Research Notes: When To Buy Risk
The biggest winners at the top are usually some of the riskiest names at the bottom. Plus four names to consider.
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As we’ve written before, the right trade at a market bottom is not to buy “quality”. It’s to buy risk. In March 2019, CNBC highlighted the best performers in the S&P 500over the decade following that index’s intraday low on March 6, 2009:
With the exception of Starbucks (SBUX) and salesforce.com (CRM), the risks to all of these names were obvious. Travel spending was going to plunge, retail was in for trouble, no one wanted growth stocks (Nvidia / Align) or ridiculous business models (Netflix — then still a heavily DVD-by-mail business).
In 2011, Business Insider called out the best 15 stocks for bottom-timers from the S&P 1500. The steepness of the early 2009 sell-off skews the results somewhat, as some of these stock prices dropped to literally pennies, but there’s a lot of junk on the list. Gulfport Energy (#4) and Stone Energy (#14) would go bankrupt later in the decade. Ruby Tuesday (#8) sold out in 2017 after years of negative returns, in a deal that focused on its real estate, not its operating business. Century Aluminum (CENX) has been dead money; so has semicap Veeco Industries (VECO).
Even in the first year off the bottom, the weakest of the S&P SPDR sector ETFs was the SPDR S&P Biotech ETF (XBI), likely the least economically-sensitive of the group. (Unsurprisingly, XBI also posted the smallest losses in the year heading into the bottom.)
To be sure, there are potential problems with buying risk. Individual portfolio considerations matter: a 52-year-old with two kids heading to college can’t ‘YOLO’ her portfolio funds into equity stubs and busted IPOs because she thinks the bottom is in.
Stock-picking matters. An investor betting on the U.S. auto industry in March 2009 could have picked Ford (F), which rallied 748% in two years off the bottom — or General Motors (GM) or Chrysler, both of which filed for bankruptcies which wiped out their shareholders. A basket and/or ETF approach mitigates this problem somewhat. But it also blunts the impact of choosing one of the biggest winners.
And, of course, timing matters. Looking at the ten-year winners, being one year early on Ulta Beauty (ULTA) cut returns to ~2,000% from over 7,000%. Gains in ABIOMED (ABMD) drop to 2,370% from 6,000%-plus. Obviously, both 11-year trades are still otherworldly, but this exercise involves nailing the absolute bottom of the worst equity market in decades and nailing the precise stocks to buy at that bottom. (And, also, not exiting with a 150% gain in order to take some risk off the proverbial table.)
Timing it Right
Pretty much any market has a 20-bagger or two out there; finding them at the right price and holding for the duration of the run is easier said than done (to put it mildly). In this context, 2008 looks like “pretty much any market”; 2009 a generational opportunity.
At the moment, it’s the timing issue that creates the biggest roadblock to buying risk right now. We’ve been firm in our belief that this market has another leg down. We don’t see the bargains out there that were literally everywhere an investor looked in March 2009. As we wrote earlier this month, even finding potential value traps is not particularly easy. Most equities are not on their face cheap relative to their earnings. In 2009, in particular, they were: the concern was not trailing valuation, but what those profits would look like in 2011 or 2014.
But it’s possible that we’re wrong, and the U.S. equity market has indeed found its footing. Even if we’re right, some big-time decliners may indeed be too cheap from a mid-term perspective; particularly with most small and mid-cap companies yet to report Q2 earnings. Some may find a short-term bounce given how low expectations truly are.
At the least, it’s worthwhile to keep an eye on where an investor should buy risk once risk becomes attractively priced. Here are a few potential ideas on that front:
Avaya Holdings (AVYA)
Common sense suggests AVYA is an obvious avoid. The communications provider already filed for bankruptcy once, back in early 2017. Even after exiting that process later the same year, Avaya still has ~$2.5 billion in net debt (post-FQ2/calendar Q1) and a business that isn’t growing (revenue for 2022 is guided below 2020 levels).
The company is talking up one of those pivots to the cloud that a) never seem to really work and b) ignore the fact that the pivot is simply shifting revenue from one offering to another, rather than driving overall growth. Net debt is ~4.2x this year’s guided Adjusted EBITDA, but that ratio is going to get worse. Guidance for operating cash flow implies ~$150M in free cash flow burn over the second half. The stronger dollar alone likely leads to a reduction in EBITDA guidance after the FQ3 release, while economic uncertainty and/or poor execution both can lead to a bigger drop.
So this is a 5x+ leveraged, ~zero-growth company in a rising-rate environment that’s already filed for bankruptcy once. It’s not a surprise that ~15% of the float is sold short: there’s an obvious “short to zero” case here (a short perhaps hedged with a long position in Avaya debt).
That said…some of the numbers here are insane. AVYA stock has declined 89% year-to-date. After FQ2, Avaya guided for adjusted EPS of $2.09-$2.25. The stock closed Tuesday at $2.07, implying a P/E below 1x. Even though that multiple is ‘fake’ to some degree (between non-GAAP adjustments and the likelihood of a post-FQ3 guidance cut), it still appears ridiculous.
As for the balance sheet, it’s obviously a concern. But Avaya raised $600 million in upsized financing just a month ago, pushing the nearest maturity out to 2027. $250 million of that financing came from exchangeable notes that Avaya, at its discretion, can repay with stock at a price of $4.30 per share. Its 2028 bonds trade at 66, seemingly implying at least some chancethat the company can salvage some equity value.
This is a name that an investor probably would feel kind of dumb to own. (It feels kind of dumb to even write about, to be honest.) These kinds of stories don’t really seem to work out all that often. It’s worth noting as well that the stock hasn’t rallied in recent weeks, when many speculative names with similarly big declines have found a bounce.
Still, AVYA is a bit tempting. Without a near-term maturity, there’s time to let volatility potentially play out in the longs’ favor. With ~15% short interest, and a P/E multiple of 1x, it wouldn’t be stunning if AVYA suddenly found a brief spike thanks to retail investor optimism. The risks here are obvious, but the potential rewards are huge.
Loyalty Holdings (LYLT)
Loyalty Holdings administers two third-party loyalty programs: the Air Miles offering in Canada, and BrandLoyalty in the Netherlands. The business was spun from what was then Alliance Data Systems (now Bread Financial Holdings (BFH)) in November. The stock rallied immediately after the spin — but since then LYLT stock has been a disaster:
What’s interesting about the decline — 94% from its highest close — is that, with one big exception, it’s been mostly death by a thousand cuts. Shares fell 11% after the Q4 release in early February and 14% after the Q1 report in late April. But that aside, until last month it had been mostly a steady drumbeat of selling between reports that did the stock in.
On June 8, Loyalty announced that Canadian grocer Sobey was exiting the program beginning in August. That news punished the stock, which was already down 75%-plus from the highs; LYLT dropped 46% and it’s been halved again since.
As with AVYA, it does seem concerning that there’s been no bounce of note during a more aggressive couple of weeks in the equity market. As with AVYA, leverage perhaps is one reason why.
Net debt as of the end of Q1 was a bit over $450 million, or ~3x trailing twelve-month Adjusted EBITDA. The company had planned for post-spin “investments”, and Q1 EBITDA dropped 36% year-over-year. Assuming the same kind of decline in Q2-Q4, and deducting Sobey (10% of EBITDA, per the company in June) the leverage ratio gets to 5x or so (and EV/EBITDA around 6x).
It’s incredibly difficult to own this ahead of an earnings report which probably is going to look pretty ugly and which almost certainly won’t have news about a replacement for Sobey. Concerns about the Canadian economy (particularly in the wake of what looks an awful lot like a housing bubble) add further pressure. But a recessionary environment is one where retailers and consumers pay more attention to value and promotions; Air Miles isn’t necessarily countercyclical, but performance in a downcycle might not be quite as bad as feared.
In 2009, in fact, Loyalty Services segment revenue declined only 5%, and Adjusted EBITDA dropped just 2%. The business had more whitespace then (the 10-K for Alliance Data cites an expanded partnership with Bank of Montreal (BMO)), to be sure, but even in that context the results held up.
This is a name that requires a lot of work to be comfortable with, certainly. But it’s a name where the work seems like it might be worth doing.
American Outdoor Brands (AOUT)
American Outdoor Brands too is a spin-off, the former accessories & outdoor products business of Smith & Wesson (SWBI) in August 2020. Like a lot of consumer-facing names, it’s become abundantly clear that AOB was a “pandemic winner”: sales in the fiscal fourth quarter (ending April) declined 29% year-over-year. Perhaps more concerningly, they were only up 6.5% over FQ4 2020, growth which seems relatively dim in the context of consumer behavior during that stretch.
The chart here certainly screams pandemic winner:
That said, there is a value case starting to build here. With net debt of about $5 million, solvency is not an issue. EV/EBITDA, based on FY22 results, is down to barely 3x. And while there’s real risk to EBITDA in FY23 — year-over-year, the figure declined by more than half in Q4 — it’s worth paying a bit closer attention to the EV half of the multiple.
AOB has an enterprise value of $112 million. In FY22, its inventories increased by more than $47 million.
Presumably, there’s going to be some discounting needed to clear that inventory. But even considering that, there’s a huge tailwind to cash flow on the way: a 50% haircut to that inventory build still cuts the EV here by about 20%.
The chart is ugly, the issue of pulled-forward demand probably has a few quarters to go, and the business has some question marks. But this is also the kind of name that gets oversold in environments like this, when investors focus on the broader theme — too much inventory, too little demand — and miss the potential details of the bull case.
If AOUT keeps heading straight south, there is a point where the valuation is incorporating all of the pain of higher inventory — and none of the benefit.
We talked a bit about Zenvia, roughly described as the Twilio (TWLO) of Latin America, in our April coverage of CPaaS (communications-platform-as-a-service) stocks. At the time, ZENV looked cheap, but as it turned out it wasn’t nearly cheap enough. Shares are down 70% since then and 90% from the 52-week high.
The problem with the CPaaS model in April was that it seemed clear that investors were only beginning to understand the problem with the way the group had been valued. CPaaS offered revenue growth, yes, but also low gross margins with the potential for further competition-driven compression. TWLO in particular, was one of the many 2021 stocks valued on a price-to-revenue basis with little or no accounting for what those multiples meant on a gross profit dollar basis.
That said, valuations are starting to get to a point where they’re at least attractive. Zenvia, pro forma for a recent acquisition that closed in May, trades at ~1x EV/revenue. Preliminary results for Q2, released ahead of Investor Day, looked strong and led to a two-day rally which has promptly reversed on Wednesday.
~1x revenue / ~3x gross profit isn’t a 2009-type valuation. But we may not get a chance at those valuations during this cycle. At the least, we are nearing the point where some real businesses in the micro and small-cap categories are being valued as if growth is going to stall out — and some of those businesses are going to surprise to the upside.
It’s still early to understand fully whether Zenvia is one of those businesses, but it’s the kind of business investors at least should have on their radar.
As of this writing, Vince Martin has no positions in any securities mentioned.
Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.
The stocks covered were in the S&P 500 on 3/6/19, not in March 2009.
One name not on the list is Dollar Thrifty, acquired by Hertz (HTZ) in 2012. It’s possible the company wasn’t in the S&P 1500 in March 2011, but Dollar Thrifty, a lower-end player in a tough and cyclical industry, certainly seemed like a junky option in 2009. DTAG stock would finish the year up more than 4,000% from its lows; Hertz paid $87.50 per share in the buyout, providing returns of over 14,000% from the March 2009 low of $0.60.
Admittedly, there’s probably reasonable recovery value here, so that price might suggest a modest chance of Avaya dodging bankruptcy between here and 2028. With a market cap of $200 million, however, the stock has a pathway to rising a few hundred percent in that scenario. A reasonable investor could model something like a 20% chance of 6x gains here, those gains requiring the company to receive something like a 7.5x EV/EBITDA multiple.