Quicksilver: A Quick Post-Mortem

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).

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Rayonier Advanced Materials: 50% cheaper in one day, but look before you leap

Outside of biotech (where binary outcomes are a dime a dozen), it’s rare to see a stock fall 50% in a day, even on horrible earnings – which is why the obliteration of Rayonier Advanced Materials (RYAM) yesterday more than piqued my interest. RYAM has had a short but tortured stock-market history. The company was spun off from parent Rayonier (RYN) barely 15 months ago, and produces both cellulose specialties (70% of FY14 sales), a feedstock polymer derived from wood pulp that goes in everything from cigarette filters to food thickeners to LCD displays; and commodity viscose (30% of FY14 sales), a raw material that goes into viscose staple fibers used primarily in the textile industry. At the time, RYAM boasted ~37% EBITDA margins (FY13), a dominant market share in the value-added cellulose specialty product arena, and tight, long-term customer relationships with premium specialty chems names like Eastman and Celanese. The stock traded above $45/share as recently as June 2014.

Fast forward barely a year and oh, how the picture has changed. The cellulose specialty segment – supposedly resistant to declining prices and cheaper competition due to its value-added, premium nature – has seen pricing collapse, driven by the advent of new supply from Brazilian and Chinese competitors and weak demand (partially a function of increased anti-smoking regulation in China, a major market for the company’s cellulose product). Multi-year contracts with long-term customers have meant relatively little, as prices tend to be negotiated yearly and take account of the changing supply/demand mix. A key customer, Celanese (14% of sales in FY13), completely dropped the company in FY14 and could presage further customer losses (more on this later). As a result, EBITDA margins have cratered, falling from the aforementioned 37% in FY13, to 23% in 1H FY15. These problems have been compounded by FX (~50% of sales are outside North America, with high-20s % in China).

Management, meanwhile, has been on a value destruction mission all of their own. In late 2014, the company added ~$90mm in long-term environmental clean-up liabilities that the former parent, Rayonier, had mysteriously neglected to provision for pre-spinoff (particularly galling given RYAM’s CEO came from the parent). More shocking, though, was the mid-2015 admittal that the company had too much capacity in its premium segment (cellulose specialty) and would spend $25mm to repurpose ~25% of its capacity in this area towards the commodity viscose product. Repurposing capacity away from supposedly high-margin, premium products towards a lower-end offering would be bad enough, but it gets worse. Management had spent ~$385mm to upgrade the commodity viscose line to cellulose specialty production just a couple of years ago – meaning management had willfully spent ~$410mm (about $10/share) to get back to a lower-margin business mix, with lower overall capacity (and hence lower growth potential). Adding insult to injury was the structure of the spin-off, whereby Rayonier added ~$930mm of net debt via a special dividend out to the parent at the time of the spin – thereby leaving RYAM precariously levered even as the market environment weakened considerably. As of 2Q FY15, most all of this debt ($830mm net) remains outstanding.

All this covers up until two days ago, and explains why RYAM fell from ~$45/share to ~$14/share over the last year – at which point, the company filed an 8-K explaining they had just launched legal action against their largest customer, Eastman Chemical (31% of sales in FY14), for breach of contract. Apparently the dispute centers around the ‘meet or release’ provisions of the supply contract, under which Eastman has the right to source a third-party price-point for the product they would buy from RYAM, and then force RYAM to either match the price (assuming it is lower) or allow Eastman to source their product away from RYAM. The locus of the disagreement concerns the amount of material covered by this clause: Eastman claims they can use the ‘meet or release’ provision for ALL their purchases, while RYAM claims it is just ~2.5% of their total sales. Either way, this catalyzed yesterday’s 50% obliteration, and provided the latest example par excellence for the well-worn Murphy’s Law precept: “anything that can go wrong, will go wrong – at the worst possible moment.”

RYAM’s CEO – who I think we have demonstrated has been a horrible steward of the business – was surprisingly blase about the whole issue, and had this to say:

Pricing negotiations are always spirited debates around a number of factors and threatened or actual litigation is one tool that parties can employ. Although Rayonier Advanced Materials would have preferred to address any concerns or negotiations around pricing privately, Eastman’s August 4 action required us to take the necessary steps to protect our contractual arrangement…We remain committed to resolving our differences with our largest customer in a constructive manner and continuing our 85 year relationship, which has been mutually beneficial to both parties, for many years to come.

This sanguine assessment, however, belies the fact that all the outcomes for RYAM are beyond bleak. Prices are generally negotiated yearly, in November/December, for the year ahead; as such, the timing of this move is strange (early-August), and begs a deeper explanation than ‘spirited debates around a number of factors.’ As the CEO mentioned, Eastman has an 85-year history with RYAM, and (to my knowledge) has not sought the courts to allow exit from contractual provisions with RYAM before; why do so now and risk the whole relationship?

The obvious answer is either 1) pricing outside of the RYAM contract has absolutely collapsed, making RYAM’s offering wildly uneconomic; or 2) Eastman is being offered large new supply (at cheaper levels) that meets their quality specs, and no longer needs RYAM in the long-term; or alternatively some combination of the two. It appears, in my view, that RYAM is becoming, or rather has become, the high-cost producer in a rapidly-commoditizing market. Ouch.

There is further evidence this is happening. As mentioned earlier, RYAM lost the Celanese business last fiscal year, due to the aggressive growth in market share won by Brazilian competitor Bracell. The largest cost (outside transportation and overhead) in producing wood pulp is, clearly, wood, and Bracell not only is fully integrated (ie, owning their own forests), they also have developed a process to create cellulose polymers from eucalyptus trees instead of the hardwood trees that RYAM relies upon. Since eucalyptus in South America (where Bracell sources) costs ~35-40% less than hardwood in North America (even before considering integration benefits, and also the currency benefits of the weak BRL), it is no surprise that Bracell should be far further down the cost curve than RYAM, and with increasing commoditization, in a position to win more business from previously-unattainable clients. RYAM effectively admitted this with its recent announcement to move a good chunk of its specialty production towards commodity viscose, as discussed.

So, RYAM lost the Celanese business because it couldn’t compete on price and didn’t offer anything extraordinary on quality; and this also could be happening with Eastman, behind the scenes. But even if Eastman doesn’t win the right to price away from RYAM on its current contract (thereby protecting FY15 revenue and margins), given most all of RYAM’s key client business will be up for re-negotiation over the next two years (including Celanese affiliate, Nantong, which constituted 18% of FY14 sales and likely goes the way of Celanese, ie, out the door), it is hard to see anything other than intense margin pain as the best case outcome for RYAM going forward.

This is why yesterday’s 50% correction may actually be too little. While of course a favorable ruling in the Eastman dispute would help RYAM stock short-term, it is tough to see how FY16 earnings are anything but substantially lower than FY15, as clients either force RYAM to match on price or walk away (the market remains in a grim oversupply, as competitor Tembec’s recent earnings release describes). RYAM is guiding to ~$210mm in EBITDA this year on revenue of ~$930mm (23% margin), putting the stock, at $7.6, at an EV of $1.16bn, ($327mm market cap, $835mm net debt), or EV/EBITDA of 5.5x, with net leverage of 4x. In reality, the valuation is a good deal higher, once you adjust for pensions ($141mm underfunding) and environmental clean-up liabilities ($157mm) – both of which are effectively debt for a company like this (in my view, in a wind-up they would be treated at least pari-passu with unsecured debt and perhaps effectively senior). Fully adjusted, I get 7x EV/EBITDA on FY15 numbers. This is not that cheap.

And while the business will throw of solid FCF in 2H 2015 (~$60mm?) and looks very juicy on a a one year, P/FCF basis, looking out to FY16 should provide nothing but more pain on both lines. Even just a 10% and 5% decline in revenues and margins respectively would see EBITDA fall to $150mm and net leverage balloon to ~5x (excluding pensions, environmental liabilities) on relatively generous cash flow assumptions; while in reality I think margins could fall a lot more (and clearly this doesn’t contemplate the loss of Eastman or Nantong business next year). At year end FY16, even allowing for organic growth in the equity through FCF-led debt paydown, at current prices the stock is ~8.8x adjusted EV/EBITDA on my FY16 EBITDA estimate – not a low multiple for a commoditized business stuck in margin purgatory and high up the cost curve. Bracell, meanwhile, trades at just ~3.3x EV/EBITDA.

None of this is in the consensus numbers (even though a good portion of the revenue decline can be justified purely on the strength of the USD), I think because analysts don’t appreciate the significance of the Eastman legal move and what it means for RYAM’s pricing power going forward. I should also add: I am NOT short RYAM at the moment (given the violence of the break lower), though I will look to initiate a position if the stock rebounds somewhat closer to $10 and/or via deep downside puts, later in the year.

Disclosure: no position in RYAM, RYN or Bracell (but may go short RYAM/long Bracell in the medium-term)

Everyone loves a comeback – but why?

“Everyone loves a comeback” – you’ve probably heard that phrase applied many times to down-on-their-luck movie stars or sportsmen trying to mount a career resurgence. But the public fascination with comebacks applies equally to the capital markets. In fact, turnaround stories are a necessary product of how the market works every day: the very nature of the capitalist system pushes the winners to expand and gain share, and the losers to shrink, regroup, and try again (as long as they’re still in business). While of course every situation is a bit different, in general turnarounds can be great opportunities for investors, as whenever a company is radically changing the composition of its business there is a higher degree of uncertainty as to what that company’s future will look like – and hence there can exist considerably divergent views on the future value of a given stock (which allows you to make $$ if you get it right).

Where I differ from most, I suppose, is that instead of looking at restructuring companies as an opportunity to buy businesses on the dip, I instead try to identify situations where the turnaround is either doomed to failure, or will take a lot longer (and be more painful) than the market is expecting. Perhaps I am pessimistic by nature, but I have noticed that investors in general – and the sell-side community in particular – perennially over-estimate the likelihood of a comeback business regaining its former glory. I am not sure if this speaks to the poor quality of sell-side analysts (perhaps), who tend to believe a given company’s managers when they promise a successful turnaround; or perhaps it is to do with the eternal optimism of human nature as it pertains to the stock market (since, of course, over the long-term economies grow and stocks invariably rise). But in any case, as these overly-optimistic expectations are disappointed, the companies’ stocks tend to underperform, and as a result you can make money betting against these nascent comebacks either not getting off the ground, or taking a whole lot longer to get going.

Perhaps a few examples will help demonstrate this idea in practice. One of my largest investments on the short side over the last year has been Elizabeth Arden (RDEN), a beauty company that over-expanded into celebrity/designer fragrances, under-invested in their core brand, and as a result announced in the third quarter last year a fairly intensive restructuring plan to try to clean up the mess. Despite fairly clear signposting from management that turning the business would be long and painful (accompanied by a number of disastrous quarterly reports), sell-side analysts as recently as April this year maintained the same level of expected profitability (ie, EBITDA) for 2016 as they had in September/October 2014 (ie, when the restructuring plan was announced). It was only in recent days – once again, after another horrid earnings report – that the numbers started to come down meaningfully (though I still feel they are too high). I am no longer short RDEN (the stock has fallen ~50% in the last year), but the sell-side’s misreading of the depth of the company’s trough in performance is instructive, and, I think, related to excessive optimism that the business could be resuscitated easily.

There are numerous other examples, many of them in the consumer space. Aeropostale (ARO), the teen retailer, and Quicksilver (ZQK), the surf/skate retailer, have seen EBITDA contract for the last four years in a row – yet looking at sell-side consensus numbers, analysts predict profitability will improve sequentially in each of the next three. This is effectively calling the current year’s earnings the trough – the only problem being that if you look back at historical estimates a year, or two years ago, sell-side consensus similarly called a bottom in the then-current year and of course extrapolated similar, multi-year improvement…only to be disappointed time and time again.

Now, I am not short ARO currently, but it has been trying to restructure its business in the face of seemingly endemic structural challenges (the decline of mall traffic, the rise of fast fashion, a collapse in teen demand for logo product, a move away from denim, etc), and has been closing some stores and restructuring others for years. The story is similar, though a bit more complex, at ZQK (where I am still short as I think it ends in bankruptcy rather soon). I suppose you could argue after years of losses these businesses are bound to turn, but in my experience, capitalism doesn’t generally work that way – both negative and positive trends take a lot of breaking (that is, the winners tend to keep winning: look at Facebook and Twitter for a current example par excellence). As mentioned above, the sell-side consensus was consistently wrong in calling the bottom in both names, even though to even mildly-informed observers the odds of a successful comeback in both appeared significantly lower than their continued deterioration at most all points over the last few years. Why, then, do analysts (and thus the investors subject to their opinions) continue to make life so difficult for themselves and try to call the trough?

The answer is mostly related to incentives and roles in the market. I don’t mean to jump on sell-side analysts too much, but in general their job is to pick stocks to buy, which by necessity involves the hazardous exercise of trying to pick bottoms in restructuring stories like RDEN, ARO, and ZQK. As per the above, this is almost an exercise in futility. To me, it is far easier – and more profitable – to identify which turnarounds are likely to continue ad infinitum or end in tears than to call an inflection point on a struggling or perhaps structurally-impaired business.

There is one main reason why this is the case: often, management will signpost – either implictly or explicitly – that a turnaround will take a while or be quite painful. The example of Sodastream (SODA), the Israeli purveyor of homemade soda, is a case in point. In response to plummeting sales of their home soda-makers in the US, they announced a large restructuring and rebranding of their entire product line – away from soda and towards flavored water – in mid-2014. Such a large transition obviously carried significant risks: the water market is more competitive, has lower price-points (in general), and the company risked alienating its core of home soda enthusiasts in Europe. Furthermore the company would be transitioning from an older production facility in a controversial location (the West Bank) to a newer, more costly one in Israel proper.

To be fair to management, the company was fairly realistic in depicting a many-quarter turnaround, and stopped giving annual guidance (always a sign that the future outlook is probably bleaker than you think). They did not over-promise and under-deliver; but it should have been quite obvious to even casual observers that this was a major company-wide brand relaunch – a complete product overhaul whose success was anything but guaranteed. And yet, the sell-side consensus as of Dec’14 (about 4 months after the restructuring was formally announced) still pegged 2015 earnings (EBITDA) at 2014 levels ($60mm) – basically the all-time earnings peak for the company, and DOUBLE reported FY13 earnings ($32mm).

Fast forward a few more quarters, and predictably, the transition is taking longer, and costing much more in lost profits, than the analysts (but not the company, to be fair) expected. The street now expects FY15 earnings to come in at $39mm (and that number is heading lower), and the stock has fallen another 25% since announcing the initial restructuring. And yet, once again, the inability to execute on the turnaround plan dulls not the belief in its viability (as perhaps it logically should) but merely pushes back to next year (FY16) the sanguine forecasts for recovery (consensus FY16 EBITDA is $51mm at the moment).

Now, I have no stake in the Sodastream story either way at the moment (though I have shorted it in the past) – but it clearly encapsulates Wall Street’s almost religious adherence to the doctrine of the successful comeback, no matter the circumstances. Whether a function of the street’s role as a corporate cheerleader, or the natural optimism of most all market players, this is an opportunity for those willing to weigh the case for a comeback not on the basis of “once it bottoms, how much could it bounce?” but instead, “will it actually bottom or is there more pain to come?” And while still difficult, in my experience the latter question is much more solvable – and more profitable – than the former.

Disclosure: short ZQK, no position in SODA, ARO, or RDEN

Quick update on Avolon (AVOL)

Avolon (AVOL), an Ireland-based aircraft lessor, has been one of my core positions on the long side for the last six months or so. You can read my original thesis and follow-up here (for those with Seeking Alpha Pro access); for those without, AVOL was basically an under-covered, cheap name in a secular growth sector (aircraft leasing) with temporary obscurity a function of recent IPO, private equity ownership overhang, and investor lethargy. Not only was it cheap but it possessed the newest fleet in the industry, had demonstrated an ability to profitably trade aircraft on the side, and had articulated an aggressive but realistic growth plan for the next couple years.

http://seekingalpha.com/article/2974306-avolon-growing-underfollowed-business-at-steep-discount-to-comps-40-percent-upside

http://seekingalpha.com/article/3152756-avolon-update-impressive-q1-execution-valuation-gap-vs-peers-will-continue-to-narrow

That’s the background; AVOL stock was at $20 about 6months ago, and had trundled along, doing pretty well but not spectacularly, rallying to ~$24 by July. However, the situation has gotten considerably more exciting in the last few weeks. Firstly a Chinese leasing company, Bohai, reached an agreement to buy 20% of AVOL at $26/share via tender offer (a premium to the then-stock price of ~$24).

This drew out other bidders, and AVOL announced today both that a) a third-party (strategic) buyer bid $30/share; and b) Bohai responded quickly to top that new offer by bidding $31/share for the whole company. AVOL remains in negotiations with both parties, and it clearly seems the company is ‘in play.’

Clearly a takeout is not something I expected in my original thesis, but we can file it under that joyous category of ‘good things happen to cheap stocks’. Even at $31/share, AVOL trades at ~10-11x my estimate for FY15 adjusted EPS, and ~9x FY16. The P/B metric looks a little high at ~1.5x vs sector comps, but adjusted for the embedded fleet value, its more like 1.2x (vs comps in the 1-1.15x range). Buyers appear quite willing to pay a premium for AVOL’s best-in-class fleet (in age and aircraft mix terms), attractively-priced order book, and track record of successful execution – aspects of the name that were originally discounted by the market, but I speculated could command a premium valuation. Size plays a factor too: AVOL remains one of the smaller names in the space, so an easier bite to swallow for foreign strategics than one of the much larger names like Air Lease (AER) or Aercap (AER).

While I would have been happy with $28 to exit a position I put on at $20, clearly in an acquisition scenario the multiples should be a bit higher and already some analysts think there could be a bit of a bidding war here. Clearly there are at least two motivated buyers, and AVOL’s initial reaction suggests they are willing to sell the company – just at the right price after an active negotiation. I view anti-trust/regulatory risk as minimal given AVOL is not a large player globally, is based in Ireland (historically a decent geography for inbound acquisitions) and is not systematic to any single country in any meaningful way. Financial risk on the bids would be something to consider once a formal bid/merger agreement is announced, however.

I would take profits on the trade in the $31-32 range, if we get there.

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.

Why I bought Greek stocks today

I just came back from a very pleasant two week vacation spent mostly in Greece, and despite the natural beauty of the islands and sunny disposition of the locals, you could not help but be affected by the mounting tension as the debt drama enters its ultimate stages. However, upon returning to Asia – and after Greek PM Alexis Tsipras’ shocking decision to put the latest EU bailout offer to a popular vote this coming weekend – I decided to take a bit of a punt on the long side in Greek stocks (via the ETF listed in the US, GREK is the ticker).

Let me explain: for the most part I am not a macro investor (other than occasional currency trades); nor am I an expert on the current European situation or the Greek debt crisis. I am however a believer in ‘behavioral finance’ and from this perspective I think the current ‘base-case’ narrative about Greece at the moment – that Greece will now default and exit the Euro – is a bit off. Let’s backtrack a little to start.

The Tsipras government was elected a few months ago with a curious mandate: the campaign was based on an anti-austerity platform, but not a “leave the Euro and go back to the drachma” platform (this is confirmed by even a cursory examination of Tsipras’ recent as well as past rhetoric). Both Tsipras and his vitriolic finance minister, Varoufakis, have been quite clear in pushing a hard line on ending austerity, but on wanting to keep Greece in the Euro. This makes sense: polls have consistently shown the majority of Greeks want to stay in the Euro, but has been a difficult course to navigate in negotiations with the EU (since any statements by the Greek leaders to the public about not leaving the Eurozone only help the EU bloc in their negotiations).

Now, whether you believe the calling of a referendum is the act of ultimate brinksmanship or not, representatives of the EU bloc – from Juncker to Merkel to Schaubel, etc – have clearly outlined that a ‘no’ vote from the people in the referendum would effectively signal a Greek exit from the Eurozone (no matter that the Greek PM claims otherwise). It is vital to understand that while these negotiations have been dragging on in recent weeks, Euro-denominated deposits have been exiting Greek banks, first in a trickle, and more recently, in a flood, as worried Greeks fear that a) their local banks will be insolvent if Greece defaults (true); b) any remaining currency may only become available to them later in drachmas in the worse case (likely true); and c) even if they do get their money back in Euros or drachmas, it could take many months to sort out the mess after a default (also likely true). The only reason Greek banks didn’t shut before this past weekend was because the ECB provided ‘Emergency Liqudity Assistance’ (ELA) – effectively, an emergency loan – to the Greek central bank, in the form of Euros which were used in turn to fund the Greek banks and allow the ongoing outflow of deposits. Hence the ECB effectively upped their exposure to Greece, assuming the negotiations would get done.

Now, however, with the calling of a referendum and the spectre of a default, the ECB has capped the ELA (ie not providing any new funds), forcing the closure of banks (and the stockmarket) to prevent a full-scale capital rout. It was this action that caught the Greek leadership completely by surprise and prompted the following response from Tsipras:

It is clear that the objective of the Eurogroup’s and ECB’s decisions is to attempt to blackmail the will of the Greek people and to hinder democratic processes, namely holding the referendum. They will not succeed. These decisions will only serve to bring about the very opposite result. They will further strengthen the resolve of the Greek people to reject the unacceptable memorandum proposals and the institutions’ ultimatums. One thing remains certain: the refusal of an extension of a few short days, and the attempt to cancel a purely democratic process is an insult and a great disgrace to Europe’s democratic traditions…What is needed in the coming days is composure and patience. The bank deposits in the Greek banks are entirely secure.

I have highlighted the statements I feel are most inaccurate and the source of the current opportunity. Tsipras can rage all he wants, but clearly bank deposits are not secure – otherwise why close the banks? More importantly, put yourself into an ordinary Greek citizen’s position at the moment. A huge percentage of adult Greeks (perhaps a quarter to a third) are unemployed: as such they rely on savings and/or pension/government assistance to survive. Banks have been shut and may disappear, and clearly the pension or government handouts could too if a Euro exit throws the country into chaos. We all know the economy has been suffering for years and even those lucky enough to have jobs, I’m sure, rely on savings/government help for subsistence.

If you were the average Greek in this situation, would you vote to maintain your supposed ‘pride’ and go along with a bunch of politicians? Or – knowing that the alternative likely bankrupts you and most all your family – would you vote to stay in the Euro and accept the supposedly unfair bailout terms? Even if a default and Euro exit happens in 6 months, at the very least you could access your bank account again and get your money out. And in any case the bailout terms could potentially be renegotiated again down the road (after all, it has happened many times before).
In short, while the politicians appeal to national solidarity, in a situation like this, for those unfortunate souls struggling at the margins – and the sad reality in Greece is that a large proportion of the population is thus positioned – you have to think of your immediate survival first. That means cash in hand – and the only way to guarantee you have that in the immediate term is to stay in the Eurozone.
Hence, I expect a solid ‘Yes’ vote from any referendum this weekend, which should provide a massive relief rally to markets globally but especially Greek stocks (which will stay closed this week but have been killed in recent weeks and were -20% in US trading yesterday). Initial opinion polls suggest a “Yes” outcome is more likely, noting the desire of most Greeks to stay in the Eurozone, though of course the situation is fluid. Such an outcome would lead most likely to the fall of the Greek government and therefore some political instability – but the will of the people to remain in the Euro will have been made clear, and that should be calming for markets (and tangentially negative for the Euro). There is also a small chance that the Tsipras government, sensing the wind of popular opinion, backs off the rhetoric a bit, the referendum doesn’t happen and sides return to the negotiation table and hammer out a deal – this would also help Greek markets, clearly.
Of course, this is a very binary outcome – Greek stocks could fall another 50% or more if they do exit the Euro – and so all the usual disclosures apply and then some: this is most definitely the ‘deep end of the pool’ (experts swimmers only). To guard against the downside case I am expressing my bullish view through call options (which limit my risk to the premium paid, if I am wrong), and I would suggest those like-minded do the same.

Yahoo: Marissa Mayer’s clock is ticking (and that’s a good thing for shareholders)

Yahoo (YHOO) was by far my largest holding on the long side for the better part of all 2014. I had a fairly simple (and somewhat consensus) view: that the core search business, weak as it was, was largely immaterial to the stock’s prospects before the Alibaba IPO; that excitement would build regarding Alibaba’s valuation and the implications for Yahoo’s large stake; and that the Alibaba IPO would go extremely well. I articulated these views in an article on Seeking Alpha and did well on the stock, buying mostly in the low-mid $30s and exiting around the Alibaba IPO in the low-mid $40s. Since then I have kept half an eye on the story and moved on to fresher pastures, since – while still cheap – the stock’s main catalyst had come and gone.

YHOO popped back onto my radar last night after plunging 8% into the close on some vague reports out of someone at the IRS that the company’s contemplated tax-free spin-off of its remaining Alibaba stake – one of Marissa Mayer’s key tasks in her promise to create more value for shareholders – could be derailed by the IRS changing its stance on these kinds of spin-offs (really, closing a loophole). By my calcs, the difference to YHOO stock between a post-tax and pre-tax Alibaba position is ~$6-7 per YHOO share, so the ~$3.5 decline in the stock on this news adequately reflects the uncertainty on the tax issue. What it doesn’t solve, however, is where the stock goes from here.

To recap briefly: the case for investing in YHOO stock has been a sum-of-the-parts (SoTP) cheapness for years. To some extent, this is true: if you back out the Alibaba (BABA) and Yahoo Japan (4689.T) stakes – even assuming full taxation (at 25%) – and deduct net cash, even a paltry 4x EBITDA multiple on the core business (about half what Verizon paid to acquire AOL recently, and quite a distressed multiple) gets you to ~$39/share. And if you assume YHOO can do the BABA/YJ spin-offs in a tax free manner, fair value on the stock is closer to $48/share. Anything more than that for the core business (and in an acquisition scenario, the multiple would indeed be higher), would be gravy. As per below (source: YHOO filings, my estimates):

yahoo 1

Of course, there are a few counterpoints to this easy optimism. One is the inherent nature of the cheapness: YHOO’s core business has been in structural decline, and presumably will remain so; as such it has always traded ‘cheap’ and what is to change that now? The other, more persuasive point to me is that whereas buying YHOO last year in the low-mid $30s involved buying the SoTP at a price still cheap to the implied private market valuation of BABA (at the time, I speculated $130bn), Alibaba now trades at a whopping $217bn with arguably cloudier near-term prospects. To put it another way – BABA could correct downwards by ~20% quite easily, still be much more expensive than it was a year ago, and make YHOO’s current ‘cheapness’ quite illusory.

On the other hand, there are deeper reasons to be optimistic on YHOO around $40 a share. For one: it appears unlikely, even now, that YHOO shareholders suffer full taxation on both their BABA and YJ stakes. Some of the stakes are held offshore, beyond the IRS’ grasp, while the recent noises from an IRS official were not official rulings nor pronouncements; indeed, with the BABA spin slated to go through this year, it could squeak by before the rules are changed, if they are changed. And even if the rules do change, YHOO management would be idiotic to continue with the spin and would likely try to pursue another angle to remove the tax burden (perhaps selling the stake back to the respective companies, or including more substantial assets in the SpinCo to pass the new rules for tax-free status, etc).

Thinking more deeply, though. there are further value levers for the company to pull. Starboard Value, a successful activist investor, had been pushing not only for the tax-free spin of Alibaba (and Yahoo Japan), but also the merger with AOL (AOL) to pursue cost synergies. Personally I never liked that idea – the marriage of two Internet 1.0 businesses – but since AOL has now agreed to be acquired by Verizon (VZ) it is off the table. But YHOO still has an incredibly bloated cost structure for a business struggling to generate growth – so Starboard is right to imply there is plenty of fat to cut.

Consider: YHOO has 12.5k employees but will post just $4.3bn of revenue this year ($345k/employee). AOL has a third as many employees (4.5k) but generates over half as much revenue ($2.7bn), or $590k/employee, close to double YHOO’s efficiency. And while clearly not a perfect comp, Google generates $60bn in revs on an employee base of 55k, for just over $1mm/employee. Clearly scale helps Google and the business is not all search/display advertising (though it is, mostly, search); but just by looking at AOL, it’s quite clear a new manager at YHOO would look to clear the decks, fire a good portion (25%?) of the workforce, and tighten the expense budget considerably.

This leads to the biggest potential wild-card upside for YHOO shareholders: potential new management. If the tax-free spin of BABA fails, and if Tumblr/Yahoo Mobile growth remains anemic, there is a decent, non-zero chance that Marissa Mayer is either forced out and replaced by value-oriented managers, or decides to shop the company to appease the activists who – rightly – would be baying for her blood. By my judgement, she probably really only has a few more quarters of leeway. While her stewardship of the BABA transaction (through IPO at least) was solid and she has repurchased a lot of stock, she hasn’t demonstrated any ability to regenerate the business and engineer growth. She has been at Yahoo for almost 3 years now and has had ample time to recast the company as she sees fit; but frankly, it has not arrested the decline. If I was a YHOO shareholder (and currently I’m not), I would be hoping beyond hope that the BABA spinoff fails and activists use it to oust Mayer, give up on her imperial dream of rebuilding a once-great business, and install a new, value-conscious manager who will either tighten the company’s belt aggressively, or break it up and sell it off for parts (or maybe a bit of both). In that scenario, the stock should crest $50 pretty easily.

Disclosure: no position in YHOO