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.

Growth
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.)

Value
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.

Out of the Money Puts?

Ridiculously overpriced garbage that might be worth owning puts on:

• TLT
• FB
• TSLA
• NFLX
• XOM

Review of Chaos Monkeys: Obscene Fortune and Random Failure in Silicon Valley by Antonio Garcia Martinez

We've been consistently skeptical of Facebook, a view which has been wrong so far, although the stock price increase has brought the valuation to almost 100x net income. (Meanwhile, the cumulative profits of the company are about half of what they spent to buy "WhatsApp" in 2014.)

Since we're also skeptical of the Techbubble 2.0 more generally, it seemed like it would be worth reading the new Chaos Monkeys, about some lame startup whose author was acqui-hired by Facebook.

I won't rehash the author, Martinez's, story, because who cares? The only thing I thought was interesting about the book was what happened to him after he landed at Facebook.

He did an odd deal where he and his two co-founders sold their startup to Twitter, but he went to work for Facebook instead of joining Twitter with the other two. He got a signing bonus which was a multi-million dollar amount of stock that would vest monthly over four years. (Note: if you have to work to get the money, it's a salary not a signing bonus.)

When Martinez joined FB, they had yet to figure out an ads strategy. The ads team ended up dividing into two camps regarding the details of how to target ads. A "friend of Zuck" in upper management was brought in to settle the dispute, and decided against whatever Martinez was advocating.

The very next day, Martinez was sacked (he says he was going to quit anyway) and lost half of his unvested stock "signing bonus".

Remember Tinker Tailor? If you work in a big organization, your real enemies are inside the organization. I observed the same principle at work in my review of Innovator's Dilemma:

Companies fail to innovate because "they are focused on maximizing the present value of their salaries, which means making sure Bob's division doesn't try to get you fired" for "disrupting" the product that Bob's division makes.

That's why people start startups. But if you start one, and get acqui-hired and negotiate for stock that will take time to vest, keep your head down. Be like Bighead at Hooli.

3/5.

High Plateau Drifter is Long Oil, Short Facebook

Somehow, correspondent High Plateau Drifter was inspired to write two pieces in January. Here is the latest:

OK, so we have begun to hear hints from oil producers including especially Russia and Saudi Arabia, Iran, Iraq and Syria - unlikely allies to be sure - that they should come to some kind of agreement on production quotas. What the market seems to forget is that the demand for oil and energy is remarkably inelastic relative to say, new motorcycles or new granite counter tops, for example.

Energy use is surprising stable even in recessions. What inelasticity of demand means is that oil producers could cut production by perhaps 6 percent and increase sales income by 30% to 50% from current levels on lower volume of exports. Thus, reaching an accord on production is an absolute no brainer for the producing states.

Now the big dissenter at present is Iran, which, due to past sanctions has had what it believes to be far less than its fair share of the market. It is not willing to decrease production but will demand an increase in production. But then the Iranians are not fools, they understand inelasticity of demand. They are not going to want to export oil at $25 per barrel. So the real issue here is how much of a production increase is Iran going to demand and what will it take to get the other big exporters, dependent upon oil revenue, to decrease their production

As investors who are not in on the ongoing talks and not privy to the precise calculations of the players, the question is not if but when they agree, behind the scenes, to cut production while giving Iran an increased quota. And of course the truth is that these other players will get a better deal while Iran's welfare and other costs are relatively low due to budget constraints imposed by past sanctions rather than to wait until their expenses of legitimizing rule of the regime (pace Joseph Tainter) have risen to the Saudi level.

Bottom line, we will have $80 oil sooner than most investors think.

OK, now on to my favorite, FB.

What we saw with the latest earnings report and ad revenue numbers is exactly what you would expect when the bazillion social media and tech startups see that funding is drying up – a blast of desperate ad spending as the end of easy VC money comes clearly into view. I am expecting next quarter's ad revenues to be up but for the growth rate to slow. I will be modestly short ahead of FB's Q2 report, and increasing that short quickly if FB stalls out.

Keep your eye on the Tech Crunch Bubble Index going forward.

Previously by Skeptics to the Ramparts, Fun on the Permanently High Plateau, Surfing the zero bound along the permanently high plateau, and Back To The Future!

2016 Begins with Ultra Distressed Energy Companies on the Brink

Judging by the bond prices, many of these are likely to file in 2016:

• ZINC, the July 2017 3.8% note trading at 20 cents; ytm 155%
• GDP, the 8.875% notes traded at 8; current yield >100%.
• EXXI, the 3% notes traded at 6; current yield 50% and ytm 145%
• TC, the 7.375% notes traded at ytm of 134%
• SD, the 8.75% notes traded at 12; ytm >100%
• PVA, the 7.25% notes traded at 13; ytm>100%
• BTU, the 6% notes traded at 18.2; ytm 88%
• CLF, the 5.95% notes traded at 28; ytm 88%
• LINE, the 8.625% notes traded at 16; ytm 78%
• XCO, the 7.5% notes traded at 27; ytm 72%
• SSE, the 6.5% notes traded at 16; ytm 54%

Energy and resources. These companies have a combined market cap of $1.67 billion. In all likelihood based on the bond prices, that is illusory. Maybe in 2016 lots of illusory wealth will be revealed as worthless.

What if FB ad revenue that is funded by VC equity contracts, and the multiple contracts, and much of that $300 billion market cap is revealed as illusory? What if the Amazon flywheel runs in the opposite direction (both AWS, as an expression of the VC bubble, and the traditional business, as an expression of consumer spending), and some of that $317 billion market cap is revealed as illusory?

What if the replacement cycle on Apple devices lengthens, or consumers get tired of paying 100% markups for memory, and some of that $587 billion market cap is revealed as illusory wealth?

Well, then, we'd have a bear market.

High Plateau Drifter: "Simplicity"

Optimists like to point to the monthly chart of the S&P 500 as showing a completed three wave correction from the high of 2000 to the low of 2002, then to the rally high of 2007, and then to the bottom in early 2009, concluding that the rally over the past 6 years from that 2009 bottom is the beginning of a brand new upleg that should last at least another 10 years.

However, when you look at a monthly chart of the NASDAQ 100, below, you will see a very different and worrying picture.

The top in 2000 produced a nice 5 wave impulse into the bottom of 2002, and from that point forward you see a very clear 3 wave corrective rally of 13 years duration though today as the NDX attempts a retest the high of year 2000 at 4816. The NDX monthly high of 2239.23 in 2007 failed to retrace even 38.2 % of the prior decline.

I would suggest that the NDX (Nasdaq 100) is the best measure of market sentiment, containing as it does the large cap tech and cocktail stock favorites.

Zero percent short term interest rates have driven the cell phone boom from 2009 through 2013, while from 2013 through the present low rates have provoked a boom in social media stocks. Ultimately the social media stocks are driven by advertising revenue. And now we hear that Facebook users are posting less content, and that one billion of its 1.5 billion users never click on an ad.

The direct internet sellers, including the most prominent survivor of the dot com craze, Amazon, and others such as Ebay, and more specialized internet sellers such as Best Buy, Midway (for guns and hunting) and others do plenty of advertising. But it is direct advertising of goods they are selling, Those goods are found by search engines to which these sellers pay for position in the search results. Advertising in the form web site maintenance and search engine position payments is a substitute for the expense of bricks and mortar locations including salary expense. It is durable ad revenue as the customer finds what he or she wants with a maximum of convenience and a minimum of wasted time.

Social media, including especially Facebook, is trying to do something very different.

They are hoping to stimulate demand by having a member click on an add and then tell their friends about their experience, thereby generating demand where it did not previously exist. It is an attempt to gin up demand through social pressure. Thus, social media advertising is highly leveraged in several ways, some of them unexpected and yet to be experienced. In the rare case that a social media advertised good or service is truly useful and desirable, likes from friends can create and spread demand like wildfire. But if the new good or service is only mediocre or competes head to head with well known and liked goods sold through search engines, then being advertised on social media is not terribly useful and the ad spend can be a total flop.

But more significant is the fact that social media advertising and its hoped for multiplier effects are entirely at the mercy of social mood. Should the social mood darken and should a big “stop spending” move become the hip and cool thing, social media ad revenue would crater. Back in the winter of 1979-80 during the Carter administration, G. William Miller, then Secretary of the Treasury, went on the nightly news and, in an effort to curb raging inflation, urged everyone to lock up their credit cards and stop spending. Retail sales collapsed 9% within two months and a publicity campaign was orchestrated to get those credit cards back out of lockup. Social media would be the perfect medium for some of the armchair revolutionaries on ZH to make “buying shit you don't need” un-cool and paying off credit card debt way cool. It would only take 25% of Americans locking up their credit cards to crash the system and destroy most of the oligarchs, all the while improving their circumstances and avoiding the unpleasantness of failed armed revolution.

Of course any such social mood and attendant campaign would vaporize social media ad revenue and ultimately, the social media stocks themselves. Of course the more immediate threat to the social media stocks is the fact that so much of their ad revenue comes from VC funded social media startups desperate to gain traction.

We may be a ways away from a profound swing in social mood, but then the anger of the vanishing middle class suddenly visible in this Presidential primary season is an early warning of what is to come. The monthly chart of the NDX from 1997 gives clear warning that a retest of the 2002 bottom is a reasonable possibility.

"Whatsapp" With That Revenue Multiple? $FB

From WSJ article:

450. WhatsApp has more than 450 million active users, and reached that number faster than any other company in history. It was just nine months ago that WhatsApp announced 200 million active users, which was already more than Twitter. Every day, more than a million people install the app and start chatting, and they remain more engaged with WhatsApp than on any other service. Incredibly, the number of daily active users of WhatsApp (compared to those who log in every month) has climbed to 72%. In contrast the industry standard is between 10% and 20%, and only a handful of companies top 50%…

1. Jan keeps a note from Brian taped to his desk that reads “No Ads! No Games! No Gimmicks!” It serves as a daily reminder of their commitment to stay focused on building a pure messaging experience. This discipline is reflected in WhatsApp’s unconventional approach to business. After one year of free use, the service costs $1 per year — with no SMS charges. This can save users trapped in expensive data plans up to $150 per year…

So, even if all 450 million users started paying the $1 per year, you're looking at $450 million forward revenue. Facebook just paid 42 times that revenue number. No big deal.

Facebook Paying $19 Billion For Something I've Never Heard Of

Crazy:

"Facebook today announced that it has reached a definitive agreement to acquire WhatsApp, a rapidly growing cross-platform mobile messaging company, for a total of approximately $16 billion, including $4 billion in cash and approximately $12 billion worth of Facebook shares. The agreement also provides for an additional $3 billion in restricted stock units to be granted to WhatsApp's founders and employees that will vest over four years subsequent to closing."

What's app! Not much of a business if you have to buy all of your competitors.

"The Facebook Fallacy"

If you're inside the Facebook galaxy (a constellation that includes an ever-expanding cloud of associated ventures) there is endless chatter about a near-utopian (but often quasi-legal or demi-ethical) new medium of marketing. "If we just ... if only ... when we will ..." goes the conversation. If, for instance, frequent-flyer programs and travel destinations actually knew when you were thinking about planning a trip.