report looked decent enough. I even contemplated calling my shot on Twitter and predicting a green close on Tuesday. But Zoom finished the regular session down 16.6%. (My long and impressive track record of completely whiffing on one-day movements is why I contemplated calling my shot on Twitter and not in my brokerage account.)

Honestly, I’m intrigued here. As I wrote, it’s not hard to see a value for “Enterprise Zoom” in the $18 billion range; Zoom’s enterprise value (as in market cap less cash) as I write this is a touch over $20 billion. The narrative of slowing top-line growth amid a return to normalcy is largely being driven by what Zoom calls the “online business.” That portion of the business — still almost half of revenue — serves the consumer and SMB customers that made Zoom a verb in 2020; management expects it will decline 7-8% this year.

There are risks, of course. Microsoft (MSFT) Teams may take share, particularly if a recession (or something like it) cuts IT budgets. (It was Teams that underpinned my 2020 short thesis for ZM, probably my second-worst call² ever.) Guidance for full-year performance in enterprise suggests a second-half deceleration on the top line, though it appears that’s driven mostly by increased deferred revenue and currency effects. And, of course, there’s the falling knife/short-term argument against buying now.

But for me personally, ZM is on the watchlist. Can this get to, say, $65 without more bad news? At that point, ZM is trading at ~6x enterprise revenue, a reasonable multiple even for those of us who don’t love buying stocks based on revenue.

$65 might be too much to ask (the 52-week low is $79) without the thesis changing. But the November 70 put (which expires before the Q3 report) offers 6%-plus return with an effective entry point below $66. At the least, I don’t hate that trade. Of course, with the stock rising on Thursday, perhaps it’s worth making the higher-reward play of betting on a “fill the gap” move higher.

Avaya Holdings (AVYA)

We highlighted AVYA in this space four weeks ago, as a name to look at when buying risk. We acknowledged that the stock was tempting, but upfront admitted that “common sense suggests AVYA is an obvious avoid.”

Avaya promptly lost more than half its value a few days later, after releasing some of the worst preliminary figures you will ever see. A further update on Aug. 9 gave more color.

Revenue of $577 million in fiscal Q3 (calendar Q2) compared to guidance of $685 million to $700 million. Avaya expected Adjusted EBITDA of $140 to $150 million; the actual print was $54 million (63% below the midpoint of guidance).

Both misses suggest a pretty big whiff for a full year range, let alone a range given for a single quarter — but it gets even worse. Bear in mind that the Q3 guidance was issued with Q2 results on the morning of May 10, the 40th day of the quarter. As bad as the entire quarter looks, the second half of Q3 must have been far worse. Bondholders are considering legal options against the company over incomplete discussions ahead of a recent refinancing, but it seems at least possible that the company didn’t do anything nefarious; unless management was flat lying on the Q2 call, Avaya executives simply were taken completely by surprise.

Based on post-Q2 guidance for the full year, Avaya was 4.2x net leveraged. That ratio probably moves to at least 6x, and potentially higher looking forward given the collapse in margins. With its Q3 update, Avaya also disclosed a so-called “going concern” warning and delayed filing its financial results. In response, a different group of bondholders said it would declare default if those results aren’t filed by mid-September.

All told, a company that only exited bankruptcy in late 2017 obviously looks headed back there again. Given the leverage ratio, declining profits, and restatements, there’s no reason to expect anything else.

Right?

source: YCharts; one-month chart

I’m not supposed to say this, so I’ll whisper it: I have no idea what is going on here. None. Zero.

There’s apparently some kind of good news here, because the 2.25% convertibles that mature in June themselves have doubled. But the only real news since the stock inflected was a Schedule 13G filed by Theodore Walker Cheng-De King last Thursday.

King now owns 15% of the equity. The 13G includes a letter to the Avaya board detailing steps that could be taken, among them the repurchase of those convertibles. On first read, it sounds like a relatively standard semi-activist letter (the filing being a 13G, rather than a 13D, means it’s technically a passive stake despite King’s advice for the board).

On second read, it gets more than a little weird. King argues that Avaya should aim for a $300 million to $500 million “strategic preferred investment” from the likes of Microsoft, Cisco (CSCO), or Zoom. This investment would include the right to make an acquisition down the line (King says “2024-2025”) at a fixed EV/revenue multiple.

But the bondholders who refinanced Avaya’s debt this summer picked up first-lien debt; from a distance, it seems highly unlikely that an acquirer could step ahead of that debt in the capital structure³. Without some sort of senior claim on assets (saying the investment is "preferred" doesn't count), it’s completely unclear why any of those companies is investing $30 million, let alone $300 million, in a company with a market capitalization of $100 million.

Also unclear is why these companies wouldn’t let Avaya go into bankruptcy, rather than propping up the equity and hoping for a turnaround that could force a far higher price⁴.

But King also seems to be arguing that the company itself should create a short squeeze. He says Avaya should buy back $30 million in stock before its 2027 debt becomes convertible; those bondholders who are short AVYA as a hedge will thus get squeezed. (I think he’s arguing the buys themselves will get AVYA up above $3.42, the floor conversion price for the convertibles. That in turn will drive conversions which wipe out that portion of the debt, but the filing isn’t entirely clear on that point.)

Where it gets really interesting is the mention of “highly unusual” market-making operations in sessions leading up to the filing. The heavy volume, to King’s eye, apparently looks like it’s coming from “synthetic shares.”

In other words, King doesn’t come out and say it, but it seems like he’s basically asking Avaya to make itself a meme stock. (Ape-vaya?) This isn’t quite as crazy as it sounds: an activist made a similar pitch to Macy’s (M) in November, albeit without the conspiratorial references to market makers and synthetic shares.

Perhaps the hope of a meme stock alone is enough for the equity to rise, and the 2023s to rally in hopes of an ATM offering or some other way to capture value.

But, to be honest, that’s simply our best guess. And it’s not a perfect theory. Yes, the 2023s have risen sharply. They still have a yield just shy of 200%. Anyone seeing value in the equity at $1.46 per share needs to believe not only that the stock is a buy here, but that it will triple by June to choose equity over debt. Unless, of course, there’s something else at play here.

(Also, per the filing, King mailed two books to Avaya headquarters for executives to read.)

Accuray (ARAY)

In mid-June, we called out ARAY stock as a buy, if a high-risk buy. The company’s fiscal Q4 release on Aug. 10, after which Accuray stock jumped 21%, shows that optimism was justified.

To be clear, we didn’t expect a big post-earnings rally. Rather, we argued that the sell-off that had occurred — ARAY had been halved in about two months — made little sense. It seemed driven far more by market forces, including a broad, steep sell-off in small-cap and/or high-risk names. Accuray, with a leveraged balance sheet, small market share, and a disappointing history, qualified on both fronts.

But Accuray indeed posted quite a strong Q4. Implied revenue guidance for the quarter was $100-$110M, and Accuray hit the high end of the range. The company expected ~breakeven Adjusted EBITDA, but in fact delivered a $5.2 million profit on that basis.

The quarter wasn’t perfect. Orders look a bit soft: $88 million on a gross basis still lags the nearly $100 million posted in each of the fourth quarters of FY18 and FY19. (One analyst on the call, however, praised the figure given some of the uncertainties swirling around the business, and it appears Accuray did recapture some orders that had “aged out” of its backlog.)

FY23 guidance shows revenue growth of just 4% to 6%; Adjusted EBITDA growth should be solid, but the outlook of $26 million to $30 million still lags the $38 million print from FY21. The midpoint of the range suggests total four-year growth of about 18%, or 4%-plus annualized. At that midpoint, ARAY still trades at ~12x forward EBITDA, with net leverage above 3x and free cash flow this year (excluding the benefit from stock-based comp) in the range of zero.

All that said, the story here looks potentially more attractive, even with ARAY up 48% since our call. Again, the decline heading into June levels (and August earnings) made little sense. Arguably, the decline alone should have led to a post-earnings pop if the quarter was merely decent.

But the news surrounding Q4 was much better than that. Profit expectations have moved materially higher: the post-Q3 guidance for FY22 was $15-$20 million, which meant an optimistic reading might have seen ~$23 million (15% growth off the high end of the range) for this coming year. Instead, we’re at $28 million.

The big opportunity in China has been delayed once again owing to the impact of the novel coronavirus pandemic in that country. That in turn puts the above-expected bottom-line growth this year in an even better light. And a new CEO and CFO detailed a potentially aggressive turnaround plan which could bear fruit as well.

This looks like a stock that still should have more room to run. Broadly speaking, the news looks better, yet shares still trade below where they did in late April, and are down 50%-plus since November. Yes, there’s potential anchoring bias there (and Accuray did cut guidance during that stretch), but as we wrote in June this isn’t some growth stock that’s crashed back to Earth.

We’re not alone in seeing value. Over at Seeking Alpha earlier this month, Stephen Simpson (an excellent and experienced analyst in the medtech space, and somehow also in financials, semis and probably one or two other sectors I’m forgetting) argued that the stock had a chance to double. From here, that looks correct.

Simpson also admitted that, 15 years after its IPO (at $18; the stock is below $3 now), investors would be forgiven for skepticism toward what’s always been a next-year story. We agree with that perspective as well.

Nu Holdings (NU)

Nu Holdings feels like the epitome of this market, in that it’s an easy buy with one notable, and pretty important, exception.

The digital bank is trying to disrupt a sclerotic, entrenched legacy banking system in its home market of Brazil as well as newer markets Mexico and Colombia. It’s having a good deal of success. Q2 earnings last week led the stock underpinned a two-day, 30% rally, thanks to 230% currency-neutral revenue growth, an overall adjusted net profit, and a modest GAAP profit in Brazil.

The company is less than a decade old, yet it has the fifth-highest number of customers in Brazil. Many of those customers are using Nu as their primary bank, and from a distance those decisions seem wise. Nu simply offers a better experience, and at a far lower cost; at the time of its IPO last year, the company estimated it spent less than $1 monthly to serve each customer, while traditional banks like Itau Unibanco (ITUB) spend ~$15.

So we’ve got exceptional growth and a long-term runway. Meanwhile, NU stock is down ~45% from its IPO price of $9 — a price at which Berkshire Hathaway (BRK.A) (BRK.B) bought $250 million in stock after investing $500 million last June. This looks like a long-term growth opportunity created by a short-term market-wide sell-off.

But if you look at this with fresh eyes, the opportunity doesn’t look quite as compelling. That IPO valuation looked potentially questionable at the time, and indeed the original range was pulled down to $8-$9 from an original $10-$11. Nu still has a market cap of $25 billion. It trades at more than 5x book, and is valued at roughly half Itau Unibanco, the country’s largest and most valuable bank.

Investing in Brazil can be fraught: the iShares MSCI Brazil ETF (EWZ) is down 41% over the past decade. And it’s possible NU, which has weakened modestly after the post-earnings pullback, has further short-term declines in store: the stock now has bounced 51% from its May lows.

And so the debate here essentially is whether the 45% decline is an opportunity — or a needed correction in terms of valuation. That’s precisely the question that so many investors, myself included, are asking about the market as a whole.

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As of this writing, Vince Martin has no positions in any securities mentioned. He may initiate a position in ARAY in the near future.

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1. To be clear, those are GAAP margins, not the adjusted ones that exclude the massive amounts of stock-based comp.

2. My worst came a year earlier when I wrote a piece saying that “it’s over” for Babcock & Wilcox (BW), only for the company to almost immediately get financing and the chief executive officer to call me out (albeit not by name) on the next earnings call. In my defense, the stock is only up 257% since then.

3. This is not legal advice, and there are ways in these situations in which bondholders can screw over one another. I’m skeptical King is referring to those types of machinations, however, or that he has enough insight into the debtholder base to have a detailed plan for moving this preferred equity up the stack.

4. The answer probably is that a bankruptcy is so damaging to the customer base that a non-bankrupt Avaya indeed is worth far more. But King also is kind of assuming the argument here; the equity and credit markets are arguing quite forcefully that this business is worth nowhere near the $2.83 billion face value of its debt. If a strategic disagreed, and wanted to pay off bondholders a face, they’re not going to get a cheaper chance than to do so right now.