Research Notes: Six Months In (Part I)
A review of our work so far with updates on past ideas including APP, NGMS, FLWS and deSPACS
Thanks to everyone who provided feedback in our previous mail. Before we begin, here’s a quick summary of this week’s research notes:
Our first post was published just under six months ago, and highlighted some of the risks that have since played out in the equity market.
In that context, our 24 recommendations haven’t done as well as they could have, though their average performance is better than the overall market.
This post is the first of several over the next few weeks that will update past pieces.
Today we’ll be covering AppLovin, de-SPACs, NeoGames, online gambling stocks, 1-800-Flowers and CPaaS stocks. Let’s dig in.
Don’t forget: a spreadsheet showing the performance of our picks can be found on our home page (on the right hand side underneath Links).
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On Mar. 31, we published an essay titled “The Bubble Has Burst, But It’s Not Over Yet.” In it, we pointed to “the unbelievable amount of stupidity that has dominated this market over the past 25 months”, arguing that said stupidity raised real risks about a significant downturn in the U.S. equity market.
In the nearly six months since then, we’ve published a deep dive each weekend as well as our mid-week Research Notes. That post in March serves as a microcosm of our overall performance so far: we saw the risks coming, but could have done a better job accounting for and reacting to those risks.
Over the next few weeks in this space, we’ll update on all of our 25 deep dives so far, as well as returning to some of the more interesting themes we’ve covered in past Research Notes entries. But, first, a quick look at our performance so far.
Performance Six Months In
Our performance to this point has been solid in the context of the market, though not quite where we would like it. On average, our first 24 ideas (we’re excluding Sunday’s long call on TDCX) have declined about 3.6% — but also have outperformed the S&P 500 by about four percentage points.
The latter figure is improved, admittedly, by the fact we’ve had 7 short calls. But our average long idea has modestly topped the market, albeit with an average beta of roughly 1.5 (which in theory would suggest underperformance in a down market). Our shorts, as we shall see, have been a mixed bag.
In the context of a wild market, it could have been worse, certainly. But given that our first post was directionally correct, it should have been better.
As we’ll see over the next few weeks, there are a few ideas we simply got wrong. In our defense, there are more than a few that we still believe we got right, even if in some cases the market doesn’t yet agree.
Under no circumstances could our first idea possibly have been a long pitch for AppLovin (APP), a stock that’s since plunged 60% and hit an all-time low last week.
Until last month, the case for APP appeared to be reasonably intact. The stock sold off in April as the broad market turned, with additional pressure on online advertising businesses. But, fundamentally, AppLovin seemed to be in decent shape: the market actually reacted positively to the Q1 report in late April, and with good reason.
Full-year revenue guidance for the software platform business was reduced, but only because the company gave bonuses to publishers brought on through the acquisition of mediation platform MoPub. Those bonuses (netted against revenue) were a one-time expense, and in our opinion, a wise decision. And they weren’t a surprise: AppLovin had tipped the decision when giving original guidance after the Q4 release.
So far this year, revenue expectations from the company’s owned games portfolio have come down — but because AppLovin has focused on profit margins. In fact, consolidated Adjusted EBITDA guidance post-Q2 is higher than it was after the fourth quarter release.
And so there’s a case that APP stock was the baby being thrown out with the online advertising bathwater. Indeed, I personally averaged down on the stock at June lows.
Fundamentally, that case still exists: based on guidance, and on an enterprise basis, shares now trade at a little over 8x EBITDA, and about 7x software platform revenue (excluding the aforementioned bonuses). For what it’s worth, the average Street target still sits at $51, implying upside of over 150%.
But as we discussed during our first Ask Us Anything in August, AppLovin threw a monkey wrench into the gears when it launched an offer for Unity Software (U). On its face, the tie-up made some sense: the two businesses are pretty much perfectly complementary. Developers could build their content on the Unity platform and market it through AppLovin’s offerings.
The catch is that AppLovin’s offer seemed a rushed response to Unity’s own announced deal, to acquire AppLovin’s smaller rival IronSource (IS). Investors rightly asked (as did we) why AppLovin was making a $20 billion offer with stock that traded at less than half its IPO price. Yes, that IPO happened in the ‘hot’ market of April 2021, but even in that context the offer looked desperate, despite management’s efforts to explain the rationale on the Q2 conference call. Indeed, I personally trimmed after thinking through that problem. (Though I still retain a position; as we say, we do eat our own cooking.)
The read-through from the effort explains why APP stock has kept falling even though Unity rejected its offer. Investors believe AppLovin management sees the Unity-IronSource tie-up as a real threat — and not without reason.
It’s difficult to see when that changes — if it changes at all. Meanwhile, Unity stock has plunged as well, which seems to suggest some very real concerns about the health of the mobile gaming industry amid a return to normalcy. (Publishers Playtika (PLTK) and SciPlay (SCPL) too have sold off, albeit not quite as sharply.) AppLovin still has a real chance to create long-term value, especially off the lows, but it has a long road ahead and a lot of confidence to regain.
Fun With de-SPACS
Our first Research Notes focused on so-called ‘de-SPACs’, companies that went public by merging with special purpose acquisition companies instead of the traditional initial public offering.
At the time, 291 de-SPAC mergers had closed since the beginning of 2020 (when the trend really took off) and the present day. Then, the average de-SPAC was down almost 33%; the average return now, incredibly, is negative 58 percent1.
This can absolutely get worse, given how many ridiculous companies went public via the SPAC route. As we noted at the time, there were five different eVTOL (electric vertical take-off and landing) companies, and by my count nine lidar developers.
In our universe, three de-SPACs already are at zero, and another 18 trade below 50 cents. Rather incredibly given how much capital was raised in the SPAC boom, there are going to be a significant number of bankruptcies over the next few years.
But there may be some value to be found in the group. Somewhat ironically, we’ve since made deep-dive long cases for a pair of de-SPACs (though admittedly neither has worked so far), and we floated a few long ideas at the time which in context haven’t performed badly. (Convenience store operator ARKO (ARKO) and self-storage supplier Janus International (JBI) both are +3%. Open Lending (LPRO) has plunged amid recession/interest rate problems; PLAYSTUDIOS (MYPS) has been hit by weakness in mobile gaming. We’ll get to the fifth momentarily.)
Still, the idea that de-SPACs on the whole are getting “too cheap” doesn’t seem to play out. In so many cases, these simply weren’t businesses that should have been on the public markets to begin with.
In April, we argued that iLottery provider NeoGames (NGMS) was a buy at $13 after an unjustified sell-off. In late September, NGMS still looks like a buy at $13 after an unjustified sell-off.
There is one big concern: Europe. NeoGames has several contracts on the Continent, and in June it closed the acquisition of its former parent, iGaming supplier Aspire Global. In 2021, Aspire generated 84% of its revenue in Europe — including more than one-third from the U.K. and Ireland.
Currency alone provides a sharp headwind; macroeconomic weakness another. That said, gaming revenue has historically held up better than might be expected. NeoGames did at least get a good deal on Aspire: the 50% of consideration paid in stock valued NGMS at $38. And this remains a long-term play, particularly on iLottery growth in North America. Indeed, in a recession stateside, budget-strapped states may look to iLottery as a new source of revenue. That aside, lottery demand has been notoriously “recession-proof”.
The exposure to Europe, and a messy fundamental story post-merger, could lead to additional short-term weakness. In that context, I’m happy sticking with the current position rather than seeing the round-trip as a renewed opportunity.
Still, at least for now this is a name I would average down on should the stock take another leg down. The long-term story looks intact, even if the mid-term environment no doubt will provide some volatility.
Online Gambling Stocks
In our second Research Notes, we asked whether online gambling stocks had become too cheap. As it turned out, no, they had not:
The group is down on average 26% since that article was published; the S&P 500 is down a little over 15%.
The underperformance is not terribly surprising given that a) valuations at the time weren’t that cheap and b) the core problem still holds: online sports betting really is not that great of a business. Hold seems to be running around 7% the wager bet; unlike physical casinos (or iGaming), markets don’t run 24/7 or anywhere close; and taxes and competition keep a lid on profitability.
And yet, once again, the group does look at least a little bit tempting. DraftKings (DKNG) was the fifth de-SPAC we floated the week before, in part because we argued the company might post at least one upside earnings surprise amid an industry-wide pullback in promotional spending.
The Q2 report seems to have qualified, and DKNG got to $20 in mid-August before pulling back. But even at $16, the stock remains intriguing but not compelling. Management seems a real risk, and the fact that the company has been so spectacularly outperformed by Flutter Entertainment (PDYPY) unit FanDuel remains a concern (and, as a consumer, honestly a bit of a mystery).
The integrated players, Penn National (PENN) and Caesars Entertainment (CZR), both are high-risk, high-reward plays. There’s certainly a sense that the industry is going to get crushed by inflation and recession, but regional casinos in particular didn’t do that badly even in 2008-09. Both companies have disappointed in their online efforts, but both at least are cutting losses in those segments.
I’ve personally liked PENN for quite a while (though I’ve fortunately lost nothing but face), and it’s not hard to wonder if CZR, down more than 40% since the start of 2020, is a buy, even with its exposure to Las Vegas. Both stocks require significant work (that admittedly we haven’t yet done), but both at least suggest there’s value in doing that work (which we plan to do).
As we wrote in April, Rush Street Interactive (RSI) is the most likely acquisition target in the space, and has performed pretty well considering its independent status. Of course, no one is making an offer here in 2022, and many RSI shareholders likely wouldn’t entertain such a deal anyhow.
But Rush Street’s balance sheet is in good shape, and the company has carved out decent enough market share that it could be of interest to an acquirer down the line. Both Penn and Caesars probably need to do something, given they’re fighting for a distant fourth behind FanDuel, BetMGM (a JV between MGM Resorts International (MGM) and Entain (GMVHY)), and DraftKings. Rush Street is probably the most logical something out there.
In this market environment, it’s difficult to try and catch these falling knives. And in this economic environment, there is the risk of sharply lower earnings (particularly for the brick-and-mortars, who have probably maxed out profit margins at this point). Still taking the long view, a few stocks in the sector are getting into range.
As we admitted at the end of the second quarter, we simply got FLWS wrong. We argued the stock was an unjustified sell-off following a bad quarter in a nervous market, but the market was correct. Earnings have continued to disappoint, as 1-800-Flowers.com has dealt with lower revenue and, unsurprisingly, sharply higher costs.
FLWS in fact hit a seven-year low this month — and at the risk of getting it wrong again, it doesn’t look all that attractive. EV/EBITDA based on FY22 (ending June) performance is in the high 5x range, but even that figure includes at least a couple of quarters with a strong macro environment and without significant inflationary effects.
Notably, pre-pandemic M&A shifted the business toward gifts and away from flowers; that shift now looks questionable given pressure on spending from both consumers and corporate (the latter a potentially key problem for fruit seller Harry & David).
If FLWS can stabilize its business, there’s probably some value to be created. Forced to choose, we’d bet the stock is higher five years from now. But even after an 83% decline from last year’s highs, it’s difficult to make a compelling case for FLWS right now.
Our coverage of CPaaS (communications-platform-as-a-service) stocks in mid-April hit at a point we’ve come to a few times: despite a big sell-off in tech, valuations simply have not been that attractive from a purely fundamental perspective.
As it turns out, the CPaaS group made the point almost perfectly. We highlighted four names in that piece, with their decline at the time from the 52-week high and their performances since:
Twilio (TWLO) -72% / -40%
Bandwidth (BAND): -87% / -51%
Kaleyra (KLR): -71% / -78%
Zenvia (ZENV): -63% / -78%
To be sure, we absolutely did not expect the group to fall another two-thirds from that point. But some kind of sell-off was not a surprise. As we wrote at the time, the market still seemed to be applying EV/revenue multiples that looked “cheap”, yet ignored the fact that gross margins in the industry were in the 50s, not the 80s as with many SaaS (software-as-a-service) plays.
So, what now? The fundamentals certainly look very different. TWLO is at ~2.4x this year’s revenue, ~5x gross profit — and growing ~30% organic. The smaller plays really look tempting.
BAND trades at 13x 2021 EPS (non-GAAP, but still) and 1.5x this year’s revenue. Though the company is dealing with the after-effects of a hacker’s attack late last year, revenue is still growing. KLR is at ~2.5x 2022 gross profit while growing revenue 30%; leverage there is dangerous, but its 2026 convertible bonds only yield a little over 12%. ZENV is building out an SaaS business and trades at less than 0.5x revenue and 1.5x gross profit. That stock is down 88% from its IPO price last year; modest net leverage is a factor, but as with KLR that leverage is a springboard if market sentiment improves.
In this market, it’s hard to take the long view. Concerns about revenue growth in 2023 and beyond help explain the more recent sell-off. Still, the group does show that there’s been a pretty big fundamental shift over the past few months. In April, down big, these stocks still looked relatively unattractive. Five months later, that’s no longer the case.
As of this writing, Vince Martin is long shares of APP and NGMS.
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This includes acquisitions and, tragically or comically depending on your perspective, several bankruptcies.