Thursday, October 27, 2022

This Earnings Season Vindicates the Value vs Growth Hypothesis

This quarter's earnings season has been vindicating the "value vs growth" hypothesis. The "growth" companies that have long been considered bulletproof and which were valued very expensively are reporting falling earnings, while value companies that are valued less expensively are turning out to have pricing power and are reporting higher earnings.

Let's go through some examples, starting with the three gigantic growth disappointments, Facebook, Google, and Amazon. These are important because the "FAAG" stocks dominate the indices and have had a tremendous run for more than a decade with consistently rising earnings and rising multiples that crescendoed last year. (Note: the second "A" in FAAG is Apple, which is arguably a value stock, and notably the only one of the four that Buffett has ever owned.)

Wasteland Capital posted a good analysis of the Facebook quarter. Revenue was down 4% in Q3 2022 vs the year ago quarter, but costs and expenses were up 19%. The result was that EBIT fell 46%, operating margin fell from 36% to 20%, and diluted earnings per share got cut in half to $1.64. 

Facebook is now trading for 15x earnings. Does that mean we should dump our Philip Morris and buy META since the multiple is about the same? Well, what if PM is actually the better business? Because the cash flow numbers for Facebook were even worse, thanks to Zuckerberg's huge investment in the "Metaverse" boondoggle. 

Look at the cash flow statement. For the first nine months of this year, Facebook had net income plus depreciation of $25 billion versus $36 billion the prior year. Capital expenditures this year to date have been $24 billion versus $14 billion. Free cash flow has dropped to nothing. As someone on Twitter pointed out, it "just swung from 50% cash flow margins to 0%, in one year, at scale, with strong market position. Are there any examples in history similar?"

What is also interesting is that the company borrowed money, despite not having free cash flow, to buy back stock. This is like looking at an oil company annual report from 2013. Someone else asked, "What if Zuck knows already that Facebook's core, advertisement based business model is ultimately doomed and that the Metaverse is the only chance to survive?"

At Google, again see Wasteland Capital's post. Revenue in the third quarter was up 6% versus the prior year, but costs were up 18%, resulting in an operating margin decrease from 32% to 25%. Earnings per share fell from $1.40 to $1.06 so it is now trading for 22x earnings. One of the big drivers is that the number of employees grew from 150k a year ago to 187k. And again, even worse is what happened to free cash flow. For the quarter, net income plus depreciation was $18 billion versus $22 billion a year ago. Capex went from $6.8 billion to $7.3 billion.

Wasteland Capital's writeup of Amazon's results is brutal: "Bezos’ China-goods flea-market delivered a steaming pile..." Operating income for the quarter was cut in half from the prior year. North America went from a small profit to a loss. Operating cash flow decreased 27% to $39.7 billion for the trailing twelve months, compared with $54.7 billion for the trailing twelve months ended September 30, 2021. Our preferred metric "Free cash flow less equipment finance leases and principal repayments of all other finance leases and financing obligations" decreased to an outflow of $21.5 billion for the trailing twelve months, compared with an outflow of $3.9 billion for the trailing twelve months ended September 30, 2021.

Investors in growth stocks were double counting - the companies were over-earning and these earnings were being capitalized at high multiples. Now that they are past peak cycle, the earnings are falling and they are being re-rated, and the shares are plunging. The NASDAQ is down 31% year-to-date. (Interestingly, the equal weight S&P 500 is down 14% YTD and SPY is down 19%.)

So those are the big three "growth" examples. We have to put that in quotes now because their earnings are declining. They still have a combined $2.6 trillion market capitalization (down from $5 trillion at the peak!) and collectively they do not generate much cash (thanks to Amazon's cash burn and Facebook's "Metaverse" bet). 

Someday, the ex-growth companies expenses will be slashed, their earnings will bottom, and by then they will undoubtedly trade at cheap multiples. But that may take a long time since Facebook and Google are dual share class corporate governance disasters. And the knock-on effects of those SG&A cuts will ripple far and wide - any prospective investment should be evaluated for such exposure. (It would be interesting to compare what percentage of tech employees use nicotine versus energy sector employees.)

Now that we have surveyed some of the growth wreckage, let us turn to the value results. As we mentioned, these companies are turning out to have pricing power and are reporting higher earnings thanks to various combinations of price increases and higher sales volumes.

Back in August the Biden administration claimed that this summer's refined fuel demand was lower than it had been in July 2020. (When fuel prices spiked in June, the EIA did not publish their data for two weeks because of a "voltage irregularity," then claimed that demand had fallen to below pandemic levels.) We knew that the data was wrong because midstream companies and refiners, like Magellan and Valero, were contradicting it in their Q2 results. Oil was below $100 per barrel for almost all of the third quarter, so it is interesting to see what third quarter reports are saying about demand. From the Valero conference call for Q3:

Q: "When you talk about demand surpassing 2019 levels for gasoline and diesel, is that primarily driven by strengthening your export channels? Is domestic demand in your areas of service equally strong?"

A: "Really, it's the domestic markets and our wholesale volumes have trended considerably higher. We set a wholesale volume record in August. We beat that in September, and we're on pace to beat it again in October. So wholesale volumes continue to trend higher. If you look at the pump market through our wholesale channels of trade, gasoline is trending about 8% above where we were pre-pandemic levels. Diesel volumes are trending about 32% above where we were pre-pandemic levels. So seeing really strong domestic demand through our wholesale channels of trade."

Q: "you talked about bulletproofing your balance sheet in the prior quarter, and you mentioned evaluating further reductions in your prepared remarks. How much lower would you like to get on your leverage"

A: "on the cash side, we're at a $4 billion cash balance, we talked about how, going forward, we like to hold more cash at $3 billion to $4 billion probably on the base level. But if you're looking at potentially higher flat price levels or economic downturn, you maybe want to hold a little bit more. So we bias to the upper end of that. So we're close to a good spot on both of those. On a long-term debt to cap -- net debt to cap, we have a 20% to 30% range that we target. We're at 24.5% now at the end of the third quarter, down from 40% at the highest point toward COVID. So we've been working in the right direction. I'd like to be even lower, you'd like to be at the 20% range [of debt to capital] to give you more financial flexibility going forward"

Q: "a part of that meeting [with the White House] was meant to see if there was any possibility if somebody could start a refinery up and we discuss -- the industry discuss the difficulty in doing that and that was really the main coming ones."

A: "there was consideration for the ability to restart refining capacity that had been shut down. And I think the general sentiment was that, that wasn't going to happen. Of course, we're not in that boat. But I mean, people had very good reasons for making the decisions that they made, and they weren't in a position to unwind those decisions. So, the solution is going to probably have to come from some waving of regulation or just reduction in demand, which we just haven't seen to-date."

Q: "You brought it up as there is obviously a risk of a slowing economic cycle out there. What level would you think about a typical recession impact in terms of fuel demand, recognizing gasoline is already well below what we would call, kind of, a normal environment. [...] I'm just wondering how you think about the typical magnitude impact of a recession on fuel demand."

A: "I guess as the guys have, kind of, gone back and looked at recessionary period in the past, they see their product demand has hit about two times GDP. So whatever GDP assumption you're going to have, you would take twice that on the impact of fuel demand. And as you mentioned, more of that is going to be diesel, less on gasoline. I think there are some unique situations as we head into next year. One, jet demand hasn't fully recovered. And so you'll have a good increase in jet demand as we would anticipate, and then Chinese oil demand has been down 20%. At some point in time, they will come out of the pandemic, and you would expect to see Chinese demand recover. So the combination of both those things is that we would expect, even with the typical recessionary period, you may see year-over-year global oil demand growth."

Valero reported earnings of $2.8 billion, or $7.19 per share, for Q3 2022, compared to $463 million, or $1.13 per share, for Q3 2021. That's less than 5x earnings on an annualized basis. Valero's net income plus depreciation for the year-to-date has been $10.5 billion. Capital expenditures have been $2 billion. With that remaining free cash flow, they spent $2.4 billion repaying debt, $1.2 billion on dividends, and $2.8 billion on share repurchases. Remember, this is only a $50 billion market capitalization company.

A few observations about the conference call excerpts. Oil and product demand is very strong even at current high fuel prices. Management is still depressed even though they are raking in money - they want to keep paying down debt. And no one sees a way to increase capacity in the industry.

We also see evidence of strong demand at Magellan Midstream, which reported results this morning. Their refined product shipments were flat Q3 2022 vs Q3 2021, but the transportation revenue per barrel shipped was up 8.7%. (And refined product shipments are up 4% year-to-date versus the first nine months of 2021, with the revenue per barrel up 3%.)

On a market cap of $11 billion and an enterprise value of $16 billion, Magellan's guidance is for $1.1 billion of distributable cash flow. So far this year, they have distributed $685 million and made $473 million of unit repurchases. (During the third quarter, they bought back 2.7 million units at an average price of about $50 per unit.) Units outstanding are down 3.5% year-to-date and the dividend yield this year has run about 8%. 

Amazingly, the MMP dividend yield was only 4% at the beginning of 2014 when the ten year bond was yielding 3%. The Magellan equity risk premium over its own 2050 note is now 160 bps, which has come down significantly. Of course, we must remember that inflation will make a big difference to the real returns of the debt holders versus the equity holders.

Altria also reported results this morning. The most important thing was that operating income in the smokeable segment (i.e. cigarettes) was up despite a bad volume decrease:

Net revenues decreased 1.6%, primarily driven by lower shipment volume and higher promotional investments, partially offset by higher pricing. Revenues net of excise taxes increased 0.4%. Reported OCI increased 1.4%, primarily driven by higher pricing, partially offset by lower shipment volume, higher promotional investments, higher costs and 2021 NPM Adjustment Items.

Smokeable income for the quarter went from $2.75 billion to $2.79 billion. Oral tobacco went from $405 to $425 million. Total operating income from $2.95 billion to $3.1 billion (5% increase). We've noticed that Altria has been heavily promoting their on! oral nicotine product, and indeed the volumes were up 68% year-over-year. 

Recall from earlier in this post how much money Facebook, Amazon, and Google are spending on capital expenditures - hundreds of billions of dollars over time. As Devin LaSarre points out regarding Altria, its capital expenditures are only a couple hundred million dollars: "unreal how much money this company makes with so little reinvested."

As we know, Altria owns 10% of AB Inbev (BUD), which also reported today. If you click through, you'll notice the pricing power (we have seen this across various branded consumer staples) - volumes up 3.7% but revenue up 12%.

Results from Suncor Energy are not in yet, but they made an interesting announcement:

Suncor Energy today announced that it has agreed to purchase an additional 21.3% working interest in the Fort Hills Project and associated sales and logistics agreements from Teck Resources Limited, for consideration of $1 billion. Upon closing, Suncor's aggregate share in the project will increase to 75.4%. The acquisition will be funded by cash from asset sale processes currently underway and the company remains on track with its previously articulated capital allocation framework.

They had previously announced that they sold their wind and solar assets to a Canadian utility, and that covers much of the cost of this working interest purchase. The one remaining partner in Fort Hills is a French energy company that thinks oil will be obsolete by 2050. It is a great sign that our management is picking up barrels, and hopefully they will buy out the stupid, politically correct French super-major oil company.

Recall what we wrote in our "New Milestones in the Value vs Growth Trade" post.

Further signs that the value vs growth trade is continuing will be redemptions from growth funds (that beget further selling), reversal of the ESG mandates and divestments of value stocks by institutions, insider selling and share issuances to fund losses at growth companies despite the lower prices, and a ripple effect up the growth quality and maturity ladders as the unprofitable growth companies buy less advertising and other services from even the profitable, mature FANGs ("cascading revenue declines"). 

It looks like the Facebook and Google are starting to suffer from the cascading revenue declines. But they must only just be starting, because Amazon Web Services is still holding up. Even Cathie Wood's "ARKK" ETF is still attracting inflows. 

A couple of ways to look at the big cap growth bubble is to chart the performance of the market capitalization weighted S&P 500 (SPY) ETF versus the equal weight S&P 500 (RSP) ETF, or chart the Vanguard IT versus Vanguard Energy.

We are still in the opening innings of the reversal in value versus growth, but today was a big drawdown for growth investors. Do you even hear any of them questioning themselves? From what I can see, they are blaming macro factors and not considering the strategic factor bet.

1 comment:

CP said...

Mark Zuckerberg has put $15 billion into the metaverse. There is simply no excuse for these products to be so awkward, bad and ugly when you are a company with such an abundance of resources, with so many “great minds,” with the ability to hire almost any engineer that you’d like. This is not a scrappy startup jostling for position - it’s a mismanaged corporate behemoth run by a clueless goon that has been running on empty for the best part of a decade