Saturday, May 13, 2023

Some Large Cap Short Ideas

There are so many cheap ideas out there - it would be nice to have higher gross exposure but also be hedged against general market and recession risk. One way to do this might be to have a short book consisting of large caps that are less susceptible to being squeezed. We would want to find businesses that have low FCF/EV yields as things stand, leverage (debt) that is going to be repricing higher, oblivious retail shareholders who own for the dividend, and a dividend which might get cut because of some combination of deteriorating demand, under-investment (rising capex), or rising costs (either operational or financial, from higher rates).

A good way to do this is to look at the list of largest companies by market capitalization and see whether there are outliers. You may recall this was the thought experiment that led to buying value in 2020, hedged with Tesla.

Did you know McDonald's is the 27th largest public company in the U.S., with a market capitalization of $218 billion and an enterprise value of $250 billion?

Revenue for the past twelve months was $23 billion. Would you have guessed that MCD was trading for 8 times sales? Ten years ago, it was a third of that. McDonald's EBITDA (ttm) was $10 billion a decade ago and now it's $11.5 billion. So our enterprise value is 22x EBITDA. Free cash flow was maybe $2 billion last quarter. That's a FCF/EV yield of 3%. The P/E is 30 times the most recent quarter's annualized earnings.

What's going on here? Jessie Felder wrote about McDonald's last month. It's one of four stocks that he calls, "the fantastic four of financial engineering." Here's how he explains their enormous increases in valuation (e.g. enterprise value to revenue):

Looking at their balance sheets, however, the answer became immediately obvious. As a group, they had taken on over $100 billion in new debt in order to finance buyback programs of almost exactly the same amount. In essence, it was just a massive equity-for-debt swap and all that new debt-financed demand for shares explained how valuations soared even as business conditions stagnated. Even as share counts fell, market cap rose due to all the buying they were doing; add in all the new debt on the balance sheet and enterprise values were soaring even faster than the share prices.

He points out that these share buybacks goosed the value of managements' stock options, and that there is a problem looming for this equity-for debt swap. That is that interest rates have risen substantially.

McDonald's indeed has increased total liabilities from $19 billion a decade ago to $58 billion today. This quarter, the interest expense on their $36.6 billion of debt was $330 million; a 3.6% cost. If it rises to the market price of around 5% that would be a $500 million hit to pre-tax interest.

Not all that much - rising interest is not going to be the big story here, although it may be at more leveraged companies. (But notice that McDonald's dividend yield is 2% and the debt yields 5%. That is a -300bps equity risk premium.) What seems more interesting is that the shares are so expensive and that the growth potential is limited. People are noticing that a McDonald's sandwich is now quite expensive. And as we see with tobacco companies, there is cheaper, better competition (In-N-Out burger, for example) for McDonald's that puts a ceiling on the price-raising strategy.

What happens if you generate "float" (investable funds) by shorting a no-growth company at 30x earnings and you buy pipelines at 10% free cash flow yields?

Another idea is Disney. The market capitalization is $170 billion and they have net liabilities exluding deferred taxes of $45 billion for an enterprise value of $215 billion. Net income of $1.3 billion for the quarter, which means it is trading for 33x earnings.

Cash from operations for the past six months was $2.3 billion, but should deduct $570 million of share-based compensation. They spent $2.4 billion on parks over the same time period - free cash flow is negative. Disney does not pay a dividend and hasn't since December 2019.

They have two segments, Media and Entertainment Distribution, which earned $1.1 billion for the quarter, and then Parks/Experiences, which earned $2.2 billion. Seems like if we had a big bad recession, the Parks earnings would get crushed. Check out these threads about how much families are spending at the properties. It is funny that met coal producers with no debt trade at 1x EBITDA because of the big, bad recession, but an entirely discretionary theme park where proles drop $5,000 on tacky Star Wars merch is worth 18x EBITDA.

Disney has not had much free cash flow since 2018 (when they bought 21st Century Fox), and they have lived beyond their means so long-term debt has grown. Interest expense for the quarter was 2.7% but their debt is now yielding more like 5.5%. That extra 280 bps on $38 billion of net debt will eventually mean an extra $1.1 billion of interest expense annually. That actually is very meaningful and a potential catalyst. We would need to think about what a reasonable valuation would be, but $215 billion for the enterprise does not seem attractive at all.

As we think about how we might generate our "float" from overvalued large cap companies, one idea that comes to mind is selling long-term, in-the-money DIS call options. Disney shares are currently $92 and a June 2024 call at a $50 strike is $45 for a breakeven of $95.

Another idea for this basket comes from a very important investing precept: if you sell an investment, you should consider shorting it. (Since people have a tendency to sell winners too early, a corollary would be not to sell something unless the valuation is so extreme that you would short it.) Recall that we sold Altria last quarter after owning it happily and collecting dividends for several years. (Dividends are great; you just have to be very careful that they are sustainable. Altria is a retail investor favorite because of the dividend.)

We sold Altria even though nicotine usage is growing, because the growth is occurring in reduced risk vaping products that are illicit (non-FDA-authorized) yet better than what big tobacco can sell. They are truly being disrupted: these new products are cannibalizing their cigarette sales and impairing the time honored strategy of raising the price of the pack to offset the volume declines.

As of the first quarter, Altria's cigarette operating income was shrinking at a 2.2% annual pace. If you have a ten percent cost of capital, you can only pay 8x earnings for an income stream shrinking at that rate. But the 2.2% that we have just seen is rather trivial. Altria's cigarette volumes actually shrank 11.4% and revenues declined 3.3%, indicating that the price of the pack was increased by a little over 9%.

The question is, what would happen if that formula breaks? The answer is that earnings shrink, and the multiple that people will pay for Altria stock rerates much lower. Let's say that investors have a 10% cost of capital and they believe that Altria earnings are going into a permanent four percent annual decline. This could mean ongoing 8% volume declines coupled with the ability to raise prices only as fast as inflation: 4%. That would justify a 7x valuation for the tobacco earnings.

That would justify about $62 billion enterprise valuation on the after-tax earnings. The current market capitalization is $82 billion, and there is also about $15 billion of debt net of cash and the (current) value of the BUD stake. Deduct that $15 billion from the $62 billion pro-forma value and you get $47 billion for the equty; about 57% of the current market cap, or a share price of $26. A January 2025 $25 call option seems to be going for $22.4, for a breakeven of $47.4 (versus the current price of $46.67)

Another idea that comes to mind for this basket is Verizon. The current market capitalization is $158 billion and they have $153 billion of debt for an enterprise value of $340 billion. For the first quarter, net income plus depreciation and amortization, less capital expenditure and wireless license acquisitions was $2.8 billion. That gives an annualized FCF/EV yield of 3.3%.

One of the keys here is that capital expenditures are running so far ahead of depreciation. For the entire year 2022, depreciation and amortization was $17 billion but capex and wireless license acquisitions totaled $36 billion. That is very substantial considering that net income was $22 billion.

During the three year period 2020-2022, Verizon generated no free cash flow. They spent $48 billion on a spectrum auction that they "won" in 2021; since that was one-time you could add arguably it back for $15.6 billion of average annual FCF. Which still makes the current enterprise valuation look expensive.

Why is capex so high? Smartphones and population growth. Everywhere that we go, cellular data capacity feels strained, implying under-investment in the networks. How sad to have to spend all of your cash flow for three years building the infrastructure that allows Apple to rake in money! And judging by the service quality, we can expect more of the same as more network investment needs to be made. 

A January 2025 $20 VZ call seems to be going to $17.65 with the stock at $37.60; right at breakeven, in other words. Again, the way that this thought experiment works is that if we sell calls we would  essentially be insuring against things getting a lot better (either earnings or valuation-wise) at very big companies with slow growth that are already expensive. It would be nice if we simply got the use of the call premiums as low or no-cost float to invest in things that are cheap. A big win would be if the earnings or valuation multiples crumbled. (Conversely, a big loss would be if the valuation multiples got even higher from already stretched levels, or if earnings grew.)

The last idea is one that Horizon Kinetics wrote about in their most recent quarterly letter: Advanced Micro Devices

The essence of the share price returns and popularity of AMD stock in the past several years is that the valuation multiple expanded 27x, from 0.4x revenue in 2015, to 10.8x in 2021. Which is to say that the return really came from people’s behavior, not from the business. Even today, with the share price down 45% from year-end 2021, AMD trades at 5.6x trailing revenue. The 30-year average valuation is less than half that: 2.1x.

The current market capitalization of AMD is $153 billion and the enterprise value is $150 billion or so. Last quarter they generated about $700 million of free cash flow. As Murray notes above, it is a rich valuation: a FCF/EV yield under two percent.

For the past three years (2020-2022), AMD generated free cash flow of $7.1 billion, or $5.4 billion if you exclude stock-based compensation. That's an average of $1.8 billion per year on the latter figure. They spent $5.5 billion on share buybacks, but look at how little effect that is actually having on the share count because of the share-based compensation.

As always, these are just thought experiments. What seems interesting is to generate "float," and hedge market and economic risk, by insuring against further share price upside on already fully valued companies that might not be able to grow earnings. With that in mind, it might be better to use blue chip dividend stocks than ones that anyone might conceivably get manic-excited about.


Pacioli said...

Great stuff as usual. I think this will prove to be very prescient.

I think Nike (NKE) might be another candidate with similar traits. Free cash hasn't grown much in 4-5 years. With enterprise value around $190 billion and FCF around $4b (and stagnant), the yield is barely 2%.

Anonymous said...

The McDonald's short is a good idea for no other reason than the stores near me are dated and dirty.

CP said...

NKE is an interesting suggestion.

Market cap $190 billion, EV just a touch higher (not much debt)

For the first quarter, net income was $1.24 billion versus $1.4 billion the year prior. (So, 38x mrq annualized earnings of $5 billion.)

In 2022 they made (net) $6 billion and in 2021 they made $5.7 billion.

Most of the earnings are in North America: $5.1 billion of EBIT in 2022.

CP said...

NKE 10-Q/10-K

CP said...

SECTORS UNDER PRESSURE: Deterioration in credit profile net of new supply. Incremental CAPEX is a “tax” on free cashflow (FCF) and leverage profile driven by regulation and/or market dynamics. Higher leverage occurs without commensurate growth in future demand and profitability.

U.S. Utilities – Over the past decade, U.S. electric utilities have intensified their capital spending, i) to reduce carbon pollution, ii) to update and replace aging infrastructure, iii) to harden systems and protect against more volatile weather and, iv) to pay for smart grid technology, increased security to safeguard against physical and cyber-attacks. Regulated Utilities’ prudent capital investments can have a positive impact on their Return on Equity (ROE), as it increases their underlying rate-base. In the near-term credit metrics can be negatively impacted as CAPEX is largely debt financed and with some lag expected before cash flow begins.

U.S. Telecoms – Despite heavy spending on 5G wireless spectrum and CAPEX, these investments do not necessarily lead to greater pricing power or revenues. Rather, carriers are forced to make these investments in order to not fall behind in network performance and guard their respective wireless market shares. New 5G use cases are preliminarily being contemplated (i.e. – augmented reality, metaverse, internet-of-things, fixed-wireless broadband), but monetization and business models remain far from clear. While a key company predicts that the addressable market size of “network-as-a-service” will expand from $340 to $460 billion from 2021-26, CAPEX spending in Telecom is currently peaking and is expected to drop measurably in 2023, as major spectrum auctions generally occur every five years.

CP said...

MCD - up 24%
DIS - down 18%
MO - down 3.5%
BTI - down 11.5%
VZ - down 29%,DIS,MO,VZ&id=p91712899573