Some idea updates and a few additional thoughts on the airline space

I’ve had a few inquiries as to how some of ideas have been going since I blogged about them, so I thought I’d do a few quick updates (in order, from oldest to newest as I discussed them on the blog):

Box (BOX): you may recall I first became interested in Box because it was in a hyper-competitive, commoditizing industry (cloud storage) and had yet to demonstrate much if any operating leverage, as costs continued to grow faster than revenues. The most recent quarter was a bit better than prior (revs +50%, opex +37% YoY) but nowhere near the scalability you would expect by now, and analysts still expect the company to be running operating losses three years from now (despite forecasting revenues to more than double). It is perplexing why analysts still remain enamored with a company that still has yet to prove they are deserving of the label ‘a business.’ The stock hasn’t really done much in the last 4 months, mostly bouncing in a $17-19 range and is currently $18.5, so ~8% above where I thought it was a good sell. While I never got involved in the name (for mostly technical reasons, such as expensive borrow costs), it is still on my watchlist given nothing has really changed and this still remains a ‘show-me’ story. Stay tuned.

Lumber Liquidators (LL): this thesis was simple, revolving around how consumers would react to a scary-but-unproven accusation concerning formaldehyde in the company’s laminates. The company went into full ‘damage control’ mode, announced their own safety investigation and stopped sourcing laminates from the problematic Chinese factory. But as expected, none of this mattered: March sales were -13% YoY, gross margins fell 8pts (suggesting massive discounting), and most all the top executives have left (CEO, CFO, and a few others). Unsurprisingly the stock has cratered, falling from $34 when I blogged to $19 today, but it’s hard to see how LL turns it around (it still doesn’t look cheap and legal liabilities/compensation costs are not yet provisioned for). Nevertheless I covered most all my short at $20 as the so-called ‘easy money’ has been mostly made.

Oil prices & airlines: I guess I didn’t make an explicit recommendation or call on oil prices, but I did suggest the US airlines stocks were a value and I was (and am) long American (AAL). The airline sector has been in a pretty bad funk for most of the year and, frankly, it is confusing. Consider: a year ago oil was $100/barrel and AAL stock was $45; today oil is $51 and AAL stock is $41. Recall also that oil makes up ~35% of AAL’s operating costs, that  they don’t hedge an iota, and that they have bought back significant amounts of stock over the last year (note: I am using AAL as an example but this and the following points apply in broad strokes to most all the legacy US carriers). In fact on a 12 month view, analysts’ consensus expectations for EPS (earnings per share) for 2016 is basically unchanged (despite riding up and down a lot), meaning the stock has suffered from massive multiple compression (almost 50%). What exactly is going on here?

Clearly sentiment has turned aggressively against the sector, and the companies have mostly only themselves to blame. Most all last year the near-universal refrain from the airlines was that, in a newly consolidated industry, there would be less margin-destroying expansion (a feature of the boom-bust airline cycle historically) and that fatter profits from lower fuel would drop most all to the bottom line. Unfortunately pricing didn’t quite cooperate. PRASM – passenger revenue per available seat mile, an industry term that effectively measures unit revenue – fell a few points in 1Q; most legacy carriers guided to 5-6% declines in 2Q; and they could fall again in 3Q before apparently recovering. More important than transitory fare weakness has been a changing rhetoric from airline CEOs: AAL’s, in particular, has stated the company will ‘respond aggressively’ to low cost carriers increasing capacity with lower pricing – not something investors wanted to hear. In fact, so bad has been the reactionary turn against the sector from the investor community that according to some analysts, investors would rather see oil prices rise back to $70/barrel as it would likely restrain capacity and force discipline onto the airlines who continue to expand their offerings, buoyed by lower oil prices.

While the whole move has been painful for me, no doubt, I really think this is missing the forest for the trees. For one, though PRASM is falling, it is partially outweighed by increasing traffic (in terms of miles flown). Thinking about it another way: if you are in the widget business, clearly you want increase the sales price of each widget, but even if widget prices drop, if you can sell more widgets, you might make some or all of the lost margin back. Secondly, of course, the benefit of lower fuel (nearly -50% YoY in 2015) is much higher to the unhedged airlines than a 5% fall in PRASM (just look at the 2014/2015 change in net income at AAL, LUV, DAL, etc). Now unit revenues may continue to decline and the pace may accelerate – this is the key risk – though analysts point to the historically mean-reverting nature of PRASM (apparently it has never had two years of negative PRASM growth in a row) while oil is likely to remain lower for longer (or, judging by recent commentary, perhaps even fall to new lows). Finally, while the airline business may not be a great one, it has a high correlation to GDP and – as far as the US is concerned – the economy is improving, air travel is growing, and the US-based airlines should be a direct beneficiary.

Of course the most important part of the equation is valuation: legacy US carriers trade at 4-10x earnings while the market is at 19x (the S&P). To me, this is an unwarranted discount. Thinking about it another way: the legacy carriers trade around 4-4.5x EV/EBITDA (not a perfect measure for airlines, I know), a level that – for cyclical industries – implies either the peak of the cycle or financial distrees – when in reality I don’t think we are anywhere near a peak (this is proven by a number of other hard metrics, such as air travel, aircraft orders, etc) and airline profitability/financial health has never been stronger. Further, the majors remain in much better shape re capex and pension liabilities, while generating gobs of free cashflow. Best of all, sentiment has swung 180 degrees from wildly optimistic to pretty pessimistic, in the space of a few months. So I have actually added to my AAL position in recent weeks (though these arguments apply more or less to Delta, Southwest, Jetblue, United, etc as well).

Barnes & Noble (BKS): the story here revolved around supposed obsolescence, a very low multiple and lack of investor interest despite ongoing restructuring, improved profitability in the core retail stores, and a catalyst in the form of a spin-off of the College business (to be completed in a few weeks). The stock has performed well, on the back of some increased interest as well as the turn in fundamentals and is now ~$28.7 (versus ~$23 when I first discussed and $20 when I entered last year). While I still think the stock gets to $30, risk/reward is less favorable now so I have taken some profits.

GoDaddy (GDDY): when GDDY went public, it followed the well-worn ‘overhyped IPO’ trope and still remains an Internet 1.0 business (domain listings) trading at a premium multiple more akin to a high-growth Internet 2.0 company. The first earnings report was actually OK, though the high multiple has limited the appeal of the stock for many and it appears stuck in neutral for now (it has come off ~8%, from $28 to $26, since I discussed it). I never ended up shorting it for lack of downside catalysts other than over-valuation, but I do think it will continue to underperform the market.

Netflix (NFLX): Another stock I didn’t short, but couldn’t get my head around why the street loved it so much. The love parade marches on: NFLX stock is a rocket ship headed to the moon, having risen another 100% since April, beloved of analysts who keep inventing new metrics to try to keep up with the meteoric stock price. The most recent quarter ‘crushed’ expectations on a number of levels (subscriber growth at home and abroad), though the company lost more money and burnt more cash. No one seems to look at the escalating costs of content but that doesn’t matter of course, and won’t matter for the foreseeable future. NFLX remains the poster-child bubble/momentum stock de jour and is headed for a massive fall at some point, but remains untradeable (on the short side) without a hard catalyst to derail the euphoria and so is very much a stay away at this point. However, stay tuned.

Voltari (VLTC): as expected, Carl Icahn’s involvement was a red herring, the retail euphoria wore off and the stock collapsed from ~$20 to $5. However in the last few days it has ripped again (once more on comments from Icahn that he ‘liked the company’, how convincing :P) and is now around $10. Not much more to say here, all my previous comments apply, though this is clearly a day-trader’s wet dream and not something you can readily invest in either way (without a high pain tolerance and ice water in your veins). I am not involved.

Greece (GREK): Clearly my initial view that the referendum would answer ‘Yes’ was wrong. Nevertheless I made out OK as a) i had purchased options, limiting my losses to a portion of the premium; and b) GREK actually rallied substantially once it became clear Greece would stay in the Euro. I since sold my call spreads at a very slight loss (fair enough considering my original view was wrong), but I am not too unhappy with how this turned out. If anything it was a lesson that macro/political trading is extremely difficult, you are dealing with so many more variables than individual stock picking and clearly not my strong suit.


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