Selective focus of Business graph charts of financial instruments with various type of indicators … [+]
My Danger Zone reports aim to identify firms that, despite more sanguine indications from traditional earnings[1] and noise traders, have struggling businesses and highly overvalued stock prices. These reports show investors how to use my research and display the transparency of my analytical process. However, I understand that at the end of the day, investors care about one thing: performance.
It pays to read my Danger Zone reports. In 2019, 25 out of my 39 Danger Zone picks outperformed the market (S&P 500) as shorts. All in, the Danger Zone stocks, including reiterated ideas, averaged a 5% return in 2019 versus the S&P 500’s 11% gain,[2] and outperformed as a short portfolio.
Next week, I’ll release my best Danger Zone picks from 2019, but this week I’m looking at where I went wrong and what I can learn from my worst-performing Danger Zone picks (as I recently did with my Long Ideas from 2019). Tesla (TSLA), Brooks Automation (BRKS), and Teladoc (TDOC) are the Danger Zone lowlights from 2019. Despite their recent momentum, I remain bearish on these stocks, and they all remain open Danger Zone picks.
Lowlight 1: Tesla (TSLA) – Full Year Performance: Up 25% vs. S&P 500 up 29% - Reiterated July 29: Up 77% vs. S&P up 7%
I’ve been bearish on Tesla since August of 2013. The stock price went against me for a long time, but over the first half of 2019 it appeared the market was finally beginning to agree. The stock dropped over 40% by the beginning of June due to production shortfalls and mounting cash losses. These issues led us to title m July 29 article “More Broken Promises from Tesla”.
Since that article, the stock has rocketed upward on the back of a profitable earnings report and the promise of the 2020 launch of the Model Y. Even an awkward debut of the Cybertruck – in which the supposedly bulletproof windows shattered – couldn’t halt the momentum.
The stock surged to hit the infamous $420 level – the price at which Elon Musk supposedly planned to take the company private in 2018 – by the end of the year. The stock is up another 50% already in 2020, and its $116 billion market cap is now larger than Ford (F) and General Motors (GM) combined.
Figure 1 shows that TSLA’s valuation at the time of writing ($480/share) implied it will grow after-tax operating profit (NOPAT) by 50% compounded annually over the next 15 years and earn more than six times the profits of GM at that point. With shares now trading over $600, the expectations are even higher.
Figure 1: Tesla Vs. General Motors: Historical and Implied NOPAT
TSLA vs. GM Growth Implied By Valuation
Tesla exceeded my expectations by achieving profitability, but the company still has a long way to go to prove it can maintain profitability or come anywhere close to achieving the profit expectations embedded in its market cap. Its trailing twelve months (TTM) return on invested capital (ROIC) is just 1%, compared to a cost of capital (WACC) of 8%. The company needs to increase its profits eightfold in order to avoid destroying shareholder value, and it needs to do much more than that to justify the market’s valuation.
Meanwhile, Tesla’s revenue declined by 8% in the most recent quarter, and its profitability has come from cutting back on R&D and capex. Given these cuts, it’s hard to see how the company hits its ambitious targets for new vehicle production and self-driving capabilities. Despite the rally in the stock, I don’t see a real change in the fundamental risks in owning Tesla stock. That said, the cars themselves are a good deal for consumers since investors are subsidizing the company’s ability to sell them below cost.
Lowlight 2: Brooks Automation (BRKS) – first published February 5: Up 34% vs. S&P up 18%
I first put BRKS in the Danger Zone in my February 5, 2021 article “Three Misleadingly Cheap Stocks.” At the time, I said the stock’s falling P/E ratio misled investors due to $49 million in non-operating income from discontinued operations that artificially increased reported earnings.
In 2019, the company continued to benefit from discontinued operations, this time disclosing $428 million in non-operating income. As a result of this non-operating income, GAAP earnings rose again, from $117 million in 2018 to $437 million in 2019, rather than falling as I predicted.
BRKS just goes to show that earnings can always get more distorted in the short-term, which can make shorting any stock difficult. Still, these non-operating items can’t last forever, and the fundamentals of BRKS remain poor. It has an ROIC of just 3%, and -$363 million (12% of market cap) in free cash flow over the past year. It’s economic earnings, which strip out non-operating items and account for the balance sheet, fell from -$125 million in 2018 to -$162 million in 2019. Figure 2 shows the disconnect between GAAP and economic earnings for 2019.
Figure 2: BRKS GAAP Net Income and Economic Earnings: 2018-2019
BRKS GAAP Net Income Vs. Economic Earnings
In addition, the company delayed its 10-K filing in December due to issues with revenue recognition, and its auditor disclosed the company had a material weakness in its internal controls over financial reporting.
These accounting issues add another risk factor to an already risky and overvalued stock.
Lowlight 3: Teladoc (TDOC) – first published March 18: Up 33% vs. S&P up 14%
I first put TDOC in the Danger Zone in my March 18, 2021 article “Danger Zone: Incentivizing Executives with Adjusted EBITDA.” Investors should try to avoid companies that tie executive compensation to Adjusted EBITDA – a metric that is easy to manipulate and has no clear link to shareholder value.
Despite the flaws of Adjusted EBITDA, investors still seem to be buying the company line for TDOC. Adjusted EBITDA more than doubled, from $8 million through the first three quarters of 2018, to $17 million through the first three quarters of 2019. The stock outperformed the market and gained 33%, in turn.
On the other hand, net operating profit after tax (NOPAT) continues to decline, from -$64 million in 2018 to -$74 million TTM. The disconnect largely comes from TDOC excluding real expenses like stock compensation expense (which increased by $17 million year-over-year in 2019) from Adjusted EBITDA. By excluding real expenses, TDOC maintains the illusion of profitability. Figure 3 shows the disconnect between NOPAT and Adjusted EBITDA.
Figure 3: TDOC NOPAT vs. Adjusted EBITDA: 2018-TTM
TDOC Adjusted EBITDA vs. NOPAT
Investors have already learned not to trust phony metrics from high-flying IPO’s like WeWork. It’s only a matter of time until they turn that same skepticism towards already-public companies like TDOC.
Disclosure: David Trainer, Kyle Guske II, and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme.
[1] All of my reports utilize the superior data and earnings adjustments featured by the HBS & MIT Sloan paper, “Core Earnings: New Data and Evidence.”
[2] The S&P 500 gained 29% in 2019, but since my picks are published over the course of the year I measure performance of my picks against the S&P 500 at the publication dates, not the beginning of the year.