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This week’s Research Notes is later, and lighter, than we’d like. There is a reason for that: it’s difficult at the moment to find much motivation to do research.

The NASDAQ 100 is down 26% year-to-date — and yet, this market does not look cheap, let alone compelling, on a fundamental basis. The biggest decliners are often junky businesses; quality names more often than not simply have fallen to more reasonable valuations.

In that kind of environment, it’s useful to, as they say, build a “shopping list” if the declines continue (as seems likely). But, to stretch the metaphor, the store may well be in a different neighborhood by the time we get our checkbooks out.

The surprising (stunning?) earnings report from Target (TGT) this week highlights the uncertainty. Was it an execution issue from Target? Does the fact that Target and Walmart (WMT) have massively increased inventory suggest consumers, after two years of stocking up on goods, might themselves put a brake on inflation ex-energy and housing? Or are those same consumers pulling back across the board, raising the risks of a near-term recession and, potentially, further declines in equities through the rest of this year?

Often, this kind of uncertainty leads to a number of buying opportunities, with March/April 2020 a prime recent example. But, again, we’re not seeing real fundamental value out there. Nor are we seeing the non-fundamental signs in the market that a bottom is close.

Yesterday, the Wall Street Journal did warn of a “lost decade” in equities, the kind of statement never made at the top but often at the bottom. But it would be far more bullish if its sister publication, Barron’s, had such a prediction on its cover.

We wrote in our first post, in late March, that the novices had to leave before real value arrived. Despite the collapse of Terra/Luna, falling crypto prices more broadly, and the continued decline of so many retail investor favorites (EVs, Tesla (TSLA), clean energy, etc. etc.), the novices are still hanging on:

source: ETF.com fund flow analyzer

The sum of the evidence points to one simple conclusion: there’s another leg down on the way. The best possible argument against that prediction is that seemingly everyone seems to agree. Of course, as we wrote at the time, that ‘contrarian’ bent was the best possible argument being bearish two months ago — and here we are.

Long-term, this obviously isn’t a bad thing. There are going to be opportunities created. And there are opportunities already. We remain firmly bullish on two of our long ideas, AppLovin (APP) and NeoGames (NGMS), both of which are trading reasonably well of late considering the current environment. Big tech looks reasonably attractive: it’s hard to imagine investors getting dinged too badly in Alphabet (GOOG) (GOOGL) or Amazon.com (AMZN) at these prices.

Retail is probably a mess going forward, but it’s been mostly a mess since before the housing crisis. Commodities remain a bet on management teams across that industry for once actually, you know, giving a s—- about their shareholders; we’ll see how that plays out. (Remember that Warren Buffett bet on the same shift in priorities in the airline industry.) Financials have the crosswinds of recessionary risk and higher rates; for investors who think the latter will predominate, there’s still a nice case for big banks at reasonable premiums to book.

Long-term, this seems potentially more of a stock-picker’s market than we’ve had in some time. That’s good news — but probably not yet. In the meantime, some mini-hits on names we already know well that may offer opportunity:

American Eagle Outfitters (AEO)

Again, retail is a mess. But, again, it’s pretty much been a mess, particularly on the mall side, since 2006 or so. And over that stretch, no matter the health of its sector, AEO stock has been a good buy around $13:

source: finviz.com

We’re around $13 (after an incredible 26-month run). The balance sheet is in good shape, American Eagle seems well-managed, and though dividends can be overrated, a 5.3% yield is nothing to sneeze at here.

At these levels — as has been the case in the past — it gets progressively easier to make the case that standalone Aerie supports the current valuation. Those sum of the parts cases are often dangerous — and moreso in bear markets — but Aerie does provide some fundamental support here.

AEO trades at 1.5x Aerie’s FY21 (ending 1/29/22) revenue. Lululemon (LULU) trades at ~4.6x FY21 sales. Lululemon is a better business — but let’s not sleep on Aerie, which significantly damaged Victoria’s Secret (VSCO) business model.

There’s not much appetite to own AEO ahead of earnings next week. But the stock is intriguing, and at the very least there are clear opportunities for a pair trade here (with long AEO / short VSCO among them).

Honest Company (HNST) (And Some Others)

In 2017, The Honest Company said publicly that it had generated over $300 million in revenue the year before. It’s possible that figure wasn’t quite true: private companies such as Sweetgreen (SG) have in the past exaggerated their financial performance. And in the S-1 ahead of its IPO last year, Honest disclosed 2018 revenue of just $238 million.

But Honest also faced a number of class-action lawsuits over “organic” claims which generated negative publicity and may have led to revenue declines in 2017 and 2018. So it’s certainly possible that the $300M figure for 2016 was at least in the range of correct.

Why that matters is that, in 2022, Honest is projecting sales of about $320 million (guidance is for ~flat performance against $319M last year). This is a consumer products company operating ostensibly in high-growth (by sector standards) categories that…can’t actually grow (six-year CAGR of 1% or so).

This is not a shock at this point: HNST is down 80% from its IPO price, and valued at ~0.7x revenue. But it does raise the question: OK, what next? It’s difficult to think of a consumer business more poorly positioned for stagflation than one that offers rather high-priced merchandise with probably questionable benefits. It’s thus tough to forecast any kind of re-acceleration of growth, after the company went from zero to $300 million in just five years.

This is a question that faces a number of other ‘trendy’ plays, with Beyond Meat (BYND) and Oatly (OTLY) two examples. Do the boards take a buyout at some point, if only for the brands? Or are these zombie stocks, destined to just kind of trod along sideways and down for years, like Groupon (GRPN) or Blue Apron (APRN)? Those companies too both seemed to offer innovative business models when they went public, only for momentum (in the business and in the stocks) to peter out almost instantly following their IPOs.

At the right price, Honest absolutely makes sense to a larger CPG name. For instance, Clorox (CLX) paid $925 million for Burt’s Bees (admittedly all the way back in 2007). Beyond Meat and Oatly could follow the path of gluten-free leader Boulder Brands, which sold at a price well below its highs to Pinnacle Foods (now part of Conagra (CAG)) after the momentum of its business and category collapsed.

Of the three, this case makes by far the most sense for Honest, whose SG&A accounted for nearly all of gross profit in Q1, and whose valuation (~$225M enterprise value) is by far the smallest. And with a reasonable amount of insider ownership (founder and actress Jessica Alba still owns ~6%), there’s going to be a capitulation in the boardroom at some point.

Even disregarding macro headwinds, this probably isn’t the time to own HNST; management likely isn’t ready to throw in the towel. When it is, however, there’s a world in which Honest cuts its losses and sells out to P&G or Unilever (UL) for $6/share and calls it a day.

Brunswick (BC) and Malibu Boats (MBUU)

From 1992 to 2006, according to industry data cited by Brunswick a few years back, retail powerboat sales in the U.S. averaged 309,000 units annually. This was down from the ~400K average seen from 1965 to 1991.

In other words, the multi-decade trend showed steadily lower sales — even when the second time period included a pair of housing bubbles (don’t forget the early 2000s edition) and an enormous peak in 2006, in particular. It’s not hard to imagine why. The days of husbands working five-day weeks and then being gone all day Sunday are over (golf, of course, has the same problem). Boats are far, far more expensive if you don’t know how to fix them, and many fewer potential owners know how to fix anything.

In 2020 and 2021, unit sales again cleared 300,000. That may well be a peak — for good. And so there still seems to be a pretty good opportunity to short the likes of BC and MBUU ahead of what could be an absolutely brutal stretch. Inflation, labor problems, and a potential recession on their own would pressure unit sales; demand pull-forward from the pandemic only compounds the problem.

The market averaged less than 200K units from 2016 to 2019 (per data cited elsewhere by Brunswick) — and that was without so many of the problems that are going to face the industry over the next few years.

To some extent, the market is pricing in these issues, and unit sales admittedly obscure the long-running trend for bigger and better and far more expensive boats.

Still, the declines have not been as big as one might think. BC is off 34% from its highs, and MBUU 36%. MasterCraft (MCFT) is down just 30%, though that was a name that long looked attractive (and indeed a name I owned during the industry’s growth pre-pandemic). That’s surprising given that the Russell 2000 is off 27%; cyclicals with significant exposure to rising input (and fuel!) costs would seem candidates for significantly larger declines in that kind of market environment.

To be sure, valuation metrics do look attractive —Brunswick raised guidance after Q1, and trades at ~7x the midpoint of that outlook — but cyclicals should look awfully cheap here. The experience of retail year-to-date (and for much of the 2010s) shows that a low P/E, on its own, is not an impediment to a successful short.

For investors bearish on the macro situation, all three represent potential short opportunities. Short interest is not that high — 5.1% for BC, 6.6% for MBUU — and there’s a combination of both cyclical and secular trends going the wrong way. Cut unit sales to 150K — not that far below the 2016-2019 average — and you’re slashing these companies’ earnings by well more than half.

The market has not been willing to value these names at more than 15x earnings for a very long time, which in turn means the sector has a real chance at 30%-plus downside if bearish macro predictions play out. That’s not a bad hedge in a market where hedging seems wise.

As of this writing, Vince Martin is long APP and NGMS.

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