Research Notes: Six Months In (Part III)

Continuing our recap of past coverage with updates on TSLA, LINC, ARAY, ABM, CRCT, TXRH and boating stocks.

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

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

TLDR:

• We think it’s important to give you regular updates on our picks and explain our thought process over time.

• At Wednesday’s close, our average idea is down modestly (0.3%), though both long and short ideas have beaten the market.

• In this post, we provide more updates on our ideas and we officially close our long pick in Cricut.

Performance Update

At Wednesday’s close, our average return has dipped to a loss of 0.32%. However, our average alpha against the S&P 500 is about ten percentage points. The average long idea has outperformed by six points; the average short idea by 22 points, and by five points even against the inverse of the index’s performance.

As we’ve written before, we take some pride in the performance, even if we’re not completely satisfied with the overall results (or, to be honest, a few specific ideas). Of course, very few investors have escaped the 2022 market unscathed.

Short Boating Stocks

Our short call on boating stocks exemplifies one of the larger errors we’ve made to this point. We generally had the broad market direction pegged well, but we badly misread the June bounce (which in retrospect looks like a clear bear market rally).

But even in that context, the performance of the sector seems a bit surprising. Since our call, the S&P 500 is down 8.3%. Our basket of six boating stocks¹ is down, on average, about 11%, with three of the names actually beating the index:

source: YCharts

The relative strength in Brunswick BC 0.00%↑ makes some sense. Owing to its parts and accessories businesses and a lower-priced portfolio, we argued BC had the weakest short case in the group (though, for similar reasons, we believed it also had the lowest upside risk).

But for the rest of the group, had we known the S&P would drop 8%-plus (though admittedly the Russell 2000 is down just 5%), we’d have bet on significantly greater downside. Only MarineMax HZO 0.00%↑ has tanked to the extent we’d have expected given sharply higher interest rates (a big problem for an industry where purchases are largely financed) and a much weaker macroeconomic outlook.

As a result, the thesis here still seems to hold, particularly for dealer OneWater Marine ONEW 0.00%↑ (which I’m personally still short). Our thesis was not just that macro factors might pressure the space, but that a massive pull-forward in demand in 2020 and 2021 would have years of lingering effects. After all, that’s precisely what happened in 2005-2007 even without the impact of a worldwide pandemic.

There is one interesting catch, however. We argued at the time that boating stocks were better shorts than recreational vehicle plays, which had a similar thesis. RV stocks at that point had fallen further, and had notably higher short interest.

Those names have actually gained since then, including a surprising rally in recent sessions:

source: YCharts

In that context, RV stocks as a whole might prove better targets for a cyclical short. But for at least OneWater and MasterCraft, it does seem like the market isn’t quite pricing in the kind of demand destruction that may be on the way.

Lincoln Educational Services

As with boating stocks, had we known how the macro discussion would change in the four months following our call on Lincoln Educational Services LINC 0.00%↑ , we’d have expected quite different performance. LINC is down 18% since our bullish article at the end of May — but in context the decline is even bigger.

After all, Lincoln now has just shy of half its market cap in cash on the balance sheet. But that doesn’t account for a pending sale of an existing campus in Nashville, Tennessee for $34 million. Pro forma for that sale, Lincoln’s enterprise value is now about $38 million — or roughly 40% less than it was in late May.

Yet this should be a countercyclical business. As we wrote at the time, for-profit education was possibly the best sector in the entire market during 2008-2009. Higher unemployment creates higher demand for education, and particularly the practical courses offered by Lincoln. Investors are fretting that Federal Reserve interest rate hikes will lead to that higher unemployment — yet seemingly ignoring one of the primary beneficiaries of that scenario actually playing out.

Admittedly, the Q2 report in August did look a bit soft. Lincoln cut its full-year guidance for revenue, new starts, and Adjusted EBITDA. But the problem, at least per management, is an inability to convert enrollments into starts — an unsurprising issue at a time when the job market remains incredibly tight.

The argument in late May was that investors were pricing LINC as if it were one of the many companies at a cyclical top, when in fact it was at a countercyclical bottom. With the stock now trading at less than 2x (yes, two times) this year’s Adjusted EBITDA (adding back stock-based comp), that argument is only strengthened.

We’re pounding the table for LINC here, and I personally will be averaging down this week.

Cricut

Our June argument for “smart cutting machine” manufacturer Cricut CRCT 0.00%↑ was that the market was pricing the company solely as a pandemic winner, and ignoring an impressive track record leading up to 2020.

As far as the stock goes, the argument has played out: CRCT has rallied 22% since. As far as the business goes, the returns are more mixed. Q2 results in August were soft, with machine revenue down a stunning 76% year-over-year due to fewer new users and higher channel inventory at retailers. Notably, accessories and materials revenue (the raw materials used in conjunction with Cricut machines) fell 41%.

Subscription revenue did grow a healthy 33%, and the international business — a key long-term opportunity — outperformed on a relative basis, though overseas sales still fell 14%. All told, Q2 highlighted both the bear case — a return to normalcy means closets full of dusty Cricuts and high subscription churn — and the bull case — low valuation supported by a recurring subscription model.

In this market, however, and with the stock nearing $10 after a strong rally in recent weeks, caution prevails. This was a story as much about valuation as about the underlying business. That business is better than investors assumed in May, but not strong enough to soar through any type of macro environment.

And so it’s probably time to take profits here. If the market bounces from this point, there are probably better choices out there to take on risk. If it keeps falling, CRCT’s recent ability to defy gravity likely breaks at some point. Forced to choose, we’d bet that Cricut stock will rise from here over the mid-term, but the great thing about individual investing is that we’re not forced to choose today.

Tesla

Our short case on Tesla TSLA 0.00%↑ was based not on the company being a fraud, or the potential short-term pressure caused by CEO Elon Musk's acquisition of Twitter TWTR 0.00%↑, a deal that a) seems highly likely to close and b) will require substantial sales of TSLA stock.

Rather, we saw TSLA as a rather typical short target in the market of this summer: an attractive business, yes, but still a cyclical one with a high valuation heading into a period of almost-certain macroeconomic pressure.

Our trade, at least to this point, has proved the old maxim that “short sellers are sometimes right, and sometimes wrong, but always early”:

source: finviz.com

With TSLA only down about 6% from our entry point, broadly speaking the case hasn’t really changed. In fact, there’s a tempting argument that our thesis might be ready to really play out.

Q3 deliveries disappointed even after a leak to always-friendly Electrek about yet another end-of-quarter push. Higher interest rates will raise financing costs for essentially the first time in Tesla’s history. The launch of the Optimus humanoid at Tesla’s AI Day was laughable, to be blunt.

Q3 numbers from General Motors GM 0.00%↑ showed strength in demand for the Bolt. The Bolt is not the Model 3, certainly. But nor is GM’s $46 billion market cap to Tesla's ~$700 billion. Other competitors continue to target the EV market.

Perhaps most importantly, Musk seems intent on neutralizing one of his company’s biggest advantages: himself. At this point, Musk is probably the most famous CEO² of the last 30 years, and in our opinion since at least the Gilded Age.

With the exception of a few critics on Twitter, Musk’s reputation outside the investment community has been (by modern standards, certainly) almost uniformly positive. He’s been compared many times to a literal superhero. Musk’s personal approval rating has provided a halo effect to Tesla more broadly.

And over the past few months, Musk has done his best to tank that approval rating. He waded into the culture wars amid the Twitter acquisition — and purely from a self-interested financial perspective, chose the wrong side (the side that presumably is far less interested in electric vehicles). He then decided to give his geopolitical takes on both Ukraine and Taiwan, sparking more criticism.

At its core, what we’ll call the ‘non-$TSLAQ’ short case for TSLA is based on it being a cult stock at a time when interest rates and macro fears are likely to crush cult stocks. Musk himself now is contributing to that thesis.

And yet…the supposed end of TSLA as a gravity-defying stock has been proclaimed many times before. The chart in May 2019, for instance, looks similar to that seen at the moment, with the stock absolutely falling off a cliff. Earnings had disappointed, and Tesla raised capital toward the beginning of the month. TSLA hit a two-year low. Late in the month, Bloomberg proclaimed “The Bursting Of The Tesla Stock Bubble” while the Wall Street Journal added its own bearish take the very same day.

Tesla stock is up 18.5x (eighteen point five times, not percent) since then. We still believe in our case (and I’m personally still short the stock), and if current trends hold there is a lot more downside ahead. (Honestly, is a $200 billion market capitalization that unlikely, or that illogical from a fundamental perspective?) But we’d caution fellow shorts about taking too fast, or too loud, a victory lap just yet.

Accuray

In June, we argued that a market-driven, no-news ~50% sell-off in Accuray ARAY 0.00%↑ created a buying opportunity. By August, however, after a reasonably well-received fiscal fourth quarter report, ARAY had gained 64%.

Now, in October, a market-driven, no-news ~30% sell-off once again looks like a buying opportunity. ARAY is about 12% up from our original call, but we essentially bottom-ticked the stock and even the current price of $2 looks attractive.

As we wrote at the time, there are risks here in terms of market share, balance sheet, and still-tepid growth. (Accuray is guiding for revenue to increase 4% to 6% in FY23). But there’s still real potential here, and once again a seemingly illogical sell-off has pushed ARAY to the point where betting on its long-awaited turnaround seems attractive.

ABM Industries

For ABM Industries ABM 0.00%↑, our opinion too is unchanged. ABM had a solid fiscal Q3 report in September; the midpoint of full-year EPS guidance in fact was raised by a nickel. The company shouldn't feel too much pain from macro factors, and has a manageable if somewhat rate-exposed balance sheet.

But what is most important here is that, like Lincoln Educational Services, ABM to some degree should be countercyclical. In this case, the cycle benefit isn’t necessarily to revenue, but to margins.

ABM has been absolutely hammered by wage inflation and staffing shortages going back to even the end of the 2010s. Relief on that front plus a lag in contract renegotiations should lead to margin expansion. Given Adjusted EBITDA margins of ~6.6% this year, leverage on the balance sheet, and a sub-12x multiple to adjusted EPS guidance, it doesn’t take that much margin help for the stock to explode higher.

As with LINC, this is a case where we’re happily doubling down on our original call, despite early underperformance.

Texas Roadhouse (TXRH)

TXRH has been our worst short call so far, and in fact the only one of seven short ideas to underperform a short S&P 500 trade. But when we missed, we missed big: TXRH is up 24.6% since our early July initiation.

We also managed to miss twice. A key part of our thesis was that the economically-sensitive casual dining space was due for a pullback, and TXRH — the most dearly-valued name in the sector — had the biggest room for downside.

That thesis has gone 0-for-2:

source: YCharts

And yet it’s not hard to wonder if the adage about being early applies here too. TXRH looks like it’s nearing resistance. It’s close to the Wall Street price target in the kind of sector where analysts play catch-up when sentiment turns. Shares trade at 24x this year’s consensus EPS, a multiple that seems exceptionally unlikely to hold in this kind of market environment.

We argued that TXRH was one of the best macro shorts remaining. It feels like that is still the case, even though we were wrong the first time around.

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Tickers mentioned: ARAY 0.00%↑, BC 0.00%↑ , CRCT 0.00%↑ , CSCO 0.00%↑, GM 0.00%↑ HZO 0.00%↑ LINC 0.00%↑ , MBUU 0.00%↑ , MCFT 0.00%↑ , MPX 0.00%↑ , ONEW 0.00%↑, TSLA 0.00%↑, TWTR 0.00%↑

As of this writing, Vince Martin is long LINC and ABM, and short ONEW, TSLA and TXRH.

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. Manufacturers Brunswick, Malibu Boats, Marine Products, and MasterCraft, plus dealers MarineMax and OneWater Marine.

2. We had a mini-discussion on this on Twitter earlier this week: my personal ranking (in order) would be Musk, Jobs, Bezos, Zuckerberg, and Jack Welch of General Electric.