New Constructs' Live Podcast: Intelligent Capital Allocation - 22 September 2023

It's unfortunately too often a narrative and trap that people fall into that they need to be either value or growth. Wall Street created this classification of companies, growth, that effectively can trade untethered to economics, and then they will just go up because their revenue It's a bad thing. One of the things I learned in the very beginning of my career was this whole value growth thing is just a misdirect. It's a way to sell you something you probably wouldn't buy otherwise.

We're going to go ahead and get started. Welcome to our live podcast, Intelligent Capital Allocation. Thanks so much for being with us today. With you, you have myself, Tamara Pesek, as well as David Trainer and Kyle Guskey II. Here are our disclosures and disclaimers. Please take a second to familiarize yourself with them. And our agenda for today. We've really appreciated you folks using the Q&A feature and nominating companies for reverse DCF analysis, logging on to Society and letting us know the topics that you want to talk about. That's incredibly helpful as we pull together our agendas. Please don't hesitate to use the Q&A during the live podcast or go out to Society and let us know the topics that you'd really like us to be talking about. We Really do want to know. Latest and forthcoming research: several pieces of research came out this week. Great Danger Zone podcast with David. The September version of the Executive Compensation and ROIC Model Portfolio featured stock came out, as well as the S&P earnings projection for 2H23. Safest dividends for September, as well as a really interesting long idea as well. Don't hesitate to go out to the WAC blog. Page on new constructs and check out that latest research. I'm going to hand it over to David in just one second to talk about interesting headlines, some queries that we've gotten recently, and then we'll head out to society and talk about the topics that you all nominated to talk about because that's what's most important to us to get to your topics. And then at the end, Kyle's going to be doing two reverse DCFs, one for arm and one for cart. So we'll see how. Those 2 new friends are doing out there in the market today. And of course, we'll end with stock picks. Kyle, again, we are going to keep these just for the live podcast. They won't be available on the replay, and they won't be available in the slides. We really appreciate you guys joining us live, and we wanted to do something special just for the folks that were able to join us live. So that's our plan going forward with the stock picks. David, what's going on out there in the world?

Well, we had a lot of news from the Fed this week. I think it's really interesting how this narrative, higher for longer, which has been around for a long time, is suddenly starting to take hold right around the time that a bunch more IPOs have gotten done and some private equity firms, especially big SoftBank firm that's big friends with Wall Street, got some, some major liquidity events it needs to keep its business afloat. It feels like everyone saw this coming, or a lot of people saw this coming for a long time, but there was this narrative on Wall Street during the summer. I think I said at the beginning of the summer, we're going to see this as the last hurrah before things get back to business and things get back to fundamentals. And we did see one heck of a summer. Animal spirits were alive and well. The IPO market opened back up and the valuations on IPOs were just about as silly as they were a few years ago. And that seems to all be coming to a close now. And even the IPOs that recently made it out under the COVID of the frothy market have already fallen back below their IPO price. Don't say we didn't warn you. We were out before these companies even IPO'd and telling you that they were way overpriced. And as one of our friends, Chuck Jaffee, likes to put it, IPO stands for it's probably overpriced. And certainly the ones that focused on for folks were very overpriced. And I think we made a really good case mathematically. I love the math logic-based driven narrative, not one that's required to believe in amazing and unusual things that are likely to never happen.

Thank you. We'll head over into some of the inquiries that we've been getting this week next, David. You know, one of the things I meant to put on the slide and I forgot is the value in small cap. So we could talk about that here, or we could talk about it when we get out to Circle as well. I totally forgot to get that on the slide.

Yeah, no problem.

No problems.

Let's, let's first talk about Match and why is it on the most dangerous stock list? That's because recently the stock's come way back down, you know, a little bit after it got, went on the most dangerous stocks list. I wonder if that's a coincidence or, or not. The economics of the business have, have really fallen off. It was a great business for a while. There's a lot of competition. And look, the risk reward's just not there anymore. And then the valuation when it was up higher here, the price charts right before this recent fall, for sure dangerous. It's one of the most dangerous stocks in the market given its competitive position, high valuation, and poor underlying economics. That's what the most dangerous stocks are. And if something goes on the list, you should watch out. The risk there is too high. And, and then the other thing I wanted to make sure we pointed out to all of our legacy Gold, Platinum, and Pro customers is that while you do not have access to a lot of the research and the research tab anymore, you still do have access to a lot of model portfolios, the same model portfolios that you had access to before, but on the portfolio page. So you can go in here and get the most attractive and most dangerous stocks. large and small cap. And you can probably— and I'm not positive— you probably download some of this stuff as well into a CSV if you're Gold. Is that right, Tam? Does it— does that work for—

I did check. I logged in as a Gold member and as a Platinum member, and they are able to download CSVs. So that is correct.

That's a super high-value add. You get to put that stuff straight down into an Excel sheet and And do what you want with it. That's— thanks for checking that, Tam. The main thing is that you still have access to the model portfolios that you're used to having access to. So they went away on the research side, but you still get them here.

Great way to see those model portfolios.

Yeah, I mean, you get access to them, you can download them. It's probably better than the, than the web-based version and the PDF from the research side, to be fair. It's a better delivery method. That's part of why we have it. So Thank you for checking that. Legacy Gold, Platinum, and Pro, folks, it's been good and it's going to get better in some ways, which gets me to my next point, which is the, the new Starter Pack 50 that we're rolling out. This is going to be a new product that really has been in design for a couple of years. Ever since we had an individual or retail offering, we've known that it probably wasn't the greatest fit. Our Legacy Gold, Platinum, and Pro products were our attempt to prepackage the different things we do on our site for people in ways that we thought made sense. And we realize now that in a lot of ways they did not make sense. So what we're going to focus on in the starter pack is something that we think is appropriate for individual, retail, and even institutional folks who are looking to get to know us. And that means you're going to have access to unlimited number of ratings. You're going to get ratings on as many stocks as you want, but you won't get details. And when I say details, I mean things like this rating breakdown and the data all behind that. You won't get to see the reconciliation. Why is that? Because for each one of these companies, that's probably worth at least $25,000. If you wanted to spend the time yourself or hire someone to do it, that's what it would cost you. When I launched the product like this, I wanted to have such an overwhelmingly strong value proposition that we would bring in millions and millions of people. And that's really not been the case. For folks who know how valuable this is, we know that there are plenty of institutional folks in there that are paying us $49 or $99 or $249 and are like, oh my gosh, I'm saving my firm hundreds of thousands of dollars a year by going to new constructs and getting this data. And the individual and retail investors don't need it anyway. If you do need it, well then you should be paying for Pro or Institutional. If you don't, you're not going to miss it. The new starter pack is going to focus on giving people access to lots of equity ratings, no credit ratings, and you're going to get all the green is good and red is bad stuff. You just won't get a lot of the detailed data screeners, etc. The idea is that we are moving away from providing institutional-level tools at retail prices. That's not a good business model for us. And it doesn't help us when our institutional clients who are paying us anywhere from $1,000 to $10,000 a month see something that they like at $49 or $99. So I hope you guys understand that what we're doing here, we think, is a very fair move. If you were getting institutional-level data from our Gold, Platinum, and Pro subscriptions, hey, you got a really, really, really, really good deal for a long We're going to slowly transition people over. We don't want to ruffle feathers. If you just need your gold and you just can't move, and we're sure you're not an institutional investor, we're going to try to work with you. We think that all of our gold and platinum, Legacy Gold and Platinum folks are really going to like the new starter pack. We think it's going to be better for you than what you're getting now. And so that's going to be a big plus unless you're an institutional customer. And needing the detailed data on NOPAT and invested capital and this rating breakdown and getting economic earnings and return on invested capital and NOPAT margins and free cash flow for 5 years of data and history. And then we get that updated across all 25, 50, or 100 companies that you have in your portfolio 4 times a year. You've seen our stats on how much value we add during filing season. You get the idea. We need to price our products and our data appropriate to the value provided. And we are proud to have given everyone a super overwhelmingly strong value proposition over the last 10+ years. And now we gotta do what's right for our business so we can continue to give people an amazing value proposition into perpetuity because we are providing the best data and analytics As proven in the marketplace. And if you're an institution, it's time to matriculate.

Did you want to touch on the value in small cap now, or do you want to head out to society?

Let's go to society because that's where it is anyway, right?

I don't know if that particular question's out there. We have a number of questions out on society right now. Spirit, fixed income, Fed funds, Cisco Splunk, a huge amount of interesting conversations happening out there. And I know you wanted to make sure that We had some time to talk about all of that.

Yeah, if it makes it to Society, we're going to be much more likely to talk about that. So if you're emailing questions in to support, you know, your chances are, you know, 50/50 or lower of getting a research-related answer. Actually, I take that back. Tam should tell me. She, she's going to answer everything, but we're going to definitely get a bigger, more focused answer if you put it on, on the Society.

You get the analyst's eyeballs on Society. Very quickly, and you get eyeballs and support. So if it's an analyst and an analyst-ish question, then it's going to be much more efficient to use Society. And you can't overuse it. If you feel like, oh wow, I asked 2 questions, I shouldn't ask another one, please go for it. Our analysts are really interested in talking about these issues.

Yes, and TAM has a reward system in the works for folks who are most active. on the society. So that's going to be something that you want to go ahead and start collecting your chits on and start getting your stats on here because the folks that are most active will be getting credits, prizes, rewards.

Badges.

Yes. Let's talk about a fixed income ETF rating. Great question. Do we want to do this? Yes. Yes. Do we, you know, where does it stand on our priority list? Not sure. You know, but I tell you, Kent, if there is a lot of people who are really wanting this, we would build it. You know, the ETF and mutual fund part of our business has not been as popular as the credit and equity rating business or this individual stock and company rating side of things. But 1000%, we've got the data and we've got the ratings. It's a no-brainer. We've, you know, we've really talked also in the past about how many mixed ETFs and mutual funds we can't cover because they're part equity and part fixed income. And we wanted to expand that because we have all the underlying financial models built, the hard part, right? Adding ETFs and mutual funds is really just some programming time and basically some sort of the programmatic version of ditch digging. And so we'd love to do it. It's on the roadmap. How, where, how high it is on the roadmap, it's hard for me to say. Let's talk about Cisco and Splunk. I got a bunch of requests from the media to talk about this one right when it happened. And as you guys know, Cisco is on our focus list. It's been a great performer for us. And quick look at how the stock has performed. I know it was down initially on the news for the acquisition, and it did take a good bit of a hit. And this is classic, classic. And anyone who's been through the New Constructs Analyst Training, and you're looking at Hakan, one of the most recent graduates, excellent grade on the final. You know, Hakan would tell you, we spent a fair amount of time talking about M&A and how often companies overpay. And Cisco buying Splunk at the really high valuation, I don't remember exactly what the number was, $28 billion, was a really significant overpayment. I think the stock rallied to like a $20 billion valuation from a $15 billion valuation in the last few weeks, probably on the rumors. No insider trading there. And then it was sold at a $28 billion valuation. Yes, we think that's smart for the strategy of Cisco to move more in the software and services, but not at that price. And as Warren Buffett has famously said, 10 years, 10 decades of good capital allocation, intelligent capital allocation decisions and decision-making can be ruined with one bad Move. And Cisco is a big enough and profitable enough company that this is not necessarily going to kill the business, but does it make us think about reconsidering our rating and its position on the focus list? Yes. Spirit Airlines, Spirit AeroSystems. This is a good one because this has also been a long idea. And Kyle, is this also on our focus list? I believe it is. Yep.

It's been one of the longer ones.

Yes. So we felt like this business was really just too beat down and that the airline business was going to come back. And so we've just been holding on here. How right have we been? Eh, not so right. This has been a tough one for us. You know, we think that in general we're bullish on travel and airlines and then Boeing itself providing new planes. But this stock has really been a tough one. It hasn't moved much, and especially in the right direction. I think in the last year it's down about 38%. Kyle, you don't have the stats handy, do you, in terms of where it is versus our original call? Like, are we—

I don't have those right at the moment.

Underwater or—

Yeah, it's always been, it has been an underperformer. I do know that.

Yeah, it's been an underperformer. I don't have a good answer here. You know, we're not always right, that's for darn sure. And risk reward is not always right. And look, we're not in the business of really giving it any investment advice per se, which we're here to provide research and insights. And it's not perfect, but I think Roger brings up a good question. You know, is it cheap? I mean, it's, it's been getting cheaper. Is this an opportunity to jump back in? And, and we've thought that for a while. Maybe we were too early. Maybe now's the time. I don't know. It's a tough one, Roger. It's a tough one. We thought a lot of this, a lot of the issues were going to go away when the issues with the 737 were resolved a while ago, and that does not seem to be the case. It feels like at some point they've got to maybe pick back up. But maybe part of this is that Boeing is losing market share and other people are selling more planes, in which case it may never pick up.

You just heard Seattle start crying.

Yeah. I mean, I think Boeing's got a few— they've got operations in other places. I think they've got a big operation in Charleston too. Yeah. Drive right by it on the way to—

yeah. Yeah.

So yeah. That's, that's an interesting one. I love Julio's Fed funds graph. Julio's up there with Roger Green for the running and some of the first badges that I think we're going to be giving out. Kent Seymour too. These are the front runners. This is an interesting analysis on where things are with the Fed and what expectations are. We now know that they did not raise, but they may raise again, which was, I think, a surprise, and things are going to be higher for longer. Ultimately, my perspective is that the Fed is probably doing this the right way. There's a lot of criticism, but if the Fed were to do things in the historical way where they came in and raised rates really fast and crushed the market and crushed the economy, that would lead to a repeat of a behavioral pattern that we've seen over the last several decades, which is buy the dip. And now that everyone understands that pattern, It doesn't work anymore to inflict pain, I think, directly and quickly. And so it's better for the Fed to sort of do this slow suffocating, raising rates maybe a little too late, raising them maybe a little too slowly, but keeping them higher for longer so as to achieve a soft landing while slowly squeezing out the malinvestment and excessive speculation in the market. So that people don't think that when the market goes down, they should just buy the dip because that's not a real strategy. And hopefully if with this sort of slow burn and higher for longer market situation, we'll be able to bring people back to earth and understand that fundamentals matter and reduce the amount of malinvestment and shareholder money wasted in buying IPOs at prices that almost immediately fall. That is a transfer of wealth from you, Mr. and Mrs. Investing Public, to SoftBank and the other big private equity firms and Wall Street firms. If you want to write them a check, write them a check. But I would rather you do that than buy some of the narrative that they've been selling so successfully for the last 20, 30 years. And I hope that you can find us as a safe haven to give you the honest, unadulterated truth around whether or not the risk-reward of an investment makes sense.

It's interesting, David, what you said there about the interaction between what the public does with their buying strategies and what the Fed is able to do, and that the correction that the Fed has been able to do in the past, they're not able to do anymore because people got wise to it.

Has that always been a tension that the Fed has had to deal It's definitely, you know, it's changed so much as everything has changed because so much is in the media now. I think the answer to the question is yes. So much attention is paid to what the Fed is projecting, what is it intimating? You know, there are even entire research businesses. A friend of mine built and sold a research business called Prattle, and all they did was download and have machines read the reports. Filed by central banks around the world in order to look at frequency of certain words used to indicate whether or not interest rates were going to go higher or lower to get ahead of where the Fed was going. And we've got all these tools that when I started in the business didn't exist that, you know, betting futures, things like that that are tracking where people think the Fed funds rate is going to go. And what does that mean? The Fed is a lot about managing expectations. It is almost all about managing expectations. And that's why every time Powell gets out in front of a microphone, people are picking over every single word to see what he means. And so they have to be really careful. And it's a tough thing because it's so meaningful and impactful to markets, but that's a big part of the game.

I do not envy Powell the amount of scrutiny that every single syllable phoneme comes under. That's brutal.

It's a tough job, right? On the one hand, you, you want to keep as much of America happy. On the other hand, you know, if you let the party go on unchecked, you know, everybody ends up in a much worse place. But it happens slowly and over a long period of time. So it's difficult to sell people on, hey, we need to maybe dial back on the fun now. Otherwise, we Suck away all the fun from the future, and that's a big part of what you see whenever markets go up. You're effectively cashing in today on the future cash flows of tomorrow, and if you do that at too high a number, you cash in at too high a number, then you're stealing from from from your future prosperity, right? Wealth is created over time. If you spend all your money now, you spend more than you have, and you spend so much more than you have that you don't have enough time or ability to make up for that overspend in the future, then what's going to happen? You go. bankrupt. You have to get money from someone else. It's a very simple concept that it applies to investing, and that's what the Fed has to try to keep under control. People want to believe that, that magical things are going to happen and somehow we're going to create value. That's just not always the case. Let's take a couple quick questions here. What are our thoughts on GM and, and the UAW strike? You know, it's been interesting to see how GM as a stock In the last week or so, it's really not suffered as much as I thought. I think they're in a big fight here and this is going to be a serious, serious issue. The industry's changed. We've liked GM and Ford. We think they've been meaningfully underpriced for a long, long time. And we thought that they were going to take care of these strikes before it went to this level, or there weren't going to be strikes. We've been wrong about that. So worth us taking a look at whether or not the cost structure of these businesses will have to change because of the strike and therefore mean, you know, that would mean that the valuation isn't as good as it looks because maybe if the price to economic book value implies there's going to be a 70% decline in profits, maybe there's going to be a pretty big decline in profits. Maybe where they've been is unsustainable because they haven't been paying their workers appropriately. So that's all, that's all in play. Keeping us on our toes, man. The world's changing all the time. What you see, you know, what we see at one point can be different at another.

I know we need to head over to Kyle for, in just a minute for the DCFs.

Yes, indeed. And then we got a question on Interactive Brokers, and I will hit this one real fast because I do want to get over to Kyle. Interactive Brokers. Thoughts on Interactive Brokers economic earnings and reported earnings seems too good to be true. Rising ROIC and EBV. Yeah, I mean, it is what it is. I don't know what about the story would be broken and that would mean that these numbers were misleading. Having worked with these folks in a business-to-business relationship, they are very price sensitive, drive a very hard bargain. That guy runs that shop with an iron fist, so I wouldn't be surprised if they're profitable and doing well. And I think like maybe a lot of financial companies, this just could be another one. Where they're throwing the baby out with the bathwater. It's cheaper than it ought to be. All right, with that, let me throw it over to Kyle to do some reverse DCF stuff. The best part of the show for sure.

So today we're going to look at Arm Holdings and Instacart, 2 recent IPOs who put the reports out David mentioned. Started with the ratings page here. The big difference in the recent IPOs is these 2 columns. They've actually been profitable, but that doesn't necessarily mean they were good investments right off the bat. Well, Jump into the DCF. I've already got it opened so we can look at expectations baked into the current price as well as a downside scenario and take a look at those. We saw the IPO pop has already come back almost all the way. I think they're trading in the 50s today, 51 or so. I've got that scenario built out around 51 a share. So we look at what we've got as far as expectations in the current stock price. That's our optimistic scenario here. We're looking at— we said they can get margins 26% pretax. I've got zero tax rates. That's also the after-tax rate. That is their fiscal 2022 after-tax rate. Fiscal 2023 fell to about 20%. This scenario implies margin improvement, no change to net working capital, no change to fixed assets. We're giving them best-case scenario here. And we look at revenue growth of 23% out each year for 10 years in that scenario. That 23% is over 3 times what Arm estimates the entire industry will grow at. So we've got massively optimistic growth in that scenario. And when we look at that, we can see on the review page what that implies as far as revenues, profits, ROIC as well. So we look at that. We've got our optimistic scenario out to 10 years, and we've got that shareholder value around $50 a share. And what that means for revenue, looking at revenues of $21 billion, it's about 8 times their current revenue. Profits, NOPAT, $5.5 billion, which is over 10 times current profits. And this is all to justify current stock price. Anything less than that, stock is worth less. I think one of the things we pointed out in the Instacart one as well applies here for Arm. The implied ROIC in these scenarios, Arm here, because we're not giving them any assumptions on increases in invested capital, would have to improve ROIC to 201%, which I think there are less than 10 companies with a higher ROIC in our entire coverage universe. And so that is Highly optimistic expectations in that $51 a share, which is right around where it IPO'd. And so that's why we put out our report of, hey, profitable business doesn't mean good investment. If you're betting on the company 10xing profits with ROICs up at 200%, that's a strong bet to make, especially when some of the competitive factors with Arm that we labeled in that report, we can see what they have to do on the downside. We'll look at A little bit more conservative scenario, not necessarily pessimistic, but more conservative. Still giving them credit for that 26% margin. Dropped the revenue growth to 13.6%, which was 2 times Arm's estimate of the total addressable market growth. So still an optimistic scenario, not quite as optimistic as what they have to do to justify the current price. And then still that same assumption on no change in invested capital to create a best-case scenario here. Let me look at that on the neutral side. We're looking at almost $10 billion in revenue, $2.5 billion in profits. So cutting in half of that, what is just to justify the current price? We're looking at a share price of $29 a share today, which is, you know, 40-plus percent downside, even if they can do $2.5 billion in profits and $10 billion in revenue. The downside risk here is pretty big. because this is still an optimistic scenario. We think given the competitive nature of the business, all the big tech companies would love to stop paying licensing fees and IP, try to develop their own. Obviously takes years. We've seen Apple, I think there was a recent Wall Street Journal article how they failed to get the modem away from Qualcomm. So it's obviously not easy, but they would love to keep trying and keep spending money to save on those fees. It's a highly competitive industry and for betting on Profits up to $2.5 billion with that still implied ROIC there of 91%. Again, downside here could be much larger. And with that, jump over to Instacart. Instacart was actually one I was expecting to open up and look entirely like Uber and Lyft with highly negative, huge losses and whatnot. But it's actually similar to Arm I mentioned. They're actually profitable. They became profitable in 2022. But that valuation is still the problem. And going forward, we're not sure if those profits can actually be sustained. The difference sort of between Instacart and Lyft, Uber model, largely Instacart has a much higher average purchase, average value of order. They're up over $100 on most of their orders where you can get an Uber and Lyft for $10, $15 sometimes. So they've got a little bit of leeway there, but they're also being pressed on all sides from Uber, DoorDash, and as well as the grocery companies that are also their partners. So there's a lot more room to face competition there as things move forward. Instacart, if they were to maintain high profits, all those grocery stores may say, hey, let's take a bigger cut. We don't need to give you as much because you're making a little too much money. And then Instacart really has no leverage in that scenario because they are reliant upon those grocery stores. So in this scenario, I updated it to current price of around $31 a share. I think in our report the mid-price IPO was $29 a share, so pretty close. Again, Instacart had that big increase. They've since come back down after the IPO pop. But in these scenarios, we're looking at NOPAT margins 4.8%, which is the 2022 margin. Again, zero tax rate, keep that NOPAT and pretax margin the same. To justify the current price, looking at 25% revenue growth out for 10 years each year. That's to justify the current price. In our more conservative scenario, we looked at 14% revenue growth, which was the midpoint of the projected online grocery industry growth rate. And so we've got sort of the— what Instacart itself says, you know, hey, we could grow between 10 to 18%. So we gave them credit for 14% to look at what they could be worth. 25% is what's required to justify that current price. And we can see on the review page here what that actually implies. And if you look in our reports, we actually take the revenue and look at what that implies for gross transaction value, because Instacart takes only a percentage of what people are spending on the platform. So we look at that optimistic scenario out 10 years to get that $31 a share. It's revenues of $24 billion, profits up to $1.1 billion and an implied ROIC of 124%, which again, I think there are 12 companies that have a higher ROIC. So Instacart has to become one of the most profitable companies under our entire coverage universe, generate $24 billion in profit and revenues, $1 billion in profits. And then we looked at the gross transaction value, what that would mean for how much they have to actually have spent on the platform. It's upwards of $240 billion. which is 8 times higher than current, and almost 2 times Uber's gross bookings, which is similar to the gross transaction value. Again, huge expectations baked into that IPO price, which is why we came out with that report saying, you know, might be profitable, but doesn't mean it's a great stock. On the downside risk, you know, sort of neutral scenario, we looked at that 14% growth rate, even if revenues got to $9.5 billion, Profit's still at $453 million, which would still be, I believe, 3 or 4 times current. You know, we're looking at $11 a share. You know, big downside risk here, almost 60% downside in a scenario where they still have 50% ROIC and again upwards almost $500 million in profits. And so we've got a scenario where if those grocery stores keep expanding their delivery, which I don't see why they wouldn't at this point, they've got the customer data to do so. They've got the customer preferences of knowing who to target. We could see that margin decline, growth decline for Instacart specifically. And so there's again, a lot of downside in that current price. And with that finishes up the DCF.

Excellent folks. Well, thank you so much for joining us this week. I hope you have a great rest of your weekend and we'll be here same time next week. Please don't hesitate to hit us up in society if you have any further questions. We do look forward to interacting with you out there.