Short thesis on Square Inc. (NYSE:SQ) (1/10/2016)

In this report, we present a unique short thesis on the common stock of a very popular payment service provider - Square Inc. (henceforth, just Square).  We believe we are contrarians on Square as several components of our thesis have not been discussed by analysts or the research community at large.  Hence, we believe our perspective is additive to the current information set available to investors on Square’s business prospects and has not been fully priced by the market.  Accordingly, we believe the downside risks to Square’s common stock at current valuations are significant and deserve more attention.   We believe Square has close to 80% downside based on a current market capitalization of $5.5 billion (and stock price of $15).  Accordingly, we recommend investors establish a short position against Square common stock to profit from its decline.

Key operating, financial metrics on Square Inc. (NYSE:SQ)

LTM 9/2016 Revenues: $1,631 million

LTM 9/2016 Gross Profits: $518.6 million

LTM 9/2016 EBITDA: $112.8 million

LTM 9/2016 Net income: $-$201.5MM

LTM 9/2016 Free Cash Flow: $40.3 million

Shares Outstanding: 343.9 million

Share Price (1/9/2016): $15.06

Market Capitalization (1/9/2016): $5,303.2 million

Cash & Cash Equivalents (9/30/2016): $514.3 million

Debt (9/30/2016): $1.3 million

Approximate Enterprise Value: $4,790.2 million

Analyst opinion on Square Inc.

Analyst Consensus Price Target: $15

Analyst Buy / Sell / Hold recommendations: 17 / 12 / 0

Price / (2017/18/19E Consensus Earnings): 170X, 55X, 35X

EV / (2017/18/19E Consensus Revenues): 5.4X, 4.3X, 3.5X

EV / (2017/18/19E Consensus EBITDA): 57X, 29X, 16.9X

Short interest statistics (as at 1/11/16)

Short interest: 19.1 million

Total float: 156.5 million

Short interest ratio: 3.3

Markit Short Interest Score: 1

S3 Blacklight Market Composite Rate: 0.31%

Short thesis on Square Inc. (NYSE:SQ)

Square - a payment processing company, that also offers financial and marketing services - is severely overvalued.  With a market cap of $5.5 billion, the market is forecasting high margin annual revenue growth of 25%+ over an extended period of time i.e. a decade or more.  Consensus is largely bullish on this company with a so-called “open-ended” growth opportunity.  We believe consensus, guided by management and by Square’s recent quarterly results, is overly optimistic about the long term business prospects of this business given the realities of Square’s business model and rapidly developing competitive landscape.   

In summary, Square’s business model in many significant ways resembles a “Ponzi” that needs a constant influx of new small business owners to replenish its existing cohort of older business owners, close to 80% of whom will eventually leave the platform due to the success OR failure of their businesses over time.  This “Ponzi” dynamic is being supported by Square’s financing arm, Square Capital, which makes small business loans to otherwise unviable business enterprises.  These small businesses are then required to rely on Square’s overpriced payment processing services to support their fledgling businesses.  The rapid growth Square has experience since inception in 2009 is not sustainable and has primarily been a function of large small business growth fueled by government supported economic growth initiatives such as the JOBS Act and several quantitative easing programs.  Square’s rapid growth from a financially disadvantaged group (i.e. small business owners) is characteristic of the beginning phases of a “Ponzi” type business.   

We believe, over time, this “Ponzi” dynamic will inevitable rear its ugly head due to increased “churn” rates that are not yet apparent due to a conducive environment for small businesses, from rising price competition on its overpriced commoditized payment processing platform and, if not sooner, from an economic slowdown, which would lead to large drops in its customer base and profitability, due to rising small business failures.  Any one or all these events, or the recognition of their high probability by the financial markets, should lead to a revaluation down of Square’s lofty stock price, which currently trades at a consensus 2018 and 2019 Price-to-Earnings ratio of 55 and 35, respectively.  

Square popular service caters primarily to the bottom rung of business owners - those with neither the resources nor sophistication to make optimal financial decisions when setting up or growing their businesses.  This is fantastic for Square at time of sale as many new business owners love the low upfront cost and convenience of Square’s services.  The drawback is that they rarely fully appreciate how expensive Square’s payment processing services actually are (as we will demonstrate below).  To be clear, Square does provide new business owners the ability to instantaneously accept credit and debit cards with no training and or messy paperwork.  Thanks to this convenience, Square is able to charge these small business owners very high payment processing fees while increasing cross sales of ancillary products in their ecosystem.  Small business owners are usually desperate to avoid upfront costs due to limited financial resources as well as complexity due to their particularly skill set of running their usually non-technical core business operations.  Square appears to be a no brainer for these under-resourced overly optimistic new business owners.     

The reality is that, according our calculations, Square will eventually lose nearly 80% of their existing customer base due to the natural lifecycle of a small business and the commoditized and overpriced nature of their payment processing services.  In due course, they will have to replace these lost customers due to “churn” with new ones, which will raise acquisition costs and reduce the company’s return on invested capital.  

To understand why this could be the case, consider three eventualities (which, given enough time, cover 100% of business outcomes):

1. The business fails: There are no transactions to process and the customer exit’s Square’s ecosystem.  (Estimated probability: 50%)
2. The business succeeds: Revenues scale and the customer realizes the overpriced nature of Square’s services and transitions to a cheaper and more professional payment processing provider. (Estimated probability: 30%)  
3. The business muddles along at break even levels: The business does not scale yet the owner continues to operate on Square’s platform as it does not represent their primary source of income. (Estimated probability: 20%)

Given enough time, we estimate that within a five year time period close to 80% of Square’s customers will eventually either go out of business (50%) or, if they are successful, seek a potentially cheaper alternative to the overpriced payment processing platform that Square currently provides (30%).  This presents a serious and potentially crippling “churn” problem for Square’s management team.

Luckily for investors, management is fully aware of this “churn” issue and goes to great pains in its conference calls to explain why businesses would want to stay with Square as they scale.  Their primary explanation is loyalty to its high quality ecosystem that provides customers with services to assist in the day-to-day management of their business, such as Employee Management, Location Management, Appointments, Payroll, Instant Deposit, Marketing and Loyalty.  

While we do not dispute the utility of such services to new small businesses already on Square’s platform, we are very skeptical that this is true for the majority of small businesses that scale.  Successful businesses have unique needs and Square’s one size fits all solution (hardware + software) is not the answer for everyone.  Many large businesses want to pick different providers for different functions.  There are also good reasons to think that larger businesses would also not find complete reliance on Square’s ecosystem to be an advantage, but rather a potential liability.  

Our theoretical view is validated by the loss of Starbucks as a Square customer in 2014.  Despite being on Square’s “ecosystem” since 2012, Starbucks was unwilling to pay more in processing fees to get access to it.  This makes sense.  

We believe other successful business, like Starbucks, will reach a similar conclusion once they grow revenues to any significant scale. There are simply better providers of day-to-day business services than Square.  Larger organizations need better tools than Square currently provides its small business startups.    

It’s worth noting that Square does offer large sellers more competitive payment processing rates to adopt and stay on their platform.  This is an implicit acknowledgment that Square’s product competes  with the largest payment processors on price, lending credibility to the thesis of its core produce being a commodity and the more limited value of its ecosystem.  

The “Ponzi” problem would be difficult enough on its own.  However, things are getting significantly more difficult for Square due to certain competitive developments.  At its heart, Square’s core payment processing solution displays three undesirable characteristics in an investment:

1. Payment processing is a commodity product that, similar to other financial transaction fees such as broker and bank processing fees, faces long term price deflation
2. Square has no “moat” as demonstrated by similar, cheaper and in some cases better product offerings (card readers, registers) from a large number of competitors e.g. First Data.  We debunk the thesis, in theory and in practice, that argues that their “ecosystem” is in fact their main competitive advantage.  R&D is CAPEX for a tech company and is very high for square
3. Square has a small Target Addressable Market.  In particular, the TAM is significantly lower than what management has “misled” the market to believe, as demonstrated by an analysis of statistics from the Small Business Association.  Analysts are also underestimating the secular trend away from physical credit cards, including EMV ((i.e. Europay, Mastercard and Visa) chip cards, and towards pure online solutions.

Over time, we believe there are three catalysts that will lead investors to recognize a significantly lower value of Square’s business in the public markets:

1. The “Ponzi” nature of the business model will become apparent as “churn” rates increase.  Notably, Square does not disclose churn rates at present, but we believe the analyst community will demand more transparency as time goes by and revenue growth and earnings underwhelm consensus estimates.
2. Pricing pressure on Square’s core payment processing solution will accelerate and revenue growth estimates will come down due to a realization of a lower TAM
3. An economic slowdown will lead to large drops in its customer base and profitability due to an increase in small business failures, thereby leading to a revaluation of its share price.  The impact of an economic slowdown on the business will be exacerbated by loss of revenue and potential credit losses from Square’s small business lending arm, Square Capital, which makes business loans.  To the extent that Square is unable to securitize any loans due to a freezing of credit markets (and is forced to hold such loans on its balance sheet), an economic downturn would pose an even greater risk.

We believe Square is more fairly valued closer to $1 billion than the current $5.5 billion valuation.  Thus, we believe the stock has significant downside from current levels.   If our thesis is correct, Jack Dorsey - currently Square’s and Twitter’s charismatic and dynamo CEO - will have his hands full over the next few years.  

In this report, dividend into six sections, we delve into each of our key conclusions to justify a bearish stance on Square Inc.  The report is structured into the following sections:

Section 1: Background on Square’s business

Section 2: Competitive landscape in the payment processing industry

Section 3: Comparing Square’s Dashboard, Reader, Register, Square Capital to competitor products

Section 4: Analysis of Square’s Target Addressable Market

Section 5: Consensus views from the Street (and why it’s wrong)

Section 6: Our fair valuation of Square using a discount cash flow model

1) Background on Square’s business

- Tailwinds to Square's business

Data supporting new business formation due to positive economic growth

Percentage new businesses that succeed or fail

• Ancillary products such as Square Capital
• Food delivery app
• Payroll services
• Quikbooks?
• Invoices, analystics, appointments

For the most part, even Jack Dorsey doesn’t think much of Caviar, as he has been looking to sell it unsuccessfully albeit for the last few years.  Given a jewel is unlikely to be on top of a CEO’s sell list, we do not think Caviar will be a big driver of value for Square in the future.

Hardware revenue is a money loser

Adjusted net revenues which nets out Starbucks revenues, 20-25% long term growth

R&D expenses are 16% - big

Sales & Marketing expenses - 10%

Transaction take rate

Total take rate

Costs per transaction?  What is the mark up?  

Split of businesses using Square?

Square is also on the wrong side of technological innovation.  Mostly moving away from phycial cards.  Consider example of PMTS and other industry player commentary.

Failure rate of small businesses

Small business failure rates vary depending on where the statistics are coming from, but Carroll said that generally 50 to 70 percent fail within the first 18 months.

Square Capital facilitates this PONZI by offering credit to businesses that might otherwise be in existence.  In many ways, this resembles the controversy around Patient Assistance programs in the pharmaceutical industry.  Or chartitable donations to the American Kidney Fund to transition people on to commercial healthcare plans that might not have otherwise been able to.  Square Capital is ultimately not a long term sustainable business since its target market has very high losses.  LOOK AT YIELDS ON SECURITIZED DEBT OF SQUARE CAPITAL LOANS.  LOW INTEREST RATE ENVIRONMENT.

Management team

Morley initially sued Square (sq, -1.00%) and its co-founders Jack Dorsey and James McKelvey in early 2014, alleging patent infringement and breach of fiduciary duty. The college professor claims that he, Dorsey, and McKelvey worked together in 2009 to figure out how to accept credit card payments through a mobile phone. Morley then alleged that he actually invented the hardware device that Square went on to use as its credit card reader. Dorsey and McKelvey then took that information and created Square, according to Morley, and cut him out of any ownership stake of the company.

2) Competitive landscape in Square’s key payment processing industry

- Comparisons to paypal, Apple Pay, Android Pay

- Square's vs. competitors

- fees comparison, services offered

- for core and ancillary products

- Reviews of Square's app

- is there a moat?

- client experience including starbucks

Analysis of Square Capital

Section 3: Comparing Square Dashboard, Reader and Register to competitor products

R&D is CAPEX for a tech company and is very high for square at 17% of revenues

http://redwoodinternet.com/about-interchange.php

https://www.burlingtonbankcard.com/home/articles/charitable-donations-interchange-plus-vs-paypal-cost-comparison/

3) Analysis of Square’s Target Addressable Market

- how many new business owners can Square have at any one time

- Management guidance on TAM

- why this is a Ponzi scheme

- Ponzi scheme targeting financially disadvantaged group

- There is also a secular trend away from using physical credit cards, including EMV cards

 

http://quickbooks.intuit.com/r/revenue/how-does-your-revenue-stack-up-to-other-small-businesses/

4) Consensus views on stock from the Street (and why it’s wrong)

file:///C:/Users/Abz/Downloads/Square-2016-Q3-Shareholder-Letter.pdf

The bullish thesis.  

While it is true that existing customers use Square’s ancillary services, the question is if their services would be desirable for an independent third party - NOT currently on their platform.

“Square currently cites a 4-5 quarter payback period for a quarterly cohort of sellers to generate transaction profit that surpasses the sales and marketing spend in the quarter of acquisition.  Based on the strong retention rates, as the business scales, there should be potential for leverage.”

Needham & Company writes on the decline in “take rate”:

“The other piece of the transaction revenue formula, transaction take rate, has been in moderate decline in recent years, though the pace and magnitude is not of great concern, particularly when the overall top line is supplemented by other types of revenue.”

This conclusion is misguided.  The reality is that Square is offering larger customers a discounted payment processing fee if they stick with the platform.  While ultimately this is a good, it also illustrates how customers have a real aversion to paying higher rates for a “bundled” service.

Needham writes:

“We see potential for Square to reach 35% EBITDA margins LT, consistent with other scaled payments, processing and software businesses.”

Transaction Take Rate 3.33%, which is very high and represents and anomalous margin with history.  

What will happen to fees charged by banks and credit card companies?

Management is very generous with SBC: $142.5MM in CY2016, $165MM estimated in CY2017 and $206.4MM estimated in CY2018.

BTIG states:

“The ongoing mix shift provides confirmation that SQ can continue to grow rapidly with larger firms even as it faces more competition in that segment than it does in pursuing growth from the micro-businesses on which it had initially focused.  The change in mix toward larger businesses also demonstrates that the company can win business from such firms by pitching all of the benefits of its “ecosystems” rather than competing on price.”

This would be a huge negative development for the company and an acknowledgement of the current high and unsustainable nature of gross margins (currently in excess of 50%).

Needham has a similar opinion:

“We note that while margin pressure does persist, we believe that Square is less dependent on discounting due to the value add from its cohesive, easy to use platform, particularly given that the bulk of payment volume still comes from sellers with less than $125K in annualized GPV.”

5) Our fair valuation of Square using a dividend discount model

to grow at anywhere near the projected growth rates given its Target Addressable Market is not as large as it has led investors to believe.  In a more negative scenario, as its core payment processing platform faces competition and price erosion, it will face the dual effects of revenue and margin headwinds, leading to underperformance on both consensus revenue estimates and margin targets.   

Cavier - a food delivery app - Jack Dorsey has been trying to sell but to no success.  Acquired for $90 million.

This dynamic puts Square in a very unfortunate position of cutting price if they would like to retain their successful clients.  However, this is a race to the bottom, given the significant differences in price between Square’s payment processing services and the larger players.  For Square, the optimal outcome is for a client to muddle along, neither growing nor going out of business.   

due to the “Ponzi” nature of its business model and several better and more competitive products currently hitting the payment processing market.  

To summarize, management and consensus is severely overestimating Square’s revenue and earning potential and this has lead to an unreasonably high market valuation.  

If things weren’t difficult enough,

payment processing platform to replenish the stock of business owners that have either exited due to a failed business or exited due to a successful business that can afford a cheaper payment processing platform.  Curtly put, Square is a business that loses its customer under two ceventually loses its customer -

As Buffett has said, "Pessimism is the friend of the long term investor, euphoria the enemy."  We believe investors in Square are experiencing a few fleeting moments of euphoria that in hindsight will become more obvious.  

If Square wants to maintain its existing number of customers, it is in the unfortunate position of having to replace existing customers exiting its ecosystem due to business failure or success (i.e. churn).  

In our opinion, Square is going to severely underwhelm investors on revenues and margin over the next decade.  We believe that the stock should re-rate lower over time to better reflect significantly worse business prospects than are currently priced in, with a target market capitalization closer to $1-1.5 billion (70%-80% below current levels of $5.5 billion).  We believe this lower market capitalization would better reflect Square’s actual revenue and profitability potential over the next decade.  

“Morley initially sued Square (sq, -1.00%) and its co-founders Jack Dorsey and James McKelvey in early 2014, alleging patent infringement and breach of fiduciary duty. The college professor claims that he, Dorsey, and McKelvey worked together in 2009 to figure out how to accept credit card payments through a mobile phone. Morley then alleged that he actually invented the hardware device that Square went on to use as its credit card reader. Dorsey and McKelvey then took that information and created Square, according to Morley, and cut him out of any ownership stake of the company.”

 

It seems like Square is trying to be evFor this to be true, Square would have to either:

a) offer a similar bundled product at a lower cost or

b) a superior product at a similar cost to the unbundled products

/

an established business would pay higher payment processing fees just to get on the ecosystem.  It doesn’t make economic sense, given Square’s entire product suite is priced at a premium to competitors given their smaller scale.

developments “on-the-ground.”  At a minimum,

Specific to the short thesis,

Background on Square Inc.

A brief description of the business from the Company’s 10-K:

Square, Inc. enables payment processing, and also offers financial and marketing services. The Company provides sellers various tools to start, run, manage and grow their businesses. It serves sellers of all sizes, ranging from a single vendor at a farmers' market to multinational businesses. It serves as a payment service provider, acting as the touch point for the seller to the rest of the payment chain. Square Register is a point of sale (POS) software application for iPhone operating software (iOS) and Android, and is available to sellers across the world. Square Reader for magnetic stripe cards plugs into the standard headset jack of a mobile device, enabling swiped transactions. Square Customer Engagement helps sellers analyze and understand their businesses, engage their buyers in ongoing conversations, and promote their offerings through e-mail marketing. Caviar offers a food delivery service to help restaurants reach new customers.

Summary

Square Inc. (henceforth, just Square) has grown revenues rapidly since its founding in 2009 by Jack Dorsey and Jim McKelvey. The success of Square has come primarily from tapping into a previously unaddressed payment processing market of small merchants, by providing access to convenient solutions for a small and transparent flat percentage fee per transaction (plus a small flat charge per unit transacted).  Square Reader and Register (and other ancillary software service offerings) have provided many small merchants with a turnkey and easy to use solution - a hardware and software package that allows small businesses to focus on business, rather than dealing with bank tellers and/or tedious bookkeeping items.  

For good reasons, this has proven to be very attractive amongst small merchants, who typically detest accounting and finance.  Square’s success and growth is undeniable.  In 2017, the company is expected to generate $682.6 million of revenues, with gross margins of nearly 50%.  2017 expects to bring 30% Year Over Year growth, with Gross Margins expanding to 54.6% and EBITDA margins expanding to 9.4%.  Consensus calls for top line annualized growth over the next four years of 24%, with EBITDA margins expanding to 25.5% in 2020 and EPS of nearly $0.62 per share.  Analysts are largely bullish on the stock with 17 buys / 12 holds / 0 sells.  Consensus largely views the opportunity as open ended, particularly with the recent quarterly financial beats over the last three quarters.  With the recent rally in the stock, the current price of $15.4 compares reasonably to average price target of $15.  

The current valuation of $5b is being supported by a string of positive short term revenue and earnings beats, a very bullish (and misleading) management team and a compliant analyst community.

Core elements of the short thesis are:

1. Square core product is a commodity facing ASP pressures and has no moat

Square’s core offering - payment processing - is a commodity product that faces long term secular pressures on ASPs (similar to broker, bank and credit card processing fees) as improved technology and increased competition from larger players such as Vantiv and First Data aggressively try to capture market share.  ASPs declines are almost guaranteed given that underlying bank and credit card processing fees are declining, which constitute a cost for payment processing providers.  

2. Client experience does not square with Square’s claims of their ecosystem being a competitive advantage

Given its front and backend technology can (and has already been) replicated by several new and existing market players in the payment processing space.  Square claims its product is superior because it offers a complete ecosystem (hardware + software).  However, almost every payment processing product offers similar features.  In this report, we compare Square’s product to its main competitors from First Data and Vantiv.  In fact, we believe Square offers an inferior product.

3. Using data from the Small Business Association, we can challenge management’s claims of their attractiveness to so called “large sellers.”  In reality, Sqaure’s Total Addressable Market (TAM) is a fraction of what they claim.

Management has severely misguided the market on their Total Addressable Market (TAM), which is a fraction of what they claim.  Simultaneously, management has convinced the analyst community that Square’s opportunity is larger than it actually is by segmenting their operating results in an unrepresentative way.  By categorizing larger sellers as those with revenues greater than $125,000 (which is a very low bar if data from the Small Business Association is to be believed), Square is “proving” the shorts wrong by growing these so-called large sellers.  In reality, these are not large sellers at all.  According to the SBA, firms with 1-4 employees generate sales averaging about $387,000, which according to Square would make these firms “large sellers.” In reality, the ultimate large seller and now a former Square client - Starbucks - tested their “ecosystem” and did not believe it was worthwhile paying a higher price to use it.  This is noteworthy because Square management believes this to be their core competitive advantage with “large sellers.”

The opportunity to short Square Inc. exists because management has created hype around the TAM and done this by “demonstrating” growth amongst customers with revenues above $125,000.  I think this segmentation is misleading, as $125,000 is hardly an objective threshold for a large merchant (considering that most of these businesses would not even qualify as microcaps).  

4. At best,

There are a few pieces of damning evidence that illustrate the lack of scale of Square Inc.’s business model.   

in part, due to the hype created by management around success with larger merchants.  

What makes Square a particularly attractive short is that unlike its larger competitors

with a limited Total Addressable Market (TAM)

is on the wrong side of a long term trend towards a compression in payment processing fees.  

Management is trying one in which price plays a big role when selecting payment processing providers.  

“We continue to grow GPV from larger sellers and maintain overall transaction revenue margin for several reasons. First, as demonstrated by positive dollar-based retention across our entire seller base, many sellers grow when they join Square. Second, larger sellers switch to Square for the benefits of our entire ecosystem, including fullyfeatured point of sale software and capabilities such as APIs (Build with Square), mobility of hardware, and customer service. In fact, we believe leading with our unique capabilities and brand—not price—is what drives larger sellers to select Square.”

Firms with…	Average Annual Receipts
1-4 employees	$387,000
5-9 employees	$1,080,000
10-19 employees	$2,164,000
20-99 employees	$7,124,000
100-499 employees	$40,775,000

1. Core product has no moat and can easily be replicated and will face margin pressure in the future.  The ecosystem is not the competitive advantage they claim.
2. TAM is lower than what management is indicating and their characterization of their large sellers is misleading.

Ross Stores: A gift that keeps on giving

Since IPO, Ross Stores has generated very attractive returns for investors. It's gone up seven fold since 2009 and now sports a juicy market cap of $27b. Of course, all this is hindsight. But its instructive to note that you could have bought Ross Stores any time since the IPO and done very well. In fact, you can still buy Ross Stores. The returns will almost certainly not be as good going forward. But the run is not over, based at least on the latest numbers.

Here is the company description:

"Ross Stores, Inc. is an off-price retailer of name brand and designer apparel, accessories, footwear, and home fashions for the entire family. The Company and its subsidiaries operate two brands of off-price retail apparel and home fashion stores: Ross Dress for Less (Ross) and dd's DISCOUNTS. Ross is an off-price apparel and home fashion chain in the United States, with approximately 1,274 locations in over 34 states, the District of Columbia and Guam. Ross' target customers are primarily from middle income households. The Company operates approximately 172 dd's DISCOUNTS stores in over 15 states. Both Ross and dd's DISCOUNTS brands target value-conscious women and men between the ages of 18 and 54. The Company owns and operates approximately six distribution processing facilities, including three in California, one in Pennsylvania, and two in South Carolina."

Now let's look at the results for the quarter:

SSS were up a whopping 7% YoY. Revenues grew 15%. Operating margin was up to 12.6%. There's a buy back in place and business is humming. Sales guidance calls for a SSS increase of 1-2% over last year's 4% increase. EPS is projected to be up 11-12% YoY. Not bad.
Ross opened 77 new stores over the last year. Growth continues. From the transcript of the quarterly call.

"As planned, we completed our 2016 store opening program during the third quarter, with the addition of 25 new Ross and nine dd's DISCOUNTS. We expect to end fiscal 2016 with 1,338 Ross and 192 dd's DISCOUNTS, an increase of 84 locations for the year."

Now let's consider Ross' valuation. The market cap is $23b on sales of 12b and the forward P/E is closer to 23. So it isn't cheap. But the valuation is well deserved. Business is humming and there is little evidence that (despite the poor retailing environment) we should sell Ross Stores. Granted returns will not be as good going forward simply because of the larger size, and there's a chance that growth slows and the stock re-rates, but this has been a huge winner and its worth keeping around in the portfolio until there are signs the growth story is over.

Footlocker is an undervalued compounder on the right side of a secular trend...

Core thesis: Footlocker is undervalued at a mere 13X NTM Consensus EPS.  This long term compounder is on the right side of a secular trend in athletic spending, sports an under-levered balance sheet with a net cash position of +$700MM, a 1.5% dividend, double digits earnings growth, a share buyback and, most importantly for a brick and mortar store, a moat against Amazon (and online spending) due to its reliance on footwear.  Unlike many other categories, most consumers feel the need to buy shoes physically in a store, due to its comfort factor that affects their day to day life.  A high teens multiple is a better reflection of the dynamics of the business, which will ultimately be realized through the financial performance of the company (earnings growth, free cash flow generation, stock buybacks) and a better valuation for brick and mortar stores more broadly.

Key points:

1) The business model is working.  Revenues grew SSS were up 4.7% (constant currency) last quarter, Revenues grew 5.5% in Constant Currency, EPS grew 13% YoY, free cash flow is strong and is being allocated to a nice 1.5% dividend and share buybacks.

2) Footlocker it is on the right side of the big long term trends towards increased spending on athletic gear. 

3) Unlike many brick and mortar stores, Footlocker is significantly more immune to the move towards online spending due to the merchandise it sells: Footwear.  People still prefer to buy shoes in brick and mortar stores, due to the comfort element of day to day wear.  It is risky to buy shoes online, because (as we all know), our theoretical "foot size" rarely translates in terms of the size of shoes we often buy.  1/2 a size up or down can make a huge difference from a comfort perspective.  And typically, we also want to take a "walk" in the shoe (akin to a test drive) before we buy the goods. 

(Note: Now there is a long term opportunity here for a tech company to introduce foot measuring software, so you can browse for shoes online, use their technology to "measure" you foot, and then custom order a shoe online.  But until that kind of software comes alone, Footlocker is one of the few brick and mortar stores that remain somewhat immune from the shift to online shopping.)

4) Given its competitive profile, free cash flow profile (+$600MM in 2018) and long term earnings potential, under-levered balance sheet (net cash of +$700MM), Footlocker is arguably undervalued at a $9.4b market cap and a mere 13X Next Twelve Months (NTM) consensus earnings.    

A description of the company:

"Foot Locker, Inc. is a retailer of shoes and apparel. The Company operates through two segments: Athletic Stores and Direct-to-Customers. The Company's Athletic Stores segment is an athletic footwear and apparel retailer whose formats include Foot Locker, Lady Foot Locker, Kids Foot Locker, Champs Sports, Footaction, SIX:02, Runners Point Group, including Runners Point and Sidestep. The Company's Direct-to-Customers segment includes Footlocker.com, Inc. and other affiliates, including Eastbay, Inc., and its international e-commerce businesses, which sell to customers through their Internet and mobile sites and catalogs. The Direct-to-Customers segment operates the Websites for eastbay.com, final-score.com, eastbayteamsales.com, and sp24.com. It operates over 3,383 primarily mall-based stores in the United States, Canada, Europe, Australia and New Zealand. The Company operates over 60 franchised stores that are located in the Middle East, Germany and Switzerland, and Republic of Korea."


 

KEMET Corporation: Stock Is Up, Will Business Follow?

Kemet is up 96% this year. More from the February low.

From the 10-K:

"KEMET Corporation ("we", "us", "our", "KEMET" and the "Company"), is a global manufacturer of passive electronic components. Through the above acquisitions and organic growth we have expanded our product base to include multilayer ceramic, solid & electrolytic aluminum and film capacitors. We compete in the passive electronic component industry, specifically multilayer ceramic, tantalum, film and aluminum (solid & electrolytic) capacitors. Product offerings include surface mount, which are attached directly to the circuit board; leaded capacitors, which are attached to the circuit board using lead wires; and chassis-mount and other pin-through-hole board-mount capacitors, which utilize attachment methods such as screw terminal and snap-in. Capacitors are electronic components that store, filter, and regulate electrical energy and current flow. As an essential passive component used in nearly all circuit boards, capacitors are typically used for coupling, decoupling, filtering, oscillating and wave shaping and are used in communication systems, servers, personal computers, tablets, cellular phones, automotive electronic systems, defense and aerospace systems, consumer electronics, power management systems and many other electronic devices and systems (basically anything that plugs in or has a battery)."

Nothing to get excited about here. It is a commodity producer of capacitors and growth has been non-existent. Gross Margins are low but have been improving over the last few quarters despite poor top line growth

Sales in 2012 were $924MM, 2015 sales were $735MM. Now there may have been divestitures over the years, so this drop is sales might not all be for the core business. I have not checked, but it doesn't look like a great business so far.

For the latest quarter:

"Net sales of $187.3 million for the quarter ended September 30, 2016 increased 1.3% from net sales of $184.9 million for the prior quarter ended June 30, 2016 and increased 0.6% from net sales of $186.1 million for the quarter ended September 30, 2015."

Okay so sales are flat. Why is the stock up so much? The semi stocks are in rally mode, which might explain part of it. Also margins have gone up:

"The non-U.S. GAAP adjusted net income was $7.0 million or $0.13 per diluted share for the quarter ended September 30, 2016 , an improvement of $3.7 million compared to non-U.S. GAAP adjusted net income of $3.3 million or $0.06 per diluted share in the quarter ended June 30, 2016 . For the quarter ended September 30, 2015 , the Company reported non-U.S. GAAP adjusted net income of $4.3 million or $0.09 per diluted share. "We continue to meet or exceed our forecast, improve operating margins, and build our cash balance," stated Per Loof, KEMET's Chief Executive Officer. "We announced further gross margin improvement actions this quarter that we expect will help us to maintain our gross margins at this level or higher. We have created significant operating leverage and are positioned well in our market segments and regions," continued Loof."

So there's an expanding margin story here due to extracting efficiencies on the cost side. Not something that has too much more potential in a low margin business but should be interesting to see if business performance improves in line with the stock price.

Stock might just have been oversold and is now over bought. Not a business that gets me too excited for its potential to surprise to the upside.

Triton International Limited: This Stock Could Fly...

...If Container Lease Rates Keep Going Up

From the 10-K:

"Triton, through its subsidiaries, leases intermodal transportation equipment, primarily maritime containers, and provides maritime container management services through a worldwide network of offices, third-party depots and other facilities. The Company operates through its subsidiaries in both international and U.S. markets. The majority of Triton's business is derived from leasing its containers to shipping line customers through a variety of long-term and short-term contractual lease arrangements. Triton also sells its own containers and containers purchased from third parties and enters into management agreements with third party container owners under which Triton manages the leasing and selling of containers on behalf of the third party owners for a fee."
The business here is very simple. And it has a lot of leverage (read: risk). And it isn't a business you want to hold forever. But this business can do very well if industry conditions are favorable. Titan has no product per say. It borrows money to buy containers and leases them out, hoping to make a spread and net income in the process.

The latest earnings report is very interesting. It is obscured by the bankruptcy of South Korean

Hanjin Shipping:

"Hanjin Shipping Co. Ltd is a South Korean integrated logistics and container transport company.

Prior to its financial demise, Hanjin Shipping was South Korea's largest container line and one of the world's top ten container carriers in terms of capacity. In August 2016, the company applied for receivership."

Let's get to the earnings report:

"Triton reported an Adjusted pre-tax loss of $2.8 million in the third quarter of 2016.

• The Adjusted pre-tax loss in the third quarter excludes $59.6 million in Transaction and other costs (which includes a $4.0 million reclassification of accrued incentive compensation expenses relating to employees transitioning out of the Company from Administrative expenses to Transaction and other costs).
• The Adjusted pre-tax loss in the third quarter includes a $29.7 million negative impact related to the default by Hanjin Shipping, and a $6.8 million net negative impact from the preliminary purchase accounting adjustments.
• Excluding the items mentioned above (except the reclassification), Triton's Adjusted pre-tax income would have been $29.7 million in the third quarter of 2016."

CEO continues:

"Despite the ongoing situation with Hanjin, our market environment has continued to improve significantly from the first half of the year. The combination of modest trade growth and limited purchasing of new containers has caused the supply and demand balance for containers to tighten. Lease transaction activity and container lease-out volumes have been strong for the last several months. Our utilization currently stands at 93.3%, which is down slightly from the end of the second quarter, but mainly because almost three percent of our containers are in the process of being recovered from Hanjin. The inventory of new and used containers in Asia is much reduced from earlier in the year, and new container prices have increased recently. While market lease rates remain well below our portfolio average, they have rebounded nicely from the low levels reached earlier in the year and continue to have positive momentum."

Mr. Sondey concluded, "Leasing demand remains strong as we start the fourth quarter, and we have not seen the usual seasonal slowdown in dry container lease-out activity. We expect our utilization to increase during the fourth quarter, and expect that increasing new container prices and the tighter supply and demand balance for containers will lead to higher used container selling prices. We also expect our merger cost savings to increase steadily for the next several quarters. However, it will take time for us to fully recover and redeploy the containers previously on-hire to Hanjin, and we will face a timing gap between the lost revenue on these containers and the expected insurance payments that protect against this lost revenue. We also continue to face ongoing pressure from lease re-pricing.

Overall, we expect our normalized level of profitability to increase from the third to the fourth quarter of 2016."

So there's evidence of a rebound in shipping rates. It is worth being long here, although these rebounds are incredibly difficult to forecast.

One thing to watch and study is the implication of the Hanjin bankruptcy:

"Hanjin Shipping Recovery Effort

Mr. Sondey continued, "The recovery process related to the Hanjin default remains a major operational effort, but we are making good progress. We have gained control or have issued delivery clearances for almost fifty percent of our containers previously on-hire to Hanjin, and we expect the share of recovered containers will increase to be in the range of seventy percent by the end of the year. We expect we will eventually recover the vast majority of our containers, but it will take time to recover the "tail" of containers that are scattered across many locations."

"We believe we are adequately covered under our credit insurance policies for lost containers and container recovery and positioning costs that are in excess of our insurance deductibles. Our credit insurance policies also provide up to six months of protection against lost leasing revenue, which was roughly $3 million per month for all of the containers on-lease to Hanjin. The $29.7 million of Hanjin impacts in the third quarter included a $23.4 million provision for bad debt and $6.3 million in lost revenue, much of which was applied toward our insurance deductibles. We expect the financial impact of the Hanjin default to be lower in future periods. Over the next few quarters, we expect that insurance recoveries will offset most of the costs of the recovery effort, though we will not recognize expected insurance payments related to lost revenue until the payments are received."

Okay, so clearly recovering containers from Hanjin is important and is a risk to their capacity, unrecoverable loss potential. But there are reasons to be positive, so it is worth a position.
The other thing to watch out for when looking at leasing companies is debt. There's about $6.3b worth here. Half is fixed, half is floating (which they have partially swapped out in a fixed for floating swap, plus an interest rate cap). Pretty standard stuff.

"As of September 30, 2016, the Company had $3.3 billion of debt outstanding on facilities with fixed interest rates and $3.1 billion of debt outstanding on facilities with interest rates based on floating rate indices (primarily LIBOR). The Company economically hedges the risks associated with fluctuations in interest rates on a portion of its floating rate borrowings by entering into interest rate swap agreements that convert a portion of its floating rate debt to a fixed rate basis, thus reducing the impact of interest rate changes on future interest expense. As of September 30, 2016, the Company had interest rate swaps in place with a notional amount of $1.6 billion to fix the floating interest rates on a portion of its floating rate debt obligations."

Now they paid $55MM in interest expense in the quarter. Annualized thats close to $220MM. So around 3.5% of debt. Since much of their borrowing is via securitizations, the borrowing rates are lower (collateralized by the containers themselves).

The business model isn't that different to car rental companies. And the swings can be vicious and unpredictable. It's worth taking a position right here, but being very vigilant. You don't want to overstay your welcome with a company like this. The leverage is huge. But right now, it looks like you want to be involved.

Etsy needs a strategy to become more mainstream...

Here's a description of Etsy:

"Etsy, Inc. (Etsy) operates a marketplace to connect people around the both online and offline for making, selling and buying goods. The Company's geographical segments include United States and International. The Company's community includes Etsy sellers, Etsy buyers, wholesale partners, manufacturers and Etsy employees. The Company's platform includes marketplace, Seller Services, technology and community, both online and offline. The Company offers a range of services to help Etsy sellers build their personal brands, engage customers and complete transactions. The Company has over three seller services: Promoted Listings, Direct Checkout and Shipping Labels. Its Promoted Listings offering enables an Etsy seller to pay a cost-per-click-based fee to feature and promote her goods in search results generated by Etsy buyers on its platform. Its Direct Checkout offering allows Etsy sellers to accept various forms of payment, such as credit cards, debit cards, PayPal and Etsy gift cards."

On the face of things, Etsy has the potential to make a great investment. Mindshare, platform value, takes a small cut from a large growing GMV.  The market cap is only $1.5b, so that could make for an awesome compounding machine if the growth opportunity is significant.

However, digging a little deeper reveals some issues for a long term investor looking for a profitable growth investment.

The long term issue for me is they need to do expand their appeal to men and more mainstream people to grow.

But that is a catch 22.  They built themselves as a vintage non-mainstream company. 

The biggest issue with Etsy for me is that men do not use it. Having the majority of your customer base as women is good, as many are loyal and willing to pay a higher price for vintage handmade products. But just like a company that only sells products to men, it reduces your customer base by 1/2. Long term, that limits growth.

Etsy also has this self righteous element to it, where people who shop on it, have a superiority complex. So basically vegan women who are members of PETA and have four cats.

Now there is nothing wrong with that. But that does not scale well. Also, Etsy has already alienated many of their core fan base by trying to appeal to a broader audience and by going public. You can't be niche vintage handmade and also grow revenues 30% a year. You can't have your cake and eat it too.

The adult female population in the world is over 2 billion, but their target market is a tiny subset of that 2b. Maybe 5% of that? 100 million buyers? Right now they have about 27MM buyers. They have done well in terms of penetration already.

So, unless they broaden their appeal, their growth rate is going to slow down from 20% YoY. Their seller services is a bigger proportion of their revenues than marketplace. In other words, they are making more money off charging sellers for services than actually off the sales that they are generating. There is something wrong with that.

I am not really impressed by their Seller Services initiates (selling services to sellers of products). I think you want to see core growth in GMV and number of buyers. If the buyers go up, the stock will go up, since that will bring more sellers (customers create demand for products). 

Is it cheap at $1.5b.  Yes, appears so since it has a loyal and growing user base.  That is worth something.  But there is a bigger growth problem here that needs to be addressed for Etsy to truly become a scale player and hence an interesting long term investment opportunity.   

Helen of Troy is a decent (but not spectacular) investment...

"Helen of Troy Limited is a leading global consumer products company offering creative solutions for its customers through a strong portfolio of well-recognized and widely-trusted brands, including: Housewares: OXO®, Good Grips®, Soft Works®, OXO tot® and OXO Steel®; Healthcare/Home Environment: Vicks®, Braun®, Honeywell®, PUR®, Febreze®, Stinger®, Duracraft® and SoftHeat®; and Personal Care: Revlon®, Vidal Sassoon®, Dr. Scholl's®, Pro Beauty Tools®, Sure®, Pert®, Infusium23®, Brut®, Ammens®, Hot Tools®, Bed Head®, Karina®, Ogilvie® and Gold 'N Hot®. The Nutritional Supplements segment was formed with the recent acquisition of Healthy Directions, a U.S. market leader in premium doctor-branded vitamins, minerals and supplements, as well as other health products sold directly to consumers. The Honeywell® trademark is used under license from Honeywell International Inc. The Vicks®, Braun®, Febreze® and Vidal Sassoon® trademarks are used under license from The Procter & Gamble Company. The Revlon® trademark is used under license from Revlon Consumer Products Corporation. The Bed Head® trademark is used under license from Unilever PLC. The Dr. Scholl's® trademark is used under license from MSD Consumer Care, Inc."

They generate significant amounts of FCF, so that will keep working for shareholders. It's a decent industry and management is laser focused on returns on invested capital. Unfortunately, unless you're Buffett, it is unreasonable to expect any manager to hit home runs with every acquisition. Maybe if it tanks due to general macro turmoil, it might be worthwhile.

Maybe they chance upon a Coca Cola one of these days? Will require balls and plenty of foresight, rather than niche tuck in acquisitions, so don't expect that. Instead, they will keep buying small companies with $10-20MM revenues and try to grow them organically.

Here's the key paragraph from their 10-K:

"Shareholder Friendly Policies – We are committed to acting in the best interests of shareholders. A key facet of our shareholder friendly policies is to leverage the strong cash flow generation of our business to make accretive acquisitions, as well as leverage the organic growth potential of our existing businesses. We effectively used our capital structure to make the Healthy Directions acquisition in June 2014 and the VapoSteam acquisition in March 2015. Shortly after the end of fiscal year 2016, we closed the acquisition of Hydro Flask, a leading designer, distributor and marketer of high performance insulated stainless steel food and beverage containers for active lifestyles. We also returned capital to shareholders by repurchasing $100 million of our common stock on the open market during fiscal year 2016. We will continue to use the strong cash flow generation of our business and the financial flexibility of our balance sheet to invest in our core business, search for accretive acquisitions, and consider return of capital to shareholders. We intend to improve our working capital efficiency through supply chain excellence and product rationalization, which we believe will further strengthen our balance sheet and free additional cash flow for capital transactions that benefit our shareholders."

An example was the acquisition of the Vicks VapoSteam system:

" On March 31, 2015, the Company completed the acquisition of the Vicks VapoSteam U.S. liquid inhalant business from The Procter & Gamble Company (“P&G”), which includes a fully paid-up license of P&G’s Vicks VapoSteam inhalants. In a related transaction, the Company acquired a fully paid-up U.S. license of P&G’s Vicks VapoPad scent pads. Our VapoSteam operations are reported in the Health & Home segment. The vast majority of Vicks VapoSteam and VapoPads are used in Vicks humidifiers, vaporizers and other health care devices already marketed by the Company. The aggregate purchase price for the two transactions was approximately $42.75 million financed primarily with borrowings under our credit facility. The VapoSteam acquisition provided incremental net sales revenue of $7.99 million for the eleven months of operations included in fiscal year 2016. The VapoSteam business is highly seasonal with peak sales occurring in our third fiscal quarter."

Hydro Flask was another one:

"On March 18, 2016, the Company acquired Steel Technology, LLC, doing business as Hydro Flask (“Hydro Flask”). Hydro Flask is a leading designer, distributor and marketer of high performance insulated stainless steel food and beverage containers for active lifestyles. Hydro Flask adds a fast growing brand that has built equity among outdoor and active lifestyle enthusiasts with a product lineup, innovation pipeline and margin profile that complements, and will operate in, our Housewares segment. The acquisition extends the segment’s reach into the outdoor and athletic specialty, natural foods and e-commerce channels. Hydro Flask’s products have a carefully cultivated brand heritage rooted in the outdoor mecca of Bend, Oregon. The aggregate purchase price for the transaction was approximately $210 million in cash, subject to customary adjustments. The purchase price was funded with borrowings under our credit facility. Hydro Flask calendar year 2015 revenue was approximately $54 million."

And here is their philosophy:

"As we look to the future, we have adopted a new way of looking at our strategic choices to improve the focus of our business segments and corporate shared service organization. These choices will guide us regarding where we will operate and how we will achieve our goals in markets around the world. The overall design of our business and organizational plan is intended to create sustainable growth and improve organizational capability. · Invest in our core businesses. We have developed a portfolio of brands that are clear market leaders or have a path to grow their market position in attractive categories. We believe that prudent investment in new products, new go-to-market plans and new marketing activities can grow them organically. During fiscal year 2016, we increased our investment in those brands with the most promising potential.
 · Strategic, disciplined mergers and acquisitions. We have a track record of successful acquisitions and are continually looking for new businesses and opportunities to expand in categories and geographies where we believe we have critical mass and can develop a competitive advantage. We also seek to increase our brand reach through new licensing opportunities. We constantly assess our full suite of businesses to ensure each is a good fit with our long-term plans. · Invest in consumer-centric innovation. We have a long history of developing or acquiring new technologies, new products that improve consumers’ lives and new designs to differentiate our products from competitors. We continue to increase our focus on innovation both in our core categories and product adjacencies. We also focus on initiatives that create commercial value for existing leadership products in order to increase their appeal and accelerate their organic growth.
 · Improve our organization and people systems. Our employees are our most valuable asset. Attracting, retaining and developing talent is a key focus of our company. To help us deliver strong business results, we have recently transformed our organizational structure in an effort to increase collaboration across the enterprise, implement best practices across divisions and departments and better leverage our scale. We have also adopted new compensation programs that we believe will promote greater accountability, better align management and shareholder interests and help attract and retain talent. · Best in class shared services. We have developed an outstanding, diversified base of suppliers in North America, China and Mexico. We have also invested heavily in our distribution centers and information technology systems. We continuously strive to improve our existing supplier base and infrastructure, and to develop new manufacturing partners to ensure our products are innovative, on time, on cost, and on quality. We are applying similar disciplines and best practices to achieve operational excellence and leverage scale in our back-office functions including customer service, product development, finance, legal services, human resources, investor relations, and corporate communications. · Asset efficiency. As we manage our businesses for long-term growth and success in the marketplace, we are also looking to manage our overall base of assets and capital structure to increase shareholder value. We are focused on maximizing cash flow, controlling our costs, increasing the efficiency of the capital we deploy, and optimizing working capital assets such as inventory and accounts receivable through improved systems. We also seek to optimize our capital structure, with the selective use of leverage to invest in acquisitions and, where appropriate, provide a return of capital to shareholders."

Walmart and Target are big customers ... both are really struggling to compete with Amazon here...

CUSTOMERS
 Sales to Wal-Mart Stores, Inc. (including its worldwide affiliates) accounted for approximately 16, 18 and 19 percent of our consolidated net sales revenue in fiscal years 2016, 2015 and 2014, respectively. Sales to our second largest customer, Target Corporation, accounted for approximately 8, 9 and 11 percent of our consolidated net sales revenue in fiscal years 2016, 2015 and 2014, respectively. No other customers accounted for 10 percent or more of consolidated net sales revenue during those fiscal years. Sales to our top five customers accounted for approximately 40, 41 and 43 percent of our consolidated net sales revenue in fiscal years 2016, 2015 and 2014, respectively. The Nutritional Supplement segment maintains a database of over 600,000 customers to whom it actively markets. A large proportion of these customers take advantage of the segment’s auto-delivery service that periodically ships a re-supply of product, resulting in a more stable and less seasonal order flow.