📍 TLDR

We revisit our famed proprietary index, the Sh—co Rule of 100.
The quickly fading case for a long trade in COIN.
HIMS surprises both in Q3 and its fundamentals.
TLS is an avoid after a two-thirds plunge.
Staying the course with a short of COOK.

Back in August, we updated our proprietary Shitco Rule of 100 list. The Rule of 100 is a play on the SaaS “Rule of 40”. The Rule of 40 is a rule of thumb which posits that the sum of a company’s revenue growth plus EBITDA margin should be 40 or greater.1 A company hitting that target in theory offers a long-term investment opportunity.

The Rule of 100 uses similarly simple math. It’s the inverse of 1-year share performance plus short interest (as a percentage of the float). The idea is to find the market’s worst companies. After all, a company down 80% that still sees short interest at 30%-plus is truly a business in trouble.

On August 18, we noted that the top eight stocks from our initial list (posted on Twitter in early June) had on average gained 73% in a month. That kind of performance seemed unsustainable, to put it mildly. Indeed, broad market indices would reverse the very next day.

It seems wise to both revisit our index and to check in on news from a couple of the market’s, shall we say, more questionable companies.

The good news is that the soft end of the market doesn’t look nearly as dangerous as it did three months ago. The bad news after Wednesday’s sell-off is that there’s still plenty of room for caution for the market as a whole.

The Sh—co Rule of 100

Score equals current short interest as % of float plus inverse of 1-year performance. Minimum market cap $2 billion; minimum short interest 15%. Score as of the close on Tuesday 11/8:

MicroStrategy 119
Wayfair 116
Asana 116
Affirm 109
GoodRx Holdings 103
Teladoc Health 102
Coinbase 102
AMC Entertainment 100
QuantumScape 99
Gingko Bioworks 95

The current list doesn’t tell us all that much. Unlike our leaders in August, the group is actually down 6.7% on average over the past month.

The leaders in our August update, however, do highlight an interesting trend. Over the past three months, the top 102 names in our index are down on average by more than one-third. Exclude Cassava Sciences , which claimed strong study results, and the mean decline is 46%.

This index is mostly tongue-in-cheek, but combined with an anecdotal look around the market it does seem to show that the junkiest companies aren’t seeing the rallies they did this summer, let alone in 2020-2021. “Press to zero” shorts are working again; there's not a crazy Reddit-driven squeeze in sight. AMC Entertainment (surprisingly the first meme stock to make a Rule of 100 list) is back where it was before its insane rally in May-June of last year. Bed Bath & Beyond rightly looks on its way out. (GameStop admittedly is still holding up.)

At the least, this bounce is notably different from the one in July and August, when the weakest stocks significantly outperformed. (Again, eight heavily-shorted and badly underperforming stocks on average rose 73% in a month.)

Last month, we concluded our six-month review by cautiously arguing that the equity market was getting healthier. There’s still room for another leg down, certainly, but the performance of this end of the market provides further evidence for that argument. Investors owning junky stocks need to have a pretty good reason.

Coinbase

Are there pretty good reasons to put on a COIN trade?

I admit it: I went long a small amount of Coinbase on Tuesday afternoon. I also admit that down ~9% I'm regretting the trade.

To be clear, it was a trade. I’m on record as being a mid- to long-term skeptic toward Coinbase. An ~$8 billion enterprise value (still!) on a negative $500 million Adjusted EBITDA base alone shows the potential fundamental downside here.

The thesis was, essentially, that COIN had fallen too far. Shares fell after Q3 earnings last week, despite the fact that the report to my eye changed absolutely nothing about the long-term story. (In fact, it didn’t look all that different from the Robinhood Q3, which was met with a much more favorable response.) The stock was at support levels that held repeatedly this spring. (That support may have finally given way on Wednesday.)

More importantly, the news that crypto exchange FTX probably being liquidated has sent COIN down 19% in two sessions. There seems to be a contrarian case that COIN should be up on the news.

From the simplest possible perspective, Coinbase just watched a pretty significant competitor take a huge hit. It’s true that FTX’s U.S. operations are separate from those facing the liquidity problems, but it’s also impossible to believe that FTX’s American business will emerge unscathed from a reputational standpoint.

The event — the latest in a long line of crypto scams and blowups this year — would seem to further dent the credibility of non-US industry participants. It’s not hard to imagine at least a few account holders at the American operations of FTX and Binance moving to Coinbase, which for its flaws at least seems to have behaved mostly ethically toward its depositors. Indeed, Coinbase CEO Brian Armstrong said Tuesday his platform was “seeing increased activity.”

This would seem to have the potential to soothe a pair of sore spots for Coinbase. In its Q3 shareholder letter, Coinbase pointed out that “crypto trading activity has been increasingly moving away from US-enabled exchanges.” In September, global volume fell 18%; US-enabled volume declined by more than half. Coinbase brought up those factors to argue for more coherent regulation in its home market, but FTX and Binance seem to be making their own argument for regulation3.

Meanwhile, Coinbase may see a particular tailwind overseas, where its performance has been the weakest. In Q3, international revenue declined 71% year-over-year.

From that perspective, this seems like a potentially beneficial event for Coinbase. Clearly, the market has not reacted as such.

The case for that reaction being logical would be this: even if Coinbase is looking at higher share, it’s higher share of a potentially much smaller market. No doubt, the blowup of FTX increases the biggest risk to the crypto ecosystem: that, eventually, individual and institutional investors decide the industry as a whole isn’t trustworthy, and global market cap goes from a pre-FTX ~$1 trillion (it was nearly $3 trillion a year ago) to something like $50 billion or worse. In that event, Coinbase almost literally doesn’t have a business model.

Given the coverage of and reaction to the FTX drama, that thesis admittedly looks stronger than my initial case. The industry is at a more perilous point than I initially realized. And with the accelerating sell-off in equities across Wednesday’s session, one wonders if the correct trade is not betting on an individual participant to benefit within the crypto market, but on contagion spreading out from it.

After all, per CoinMarketCap, over $200 billion in cryptocurrency value has been destroyed in just two days — more than 20% of the total value on Monday. In that context, perhaps the sell-off in COIN hasn’t yet been enough.

Hims & Hers Health

After rallying 20% on Tuesday following third quarter earnings, Hims & Hers Health has a fully-diluted enterprise value right at $1 billion. On its face, that figure alone seems to support the argument that there are still plenty of short candidates out there. After all, generic boner pills and baldness cures do not a billion-dollar company make.

Or do they? From a quantitative perspective, Hims & Hers looks like a pretty decent business:

source: HIMS Q3 presentation

Gross margins are nearing 80% on a GAAP basis. Retention is solid. Subscriptions are growing. HIMS is guiding for Adjusted EBITDA profitability in Q4.

Yes, EBITDA is “bullsh— earnings”, as Charlie Munger famously put it. But HIMS has no debt (so no ‘I’) and minimal capex (sub-$2 million run rate year-to-date). As with pretty much every other company these days, Hims excludes share-based comp from its Adjusted EBITDA figure. But at 7-8% of revenue dilution it isn’t nearly as extreme as it is elsewhere. With EBITDA margins up ~900 bps y/y in Q3, HIMS should be generating real cash flow beyond dilution by 2024.

There’s one more reason for potential optimism. In Q3, marketing spend on a GAAP basis was 54% of revenue. The plunge in online ad prices that is impacting everyone in that space should provide a tailwind for Hims. (Telehealth play Teladoc Health has been talking up elevated keyword costs and lower yields all year.)

Admittedly, it’s difficult to get over the hump to actually owning this company at a ~$1 billion enterprise value. But there does appear to be a real business here, and that might be a business worth owning if the recent rally reverses and HIMS gives back these post-earnings gains.

Telos

Oof:

source: finviz.com

We’ve seen some pretty sharp “dead cat bounces” on these sell-offs of late. Funko dropped 59% after earnings and gained 28% the next day. Cardlytics, which we covered last week, went -53% and +25% before losing another 35%. Varonis Systems has caught a bounce.

It’s a bit tempting to consider Telos here. The company ended Q3 with $125M in cash, a little over half its post-plunge market cap. A contract to be a PreCheck operator for the U.S. Transportation Security Administration should start generating revenue in Q4. Full-year Adjusted EBITDA should still be positive. Even for Q4, the loss is expected to be quite narrow (breakeven to negative $2 million).

But looking closer, this story simply may not work at any valuation above cash on hand (a bit shy of $2 per share). In fact, it’s surprising that more short sellers didn’t see huge profits this week. (About 4% of the float is sold short.)

For one, this doesn’t appear to be the business investors thought they were buying at the 2020 IPO. Telos pitches itself as a cybersecurity company, but it looks more like a cyclical government contractor. The federal government drove 96% of revenue last year, with the U.S. Department of Defense more than three-quarters of that total. Meanwhile, the ugly guidance for Q4, and a suggestion on the Q3 conference call that revenue might fall in 2023 stems from Telos’s inability to replace expiring contracts.

Second, EBITDA here is significantly inflated. Telos excludes stock-based comp, of course, but that figure totaled more than one-fourth of revenue through the first nine months. That reliance is a problem fundamentally; it’s a problem in terms of employee retention as well after a 68% plunge. The company also capitalizes software development costs (~5% of YTD revenue), but the amortization of those costs is then excluded from Adjusted EBITDA.

These issues were not exactly hidden before the Q3 release. They’re definitely out in the open now. To top it off, there are serious questions about capital allocation. Telos spent $1 million buying back stock above $9 after the quarter ended.

Traeger

On Sunday morning, we recommended a short of grill manufacturer Traeger into earnings. For about ten minutes on Wednesday, that trade played out as well as could possibly be hoped:

source: Google Finance

To be honest, I missed the steepest part of the decline, or I probably would have covered under $3 after shorting just above $4. As for the quick recovery, it does seem to mostly match the conference call — and, to be honest, that does make some sense.

Management was relatively insistent on the Q3 call that sell-through was in line with expectations. The problem was that retail customers are destocking more aggressively than planned. In that context, Q3 doesn’t really change the mid-term thesis.

The modestly lowered EBITDA guidance that led to the initial after-hours plunge doesn’t change much, either. From a multi-quarter, let alone a multi-year perspective, the level of softness in Q4 is largely immaterial. The key question is when and to what extent the company returns to consistent profitability.

All that said, a closer look (and listen) only confirms our initial thesis. Sell-through was good — but because Traeger ramped promotions in the quarter. As we noted, that strategy is in direct contrast to prior statements from management about the lack of “obsolete” inventory, and likely driven by a significantly stretched balance sheet.

Consumable sales, meanwhile, declined 10% year-over-year, a key data point for usage. Cost of grilling with a Traeger is significantly more expensive, a potential headwind to consumable and grill sales in 2023 and beyond.

We wrote on Sunday that the buyout offer at rival Weber (WEBR) led to an unsustainable rally in COOK that was likely to reverse. The stock is now down almost 10% from Monday’s open. We’ll see how the market reacts in the regular session. A modest relief rally wouldn’t be stunning — but the path remains for COOK to dip back to its lows under $3.

As of this writing, Vince Martin is long COIN and short COOK.

Stocks 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.

1

Bear in mind that in this rough model EBITDA margins can be negative; the company simply must grow revenue 40%-plus.

2

ASTR, CVNA, CZOO, FUBO, MSPR, PRCH, NVAX, NVTA, SAVA, UPST

3

Admittedly, one contrary point here would be that even after Luna, Celsius, Axie Infinity, bridge hacks, etc., volume still was/is moving away from US-enabled exchanges. It does seem like exchanges getting in on the act might change sentiment, however.

Overlooked Alpha

Research Notes: Junky Earnings