January was a rough month for stocks in general, with major global averages falling 5-10% and all manner of sectors (oil & gas, REITs, MLPs, etc) punished far more than that. While there have likely been a lot of babies thrown out with the collective bathwater, one under-performing sector that has especially piqued my interest has been aircraft leasing. There are only four major listed pure-play aircraft leasing companies on US exchanges (AER, AL, AYR, and FLY), making this a small and often misunderstood sub-segment of the broader financials universe. See below for performance this month (in percent):

Aercap (AER), the largest listed player and a close second in terms of global scale to GE’s aircraft leasing business, is one of my largest holdings, so this move has been painful to say the least.

That aside, there have been a number of (often-conflicting) narratives concerning the current business environment for lessors, all of which have weighed on the stocks near-term. To name a few:

• aircraft valuations, especially for older wide-bodies, are under pressure (cf. recent analyst notes, lessor commentary in the last month, and Delta CEO’s claim a few months ago that there was a ‘bubble’ in wide-body aircraft);
• Boeing’s recent production cuts to the 747 cargo plane and also the old-gen 777, suggesting lower demand;
• emerging market pain will cause distress amongst EM airlines (in particular, China exposure is thought to be problematic);
• low oil prices are bad for the lessors since they decrease demand from airlines to upgrade to newer, fuel-efficient aircraft.

Since the lessors now trade for ~25-35% below book value – which, as we shall see, is likely understated in any case – Mr Market is suggesting that a combination of these factors will cause an imminent and material impairment to the carrying value of the lessors’ fleets.

On the other hand, I think the market is too fixated on a couple of isolated and perhaps temporary signs of weakness in the market – ie, tepid demand for new Boeing wide-bodies – and is completely missing the bigger picture (that aircraft leasing is healthy and in a solid go-forward position). Here’s how I get there.

Aircraft leasing: two major ways you can lose (assuming you do indeed lose)

Much like other leasing businesses, there are really only two main ways a lessor can take a large loss: either one or more of its clients goes out of business (or otherwise gets into enough financial trouble that it breaks its leases); or, aircraft held without a lease cannot find a new lessee and need to be written down in value as a result. It is important to recognize that as long as a client is current on lease payments, it would be extremely rare to impair the value of the leased asset (think of car leases as an equivalent example).

This of course means there is and should be a reasonably high correlation between lessor impairments and the health of their clients – the global aviation industry. This is where one of the major tenets of the bear case – that low oil prices are bad for lessors due to a decrease in demand for newer, fuel-efficient aircraft – simply falls apart. The vast majority of the global airline industry is in high cotton; in fact the IATA forecasts that 2016 will be the most profitable year on record for the industry (following on from 2015, which was also the then-most profitable year). Outside of a couple of problematic jurisdictions – Russia, Brazil, and Malaysia, for example – the global aviation industry has never been more profitable.

As you might expect, record profits are prompting many airlines to grow their fleets and expand into new routes – this has caused pressure on yields (‘passenger revenue per available seat mile’, or PRASM), since the addition of capacity generally forces prices down (especially when coupled with lower fuel and healthier airlines competing for share). This may be an issue for airlines’ profit margins on a per-unit basis (though overall profit dollars are clearly still rising). But it is very difficult to reconcile record profits and higher growth at the major airline clients with meaningfully lower aircraft valuations – for the simple reason that there are no major bankruptcies that would cause a flood of un-utilized planes to hit the market. A case in point: AER’s plane utilization currently is 99.3%, and has not dipped below 97.5% since 2005 (from AER Sep’15 investor day presentation):

However, it would still be theoretically possible for lessors to take losses on aircraft coming off lease, if there was not enough extant demand for them to sign new leases at rates that preserved the then-values of the aircraft. This appears to be something of a concern within certain segments of the market, in particular for older Boeing wide-body aircraft. We will look at specific exposures for Aercap in particular shortly, but for now it is important to recognize that leases are generally long-term agreements spanning 10-20 years – often, the majority of an aircraft’s life usable life. Lessors take special care to place and lease aircraft in such a way that large chunks of their fleets do not come off lease at the same time, potentially pressuring residual values. As a result, the idea that a large portion of a given lessors’ fleet could or should be impaired imminently stretches credulity.

Take Aercap, for example. As of end-2014 (the last full year of reported data), an average lease term on a new lease came to 144 months (ie, 12 years), while even re-leases came to 7.5 years. The company also was active in extending current leases with clients, with the average term on extensions amounting to 4 years. In terms of lease expirations, AER discloses that total planes rolling off lease amount to 176 planes in 2016 and 172 planes in 2017 – this amounts to ~14% of their total fleet. Again – this was as of Dec’14, so it is highly likely that a number of these planes to be rolled off have already been re-leased or extended, given current utilization rate is still 99%+.

But even so, digging a little deeper: the Boeing wide-body proportion of AER’s total fleet is ~22%, but the number of Boeing wide-body aircraft rolling off in 2016 and 2017 are only 10 and 20 respectively. This constitutes ~5-10% of total lease roll-offs in either year, or, more importantly, around 1-2% of the total fleet (by aircraft number) or maybe 2-4% of the total fleet by weighted book value. The point is simply that even assuming a) the number of Boeing wide-bodies rolling off in the next two years is this high, and b) it is impossible to re-lease these planes globally at all, and c) a full impairment of these assets is necessary – then even in that case the impact to AER’s net book value is likely only a couple of percentage points.

In reality, even this assessment is too bearish. For one – the average age of AER’s fleet is ~7 years, meaning old-tech, less-fuel efficient planes should actually see higher residual demand than in previous roll-offs due to the much higher operating leverage they provide at lower fuel prices. Hence, I expect secondary demand for these kinds of planes, absent near-term volatility, to be solid. Secondly – an independent valuation of AER’s fleet, conducted about a year ago, suggest the net book value of the fleet added an additional ~30% to stated book values as recorded in AER accounts. See below from AER’s investor day last September:

While valuations have undoubtedly come off since then, it nevertheless accords AER a huge buffer against potential impairments in that a good portion of the true value of the fleet has not yet made it into AER’s state book value. As a check on this number, bears may want to consider AER’s long-term track record of trading aircraft: since 2006, AER has sold over 400 planes at an average gain of $1.6m per plane.

Explaining the pessimism

AER now trades at ~70% of (understated) book value whilst generating 15%+ sustainable RoEs, has the best order book in the industry, the most scale and customer diversification in the industry, and has de-levered to the point where it likely gets an investment grade rating in the next 1-2 quarters. Most interestingly, there is a massive disconnect between where the equity trades – a large discount to book, and <2x operating cash flows – and the credit – where benchmark 5yr senior unsecured paper trades just under par and exhibits little if any distress. In my experience, the credit market usually gets it right.

While I have been talking most entirely about Aercap, there is a level of pessimism here regarding the industry that seems far too short-sighted, and I am at a loss as to why these values exist in the market today (this explains why I have been buying!). Boeing’s announced production cuts reflect either weakness in the cargo market (which is almost totally peripheral to AER, and of minimal importance to the lessors generally), or in the pre next-gen delivery schedule for the 777. Indeed, at the same time as cutting the 777 production schedule, Boeing increased the production rate for their narrow-body offerings, suggesting the 777 production cut could simply be an issue of clients not wanting to buy ahead of new tech offerings to be launched from 2020. You could even conceivably argue that OEM supply-side discipline in cutting production is a good thing and supportive of valuations. As I have previously argued, the effective duopoly in aircraft manufacturing is beneficial to the maintenance of such production discipline because ultimately Boeing/Airbus are the biggest losers if they over-produce and flood the market.

Ultimately, I think much of the recent price action can be explained by technicals. AER is a well-owned hedge fund stock, and has signficantly under-performed the more-expensive, less-diversified but less-owned Aircastle (AYR) by ~12% in the last month alone (see above). Not only that, AER has perceived greater wide-body exposure than some peers as well as a larger China business (around 10% of the fleet is in China, though the CEO made pointed comments China’s secular growth outlook for air travel is unchanged). But as this discussion suggests, I view the majority of issues facing the company and indeed the sector as transitory, and the recent weakness as the reaction of the fearful rather than the prescient. At ~$30, the stock could retrace 50% and still look cheap (near 1x 2016 book and 7.3x EPS) – so I have been sizeably adding to my long position.

Disclosure: long AER

Regular readers will be aware that I have something of a penchant for investing/trading not just with a view to the underlying fundamentals, but also occasionally in advance of behavioral changes that can affect those fundamentals and thus move a given stock. In this vein, I shorted Lumber Liquidators (LL) earlier this year, purely on the basis of a massive consumer shift away from LL product after the damning 60 Minutes allegations of carcinogens in some of their laminates. Guilty or not, I reasoned, the cost of remaining a LL customer was, for the ordinary consumer, simply not worth the risk of buying even at discounted prices. LL stock is now $15.

With regard to the power of ‘behavioral investing’ the current situation regarding Chipotle Mexican Grill (CMG), the ubiquitous and heretofore incredibly successful Mexican fast food restaurant chain, is another case in point. CMG has been a massive multi-year investment winner, is (or was, until very recently) a core holding of growth investment managers, and has a large and growing base of dedicated consumers across the United States. Operational excellence – CMG had mastered the art of serving customers faster than any other QSR chain – and secular growth potential (due to the increasing Hispanic population) had led to long-term above double-digit growth in sales and EPS, and the stock enjoyed a huge multi-year run. Ten years ago, the stock was $50; a month ago it was over $700.

Much of this thesis has changed in the last couple months, however. The first warning shot came with the 3Q report, where CMG reported comp store sales growth fell below 3% (+2.6%) vs +4.2% in 2Q. Positive comps in a difficult environment are nothing to sneeze at, to be sure, but it has become clear in recent quarters that CMG is running up against the natural limits of comp sales increases, having enjoyed heady comp store growth for so, so long. Sure, the company is still guiding to opening ~200 stores a year, providing for ~10%+ sales growth (current store count is ~1700) assuming flat comps. But with the stock trading in mid-October at ~40x earnings, low-single digit comp growth was taken negatively, and the stock fell below $700, to ~$675.

More recent newsflow has been much worse, and directly relates to the opportunity now. In early November, CMG announced they were shutting 43 stores in Portland and Washington state, due to the outbreak of the E.Coli virus amongst a number of people who had eaten at Chipotle restaurants in those states. CMG stock fell further – to $610 – though it initially appeared that the damage could be limited to a local supplier to restaurants in Washington and Oregon.

But despite subsequently re-opening these stores, by last week, it had become clear that E.Coli cases had spread to nine states, including the Mid-West and East Coast (casting doubt upon a whole new batch of regional suppliers, or indeed something specific to CMG’s supply chain processes). Worse, after the close Friday, CMG reported that consumers were abandoning the chain en masse: comp sales – predicted to be +3% just a month earlier – posted -20% in the days following the 43 restaurant closure, before moderating to -16% in the back end of November. As a result, the company pulled its 2016 comp view (for low-mid single digit comp increases) and, to my mind, it now appears highly likely comp sales will meaningfully decline in 2016. It was in the after-market on Friday – with the stock already down 30%+ from the highs – that I shorted CMG, at $525.

The behavioral calculus here is pretty simple: why would anyone in their right mind eat at Chipotle in the near-term? E.Coli is a very nasty virus, and can be deadly; and it is quite clear this is not an isolated outbreak anymore (nine states, over 50 hospitalizations). Consumers are clearly voting with their feet, and thinking logically, the cost to a consumer for not eating Chipotle (and say, going to Qdoba instead) is zero, while the penalty for not changing your behavior could be very severe. It is almost a given, then, that comps will turn meaningfully negative in the short/medium-term.

I would also be wary of banking on a quick rebound in comps, even if the situation appears to be brought under control. As mentioned above, there are very low to non-existent switching costs here and there are a plethora of other similar options in most US locations (Taco Bell, Qdoba, El Pollo Loco, Chuy’s, etc). Furthermore, food scandals in particular capture the public imagination and provide plenty of scary headlines for 24 hour news channels, which, combined with the low switching costs mentioned, could keep CMG demand quite low for the forseeable future. And finally, even if no other cases of E.Coli are reported, it seems quite likely some of the victims will have viable cases to press for damages from CMG, especially if ongoing investigations reveal meaningful fault on the part of CMG’s processes (not inconceivable given how widespread the problems have become).

None of this should be life-threatening to CMG as a company. But the beauty of this situation is CMG is still priced not just for growth but for high growth. Consider: at $560 (Friday close), CMG trades at 30x next years consensus EPS, and 15x EV/EBITDA, despite just 11% expected sales growth, and 9% EPS growth. I would argue that these numbers must continue to come down, especially in light of the recent disclosures that the company is seeing recent comp sales in the -16-20% range. But even before the E.Coli scandal. this was a rapidly maturing growth stock that somehow garnered the kind of lofty multiple deserved by a mid-life growth story with a long, long run-way still ahead of it. As anyone who has followed retail or restaurant chains from Michael Kors (KORS) to El Pollo Loco (LOCO) will tell you, generally speaking you do not want to be left holding a richly-priced growth stock when the growth disappears – and E.Coli scare aside, CMG could be confronting that exact point now. The E.Coli situation may just catalyze and clarify the downside in the nearer-term.

To my mind, current consensus models about a 10-11% sales hike from new stores and a flat to low single digit hike from comp sales next year, all with some margin compression (50bps or so at the GM level) to get you to ~9% EPS growth. To me, this is wildly optimistic and I would expect both much lower comps, as well as a slower pace of store openings, as the company struggles to get to grips with the E.Coli fallout. In a scenario where comps drop modestly (5%?), store openings slow to ~7% unit growth, there is some margin compression due to discounting (but not counting the announced ‘one-time’ costs to clean up the supply chain),  it is not hard to see CMG posting flat to +5% EPS growth next year, or say ~~$17-17.5 vs current consensus of $18.6.

This may not seem like a huge delta but in reality I would not be surprised to see consensus fall to year-on-year earnings declines. Putting even just a 25x multiple on say $17 of earnings – still a huge premium to the growth rate – suggests a $425 stock, or another ~20%+ downside from here, and frankly I don’t think 25x is the right multiple anyway (hint: it should be lower). The upside risk case is fairly moot given E.Coli newsflow should remain negative and even if it doesn’t, the behavioral thesis suggests consumers will really take their time coming back to the stores – which in any case were running at much slower comp rates than historically, despite the cheap stock.

Adding it all up, and CMG looks like another good ‘behaviorable’ risk/reward trade on the short side.

Disclosure: short CMG

Square (SQ), the San Francisco-based upstart payments processor, is an intriguing company on a number of levels: for one, it’s CEO, Jack Dorsey, invented Twitter, has had numerous profiles appear in respected publications like The New Yorker and Wired, and has even been compared to his erstwhile idol, Steve Jobs. But aside from the ‘Dorsey effect’, Square has been ‘through the ringer’ as a private company and is going public at an interesting time in its corporate evolution. All this piqued my interest so I decided to take a closer look at the company.

Square burst onto the start-up scene in 2010 with a good, or perhaps even great, answer to an unmet need: how could small businesses (often mobile) accept payment by credit card? The original Square dongle – a small white appendage you plug into the headphone jack of an iPhone – immediately took off with small businesses across the US due its combination of form (sleek and sexy), functionality (easy to sign up and use), and cost (original dongles were given away free to build share; processing fees were and are set lower than the comp as well). The visual similarities, along with the innovative yet simple solution to a pressing need, initially drew the Jobs comparisons.

Those comparisons were short-sighted, however, for a few reasons, but mostly because Steve Jobs would never sell a premium product at a discount to market – in fact he was famous for making the best possible product and letting consumers come to his product on his terms. Dorsey, of course, did not have this luxury: payment processing margins are so thin (around 1% net of each transaction, after paying fees to the credit cards, and before provisioning for operating costs) that he could not simply build the coolest product and hope the customer would show up at his door. Instead, he would need to seek out the customer (via loss-leading dongle giveaways), build scale, then hope to up-sell ancillary services (POS systems, invoice/receipt management, tax-related services, credit provision, etc) to build profitability later. Along the way, Square would hope to transition – or at least grow exposure to – much higher-volume enterprise (read: big business) users, since small businesses of course process many fewer transactions, are harder to scale (a new client win counts for relatively little) and are smaller targets for add-on upselling.

Win share with low-value customers, build relevance, transition from low-value to high-value customers once demonstrating a value proposition, then make money – not a bad model, as far as it goes (except perhaps the part about starting with low-value customers). Of course, note that success is dependent not just on growing low-end share but ALSO upon transition the offering up the value chain. The fundamental issue for Square today is that, four years in, it has become painfully clear that no matter how much the small-business segment has been a success, growing share with larger payers has been, all told, a failure – and it is thus extremely unclear whether the model will ever profitably scale. Square’s experience with Starbucks is a telling example.

When Square first announced its deal (2012) to provide POS solutions and process all card transactions at Starbucks’ 7000+ US outlets, it seemed like a massive win. Square was moving beyond small business and into the enterprise; it could push out ancillary products (Square Wallet, etc) to Starbucks users as well as hopefully to Starbucks corporate; and Starbucks even took an equity stake in the company.

But fast forward just three years and Square’s S-1 (pre-IPO) document depicts promising opportunity gone awry. Square cumulatively lost ~$80mm on Starbucks transaction processing alone (ie, not counting the operating expenses to support the business), while Starbucks has opted to move to another payments process from October this year. The problems were various: transaction volumes at Starbucks basically stopped growing this year – implying  consumers simply didn’t care to use the product – while Square was unable to up-sell ancillary products either to Starbucks customers (eg, the failure and eventual shut-down of Square Wallet, a Paypal/Venmo/Google Wallet competitor) or to the company. Subsequently, various articles have suggested Square only won the business back in 2012 by severely under-cutting the then-processor (Bank of America) on price – not exactly a sustainable way to profitably win new business.

The financial implications as reported by Square are also troubling. In the IPO offering docs, Square takes the somewhat aggressive approach of removing all the Starbucks related business from their ‘Adjusted’ revenue and EBITDA metrics. This effectively treats the Starbucks experiment as a discontinued operation, which it is, given the service will stop from October this year. But the adjustment of Square’s financial reporting to remove Starbucks numbers also gives the impression that this experiment – despite being ~15% of Square’s total transaction revenues in 2014 and 1H 2015 – is immaterial to Square’s on-going operations and prospects, which I believe is severely misleading. After all, earlier in the S-1, Square proudly trotted out the below ‘GPV’ (Gross Purchasing Volume, a measure of the $ value of all transactions processed by Square) chart, suggesting a successful transition to larger merchants was an ongoing part of the Square growth story:

Looking at the financials, it is clear that Starbucks represents most all of the ‘>$500k annualized GPV’ exposure (and likely a good chunk of the ‘$125k-$500k’ range as well), since they accounted for 15% of transaction revenues and at lower-than-average take-rates (thus implying higher % exposure of GPV). As such, the spectacular failure of the Starbuck deal demonstrates both that go-forward Square will be, once again, most entirely a small-business focused payment processor; and that the company cannot make money serving enterprise clients. Both of these deductions suggest serious concerns over the ultimate scalability of the model.

At this point, you are probably wondering why Square hasn’t caught on with enterprise clients or larger consumer-facing businesses (despite the Starbucks debacle). After all – if it is such a hit with smaller businesses, surely the offering has something going for it? But recall that Square’s initial market-share gains were a function of a) unmet needs; b) winning share on price; and c) ease/efficiency of use. Of these three factors, you could argue only in the last instance does Square hold an advantage when it comes to larger enterprises (if you believe Square’s POS interface, and back-end offerings are more efficient than the comp), though even this is debatable. But as for points a) and b): clearly the corporate market is highly competitive (Micros, NCR, First Data, a number of banks, and even the likes of Paypal now are all here), and Square cannot waltz in and offer a solution to an unmet need because, frankly, the need is being met. As for b): the Starbucks disaster clearly demonstrated how competing purely on price for larger-scale business worked neither for Square nor the client. That is not to say it will never work, and Square won’t win any share – but certainly we should deduce that the chances of Square being able to replicate its initial and ongoing success with small businesses amongst larger enterprises – in the face of furious competition with more experienced, cashed-up players – is much, much lower.

Competition is coming to the small business market

The challenges Square appears to be facing vis-a-vis large enterprises are tough enough; but the coming threat to its bread-and-butter business of serving small businesses could be existential. As discussed, Square is winning in small businesses mostly because they were a first mover to an unmet need – but they are no longer the only player in town. Both Paypal and Verifone (amongst others) have already released competing dongles designed for mobile small businesses; others, like Google could soon follow. I will be the first to admit the Paypal and Verifone dongles don’t look very cool but both companies have significantly greater financial resources than Square,  and Paypal especially is on a growth mission to prove its relevance and defend its dominant share in another vertical (P2P payments) by expanding turf. Furthermore it has been an aggressive acquirer of ancillary services like Venmo and Xoom – both far superior offerings to Square’s nascent ‘Square Cash’ money-sending app (and we already mentioned the abject failure of Square Wallet). Suffice to say that the small-business payment processing space, though still likely to grow rapidly, may become much more price competitive going forward.

The other corollary of this trend would be the need for Square to spend much more in advertising dollars to defend or win share – a problem when the business is already having trouble scaling, and advertising dollars were actually cut in 2Q’15 to make incremental operating losses seem less bad (likely to try to juice numbers for the IPO). As Square says in its S-1:

Nearly half of our sellers find us and sign up, rather than us finding them. This is the result of building services that deliver value and that sellers eagerly recommend.

While of course it is great to have a killer product that customers eagerly recommend, sentences like the above read to me as code for increasing marketing spend as the company grows beyond its initial core of early adopters – especially in the face of new and fierce competition. This does not bode well for trying to scale operating margins.

The future of payments is…Apple Pay or die?

I specifically haven’t talked much about where the payments industry is heading, frankly because I am not an industry expert. But even a few very broad strokes suggest a problematic outlook for Square. We already know Square is facing Herculean challenges in entering the large-enterprise space against entrenched, capital-rich competitors. But even looking at changes coming to the point of sale (POS), it is difficult to see how Square can maintain a value proposition in the far future.

Take Apple Pay, for example. At the moment this is basically a function that allows you to swipe your iPhone in front of a NFC (near field communication) terminal at CVS and pay for your groceries (via a link to your debit/credit card, etc) without dipping your card. That is to say, at the moment, the payment architecture (whereby payment processor routes the transaction through the credit card network, receives approval/denial from the issuer, and routes it back) does not change – the consumer simply does not dip the card. This allows room for payment processors, like Square but including the behemoths like First Data, etc, the ability to take a fee for processing the transaction.

But if Apple Pay goes mainstream (as I and many think it will) and the technology improves slightly to allow for ‘phone-to-phone’ NFC payments (this was already speculated a year ago and in my view happens in the near-term), all of a sudden it becomes much more murky for payment processors. Of course, such a move immediately obviates the need for a physical dongle: this immediately puts Square’s main hardware offering (and key network building-block) atop the technology dustbin. As already discussed, since Square is an entirely small-business focused processor, this move alone likely hits them harder than any of its competitors as all of a sudden their core user-base will no longer need their Square dongle and hence a good chunk of their transaction revenue could dry up.

But taking this one step further, it is not a huge leap to think that Apple – already possessing many hundreds of millions of customer accounts and having built its own physical ‘network’ through the dispersion of hundreds of millions of iPhones-cum-payment terminals – will just become a payment processor itself. This puts the entire payment processing industry in Apple’s headlamps – not the place you generally want to be, given their resources and track record. (As an aside: the credit card companies, who provide value because they can price the credit risk of their customers, probably have more survivability in this scenario, but will still probably see price pressure from such a development).

Other issues – fraud costs a function of under-investment?

This is all pretty scary stuff, and we haven’t even gotten to the pricing of the shares! Actually, since the price hasn’t been set, I will skip an in-depth analysis of the ‘right’ valuation for Square and suffice by saying that a very high multiple of revenues (maybe 9-10x, assuming it comes at a premium to the $6bn valuation achieved in the last private financing round late last year) for a high-growth yet high-loss, high-cash burn, minimally-scaling business with demonstrated failure beyond its unprofitable core market and existential threats probably just a couple of years out, is fairly crazy. The only thing this IPO will do is make Paypal (PYPL) look exceedingly cheap at ~4x sales, low double digit EBITDA multiples for a much-better positioned company (already fully scaled and dominant in its core vertical) churning out 20% operating margins and 20% top line growth today.

What is actually more interesting is a couple of line items in the S-1 that may not be noticed by many but I think could be important: namely, “Transaction and advance losses“, as well as net capex spend in recent years. “Transaction and advance losses” is a line in operating expenses that the company describes as:

We are exposed to transaction losses due to chargebacks as a result of fraud or uncollectibility. Examples of transaction losses include chargebacks for unauthorized credit card use and inability to collect on disputes between buyers and sellers over the delivery of goods or services…For the year ended December 31, 2014, our transaction and advance losses accounted for approximately 0.1% of GPV.

These losses have been small in % GPV terms as the company chooses to emphasize – but when reflected as a % of either gross (ie, before paying fees to credit cards, banks) or net transaction revenues, these losses are concerning (4.6% of gross, and 15.7% of net transaction revenues, respectively, in 1H 2015).

Clearly 16% of your net transaction revenue – when gross margins (even excluding Starbucks) are only ~35% – is highly problematic. And thinking about it another way – on a gross basis, this scale of fraud-related loss – around 5% – is strange given this is roughly what American Express provisions for credit losses – but Square is of course not a credit provider, it is just processing the transactions. To have this level of fraud-related losses hit them is fairly inexplicable and I think speaks to under-investment in necessary fraud-prevention software, human support, fail-safe transaction oversight, etc – itself a function of how capital-poor the company has been for much of the last couple of years. There could also be a corollary to Square’s ease-of-use business model: the company promises transactions clear for merchants in 24 hours, which limits the window in which they can catch potentially fraudulent transactions and thus save themselves from these kinds of losses.

This brings me to Square’s capex, or rather lack of it. Square has spent a pitifully low amount on capex in recent years: just $29mm in 2014, and only $20mm in 1H 2015. This equates to 3-4% of revenues, while direct competitors like Paypal are spending 8-10% of revenues (on a much larger revenue base) and of course behemoths like Apple, Google, have limitless resources. It is just really tough to see how Square can even attempt to keep up with the Joneses at this level of capex intensity. Simply put – they won’t.

Why IPO now?

All this leads back to the most important question: why IPO now? There have been persistent sale rumors regarding Square in the last year or so – apparently they were going to be sold to Apple for $3bn last December, though Dorsey turned that down and instead Apple focused on Apple Pay, while Square did another funding round at $6bn implied. Retrospectively, that move is looking more and more to me like Dorsey won the battle but lost the war.

Frankly, the company as currently constituted – one good idea and great product, a number of product failures and unproven new ventures, highly cash consumptive, large market opportunity but increasing competition and existential threats around the corner, and very limited cash resources – would fit much better within the fold of a larger, cashed-up organization like an Apple or a Google than fighting on its own in the unforgiving public markets (my guess is this is what happens down the line, assuming they maintain relevance). Which of course begs the question, ‘Why IPO?’, and the pertinent answer is most likely ‘dumb money’ – that is to say, strategic acquirers had no interest in paying nosebleed valuations but the unknowing public presumably will (but not you, dear reader!).

It will be interesting to see how Square prices and trades: the IPO market has been quite tough, given recent volatility (First Data repriced their IPO and it traded poorly), and Square will be a ‘pie in the sky’ speculative offering. But even if it defies the gloomy backdrop and trades well, this is another hot tech IPO that, like so many others (Etsy, Groupon, etc) is more likely to end in tears. Caveat emptor.

Disclosure: no positions (but may go long PYPL short Square post-IPO)

The recent Volkswagen (VLKAY) emissions tampering scandal is about the worst thing that can happen to an investor – the kind of idiosyncratic, ‘deus ex machina‘ event that can devastate an investment thesis and yet is both uncontrollable and – for those of us who cannot afford to conduct a road emissions test of a VW – entirely unpredictable. Much like BP post the Macondo oil spill, VW stock has become effectively un-investable: the scale and scope of potential financial consequences are so wide (and so dependent on different variables) as to make valuing the stock next to impossible. If I was a VW investor (and thankfully I’m not), I would likely just dump it, take the pain, and move on – which, judging by the stock’s ~36% obliteration, seems to have been the choice of many. Painful, of course, but at least an exit strategy.

To me, more interesting are the broader consequences for the auto space, which has been crushed alongside VW. The VW-related auto supply chain names are variously down ~15%+, while even well-diversified (and minimally-VW exposed) other suppliers are down 10-15%; Europe-focused OEMs, meanwhile, are down ~15%+ (eg, Fiat Chrysler, Daimler, etc).  The market appears to harbor two main concerns:

• VW was not alone in manipulating their emissions tests and this could be industry-wide behavior (cf the Auto Bild article accusing BMW of similar behavior, although that article was later recanted);
• the scandal will force the entire industry to tighten standards (particularly in Europe), increasing costs and lowering profitability

I have a few problems with both of these conclusions. To the first point: the VW attempt was so brazen, and so outlandish, that I have a hard time concluding that this kind of behavior was widespread (especially when most all the other key OEMs have emphatically denied cheating their emissions tests). You could call me naive, but the sheer myopic idiocy of the VW leadership in pursuing such a high-risk, low-reward strategy suggests to me the actions of a deranged few. The uniform condemnation of VW’s behavior from other OEM execs, as well as the shock expressed, also supports this view. I firmly believe that subsequent tests and investigations into the other OEMs – even if they detect emissions over the limit – will demonstrate no purposeful manipulation of emissions tests themselves (this is key for brand and reputation).

The second contention – that tighter emissions standard industry-wide will curb profits due to higher costs – is more defensible, I suppose, but still lacks an internal logic to me, because if costs rise for everyone then either everyone raises prices to compensate, or they push costs down onto their supply chains to compensate; or some combination thereof. Bears may say this is short-sighted, and that some OEMs will look to absorb these increased costs in order to gain share. But how much increased costs are we actually talking about?

VW has already provisioned $7.3bn in costs to recall and upgrade 11mm vehicles, to bring them into line with emissions standards. This equates to about $660 per vehicle – or about ~2% of the average cost of a VW (looking at 2013 stats). I think the new-build cost per vehicle of meeting stricter emissions standards is likely lower than this (as this number should include a number of idiosyncratic recall-related costs). But even if we take the whole number, while clearly significant in the context of industry profitability (VW EBITDA margins, for example, have been in the 13-15% range the last 5yrs), I do not think it is unreasonable to think autos could, say, increase prices uniformly by 1% and push the additional 1% of their costs onto their supply chain. This behavior would only work if a) all the auto OEMs suffer the same new draconian regulations; and b) the OEMs have a mostly captive supply chain. Thankfully, in this case, both of these tenets apply.

So, not only are VW’s troubles likely unique to VW, but the specter of decimated industry profitability, on account of new regulations, is probably overstated too. How about the potential hit to VW’s sales – what could that look like?

We are getting a bit further into the weeds here, as the current scandal is largely without precedent. But other recall scandals may give us some idea of what could happen to VW. The Toyota sudden acceleration recall scandal in 2010-11 is a decent place to start: it involved a similar number of vehicles (10mm++), and involved a large management cover-up (Toyota management lied to investigators and hid the scope of the problem). Of course, Toyota did not purposefully cheat on tests, nor was their brake pad issue a massive environmental problem. On the other hand, over 100 deaths were ultimately tied to the Toyota issue (though the company admitted only a dozen or so directly caused), so the human cost was immeasurably higher. Additionally, from a reputation perspective, you could conceivably argue the Toyota case was more troubling for the company’s go-forward brand as it involved safety.

Taking all these differences into consideration, in FY12 – the first full-year of sales after the scope of Toyota’s issues came to light – saw Toyota North American sales (where the problem lay exclusively) fall 8% in unit terms; but other regions saw minimal declines or even increases. Perhaps more importantly, the following year, Toyota sales in North America rebounded 32% in volume terms, as the company’s full mea culpa found consumer forgiveness (admittedly the market recovery helped a lot too). Toyota’s US sales have been growing ever since.

So, despite a barrage of horrible headlines, and a memorable excoriation before the US senate, the actual sales damage done by the Toyota scandal was, in retrospect, localized, temporary, and very manageable. This has important analogues for the VW case, because – simply put – new car buyers do NOT seem to prioritize environmental considerations highly. Surveys on car buying considerations are a dime a dozen, but in a smattering of recent ones (here, here, here, and here), I could not find one where environmental considerations ranked highly for choosing a brand. Instead, reliability, quality and fuel economy were consistently ranked in the upper factors, while safety is important too (though not as important as it used to be as overall car safety has increased immeasurably); meanwhile more mundane considerations like styling, warranty features, and, of course, price all seem to outrank environmental considerations in this particular survey (from Feb 15):

This is not to say VW won’t suffer a sales backlash – of course they will. And their reputation for quality will certainly suffer alongside; this too will affect sales. But if VW management can demonstrate – and indeed their survival depends upon this – that the test cheating applied only to emissions and did not affect their safety ratings in any way, it is my contention that you will see a temporary, Toyota-like pullback in sales (-10%?)  followed by a recovery.

This is not to be confused with a recommendation to buy VW stock; as per my initial comment, the regulatory/legal financial penalty will be Sisyphean, such that – again, as per BP – VW equity should be in the penalty box for years. But the corollary for the broader auto parts supply chain is quite favorable. Consider the following:

• (as per above) VW issues are likely idiosyncratic and not systemic;
• (as per above) increased costs related to tougher emissions standards – even if they are realized, which is not a given – are likely at least partially funded by OEMs and/or passed on to the consumer;
• (as per above) VW-related sales will take a hit but this likely proves transitory in all but the most bearish, ‘doomsday’ type outcomes, and meanwhile the broader market is firm;
• the US auto market is enjoying days of ‘high cotton’, driven by pent-up post-recession demand, and ongoing low interest rates (thank you Janet!), such that August SAAR is likely to post a record 17.8mm units, the highest pace since July 2005;
• the European auto market (particularly Western Europe) has been recovering since QE began under Draghi, with new vehicle registrations rising 9% in Aug (the eighth consecutive YoY increase);
• meanwhile valuations – already low pre-VW – took another ~15% beating and now discount a ton of bad news

A final, more speculative bullish argument for the auto supply chain involves the potential for consolidation: while some of the auto OEMs (particularly Fiat Chrysler) have been championing OEM consolidation, a similar argument could be (and has been) made for the suppliers – ie, it is time to get bigger to gain more leverage versus the OEMs, especially in a world of tighter standards and higher specifications.

Within the space, I am long Tower International (TOWR), a supplier of body structures (think the skeleton of a car) to most all the major OEMs in the US and Europe. While – unfortunately – VW is a 15% customer, at this point (-15%) the bad news is mostly priced in, while the company has been consistently winning new business in North America, is in the process of divesting under-earning Chinese assets, should yield 15-20% FCF to equity in the next two years, is not aggressively levered (1.5x net) and would be a prospective acquisition candidate for larger names like Magna (MGA) or Martinrea (MRETF). You can read a more in-depth investment thesis for TOWR here.

Disclosure: long TOWR

Quicksilver (ZQK) has been one of my core bearish positions for most of the last year, as I viewed the company’s ~$800mm net debt load as unsustainable in the face of interminable secular trends and poor management. I highlighted some of the problems facing the company in a couple of Seeking Alpha articles here, here, and here.

Without rehashing the entire thesis, the basic premise was that in the short term, ZQK’s financial leverage was both unsupportable – too much leverage for a company seeing EBITDA crater and negative FCF – and also poorly structured – ~85% of the debt being subordinated to a small amount of senior debt outstanding which became the only source of liquidity and yet had nothing to gain by waiving covenants. In the medium term, the viability of ZQK’s three core brands – Quicksilver, Roxy, and DC – was threatened by the myopic decision ~2yrs ago to aggressively curtail athlete sponsorship and other marketing, thereby denuding any hope of meaningful brand recovery in the competitive teen apparel space and effectively condemning ZQK to low-margin, commoditized ‘retail hell’ (my pet term).

Horrid execution and FX headwinds (ZQK has 50% of sales outside the US) only added to the company’s woes, and ZQK filed for bankruptcy in the US today. While the company did not detail the immediate cause, I suspect an imminent covenant breach on its senior lending facility (which had minimum availability covenants threatened by ongoing cash burn, no other liquidity, and a shrinking borrowing base as the asset base shrank) was probably likely, as I had speculated last earnings report that best case, ZQK probably only had enough cash for a couple more quarters; ZQK likely tried to negotiate a waiver but since senior lenders had nothing to gain by extending more credit (given their tiny piece of the outstanding debt), it seems likely they simply refused to waive covenants and effectively tipped the company (super senior bank lenders will be made whole as a result). The various debt pieces reflect this reality: senior secured EUR and USD paper trade at the relatively lofty levels of 70-80c on the dollar, while the second lien USD bonds trade at 5c – a level that all but guarantees equity recovery will be a stone cold zero. Indeed, it is likely as well that unsecured creditors receive nothing in recovery other than a very, very small sliver of the new company’s equity (which Oaktree will control via their provision of DIP financing).

Before moving on to new business, it is worth reiterating what I believe is the main lesson of the ZQK story. Certainly, the company was caught in a maelstrom of secular forces, many of which – declining mall traffic, the rise of fast fashion, and a trough in surf and skate fashion interest among teens – appeared beyond its control. But more important, to me, were the horrible strategic decisions a succession of management teams made in the face of these challenges. Not one but two management teams chose to not pursue debt restructuring for years after it became clear the company was far too levered to effectively invest and market their product; this lesson was almost driven home (via bankruptcy) post Lehman, yet the company chose not to heed the warning the next time the business took another leg lower. Hence even when business – and the stock price – recovered, temporarily, a few years ago, there was no delevering through equity or asset sales when the chance was there. After that, ZQK made the odious choice to cut sponsorships – sacrosanct for a would-be premium athletics label – and also deracinate key staff – fatal to morale in recent years – just to maintain the debt burden, instead of, say, selling one of its core businesses or contemplating an earlier debt-for-equity exchange. This, in turn, only accelerated the vicious brand-destroying cycle, virtually guaranteeing ZQK’s fate.

Thus, if ever there was a poster child for the adage ‘you can’t cut your way to prosperity’, ZQK would be it. Hopefully the savvy new owners at Oaktree will realize this and – freed from the legacy debt burden – will rebuild the brand through investment, thereby righting recent management’s many missteps. Unfortunately, of course, this will come too late to help common shareholders – which was the core equity short thesis all along.

Disclosure: short ZQK (but not for much longer).