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This is Part II recapping our coverage over the last six months. Click here for Part I.

📍 Don’t forget: You can view the performance of all our picks via the ‘Performance’ spreadsheet linked on our homepage.

TLDR:

• A rally this week has moved our average return into the black, while both long and short ideas have outperformed the index.

• Our best call, a short of CVNA, looks intact fundamentally — but dangerous in this market, as evidenced by the last three sessions.

• NATH and NX both appear to have further upside from here.

• FTCH and HNST are intriguing stories in very different ways.

Performance Update

After another wild week in the market, our average return has moved positive, if marginally so (0.28%). Our average alpha is about three points against the S&P 500, including 3 points on long ideas, 14 points on short ideas, and 6 points on short ideas against the decline in the index.

In this volatile market, overall performance will change again. But as we wrote last week, we’re generally satisfied with the results to this point, while also believing we can and will do better.

Carvana

Our best call was a short of Carvana in late April. The performance benefited from timing, as the growth sell-off accelerated into May. That said, a core part of our thesis was avoiding anchoring bias, and thus seeing fundamental downside in the stock.

Over the next six weeks, the stock fell 70%. It’s down another 19% since, as CVNA continues to provide new versions of the old joke. (How does a stock fall 90%? It drops 80% and then gets halved).

We did recommend a cover early, with the stock around $40. And for similar reasons it’s difficult to argue too forcefully for a short here. From a fundamental perspective, the short thesis still holds. CVNA still has an enterprise value over $10 billion. CarMax, whose stock hit a 29-month low after posting disappointing results last week, is at about $13 billion1.

Given those comparisons, a long position in CVNA still requires a belief that the company is going to be the largest used auto dealer in the country at some point in the future. That’s a tough belief to have given recent results in an environment that doesn’t have a flush consumer or low interest rates. The comparison of the two companies in terms of valuation, current performance, and management was a key part of our short thesis in April.

Meanwhile, Carvana still isn’t close to profitable, even with a boost to near-term profits thanks to how the company accounts for its securitized loans. Those profits presumably recede in a tougher environment. And it bears repeating: the company still has a valuation in the range of $10 billion.

The problem with shorting here, however, is the risk of the trade moving in the wrong direction in a hurry. Support generally has held for CVNA around $20. In June, the stock bounced quickly to $30. Starting July 14, shares rose 170% in less than five weeks, including an unusual 40% post-earnings bounce.

Given still-heavy short interest, some traders clearly are willing to take on the risk with a “short to zero” thesis. (Some of that short interest presumably is driven by hedging long positions in Carvana debt.) But there’s timing risk to a short here, as shown this week: on Monday and Tuesday, CVNA rose 12% before retreating 7% on Wednesday. It does seem like there are easier shorts out there, even in a bear market.

Mega-Caps In April

On Apr. 27, we looked at some mega-cap names, including Alphabet after the company’s first quarter earnings report. The stock has declined another 11% since then. What’s interesting is that the debate now is not terribly different than it was then.

Yes, GOOG is cheap. Trailing twelve-month operating income for Google Services (search, YouTube, Android, etc.) is about $96 billion. After-tax (2021 effective rate of 16%), that’s $80 billion or so. Enterprise value is in the range of $1.3 trillion — so we’re down to about 16x-17x earnings for Services, plus “everything else” for free.

In April, bulls were making the same argument, with Services valued more at 19-20x earnings. But then and now, both sides have concerns.

Google ad prices benefited enormously from the post-pandemic environment. A macro recession plus an ‘ad recession’ suggest earnings may come down; indeed, Services operating income rose just 2% year-over-year in Q2.

As for the rest of the business, the point made in April still holds: how much is the rest of the business worth? What’s the valuation on $23 billion in TTM Google Cloud revenue, when the business remains unprofitable? What are the Other Bets businesses like Waymo and Verily worth? In the context of a $1.3 trillion market cap, they’re material. But even now, the valuation assigned to Alphabet as a whole doesn’t necessarily look bad.

The same sense holds for the other stocks discussed in that piece: Procter & Gamble, Coca-Cola, and Apple. All three names to that point had held up, as is often the case with these sell-offs: these defensive plays are usually the last to go. All three since have declined, with AAPL down 7%, KO 14%, and PG (which we floated a short of via call spreads) 19%.

Yet none of the names look hugely attractive here. Apple’s resilience is surprising given reports of a canceled production increase, and the macro risk to the upgrade cycle. That risk appears supported by the fact that App Store revenue stalled out in September, yet the stock still trades at 22x this year’s earnings even excluding net cash.

Indeed, I’ve heard from some smart investors, online and off, who have argued for shorting AAPL. There’s a pretty reasonable argument to make: a combination of an unexpected decline in the Services segment plus the early/mid-2010s argument that smartphones would eventually become commoditized.

PG and KO both face headwinds from the strong dollar. Currency was a huge problem for P&G even with the dollar at a lower level in the mid-2010s; Coca-Cola projects a nine-point headwind to this year’s earnings per share growth due to FX. Neither of those stocks looks cheap, either, and the “bond substitute/dividend” argument has faded with 2-year Treasuries above 4%.

In late April, the valuations for the four stocks suggested some caution. In early October, they’re an indicator that U.S. stocks are cheaper, but not yet truly cheap.

Nathan’s Famous

Our best long idea so far, NATH (including dividends) has returned 39% since our recommendation in early May, while the S&P 500 has dropped 8%.

We’re not ready to let go just yet. The core pillars of the May bull case still seem solidly intact. Valuation is reasonable: on a trailing twelve-month basis, NATH trades at ~15x free cash flow and ~10x EV/EBITDA.

In November, Nathan’s 6.625% bonds are redeemable at par; in May, that fact seemed to augur the potential for interest savings, but with the bonds now yielding 7.9% Nathan may instead choose to add a few more years of share buybacks. Given the company’s long history of strong capital allocation — since 2007, the company has retired more than half of its float, even though its 2015 recapitalization was clumsily executed — that flexibility is a plus.

Most importantly, results so far continue to hold up, despite fears that the licensing business, the core profit driver, would prove to be a pandemic winner. Adjusted EBITDA (which excludes very modest stock-based comp and a non-cash loss on debt extinguishment) increased 14% in FY22 (ending March), 10% in Q4, and 9% in the first quarter. License royalties rose 6% in Q1, and the Branded Product Program (which sells to foodservice operators) saw volume increase 29% amid a return to normalcy.

The risks that presumably sent NATH to a five-year low (excluding a brief 2020 dip) in May still exist. Inflation may pressure licensing volumes; indeed, volume declined 8% year-over-year in Q1. But Nathan’s Famous gets its royalties on total revenue: a 15% increase in selling price helped lead segment results higher.

NATH is a stock that makes big moves for reasons that aren’t completely clear, so we’ll be watching the position closely. But, fundamentally, $65 still seems like an attractive price, even if it’s not quite the opportunity presented at $47.

Quanex Building Products

NX stock essentially has round-tripped since our recommendation. The opportunity looks potentially more attractive here.

Notably, the stock is only 3% more expensive — but there’s a case that the upside should have been greater. After the fiscal Q2 report in June, the manufacturer of window components raised full-year guidance.

Strong free cash flow over the past two quarters also has brought net debt down to just $5.5 million from $46 million after Q1. The company has even bought back almost 1% of shares outstanding. As a result, EV/EBITDA has compressed to just 4.4x — likely the lowest such multiple applied to this version of the business, save for pandemic-driven lows.

That cheaper valuation might be justified by a more negative outlook for the housing market. But the iShares Home Construction ETF (ITB) is down only about 8% since then; housing market worries didn’t suddenly arise during the last five months.

Indeed, we argued in that piece that, as far as housing suppliers went, the market might have been mistaking weakness in housing prices for weakness in housing demand. Both the U.S. and the U.K. — the key international market — are facing long-term housing shortages.

The strong dollar is a concern — 27% of FY21 revenue came from overseas, a proportion that seems roughly the same through the first three quarters of FY22 — and obviously so is the cycle. But using the average of FY16 to FY19 performance, NX trades at less than 7x EBITDA and ~13x normalized free cash flow. And this does seem to be a better business, with market share gains, improved efficiency, and even signs of life in the long-struggling cabinet segment.

It’s always risky to own a cyclical at a tail end of the cycle just because it’s “cheap”, but even with that in mind NX again looks like a long-term buy.

Farfetch

FTCH stock trades two pennies lower than it did ahead of our cautious recommendation of the stock on May 15. But it’s been an eventful five months.

Both earnings reports have been well-received by the market. FTCH gained 27% after the Q1 report in late May, despite missing estimates. A much stronger Q2 print (at least relative to expectations) drove a 26% rally. FTCH got another 21% bounce after agreeing to buy 47.5% of rival Yoox Net-A-Porter from Richemont in August.

Unsurprisingly for a luxury e-commerce play in this market, there have been big sell-offs as well. FTCH has dropped more than 10% seven times, with an equal number of single-day declines between 8% and 10%.

Still, overall, the flattish trading does seem moderately bullish. This is precisely the kind of name — a pandemic winner (to some extent) still a good deal away from ‘true’ profitability — that’s been crushed in this market. To be sure, FTCH was already down big when we pitched it (it traded below $9 against a 2018 IPO price of $20 and a first-day close of $28), but many similar stocks extended their losses over the past four months.

And, at the very least, the May pitch still holds up here in October. The complex YNAP deal2 makes some sense to give Farfetch scale and better control of the multi-brand market. In Richemont, Farfetch also snags a whale for its Farfetch Platform Services fulfillment offering.

Getting a platform business “cheap” is a risk, and Richemont clearly was desperate to get YNAP off its P&L. Of course, that’s not a bad thing: negotiating with a desperate counterparty can result in a good deal.

Meanwhile, the deal has some internal hedging to it. If YNAP struggles, the price comes down thanks to the “payment waterwall”. If Farfetch struggles, the price too comes down (since the consideration is coming solely in the form of stock). The worst-case scenario from an acquisition value perspective appears to be Farfetch stock gaining despite the YNAP stake not working out; for this kind of name in this kind of market, that’s quite a positive worst-case scenario.

All that movement aside, however, the bull/bear argument here remains relatively simple. If Farfetch can become a legitimate, material, and profitable part of the luxury ecosystem, FTCH stock has solid upside from here. 2022 guidance for overall GMV (gross merchandise value) growth in the high-single-digits suggests otherwise, but in the context of a difficult comparison (GMV nearly doubled between 2019 and 2021) that guidance implies the long-term trend is reasonably intact.

A 19% rally in this week’s three trading sessions does take away some of the potential upside, and suggests that there’s no need to rush in just yet. But, as was the case in May, there remains a reasonable path toward a multi-year double as long as Farfetch — and now YNAP — continue to execute.

The Honest Company

We took a quick look at HNST in mid-May, arguing that the company needed to take a buyout. To some extent, the market may well agree: HNST since then has gained about 2% against a 5% decline for the Russell 3000.

The point made at the time was that a) HNST, given a high price point coming into 2022, was “poorly positioned for stagflation” and b) the company still has some insider ownership, with celebrity founder Jessica Alba owning 6.5% of the company, a stake worth ~$22 million at Wednesday’s close.

That take seems supported by the second quarter report in mid-August. Honest kept full-year revenue guidance intact, which actually might be a modest disappointment considering the company raised prices in June (for the second time this year). Full-year gross margins now are guided to just 30-32%, because of input cost pressures but also because of the company’s third-party manufacturing model. Adjusted EBITDA guidance was lowered to a loss of $10 to $20 million; add back stock-based comp and EBITDA margins this year almost certainly are worse than -10%.

It’s difficult to see this company succeeding in a difficult economic environment. But that would not be nearly as big of a problem if Honest were owned by a scaled CPG (consumer packaged goods) player. Unilever or Procter & Gamble could bring manufacturing in-house, which would increase gross margins at least 1500 bps. (P&G’s consolidated gross margin in FY22 was 47%, and Honest would be one of the higher-priced products in its portfolio.). Honest’s SG&A was 24% of sales in the first half; that could get slashed.

It’s pretty simple to model an accretive acquisition at a, say, $500 million valuation. Move EBITDA margins from -12% to +15% (15 points from gross margin expansion, 12 points from halving SG&A) on $320 million in revenue and you get $48 million in EBITDA; 10x-plus EBITDA gets to our $500 million figure. Even with the need for some capex to build out manufacturing capacity, those numbers probably work out for a larger player (who also has the ability to expand distribution, improve shelf space, etc.)

Honest has an enterprise value of $255 million. Either Unilever or P&G would have to at least think about paying $6 per share (a 67% premium to the current price). And given its 2022 outlook, Honest has to start thinking about taking that kind of deal, as do a number of the other young consumer brands we covered in a pair of articles in June.

We’re seeing a clear shift away from the “growth at any cost” mentality to a focus on profitability. The problem is that some of the companies that went public in the old environment can’t easily flip the switch to desired profitability in the new environment.

The management teams that figure that out quickly might be able to salvage some value for shareholders. The ones that don’t are going to be the next Groupon, Blue Apron, or GoPro, watching valuation erode while promising that this turnaround plan or this new CEO will be the ones that finally work. Investors that can distinguish between the two should be able to profit — by going long or by going short.

Tickers mentioned: AAPL 0.00 , $CFRUY , CVNA 0.00 , FTCH 0.00 , GOOG 0.00 , GOOGL 0.00 , HNST 0.00 , ITB 0.00 , KMX 0.00 , KO 0.00 , NATH 0.00 , NX 0.00 , PG 0.00 , UL 0.00

As of this writing, Vince Martin is long NATH and NX. He has no positions in any other 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.