Research Notes: Bottom Fishing

Why mucking in the swamp seems unlikely to pay off

📍 TLDR

• In this market, big declines have been warranted. In many cases, business models simply don’t work in a normalized environment. Others don’t work in any environment.

• That makes bottom-fishing difficult but we look at a few ideas here.

• The market’s negative reaction to the Muddy Waters report on DLocal seems on point.

• LYLT still seems intriguing after tripling; the path to upside in OPEN is closed; growth investors can maybe look at SE; PLBY has a management problem.

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One argument that the equity market is headed for another leg down is that, essentially, the sell-off is only half-finished. The 16% sell-off in the S&P 500, and the 29% plunge in the NASDAQ 100 (both relative to 52-week and all-time highs) have come from much-needed multiple compression. That still leaves the problem of the earnings to which those multiples are being applied.

After all, there’s a strong case that U.S. corporations overearned during the last 2 to 25 years (depending on one’s perspective). Combine multiple compression plus lower earnings plus higher leverage and there’s a recipe for equity values to fall much further than simply 15-30%.

Admittedly, we’re not completely convinced by that argument. If we were, we wouldn’t still be posting long ideas. My own portfolio wouldn’t be (modestly) net long. But we do give it some credence.

As a result, when we’ve recommended buying risk we’ve done so thoughtfully but aggressively. We’ve also looked for defensive and/or countercyclical long ideas. But the gloomy long-term scenario we highlighted back in June remains on the table.

It bears repeating: we’re not betting on the most bearish outcome(s) arriving. But this sell-off is different from, say, 2011 or 2018. This broad market decline is not being driven solely by spooked investors, or Federal Reserve rate hikes. Nor is this just a correction in terms of multiples and valuations. There is, at least looking at the past couple of decades, an unprecedented amount of uncertainty and (probably) an unprecedented amount of risk.

That makes it somewhat difficult to bottom-fish the market. For some of the most well-known, 90%-plus decliners (think Affirm, Carvana, and Upstart) the plunges seem completely warranted. After all, there’s a real question as to whether those business models even work at all in a normalized interest rate environment.

A 20-40% decline in 2011 or 2018 looked potentially attractive in a spooked market. But in 2022, declines suggest not only multiple compression and changing investor sentiment, but a significant revaluation of the earnings power of the underlying business.

And so, even with a healthy understanding of anchoring bias, this is not necessarily the market to go looking for value in wrecked stocks. Or, at the very least, it’s a market in which to do so carefully. We’re doing precisely that in this week’s Research Notes, beginning with a headline-grabbing move on Wednesday.

DLocal

I’ll be honest. I wasn’t sure Carson Block still had it in him. The head of Muddy Waters Research made his name targeting overseas frauds, but post-January 2021 the firm seemed to have morphed into an unremarkable, if solid, short-seller.

But the report on Wednesday targeting cross-border payment processor DLocal (available at the firm’s website) seems like the ‘old’ MW at work. It’s well-done, deeply-researched, and focuses on discrepancies between reports from the consolidated entity and those filed at the local subsidiary level.

The core allegation is that DLocal is inflating its take rate (the percentage of volume being turned into revenue). This isn’t necessarily surprising. The company’s reported take rate is multiple times higher than those of peers. I’d assumed that take rate would be competed away to some extent (see a good Twitter discussion here). But even with that risk I was intrigued as the stock dipped below $20 earlier this year.

The Muddy Waters report, however, strongly suggests the reported take rate is inaccurate. DLO nearly halved in trading on Wednesday after the release. It’s now down more than 80% from 2021 highs.

From here, however, the MW report blows up any real bull thesis. Even at $21, an eroding take rate was just enough reason to stay cautious. At $11, a potentially imaginary take rate is more than enough reason to stay away.

Loyalty Ventures

We talked about Loyalty Ventures back in late July in a discussion of buying risk. LYLT qualified as high-risk then, and it certainly does now.

The spin-off from Bread Financial (formerly Alliance Data Systems) operates two businesses. BrandLoyalty runs promotional campaigns for grocers, mostly in Europe. AIR MILES offers frequent flier miles through retail outlets in Canada.

Obviously, the stronger dollar has been a huge issue for the company this year. So has inflation on the Continent. BrandLoyalty actually is the bigger business, and 46% of 2021 revenue came from Europe, the Middle East and Asia. Another 41% came from Canada.

As a result, Adjusted EBITDA is guided to $110 million this year, against $166 million last year. Given a balance sheet that (based on guidance) is 5.6x net levered, LYLT has plunged 94% from its 52-week high. And that’s with the stock tripling over the past few weeks.

But we were intrigued in July, at a modestly higher price, and LYLT is still intriguing now. The downside risk is obvious: there’s a material chance of a zero here.

That said, normalized free cash flow should still be positive. After the loss of a key customer in June (Canadian grocer Sobey), remaining customers haven’t gone anywhere. On the Q3 call, the company disclosed efforts to cut costs and refocus BrandLoyalty promotions on lower-end, more affordable rewards as opposed to “aspirational luxuries”. In other words, cookware instead of luxuries.

As opposed to so many of this year’s biggest losers, this is a real, established business. Some of its relationships go back more than 30 years. And performance has never been quite this bad. Chief executive officer Charles Horn called the Q4 outlook “unwelcome and unprecedented.” (As we noted in July, the business, then still part of ADS, held up nicely during the financial crisis.)

Even with that guidance, both Q3 and Q4 suggest some level of stabilization, and management potentially getting a handle on the company’s various challenges. With the market cap at just $59 million, LYLT stock is a multi-bagger if Loyalty Ventures survives.

To be sure, it’s exceptionally difficult to take on the risk of the company not surviving (and pretty much impossible to aggressively recommend that others do so) but the range of outcomes here seem to be in the bulls’ favor. There’s a case for buying here even after the run-up, and some logic to the sharp gains over the past few weeks.

Opendoor Technologies

There appears to be three paths to value in Opendoor stock:

1. The sell-off has been steep enough that even a reasonable haircut to the value of existing inventory still leaves tangible book value at least in the range of current market capitalization.

2. The company can exit the iBuying business entirely and still have residual equity value at least in the range of current market capitalization.

3. Either the iBuying business and/or the marketplace platform create value over the long haul, despite significant near-term headwinds.

To be honest, we’re a little surprised how closed off all of these avenues appear, even with OPEN trading below $2.

At the end of Q3, book value less goodwill and intangibles was $1.38 billion. That’s about in line with the fully-diluted market cap. But cut the value of inventory by 10% and that chops $610 million off book value.

Q4 guidance is for an Adjusted EBITDA loss of $335 million-plus. That loss does includes moving houses at a loss, which perhaps offsets some of the $610 million inventory reduction (following a $573M writedown in Q3). But that still implies book value declining further in Q4, and as a result we’re looking at book value getting to half of market cap or worse in a hurry.

That inventory is held in VIEs (variable interest entities), and backed by debt that is non-recourse to Opendoor. In theory, the company could send its inventory plus $1.75 billion in restricted cash¹ to the VIE lenders. Opendoor would retain its $1.33 billion in balance sheet cash — but it also has $957 million in convertible bonds that mature in 2026. That's not getting us near the $1.3 billion market cap, and it's difficult to imagine a defanged business covering the nearly $900 million pro forma enterprise value.

So maybe iBuying works? It seems unlikely. The marketplace business? It’s only in three Texas markets. The pitch that it’s like “shopping for a home on Amazon” raises the question of why Amazon itself, or any other deep-pocketed tech or real estate giant didn’t come up with this fantastic idea.

Again, we’re surprised. We thought there might be a contrarian opinion on OPEN at least worth exploring. There doesn’t seem to be.

Sea Limited

Oof:

For a number of reasons (including one that will be apparent shortly), we’re not going to pick on the author of this quote. After all, it’s not like he was alone in seeing Sea as a “powerhouse”. This is a business that barely a year ago had a market capitalization nearing $200 billion. Of course, Amazon, Shopify, Affirm, et al. had much higher valuations then as well, making SE’s portfolio seem much more attractive.

But with the market cap at $33 billion, and enterprise value in the $30 billion range, SE does seem intriguing even after a 36% post-earnings gain on Tuesday.

The Digital Entertainment segment is headed in the wrong direction, with year-over-year Adjusted EBITDA declines increasing sequentially (-59.5% Q3 against -39.9% in Q1). But the comparison gets much easier in Q4 (adjusted profit fell in the year-prior quarter), and full-year profit should be in the $1.5 billion range. A 7x-8x multiple there gets to a $10-$12 billion valuation, accounting for a good chunk of overall EV.

E-commerce GMV (gross merchandise value) in Q3 was more than 40% that of Shopify. It grew faster even on a reported basis, and nearly twice as fast in constant currency. Give Sea’s business half the GMV multiple of Shopify and the e-commerce business is worth $8 billion.

The Digital Financial Services segment is growing at an impressive clip, with revenue up 147% year-over-year in Q3. Revenue this year is headed for $1.2 billion or so. Can we go to 5 times revenue here with Paypal and Block at 2x-plus?

If so, our model gets us to $25 billion through pretty conservative assumptions. Add net cash and fair value sits at ~$50, against Wednesday’s close of $58. There are some other services as well which might have some value, and we’d note that Digital Entertainment profits include the segment’s portion of corporate costs². With SE giving back some gains Wednesday (-5.7%), if the stock ‘fills the gap’ downward there seems to be a potential long-term opportunity here.

On the other hand…this is a business with a $30 billion valuation that is nowhere close to profitability. Adjusted EBITDA in Q3 was negative ~$550 million when adding back share-based compensation, or about 17% of revenue. Macro headwinds in southeast Asia probably aren’t going anywhere yet. If the broad market reverses, SE almost certainly does as well. A sum of the parts model seems too thin a defense against those worries.

From a longer-term perspective, we’re at least nearing a valuation where SE starts to get intriguing. $58 isn’t it. $50 probably isn’t either, given short-term worries. But there is a possibility that eventually our anonymous bull is proven not necessarily wrong, but early. In that context, might I interest you in selling June 35 puts, which return a touch over 10%?

PLBY Group

I owned PLBY last year, if briefly, taking a loss in the process. This is one of the reasons I’m not criticizing anyone (see above) for getting a stock wrong.

PLBY is down about 90% from where I bought it, though in my defense it’s also fallen more than 80% from where I sold it. One of the earlier de-SPACs, like so many of its peers PLBY has badly missed its projections. Year-to-date Adjusted EBITDA is essentially zero, against $17.8 million the year before. PLBY had targeted $40 million in EBITDA last year, en route to ~$100 million in 2025.

After the plunge, fundamentally there’s a case here. PLBY trades at a little over 1x revenue, despite the fact that a decent chunk of that revenue comes from licensing (23% of YTD sales). Those revenues are exceptionally high-margin: YTD operating income excluding an impairment is about 69% of revenue. Its enterprise value of ~$310 million is less than the $333 million PLBY paid for Australian lingerie brand Honey Birdette last year.

Qualitatively, there’s an argument as well. One of the core points PLBY made at the time the SPAC merger was announced was that the brand was stronger, notably in Asia, than American investors realize. One of the key plans going forward was to capitalize on that strength by bringing some level of merchandising in-house, which in theory would sharply increase profit dollars relative to the previous, licensing-heavy strategy. I was not alone in being intrigued on both counts: Hedgeye set an out-year market cap target of $10 billion.

The one catch (and it’s a big one) is that PLBY hasn’t really done much of anything. CEO Ben Kohn has been at the top since 2016, but management commentary still seems to be about all of the great things that are going to happen. To this point, no major steps in the strategic transformation (beyond acquisitions) have occurred. Obviously, the environment of late hasn’t helped, but there’s a sense that management is highlighting challenges as opportunities, when those challenges should have been addressed years ago.

PLBY has made acquisitions, two of which simply don’t appear to have worked. Online lingerie retailer Yandy has been crushed by iOS privacy changes. Adult chain Lovers is fading as well. The Centerfold app, supposedly an OnlyFans competitor, doesn’t seem to have hit, and its desktop website bizarrely seems to be just a copy of the app.

On paper, there’s still value here. Honey Birdette is worth something, even if not quite $333 million. Playboy went private more than a decade ago at just over $200 million; it’s difficult to believe the brand has been significantly damaged since then.

But on paper isn’t good enough. PLBY management needs to give investors a reason to own PLBY stock, and since going public they just haven’t done so. It’s probably time for new blood at the top. Without it, it’s hard to get too excited at the lows.

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As of this writing, Vince Martin has no positions in any securities mentioned.

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Stocks mentioned: AFRM 0.00%↑, AMZN 0.00%↑, CVNA 0.00%↑, DLO 0.00%↑, LYLT 0.00%↑, OPEN 0.00%↑, PLBY 0.00%↑, PYPL 0.00%↑, SHOP 0.00%↑, SQ 0.00%↑, UPST 0.00%↑

1. Per filings, essentially all of that restricted cash is in the VIEs.

2. That in turn avoids a common error with SOTP models, which too often ignore corporate costs. Peer comparisons in the other two segments in theory include some accounting for those costs, since peer price-to-revenue multiples account for those companies’ corporate expense.