Today, we’re following up on Coinbase.

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Why Is Coinbase Stock Dropping?

“2022 is an investment year.” — CFO Alesia Haas on Coinbase’s 4Q earnings call

Coinbase has endured a drubbing ever since its direct listing last April. Shares of COIN have shriveled by 65%. 

What’s going on? 

There are several forces at play. 

Catalyst #1

For starters, the direct listing format was an ideal exit point for Coinbase’s pre-IPO shareholders — like CEO Brian Armstrong — and a horrific entry point for the general public. Here’s an excerpt from our initial COIN DD report:

Coinbase chose to go public via a direct listing, so it didn’t undergo the traditional underwriting process that helps evaluate and price a stock. As a result, Nasdaq offered a “reference price” of $250 per share, which was based on recent private market trades and the input of investment firms. However, the expectation was that COIN would open at an even higher price — and it did. 

Within minutes of listing, COIN surged to almost $430. 

Roughly a week later, it tumbled below $300. 

So, Coinbase’s valuation before entering the public markets was about $250, and despite the initial pop, it eased back to around this level in the following months before jumping yet again in October to about $343. 

Which brings us to our second and third catalysts. 

Catalysts #2/3

As a tech company, Coinbase has suffered alongside the broader sell-off. No surprise there.

Moreover, COIN shares tend to move in tandem with the crypto market, and for good reason considering Coinbase operations are reliant on crypto trading volume. Just like stocks, cryptos have been crushed since November too — Bitcoin is down nearly 50%. 

That’s exactly why the company is trying to untether itself from this volatility through subscription-based revenue. (FY21 subscription revenue hit $517.5 million compared to $45 million in FY20.)

Catalyst #4

Coinbase did so well last year. Just look at their top- and bottom-line growth.

Now, Coinbase is flushed with capital — $7.1 billion of unrestricted cash as of 12/31. 

But how could all of this growth possibly drive COIN shares down? 

When the company released its Q4 shareholder letter, it announced a plan to aggressively reinvest profits in its business. Coinbase expects to hire 6,000 employees in 2022, particularly for its technology and development teams. To give you an idea of how ambitious this is, Coinbase had 3,730 employees at the end of 2021 — and 1,249 at the end of 2020. 

So, management plans to nearly triple the company’s workforce (again). 

That won’t be cheap. Coinbase estimates between $4.25 and $5.25 billion of expenses related to this buildout (including $1.5 billion of stock-based compensation), dwarfing previous years. 

Coinbase has the capital to exponentially grow without jeopardizing liquidity. Still, margins could take a pretty large hit. Coupled with a potential lull in trading amidst recession fears (the average retail investor typically avoids riskier assets when markets are falling), Coinbase faces some near-term profitability concerns. 

Management projects monthly transacting users (MTUs, a key business metric) between 5 and 15 million — a very broad range with significant implications for revenue. 

If we perform to the middle or the high end of this range, we expect to be profitable. If we perform on the low end of this range, we plan to manage our business such that our Adjusted EBITDA loss would be no more than $500 million. Against our $7 billion of cash that we ended the year with, we think this is a very manageable loss if we choose to take it because the investment for the long-term is the most important thing we can do because we're in the early days of crypto.

Along the same lines, management expects its average transaction revenue per user (ARPU) to revert back to pre-2021 levels, which averages out to $45 per MTU. 

So, what does this look like from a financial standpoint?

Using a few assumptions and Coinbase’s outlook, we can set some parameters for Coinbase’s 2022 performance. 

Management guidance:

• MTUs = 5 million low end, 15 million high end

• ARPU pre-2021 levels = $45 per MTU

• Transaction expenses = “low 20%s” (I’ve assumed 22%)

• Sales and marketing expense = 12 to 15%

• Technology & Development (T&D) + G&A = $4.25 to $5.25 billion

Assumptions:

• Net revenue (Institutional) grows relative to 2020, but down significantly compared to 2021

• Same for “other revenue” (i.e., crypto sale gains)

• Other expenses relate to impairments, assuming this essentially cancels out other revenue.

Based on our inputs, Coinbase projects to operate at a loss in FY22, which Brian Armstrong already teed up as a realistic possibility when he mentioned managing adjusted EBITDA to no more than a $500 million loss. 

Still, these are investments — ones that should allow Coinbase to continue expanding its market share. Here’s CFO Alesia Haas’ response to a question about this very topic: (Lightly edited for readability)

The investments that we're making in our investment platform — for example, adding new assets, adding payment rails — we expect those to impact our 2022 revenue. As we've seen, the continued diversification of assets on our platform contributes to near-term revenue generation. For example, in 2021, we saw more revenue come from the long tail of crypto than from Bitcoin and Ethereum.

Other investments that we're making, for example, in the dApp platform and NFTs. I don’t think they will have as material of an impact in 2022. They’re more long-term bets that we think will have significant impacts on the longer-term revenues of our company. Similar to international, it'll take us…quarters or years to see those investments turn into meaningful revenue streams. So we think they’re the right long-term investments to make.

Last, we're putting a lot of effort into just increasing the reliability, the stability, and the infrastructure on our platform…the volume pickup from 2020 to 2021 was extraordinary. 

To read more about Coinbase’s specific investment plans, check out the Looking Ahead section of its shareholder letter.

Shares of COIN closed at $114.25 on Thursday. Wall Street’s consensus price target is $278.18.

Further Reading

For your (crypto) reading pleasure:

• SEC nearly doubles crypto unit staff to crack down on abuses in the booming market

• California Moves to Embrace Cryptocurrency and Regulate It

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Today’s Due Diligence report covers MP Materials Corp (MP), a mining company that’s on its way to becoming the first vertically integrated supplier of rare-earth products in the Western Hemisphere. 

Considering rare-earth elements are integral to modern technology, that’s a pretty big deal. 

Yet, shares of MP are down 16.1% this year — should investors beware or is MP stock trading at a bargain?

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Stock Report: MP Materials Corp (MP)

“HREEs are fundamental building blocks of the modern economy, enabling trillions of dollars in global economic development via a wide range of clean energy, information technology, defense, and industrial applications,” Andrew Hunter, Assistant Secretary of the Air Force (Acquisition, Technology & Logistics). 

What on earth are HREEs? Heavy rare-earth elements like terbium, dysprosium, and holmium. Collectively, there are 17 rare-earth elements (REEs), several of which are integral to the production of high-tech consumer, industrial, and defense products.  

From the early 1950s until the 1990s, the United States reigned supreme as the major supplier of REEs thanks to a mine located 53 miles southwest of Las Vegas: Mountain Pass. It’s one of the few economically mineable sources of REEs in the world. 

A company by the name of Molycorp oversaw the mine for decades. However, the tides started to shift when stringent environmental regulations made domestic mining arduous and laden with red tape. Eventually, the US chose to shut down operations at Mountain Pass and outsource to a lower cost, less environmentally rigid source: China.

Fast forward 20 years, REEs are the backbone of modern manufacturing. Everything from smartphones and computers to EVs and military jets need these precious minerals. Except now, China has supplanted the US as the largest REE supplier and is reportedly responsible for 55% of global rare-earth mining and 85% of the refining process. Unsurprisingly, the United States and its allies do not want to be totally reliant on China for such essential materials. 

Fortunately for them, in 2008, a group of forward-thinking investors realized that rejuvenating mining efforts at Mountain Pass could pay handsomely down the road. So, they purchased the rights to the mine as well as the Molycorp name in an effort to revive rare-earth mining in the US. 

Over the next decade, Molycorp would invest over $1.7 billion into the mine, constructing processing and separation facilities. However, the company’s mining process flow was operationally challenged, leading to environmental issues, excessive costs, and, ultimately, bankruptcy (RIP Molycorp). 

But Molycorp’s effort and immense capital input were not wasted. In 2017, MP Materials purchased Mountain Pass out of bankruptcy, still seeking to establish the US’s rare-earth supply chain. 

What Does MP Materials Do?

MP Materials Corp. (MP) is a rare-earth mining company — the only one operating at scale in North America. Since purchasing Mountain Pass out of bankruptcy in 2017, MP has revamped the mine’s process flow and established a profitable, environmentally-friendlier operation. Currently, the company is still reliant on China for processing, but a three-stage plan to build out its infrastructure and become a fully-integrated supplier of REEs is underway. (We’ll explore this later.)

To truly understand what MP Materials does, we have to explore rare-earth minerals and the mining process. Before we dive into an explanation, here’s a solid video overview:

As the name implies, rare-earth elements need to be mined. That’s not easy or, in many cases, economically feasible. Why? Because they’re rare-earth elements. Not rare in terms of abundance (they’re actually quite abundant), but in terms of concentration. You won’t find an open pit of pure Neodymium anywhere. Instead, REEs comprise low percentages of other intrusive rocks (i.e., rocks formed deep under the planet’s surface). 

MP Materials’ primary interest is bastnaesite ore, as rare earth typically comprises 60–70% of this mineral. The company mines bastnaesite ore from the open pit at Mountain Pass, relocates it to a crushing facility (where it’s, surprise, crushed), moves the crushed material to a mill where it’s ground even further, before finally transporting the product to a floatation plant. As of right now, the flotation process is the final phase of MP’s operation. Here, the bastnaesite is separated from unwanted materials, leaving the company with its “finished” product: rare-earth concentrate. 

As the CNBC video points out, MP controls 15% of the world’s rare-earth supply. According to the company’s latest 10-K, Mountain Pass has roughly 30 million tons of proven and probable reserves with an average grade of 6.34% (meaning rare-earth makes up about 6% of these minerals). That doesn’t include about 9 million tons of indicated/inferred mineral resources (essentially, less confident estimates). 

Based on these estimates and expected production, the company expected the mine to last for approximately 36 years, including a partial year in 2021 and a partial year in 2056. At that point, MP Materials would retire the mine. However, that date is subject to movement as the company continues evaluating reserves. 

Who Does MP Materials Sell to?

Speaking of concentrate, MP Materials has significant customer concentration risk because, well, it only has one customer at the moment: Shenghe Resources, a Chinese rare-earth company. 

Shenghe buys MP’s rare-earth concentrate, separates it into rare-earth oxides (REOs), and then sells them to refiners — which is a very simple sentence that drastically understates the extensive process of rare earth separation, especially at an industrial scale. 

Shenghe was actually integral to the 2017 revamp of Mountain Pass, advancing MP Materials $110 million to help re-establish operations (and another $35.5 million in 2020). In exchange for initial funding and technical services, Shenghe received a 9.99% nonvoting interest in the company, as well as entitlement to all rare-earth concentrate from the mine until the investment was repaid. 

Since then, the original agreements between MP and Shenghe have either been terminated or restructured. MP’s operations took off faster and more efficiently than expected, so the arrangement no longer appropriately valued MP’s services. On the other side, Shenghe would have been on the hook for significant funding requirements in Stage II of the company’s expansion plan. 

Even though MP is not contractually obligated to sell to Shenghe once it repays them, Shenghe is likely to remain MP’s primary customer in the near future. That said, the company’s goal is to build out its infrastructure so that it can separate and refine its own concentrate, eliminating the need to sell it to Shenghe — or anyone else for that matter. 

The company’s remaining unpaid balance is only $16.6 million, which should have been repaid in the first quarter of this fiscal year. Regardless, Shenghe still has an equity interest in the company. 

MP Materials supply chain development

“We understand that MP Materials will be the only producer of PrNd oxide within the USA in the near future.” — SRK Consulting in MP’s Technical Report

The most sought-after and valuable REEs are neodymium (Nd) and praseodymium (Pr; together, NdPr or PrNd) — two key components of permanent magnets. If you aren’t familiar, I recommend scanning this article for an easy explanation. (TL;DR: Really important things like refrigerators, smartphones, EVs, wind turbines, and even jets and missiles need permanent magnets. But China controls most of the world’s supply.) 

MP Materials (and the US government) want to change that. At the moment, thanks to Mountain Pass, the US has a bountiful source of REEs — but that’s the extent of its supply chain. 

Here’s a perfect overview from a 2021 Innovation Metals Corp. investor deck. 

So long as the above remains true, the US must rely on China. However, MP is currently progressing through a three-stage process that will conclude with a vertically integrated operation, all the way from mining REEs to producing permanent magnets and selling them to manufacturers. 

Stage I

Naturally, the initial stage commenced with the purchase of Mountain Pass in 2017. MP leveraged the existing facility — which Molycorp had already put a sizable amount of funds into — and implemented changes to improve efficiency, plant up-time, and mineral recovery. All said and done, MP’s adjustments helped achieve 3.5x more REO production volume than the mine managed under Molycorp. 

Stage II

“Upon completion of Stage II, we expect to be a global low-cost, high-volume producer of NdPr oxide, which represents a majority of the value contained in our ore.” — MP’s 10-K

Stage II is currently underway. In short, MP is expanding its operations to enable the separation of rare-earth concentrate — the “Downstream REE Refining” phase of the above supply chain graphic. As the following table outlines, this is no small feat. 

MP’s upgrades to facilities and broader process flow should translate to lower cost separation and a smaller environmental footprint. The company expects to achieve full run-rate production volume for Stage II in 2023. Once the separation facility is operating, MP will be able to separate its concentrate into four products:

1. Neodymium-praseodymium (NdPr) oxide

2. Samarium, europium, and gadolinium (SEG+)

3. Oxalate, Lanthanum (La) carbonate

4. Cerium (Ce) chloride

More recently, the Department of Defense awarded MP Materials a $35 million contract to develop an HREE processing facility at Mountain Pass, which will be the first of its kind in the US. 

Stage III

The final stage of this operational revamp will establish MP as the only vertically-integrated rare-earth magnets producer in the Western Hemisphere. These facilities would enable MP to convert NdPr into permanent magnets, which are integral components of EV motors. Again, referring back to the Innovation Metals Corp. graphic, MP will have built out the “Downstream REE Metals” and “Downstream REE Magnets” segments of the rare-earth supply chain. 

In December 2021, MP announced the development of its initial magnet manufacturing facility in Fort Worth, Texas — as well as a long-term supplier agreement with General Motors to source and manufacture the finished magnets necessary for more than a dozen GM electric vehicle models. The company expects to begin delivering alloys in late 2023 and magnets in 2025.

The facility is expected to produce 1,000 metric tons of finished NdFeB magnets (NdPr, iron, and boron) each year, which is enough material to power roughly 500,000 EV motors. And this would only account for roughly 10% of the company’s NdPr output, giving it much more runway to sell these magnets to other manufacturers. 

Who Are MP Materials’ Competitors?

“China” is an easy, albeit vague answer. There aren’t many players in the rare earth mining space, but it’s not due to a lack of interest. 

China is home to most of them, although the Chinese market is undergoing consolidation. In December, Beijing approved a mega rare-earth metals merger between three state-owned enterprises and two private companies, which will operate under the name China Rare Earth Group. Per a South China Morning Post article:

The merger is the largest of its kind in the world. Based on 2021 data, the group will have 52,719 metric tonnes of mining quota, or 31% of the national total, and 47,129 metric tonnes of smelting quota, or 29% of China’s total. It accounts for about 62% of heavy rare earth supplies nationally.

The only other major rare-earth mining company operating at scale, besides MP Materials, is an Australian company by the name of Lynas Rare Earths Ltd (LYSDY). If you recall, the DoD pledged $35 million to MP to construct an HREE processing plant at Mountain Pass. Well, the DoD also awarded a $30 million contract to Lynas in support of a light rare-earth element (LREE) plant in Hondo, Texas. Per the announcement, Lynas will account for 25% of the world’s supply of REOs upon completion (est. 2025). 

How Profitable Is MP Materials?

As of FY2021, MP Materials is a profitable business, generating $135 million of net income at a healthy margin (41%). The company has grown faster than the company expected, especially considering it only became commercially operational in July 2019. 

It was a good year for MP Materials — revenue grew by 147% after a 10% increase in sales volume of REOs. The company attributes the bump to process efficiencies and greater than 90% plant uptime. More importantly, retail prices of REO concentrate skyrocketed. To give you an idea, here’s NdPr oxide’s five-year price history (also referred to as PrNd). 

Extreme demand for these elements helped drive up MP’s Realized Price per metric ton of REO sold by 134% year-over-year. 

Two operational notes: 

• When MP and Shenghe modified/terminated agreements in 2020, they generated a $66.6 million non-cash settlement charge. 

• If you exclude the company’s repayments to Shenghe ($55 million), growth capex for Stage II ($113 million), and some minimal non-recurring plant expenses ($3 million), the company’s free cash flow for 2021 would have been $153.5 million. 

How Profitable Can MP Materials Be?

That’s the multi-billion-dollar question, isn’t it? Fortunately, we have unique insight into MP’s anticipated cash flow and potential profitability through a market report within the company’s 10-K (performed by a third-party consulting company). This report shares an economic feasibility study, including future revenue and cash flow based on mine output, projected commodity prices, etc. Needless to say, the following charts and figures are based on a long list of assumptions that may or may not pan out.

One of the key drivers of the company’s future mining profitability is the expected supply deficit of NdPr. Per the report:

Chinese rare earth production quotas have increased significantly in the last three years, from just 105kt in 2017 to 140kt in 2020. This pushed the rare earths market into oversupply. CRU expects oversupply in 2021, but from 2022 onwards we expect the market to swing back into a sustained deficit for the remainder of the forecast period. The start-up of several new projects, most notably Arafura’s Nolans project and Hastings’ Yangibana Project, will likely slow, but not prevent, the market’s steady shift into market deficit in the mid-2020s.

In response to this gap, the report projects significant upward price pressure on NdPr, which is expected to result in additional production and capacity in the latter half of the 2020s — especially with the US’s defense interest.

The price response to this market deficit is naturally uncertain, but commodity markets historically have seen upward price responses to markets where supply struggles to meet demand. As such, if these market conditions eventuate, NdFeB magnet constituents – most notably Nd, Pr and Dy – are likely to respond to this relative scarcity by increasing in price.

Long story short, the report predicts a significant supply deficit of NdPr for the majority of this decade. As such, the price for this valuable oxide is expected to skyrocket — which would be good news for MP. 

Upon reaching anticipated production rates for REO and other planned downstream products at Mountain Pass, we expect to produce approximately 20,000 metric tons of separated REO per year, excluding cerium concentrate, consisting of approximately 6,075 metric tons of NdPr oxide per year. Prior to reaching expected production rates for REO and other planned downstream products at Mountain Pass, we intend to enter into short- and long-term sales contracts with new customers.

Using a simple calculation, assuming NdPr spikes to $110 per kg, that’s over $600 million of annual revenue from just NdPr oxide. 

MP Materials Risks

At its current state, MP obviously faces two fairly significant risks: customer concentration risk and supply chain constraints. But that’s obviously going to change once it completes its own processing facilities. 

Instead, we’re going to highlight two other prominent risks: pricing volatility and permanent magnet alternatives. 

"Commodity prices are always volatile. In this sense, rare earths are no different from oil and gas, and that translates into choppy revenue and earnings." — Pavel Molchanov, analyst with Raymond James & Associates.

The former is quite simple — who knows how much the price of NdPr oxide will be in a year, five years, or 10 years. As thorough as the previous market report is, its pricing assumptions are not guaranteed to play out. For instance, China is somewhat of an unpredictable lever, as they can drastically alter supply through their own quotas. Excess supply of NdPr could put a damper on prices and, in turn, MP’s upside. 

The latter risk could also pose a risk to MP’s bottom line. Rare-earth magnets are typically viewed as the most efficient way to power EVs. But they aren’t the only way — rare-earth-free permanent magnets exist, and while they aren’t as efficient, they’re cheaper. Several automakers have already elected to use them over NdPr magnets in some of their EV models. 

Experts still predict that the market for NdPr-backed motors will persist and grow at a faster rate than rare-earth-free motors. That said, if rare-earth-free permanent magnets are able to scale faster than expected, that will be bad news for MP. 

MP Materials Stock Forecast

The broader downturn has made MP more affordable. Shares of MP closed at $40 on Thursday — well below its 52-week high of $60.19 per share. Wall Street’s consensus price target for MP is $50.78. 

MP Materials Stock Valuation

So, how much is MP Materials stock worth, especially once you factor in completion of these stages? Management didn’t offer formal earnings guidance, but they did provide a couple of insightful tidbits that we can use to estimate the value of MP Materials’ shares. Here’s the first snippet from the 4Q earnings call:

So, what will that investment get you, our shareholders, when we are fully operating our separations capability, including heavies and our initial magnet facility is at run rate or the benchmark? And I say this with all of our caveats around forward-looking statements, where we do assume current spot pricing for the full year of 2022, we would expect to be currently at a run rate of $450 million to $500 million of annualized adjusted EBITDA from sales of concentrate, i.e., our current business.

Of course, we always have to be cautious with “Adjusted” EBITDA, but most of MP’s adjustments are the usual add-backs (e.g., stock-based comp, some non-recurring transaction costs).

The second tidbit sheds light on the potential scale of MP’s business once Stage II is complete.

After our investments in Stage II, including heavies and the achievement of full run rate in our initial magnetics facility, our model indicates expected total adjusted EBITDA for MP with nearly double through approximately $900 million to $1 billion at current spot prices.

Now, we have to make some assumptions using the company’s latest operating results, particularly its margins.

• Assume MP lands in the middle of their run-rate projections.

• Adjusted EBITDA margin of 66% based on FY21, which allows us to back into implied revenue.

• Net income margin of 41% based on FY21, which allows us to estimate EPS based on shares outstanding at the end of 2021.

• If NdPr prices remain high — and signs seem to indicate they will — REE mining can remain a very profitable business. Still, 41% is pretty high, so I’ve also included an adjusted Stage II valuation that lowers MP’s projected profit margin to 30%.

In all likelihood, MP’s current price-to-earnings ratio already factors in some of their anticipated bottom-line growth post-Stage II. So, it’s hard to imagine investors paying such a premium (50x earnings) once the company reaches that point operationally.

On the other hand, the average PE ratio of the holdings within the S&P 500 Metals & Mining Index seems more realistic at 23. This would imply that MP is reasonably priced pre-Stage II ($37.87), while it could trade between $55 and $75 upon completion of Stage II.

The usual disclaimer: this valuation approach is imperfect and not guaranteed to ever be reflected in the company’s share price. Fluctuations in the company’s margins relative to FY21 would drastically impact implied share prices.

Is MP Materials a Good Buy?

MP Materials only controls a relative sliver of the REE mining market — still, it’s a pretty impressive sliver. Within the next few years, MP Materials should have a vertically-integrated rare-earth supply chain. They already have significant backing from the US government. They already have a long-term agreement with GM to produce a dozen or so EV models (and they can sign additional partnerships beyond that with plenty of NdPr to spare). Oh, and the worldwide push to clean energy sources like wind could be a nice boon too.

In line with a projected 1100% increase in wind energy capacity addition to 2040, NdFeB magnet demand from wind energy is expected to increase to 230 kt/y. Assuming a somewhat conservative ‘wind energy grade’ NdFeB price per kg of US$90-100/kg, this would mean magnet production for wind energy alone could become a market valued more thanUS$20 billion per year.

Although Mountain Pass will be retired one day, MP is well-positioned in the “near term” (i.e., the next 10 to 20+ years) to profit handsomely from the world’s high demand for permanent magnets. I like MP as a long-term investment (5-10+ years). 

Thanks for reading. Don’t forget to hit the heart button if you enjoyed today’s report.

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Today, we’re following up on a company that’s had a pretty rough year: fuboTV.

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Why Is FUBO Stock Dropping?

“There can be no assurance that revenues from content based on [progamming] rights will exceed the cost of the rights plus the other costs of producing and distributing the content.” — an excerpt from one of fuboTV’s Risk Factors in its latest 10-K

When portfolios ride the bull and returns glow green, it’s easy to jump aboard growth stock bandwagons. 

When bears come stampeding into the market and returns burn red, growth stocks often get annihilated. 

fuboTV is getting annihilated. 

But let’s back up. As you’ll recall from our DD report, FUBO offers live TV streaming services, particularly in the world of sports. The broader “cord-cutting” movement has benefitted platforms like fuboTV, which serve as a cost-effective alternative to traditional cable and satellite TV packages. And it shows in the company’s subscriber figures:

To better illustrate that 140% year-over-year increase, here’s a quarterly breakdown of paid subscriber growth.

There’s no doubt that fuboTV is attracting subscribers to its platform, and that’s led the company to post record revenue growth as well. The issue is the cost of acquiring and maintaining those subscriptions. 

fuboTV spent $142.4 million on sales and marketing last year. A large expense, but clearly, it worked. The more foreboding concern is the company’s subscriber-related expenses, which are essentially the fees fuboTV pays to air live programming. Live sports are expensive, so much so that these rights fees cost more ($593 million) than the revenue they generate ($564 million). 

Long story short, fuboTV sells its primary product at a loss. 

Add in the cost of actually running/growing the business, and you’ve got a sizable operating loss. 

I even removed an asset impairment of $249 million in FY20 from Operating expenses.

Revenue is on the wrong side of that gap. Their operating losses have only continued to grow. That’s obviously a problem, one that investors don’t think fuboTV will solve. 

Unfortunately, it could get worse before it gets better. The company added the following risk to its latest 10-K (emboldened for emphasis):

Risk: Our results may be adversely affected if long-term content contracts are not renewed on sufficiently favorable terms.

We enter into long-term contracts for both the acquisition and the distribution of media content, including contracts for the acquisition of content rights for sportingevents and other programs. As these contracts expire, we must renew or renegotiate the contracts, and if we are unable to renew them on acceptable terms, we may lose content rights or distribution rights.

Even if these contracts are renewed, the cost of obtaining content rights may increase (or increase at faster rates than our historical experience). Moreover, our ability to renew these contracts on favorable terms may be affected by consolidation in the market for content distribution, the entrance of new participants in the market for distribution of content on digital platforms and the impacts of COVID-19. With respect to the acquisition of content rights, particularly sports content rights, the impact of these long-term contracts on our results over the term of the contracts depends on a number offactors, including the strength of advertising markets, subscription levels and rates for content, effectiveness of marketing efforts and the size of viewer audiences. There can be no assurance that revenues from content based on these rights will exceed the cost of the rights plus the other costs of producing and distributing the content.

If rights fees rise, FUBO may not be able to overcome its mounting operating expenses. How can FUBO revamp this cash-burning, loss-generating business model? Management has expressed that they expect sales and marketing, G&A, and subscriber-related expenses to improve over time (in that order, but we’ll see). On the revenue side of things, the company has two areas of opportunity: 

1. Advertising

2. Sports betting

As nettlesome as they can be, advertisements have a longstanding partnership with television. This is an area of opportunity for fuboTV because advertising is a high-margin business segment that could help lessen the company’s profitability gap. Fortunately for FUBO, as its subscribership has grown, so too has its ad revenue. 

fuboTV management has kept its sportsbook trial results close to the vest, but they had previously predicted this business segment would generate 50% gross margins. Here’s the latest from CEO David Gandler:

We now have market access deals in 10 states, and we expect to launch fubo Sportsbook in additional markets soon. We believe entry into new markets will allow us to more effectively monetize our existing subscriber network. And we will create efficiencies in customer acquisition and retention and a deliberate, measured approach to growing our sportsbook with limited marketing spend.

We believe the ability to watch and wager within a single ecosystem is a feature that only fuboTV has brought to market.

Still, it remains to be seen if FUBO can scale these ancillary revenue sources to a point of materiality. They may be profitable in their own vacuums, but the bigger issue is whether FUBO can keep content spending and G&A expenses honest while it grows its subscriber base.

Do they have the liquidity to make it happen?

fuboTV operations burned through almost $193 million in 2021, however, thanks to a convertible notes issuance, the company has plenty of liquidity ($374 million of cash as of 12/31). So, at least in the near term, fuboTV should be able to execute its growth strategy. The more relevant question is, can the company turn that growth into profits and free cash flow?

Only time will tell.

As I mentioned in the September FUBO report, the company seemed pricy at $27.55, and I expected a better entry point in the coming months. Well, FUBO closed at $4.73 on Thursday. Assuming you believe in the company’s business model, that’s not a bad price tag for a growth stock that once traded in the $30s a year ago. 

That said, the current macroeconomic climate isn’t exactly rosy. So, if you’re buying into FUBO, you’re likely holding for at least 3-5 years to see if the company can make good on its initiatives. 

Wall Street’s consensus price target is $14.63.

News Roundup

For your reading pleasure:

• Netflix Plans to Launch Cheaper Ad-Supported Plans

• Florida votes to dissolve Disney’s special district, eliminating privileges, setting up legal battle

Thanks for reading. Don’t forget to hit the heart button if you enjoyed today’s report.

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Today, we’re following up on a company that may or may not be considered a meme stock: Palantir.

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Without further ado…

Palantir Technologies Inc (PLTR)

“Bad times are very good for Palantir because we build products that are robust, that are built for danger.” —Alex Karp, Co-Founder and Chief Executive Officer of Palantir

Palantir stock has seen better days. It’s still up 45% relative to its 2020 IPO price, however, PLTR once traded around $35 a share, and now it’s $13.39. 

What’s giving Palantir trouble lately? The broader tech sell-off did the company no favors, as shares dropped almost 49% from November to January. Then an earnings miss for Q4 didn’t help matters in February. 

Is Palantir in trouble?

Aside from the fact that EPS is a convoluted metric for PLTR — since they have so many outstanding shares — I think charts and tables can give a reasonably definitive answer. 

Here’s Palantir’s quarterly revenue output since the beginning of 2019. See a trend?

What’s driving this pattern? 

Robust growth within both of the company’s operating segments, Government and Commercial. From Palantir’s earnings release:

• Commercial revenue grew 34% year-over-year to $645 million.

• US commercial revenue grew 102% year-over-year.

• Government revenue grew 47% to $897 million.

• Relative to 2020, Commercial customer count tripled to 147 customers.

• US commercial customers increased from 17 in FY20 to 80 as of 12/31/21.

But what about Palantir’s inability to generate profits? Clearly, investors didn’t like the $0.02 EPS miss for FY21. 

Well, that’s another quandary that a chart can shed light on.

If you recall from my Palantir DD report, the company pays its employees very well, particularly in the form of stock compensation. So much so that stock-based comp has represented about 50% of Palantir’s total operating expenses each quarter since the company went public (ignoring the IPO quarter). 

Although dilutive, this approach is common for growth-oriented companies. 

As a percentage of gross profit, Palantir’s operating expenses (excluding share-based comp) have steadily declined since 2019, from 185% in 1Q19 to 70% — consistently — every quarter of this past year. Simply put, the company’s growth model (which emphasizes cash flow) is working exceptionally well. Its share-based comp just muddies the waters of profitability. 

For further illustration, here’s Palantir’s reported operating income, inclusive of share-based compensation.

Consistent operating losses. However, here’s what Palatinr’s operating income would look like if we backed out share-based compensation. 

Obviously, stock-based comp is still an expense — one that dilutes shareholder value. As investors, that’s important. But from the operational side of things, PLTR has less cash going out the door and more to invest in its business (as well as other businesses, which we discussed in Palantir’s DD report.) 

This leads us to our final chart…

Free cash flow.

“You can't be GAAP profitable if you're diluting people or your stock-based comp is not in conformity with other companies. So, you're seeing a normalization. This will change. It will change in the relatively near future.” — Alex Karp, lightly edited for readability

How long until this non-cash expense situation normalizes? Karp estimates a year and a half, two at most. 

In September, I noted my hesitancies about Palantir’s exceedingly high outstanding share total, which made the company less appealing at its $26+ price tag at the time. However, the free cash flow reversal is a positive sign. With sustained success, it could open the door for opportunities to increase shareholder value — business reinvestment, investments in other businesses, perhaps a share-buyback program. 

So, it’s a question of whether investors believe Palantir will continue growing the business as well as free cash flow so that, eventually, the company achieves profitability. 

The charts seem to foretell good fortunes. 

Shares of PLTR closed at $13.39 on Thursday. Wall Street’s consensus price target is $13.13.

News Roundup

For your reading pleasure:

• Russian stock market, crushed by war, opens with big limits

• Nvidia unveils new technology to speed up AI, launches new supercomputer

• Maker's Mark Just Hopped On The NFT Bandwagon. Here's What We Know So Far

Earnings Call Quote of the Week

“We acknowledge we are not yet where we want to be with new client acquisitions and conversion…” — Elizabeth Spaulding, President of Stitch Fix, on the company’s 4Q earnings call.

Losing 161,000 active clients isn’t good for business. But that’s what happened to Stitch Fix during their second quarter of FY22. The culprits? Onboarding inefficiencies and iOS changes to privacy policies, which hurt the company’s targeted advertisements. 

As a result, the company curtailed its marketing spend while it streamlines its onboarding process — coupled with less active users, management lowered revenue expectations for the year. 

All that said, shares are still a far cry from what they were when I composed the SFIX Due Diligence report — and an even farther cry from its January 2021 high of $113.76. Although the latter was predominantly driven by the meme stock craze.

Shares of SFIX closed at $10.77 on Thursday.

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Cryptocurrency is famous (or infamous, depending on your opinion). It’s embedded in the financial world and spurred cultural revolutions. However, in many respects, crypto is still enshrouded in controversy and uncertainty. 

Its underlying technology is another story. 

Today’s ETF report discusses a few ways investors can add blockchain exposure to their portfolios, including the Global X Blockchain ETF.

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Without further ado…

BKCH ETF Review

The Global X Blockchain ETF (BKCH or the “Fund”) is a passive fund that tracks the Solactive Blockchain Index (the “Index”). As you can probably guess, the companies comprising this index do business — one way or another — in the realm of blockchain technologies, including mining, transactions, applications, hardware, and integration (collectively, “Blockchain Activities”).

What is a blockchain?

A blockchain is a digital, decentralized ledger (i.e., a record of transactions) that’s publicly distributed across a computer network. 

As the name implies, a blockchain is organized into “blocks” of data that are linked together. Blocks can only store so much data, so, once they’re at capacity, they close and link to the end of the chain. The end result is an ongoing, unchangeable record of transactions that’s time-stamped and secure.

The “decentralized” aspect means there isn’t a central authority overseeing the network — like the Federal Reserve oversees the dollar. Instead, it’s a community-based system. Miners dedicate their computing power to solving complex computational problems that help facilitate transactions through the ledger and create new coins. 

Here’s a simple overview:

How is blockchain useful?

Blockchain is most prevalent in the crypto-sphere, as well as the financial sector. That’s because it enables the digitization and safekeeping of transactions. Tamper-proof and time-stamped records have a natural appeal to banks and related entities. 

But blockchain’s usefulness extends beyond finance. 

In a recent report, Deloitte identified trends within the blockchain industry, including a variety of use cases. Andre Luckow, the head of emerging technologies at BMW Group IT, recounted his experience with the design and deployment of blockchain at BMW. As a global vehicle manufacturer, BMW’s supply chain is very complex. So, Luckow and his team turned to blockchain to sort out the mess:

“Not so long ago, we still relied on spreadsheets and email. Fraud, limited visibility into second-tier suppliers, and mismatch of supply and demand were common issues that had the potential to cause production disruption and quality issues. My team started with a proof of concept that allowed the BMW Group and a handful of suppliers to share supply chain data more easily over a blockchain. Real-time visibility, shared among all supply chain members, prevented overstocking and shortages. The transparency not only benefited us with more information about part origins but also enabled our suppliers to uncover improvement opportunities.”

We’ll revisit Luckow’s perspective and Deloitte’s findings shortly. 

What is the investment thesis of Global X Blockchain ETF?

As a passive ETF, the goal of BKCH is to mirror the performance of its underlying index. Neither the Fund nor the Index invests directly in cryptocurrency. That said, there are ETF products that (sort of) do — such as the Global X Blockchain & Bitcoin Strategy ETF (BITS). The BITS ETF invests in Bitcoin futures as well as equities found within BKCH. 

What is the Solactive Blockchain Index?

The Solactive Blockchain Index (the “Index”) tracks the performance of blockchain companies, which it divides into three categories, ranked by priority in terms of security selection:

1. Pure-Play: The company generates at least 50% of its revenue from Blockchain Activities. 

2. Pre-Revenue: The company’s primary business is based on blockchain technology — but it doesn’t generate revenue yet.

3. Diversified: The company generates less than 50% of its revenue from Blockchain Activities.

If there are less than 25 qualifying Pure-Play companies, Pre-Revenue companies are included until the Index reaches 25 holdings. The same process goes for Diversified companies. 

To be eligible to join the Index, companies must have a greater than $200 million market cap and an average daily trading value of $2 million over the last six months. Moreover, at least 10% of a company’s shares must be publicly tradable (i.e., free float) or be worth $1 billion of market cap.

Lastly, there are a few specifications around weighting:

• The Fund’s weighting is based on a modified market capitalization method. The max weight for an individual holding is 12% while the minimum weight is 0.3%. 

• The aggregate weight of companies that comprise at least 4.5% of the index can’t exceed 45% of the total index. At the moment, the Fund’s top 10 holdings are each greater than 4.5% of the index — and collectively almost 75%. So, the index will face extensive rebalancing in May. 

• The aggregate weight of Pre-Revenue and Diversified companies is capped at 10% of the total index. And each individual company within these categories can’t exceed 2% of the index. 

What Companies Are in BKCH?

True to its investment thesis, the BKCH ETF consists of the same 25 stocks that are within the Index, which includes several large-cap stocks (e.g., Coinbase, Block, and PayPal) as well as quite a few small-cap stocks (e.g., Riot Blockchain, Hut 8 Mining, and Hive Blockchain).

Here’s a list of the top ten holdings within BKCH, organized by fund weighting. BKCH is very concentrated, as these companies account for nearly 75% of the entire fund.

Top 3 holdings of BKCH

The top three holdings of BKCH are Coinbase, Riot Blockchain, and Marathon Digital. Together, they represent over 35% of the Fund — as these companies rise and fall, so too does the Index. 

It’s been a horrible year for each stock. But, then again, that sentiment holds true for most tech stocks out there right now. 

Still, the Fund has taken a beating as a result, as it’s down 27.6% this year. 

Coinbase (COIN) is one of the world’s most popular cryptocurrency exchanges. (Long-time Due Diligence readers should be familiar with Coinbase, as we covered it back in April 2021.) Just like any type of asset exchange, Coinbase enables individuals and institutions to trade crypto.

Coinbase generates revenue primarily via transaction fees, but it also makes money from ancillary sources like staking (in simplest terms, validating blocks), custodial accounts, and educational campaigns. 

In case you’ve forgotten, last year saw the dawn of meme investments — one of which was dogecoin. The crypto markets experienced a flurry of activity, which helped Coinbase grow revenue by 514% — or $1.3 billion in FY20 to $7.8 billion in FY21. 

Riot Blockchain (RIOT) is a cryptocurrency mining operation. It accumulates and deploys mining rigs, which are designed to solve the complex computer problems behind the data blocks on the Bitcoin blockchain. Upon solving these problems and completing blocks, the successful miner receives a reward. This is how RIOT makes money. 

Last year, Riot significantly scaled its ability to mine Bitcoin, leading to unprecedented revenue levels for the company. In 2021, Riot generated $213.2 million of revenue, compared to just $12.1 million in FY20. One of the primary catalysts was its investment in mining facilities and rigs. In May 2021, it purchased Whinstone US Inc. from Northern Data AG (another company within the Index). Whinstone owns what is believed to be the largest single facility in North America dedicated to mining Bitcoin. Riot had 30,907 mining rigs as of 12/31. 

Although it doesn’t generate a profit, Riot appears to be decently positioned to continue mining Bitcoin. However, the company has a rather peculiar history — one that’s worth delving into since RIOT comprises a sizable percentage of BKCH. 

Before it overhauled its business, Riot operated under the name Bioptix and worked in medical diagnostics, which included animal testing as well as a diagnostic for acute appendicitis in children, adolescents, and young adults. The latter failed as it never received FDA approval. Bitcoin, and crypto as a whole, has a shady past. Perhaps it’s only fitting that Riot does too. But it’s still somewhat of a red flag.  

Marathon Digital (MARA) is another cryptocurrency mining operation that prioritizes Bitcoin. 

Like Riot, Marathon had an exciting 2021 — revenue grew from $4.4 million in FY20 to $150.5 million last year. Perhaps more importantly, Marathon invested more than a Brinks truck’s worth of cash ($709 million) in mining facilities and rigs, as the company aims for a total fleet of roughly 199,000 state-of-the-art bitcoin miners by the end of the year. 

Marathon’s history is equally back-and-forth. Just read this timeline from MARA’s latest 10-K, which I’ve organized into a bulleted list and emboldened for emphasis:

• On December 7, 2011, we changed our name to American Strategic Minerals Corporation [from Verve Ventures, Inc.] and were engaged in exploration and potential development of uranium and vanadium minerals business. 

• In June 2012, we discontinued our minerals business and began to invest in real estate properties in Southern California. 

• In October 2012, we discontinued our real estate business and we commenced our IP licensing operations, at which time the Company’s name was changed to Marathon Patent Group, Inc. 

• On November 1, 2017, we entered into a merger agreement with Global Bit Ventures, Inc. (“GBV”), which is focused on mining digital assets. We have since purchased our cryptocurrency mining machines and established a data center in Canada to mine digital assets. (MARA would eventually terminate the merger acquisition.)

Much like Riot, Marathon’s sizable investments in crypto mining are clear indicators that it’s a legitimate player in this space. Its track record of bouncing around just raises concerns from the perspective of a potential long-term shareholder. 

The Appeal of Blockchain

“Blockchain and [distributed ledger technology] platforms have crossed the disillusionment trough of the hype cycle and are well on their way to driving real productivity.” — Deloitte article, Blockchain: Ready for business

Blockchain’s future is bright. Cryptocurrency, decentralized finance (DeFi), supply chain management, digital identification — there is a budding list of use cases for this technology. One report estimates that the US blockchain market will grow at an astounding 84.5% compound annual growth rate through 2030. And the global market is anticipated to generate $1.4 trillion of revenue by the end of the decade. 

Of course, there’s a lot of time between now and 2030. 

Deloitte’s report outlined several applications of blockchain technology that are gaining traction:

• Self-sovereign data and digital personal identity. In other words, reliable and secure ownership over personal data, which could impact access to public health information and even voting procedures. 

• Trusted data-sharing among third parties. This goes back to the earlier BMW supply chain example. Centralized technology can be limited by silos and privacy restrictions. However, blockchain enables companies to share data with ecosystem partners without jeopardizing security. 

• Grant funding. The transparency embedded in a blockchain ledger system alleviates the burden of monitoring and reporting financial results. 

• Intercompany accounting. Large enterprises typically have complex, multi-tiered corporate structures that can span ecosystems, industries, continents, etc. Blockchain simplifies intercompany clearance and settlement by validating transactions and maintaining an immutable record. 

• Supply chain transparency. Beyond simplifying data sharing, blockchain’s proven record-keeping capabilities also help companies maintain transparency during the procurement process. 

• Customer and fan engagement. Whether or not you see any value in NFTs, they’ve changed the world of collectibles. Entire communities have been built around these digital images. 

• Creator monetization. Blockchain and other DLT platforms allow creators to control and monetize their IP. For instance, BitClout — a decentralized social media platform — gives creators the ability to sell “creator coins” and profit from their content and reputation.

The Risks of Blockchain

In terms of broader application, blockchain is still in its infancy. However, the technology itself isn’t the most concerning risk. For all intents and purposes, blockchain has a variety of use cases and several industries, particularly financial services, have invested heavily in this technology. 

But an investment in BKCH is also investing in the original and most prominent use case for blockchain — cryptocurrency. 

Just following the money, I’m hardpressed to believe crypto will vanish anytime soon. At this stage, Bitcoin has a better chance of hitting $150,000 than it does tumbling to $0. Every subsequent dip (or even crash) begets a new wave of buy orders. 

Still, Bitcoin and its fleet of altcoins are hardly stable assets. Uncertainty breeds volatility, and most investors still don’t have a firm understanding of this asset class. Plus, there are mounting concerns around the environmental impact and sustainability of crypto. Considering BKCH dips deep into the trough of crypto mining, its performance is highly correlated to crypto movements rather than the application of blockchain. 

ETF comparison BKCH vs. Peers 

There are plenty of blockchain ETFs to choose from, including active and passive funds. Here’s a side-by-side comparison of BKCH and several other funds. 

Highlights

• There are a variety of ways to evaluate whether a company falls within the thematic umbrella of “blockchain.” To give you an idea, there’s minimal overlap between BKCH and LEGR (NVIDIA and PayPal are the only two shared stocks). While BKCH focuses on companies that generate revenue via blockchain activities (mining, applications, transactions, etc.), LEGR selects from a pool of companies that either develop or use blockchain technology — so it doesn’t necessarily need to be a business’s primary means of operation. Hence why LEGR consists of companies like IBM, Oracle, and Walmart, which have successful, standalone businesses outside of the blockchain ecosystem.  

• BKCH is, by far, the most concentrated fund. It’s also the least expensive. 

• AS a whole, blockchain ETFs have grown in popularity, but they’re still small relative to other thematic funds. 

BKCH Outlook

The future of crypto mining, particularly for bitcoins, is foggy. Crypto is unlikely to disappear anytime soon, and staking could very well replace proof of work and assuage concerns around environmental impact. But the long-term sustainability is questionable. 

As a “blockchain” fund, BKCH slants toward mining operations. Out of its top 10 holdings — which, as a reminder, represent roughly 75% of the fund — 6 companies predominantly operate as crypto miners (7 if you include Canaan, which sells the hardware for it). That’s not exactly a surprise considering the Fund’s selection pool is driven by revenue from blockchain rather than the development of blockchain. 

But its slant toward mining operations translates to a reliance on Bitcoin. 

COIN holds roughly 8,000 bitcoins.

RIOT holds roughly 3,500 bitcoins.

MARA holds 3,321 bitcoins. 

A rising Bitcoin tide lifts all crypto stocks. Conversely, they also retreat with a falling tide.

Investors can leverage a product like Global X Blockchain ETF to get indirect exposure to crypto, namely Bitcoin, but it’s not ideal for maximizing the diverse applications of the actual technology — which I think has a much more promising outlook. 

To conclude, let’s revisit our BMW story from the Deloitte report, emboldened for emphasis:

“Looking back on the hype around blockchain in 2018 and the progress the BMW Group has made since, two things are clear. One, blockchain is transformative, and one day we will be using blockchain-based technologies without even realizing it because of the potential they have to build better business processes and customer experiences. Two, the transformation may take longer than anyone anticipated. Businesses need to adopt broader thinking as to which new markets or ecosystems can be supported and simplified through blockchain; they need to ask the right data-driven questions to find their appropriate use cases. If we push the technology forward from all sides, we’re bound to see even more great ideas surface.”

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Today’s Due Diligence report covers UserTesting Inc (USER). 

User testing (also known as usability testing) is exactly what it sounds like — the process of evaluating customer interactions with a particular product, service, brand, etc. In turn, businesses can glean insights from the experience and use them to improve their offerings.

UserTesting, the company, was founded in 2007 but only recently went public in November 2021. Since its IPO, USER stock has retreated. But it’s gaining momentum again in 2022.

USER’s stock price is up 17.6% this year.

Are investors overlooking it?

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Now, without further ado...

Stock Report: UserTesting Inc. (USER)

What if you could see experiences through your customers’ eyes? — UserTesting prospectus

True to its name, UserTesting Inc. (USER) is a software platform that allows businesses to get immediate, genuine customer feedback. Companies can watch and listen to their customers as they engage with products, services, apps, processes, designs, brands, etc.

In short, UserTesting strives to revolutionize qualitative feedback, which has been a time-consuming and laborsome process historically (e.g., focus groups).

CEO Andy MacMillan outlined the company’s value proposition in the USER prospectus:

When I was a product executive at organizations like Oracle and Salesforce, I would have loved to get this type of rich insight from current and future customers as we iterated on product designs. We either struggled to find customers to talk to when we needed the input, or, more often, we paid agencies tens or hundreds of thousands of dollars to go talk to our customers for us!”

The value of this platform is undeniable. Here are a few examples of use cases: 

• Product teams can vet new markets and gauge customer needs.

• Marketing teams can get instant reactions to product/service names, brand messaging, marketing campaigns, landing pages, pricing, etc.

• R&D teams can analyze customer behavior and cognitive processes to pinpoint usability strengths and weaknesses.

• Customer service teams can understand each touchpoint of the customer journey and work to improve each interaction.

• Companies can even benchmark their customer experiences against their competitors.

How Does UserTesting Work?

Users sign up to participate in various types of consumer tests, such as surveys about a brand or the use of a new product. The UserTesting platform records the screens or actions of users via camera as they engage with whatever predetermined task, product, service, etc. The video recording captures intonation, facial expressions, body language, actions, and real-time narration.

Each test represents a Customer Experience Narrative (CxN), which is then delivered to the relevant business within a day. 

Using machine learning, the UserTesting platform also identifies “key moments,” giving businesses immediate insight. 

How Does UserTesting Get Users?

UserTesting’s contributor network, which was more than 600,000 contributors as of November, is arguably its biggest selling point and asset. Collectively, these contributors created 1.4 million CxNs in 2020.

The primary appeal from the “tester” side is, quite simply, money.

The platform pays contributors for each test they perform, ranging from $4 to $120 based on the test’s duration. For instance, a 5-minute survey would pay $4, while a 20-minute screen and audio recording would pay $10.

But, as Andy MacMillan noted on the company’s first earnings call, contributors from higher-earnings brackets value being heard more than being compensated. Since these CxNs go straight to the brands, people can voice their opinions with confidence that businesses will listen. 

How Much Are UserTesting’s Services Compared to Competitors?

UserTesting targets major corporations. Its enterprise subscription isn’t for the financially faint of heart — starting somewhere around $18,000 to $20,000 per year based on some public feedback. (UserTesting’s site doesn’t outright state its pricing models.) 

This platform is not for small businesses and startups. Still, it’s hardly the only option. 

There are much more affordable alternatives out there, such as Maze and Lookback. But, for what it does, UserTesting appears to offer the best video capabilities relative to its competitors based on public feedback. 

According to G2, UserTesting is the top-rated solution in the following categories: 

• User Research 

• Software Testing 

• Consumer Video Feedback

From a public company standpoint, there’s also Qualtrics (XM), Amplitude (AMPL), and Momentive Global (MNTV; the parent company of Survey Monkey) — but there’s not as much product overlap as private competitors. In fact, UserTesting formed a partnership with Qualtrics in 2019.

How Profitable Is UserTesting?

Revenue growth has been consistent, which is a benefit of their subscription model but also a testament to both their client retention and client acquisition.

UserTesting now has 2,350 customers — up 37% from a year ago. Many of which are mega enterprises; the platform serves over half of the world’s top 100 most valuable brands, according to Forbes. 

In just the fourth quarter, the company “landed or expanded” customer relationships with AMC Entertainment, Anheuser-Busch, Hawaiian Airlines, Home Shop, Lowe's, MetLife, Philips, Phoenix Group, Reddit, and Vestiaire Collective SA. Full-year revenue for 2022 is expected to be around $196.5 million, which would represent 33% year-over-year growth. 

Gross profit margins are healthy (a hair under 75% in FY21). (In other words, UserTesting retains about $0.75 of every dollar of revenue after netting out things like contributor payments.) But that revenue growth has come at a price — UserTesting has consistently increased its marketing spend every quarter. Sales and marketing expenses as a percentage of revenue have grown from 48.6% to 58.5% to 62.2% over the last three fiscal years. It’s easily the company’s largest expense each period ($91.6 million in FY21).

In turn, the company’s net loss ballooned from roughly $34 million for FY20 to about $50 million last year. 

That’s not exactly a surprise though, considering USER is an emerging growth company trying to expand its business both domestically and internationally — the latter of which is a key element of the company’s growth strategy (international revenue was up 76% in FY21).

USER Stock Forecast

Consumer research is a highly competitive field already. On top of that, UserTesting’s solutions aren’t exactly irreplaceable, so there’s a fairly low barrier to entry. Only time will tell if UserTesting can execute its growth strategy, keep SG&A spending in check, and turn a profit. The company is currently cash flow negative, but its recent IPO helped boost liquidity. 

The broader tech sell-off amidst concerns over inflation and rising interest rates has made USER more affordable. Shares of USER closed at $10.09 on Thursday — still well below its IPO issuance at $14 per share. Wall Street’s consensus price target for USER is $13.90. 

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Today, we’re following up on a company that empowers people to “belong anywhere”: Airbnb.

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Without further ado…

Airbnb Inc (ABNB)

Nearly two years into the pandemic, it’s now clear that we are undergoing the biggest change to travel since the advent of commercial flying. Remote work has untethered many people from the need to be in an office every day. As a result, people are spreading out to thousands of towns and cities, staying for weeks, months, or even entire seasons at a time. For the first time ever, millions of people can now live anywhere. 

This glowing synopsis of the travel industry is the opening paragraph of Airbnb’s 4Q shareholder letter. It appears that people are finally scratching their pandemic-induced travel itches. The monumental shift to remote work infrastructure and more lenient corporate policies have enabled people to mix business with pleasure — and thanks to Airbnb’s sprawling network of hosts, practically anywhere is an option. 

ABNB stock is down this year (although it was up 8% a week ago), but that’s largely a result of broader market sell-offs and, more recently, escalating war tensions in eastern Europe. The latter is still unfolding and poses a significant threat to economic activity everywhere. Nevertheless, we’re here to focus on Airbnb.

Let’s take a look at key trends listed within Airbnb’s 4Q shareholder letter:

• A travel boost to small towns and rural communities. Non-urban gross nights booked increased nearly 45% relative to Q4 2019. (2019 is a better benchmark since 2020 results were suppressed by the pandemic.)

• Cities are recovering too. Globally, urban gross nights booked almost reached Q4 2019 levels; in the US, the same figure exceeded Q4 2019.

• What pandemic? Gross nights booked grew by roughly 40% in December 2021 relative to December 2020. Moreover, at the end of January, there were 25% more nights booked for the upcoming summer than in January 2019. 

• Extended getaways. On theme, the average trip length for Airbnb patrons has increased by about 15%; stays that exceed a week represent almost half of all gross nights booked. Moreover, long-term stays (28+ nights — talk about a vacation) represented 22% of gross nights booked in Q4. 

• I’m Flexible. The company’s latest product feature, I’m Flexible, allows users who aren’t tied to dates or locations to search Airbnb for the best spots. 

Naturally, the company’s financial results are just as promising. There’s no doubt that Airbnb suffered amidst travel restrictions in 2020, so it’s more appropriate to judge last quarter’s results against 2019 (i.e., pre-pandemic). Here’s a side-by-side comparison of Airbnb’s revenue, net income, and free cash flow over the last three 4Qs. (Note that I’ve removed share-based compensation from 4Q20, which was when ABNB went public, to get a more realistic comparison.) 

Although pandemic restrictions still linger, it’s fair to say Airbnb bounced back last year. 4Q 2021 was the company’s most (and only) profitable fourth quarter to date — a positive sign for earnings growth this year and going forward. 

As a travel company, Airbnb is subject to seasonality (its third quarter routinely outperforms all others). To get the full picture of Airbnb’s comeback, I’ve outlined the company’s growth by quarter over the last three fiscal years. 

2021 revenue and free cash flow exceeded 2019 levels in every quarter. The same can almost be said for net income, with the exception of Q1. 

Free cash flow generation is particularly encouraging. In the 4Q shareholder letter, company management reiterated that 2021 was all about bolstering its core service in anticipation of the travel rebound. In 2022 and beyond, Airbnb wants to (a) expand its extended-stay offerings to “make it easier to live on Airbnb,” (b) add more hosts, and (c) personalize the guest experience. An influx of free cash flow should empower the company to execute its strategic goals. 

Shares of ABNB closed at $158.26 on Thursday. Wall Street’s consensus price target is $205.83.

News Roundup

For your reading pleasure:

• Dow drops 700 points after Russia attacks Ukraine, sending oil spiking and investors fleeing risk

• The chip shortage is so bad GM dropped heated seats in winter

• These crypto enthusiasts are trying to raise $4 billion to buy the Denver Broncos

Earnings Call Quote of the Week

“By the way, we just passed 31,000 orders.”

During Fisker’s 4Q earnings call on February 17, Henrik Fisker was explaining the average selling price of the company’s Ocean reservations. At one point, he figured he’d slip in a key performance metric: his inaugural EV model’s reservation totals. In August, that figure was 17,500, so Fisker’s marketing appears to be paying off. 

Assuming those reservations hold true, that’s $1.7 billion of revenue. Henrik would later add:

“I mean, seeing the rate that we're running in at now is 31,000, I don't see any problem in easily getting way past our goal of 50,000 reservations this year — in fact, probably a lot higher.”

Shares of FSR closed at $11.86 on Thursday.

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We’re back with another ETF report. This time, we’re looking at a passive fund with exposure to a very active field: the Global X Robotics & Artificial Intelligence ETF.

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Without further ado…

BOTZ ETF Review

The Global X Robotics & Artificial Intelligence ETF (BOTZ or the “Fund”) is a passive fund that tracks…don’t hold your breath…the Indxx Global Robotics & Artificial Intelligence Thematic Index (the “Index”). As these long-winded titles imply, we’re dealing with companies that strive to remove human intervention from various walks of life. 

Industrial robotics is the *classic* use case (e.g., robot arms pulling indefinite shifts on an assembly line), but there are also medical, agricultural, professional, and transportive applications for our robot companions. To give you an example, a team at the University of Cambridge developed the Vegebot, which uses machine learning to harvest Iceberg lettuce. 

The BOTZ ETF gives investors exposure to companies that prioritize the development and application of these types of machines by mirroring the holdings of the Index. 

What is the Indxx Global Robotics & Artificial Intelligence Thematic Index?

Indxx is a frustratingly named index provider. The Indxx Global Robotics & Artificial Intelligence Thematic Index measures the general performance of a particular subset of the stock market — robotics and AI-focused companies. Currently, the Index consists of 38 stocks that play some sort of role in these technological spaces. 

To qualify for the Index, companies must have “significant exposure” to the robotics/AI theme and a market cap of at least $300 million. Significant exposure is loosely defined as (a) deriving a “significant portion” of revenue from robotics/AI themes or (b) its primary business is focused on these themes.  

Who runs the BOTZ ETF?

The portfolio managers behind BOTZ are John Belanger (COO of Global X ETFs), Nam To, Wayne Xie, Kimberly Chan, and Vanessa Yang. 

What Companies Are in BOTZ?

The BOTZ ETF is composed of the same 38 stocks that are within the Index, which includes household names like Nvidia, ABB, and Intuitive Surgical as well as lesser-known companies such as AeroVironment and Ageagle Aerial Systems. (That said, Ageagle (UAVS) could get the boot once the index reviews its holdings in June; shares of UAVS are down roughly 93% over the last year. Fortunately, it’s the fund’s smallest holding at 0.07%.)

BOTZ’s prospectus specifically describes eligible companies as those “developing industrial robots and production systems, automated inventory management, unmanned vehicles, voice/image/text recognition, and medical robots or robotic instruments.”

Here’s a list of the top ten holdings within BOTZ, organized by fund weighting. As you can see, BOTZ is rather concentrated, as these companies represent two-thirds of the entire fund.

Top 3 holdings of BOTZ

BOTZ (and its underlying index) are weighted by market cap, as opposed to an equal weighting regardless of size. Naturally, this leads to concentration; the top three positions equate to 28.6% of the Fund. Since these companies predominantly drive performance, let’s explore them a little further, particularly how they’re involved in robotics.  

NVIDIA is a well-known producer of computer chips and one of the largest companies in the world by market cap (hence why it claims such a high percentage of BOTZ). But did you know this semiconductor company is at the forefront of robotics and AI research? 

For instance, NVIDIA’s hardware for self-driving cars, NVIDIA DRIVE, has been adopted by several auto manufacturers — most recently, Kodiak Robotics (a self-driving truck startup), Lotus (sports cars), QCraft (autonomous buses), and WM Motor (an EV startup). Beyond autonomous vehicles, the company is also responsible for lots of innovative research in robotics, testing actions like grasping and placement. And that’s just scratching the surface of what NVIDIA does in the robotics/AI space. 

ABB is one of the leading suppliers of robotics and machine automation solutions. It also has its hands in various industries, including logistics, construction, and electronics. For example, ABB recently helped a medical machinery manufacturer automate the production of biomedical disposables for dialysis and infusions. 

Intuitive Surgical produces robotics-assisted surgical systems (most notably, the da Vinci) to provide minimally-invasive surgeries and improve clinical outcomes — like taking lung biopsy samples. And the company is doing quite well. In 2016, Intuitive shipped 537 units and generated $2.7 billion in revenue. Last year, those figures were 1,347 and $5.7 billion. 

The Appeal of Robotics

“We expect the global robotics market to climb from about $25 billion this year to between $160 billion and $260 billion by 2030, with market share for professional services robots hitting up to $170 billion and industrial and logistics robot sales topping off at about $80 billion.” — BCG Robotics Outlook 2030

Robotics is widely considered to be an emerging technology that will shape the future of mankind. Companies wouldn’t be pouring billions of dollars into it otherwise. If you want a firmer understanding of the potential application and trends of robotics, I highly recommend reading BCG’s robotics outlook. It provides trends that will guide industry growth as well as three market scenarios. The trends are as follows:

• Professional services robots will dominate the sector (see chart below). Think activities like cleaning services, construction, and underwater exploration.

• Changing consumer preferences and social trends will accelerate the need for advanced robotics solutions.

• Robots will increasingly take over traditionally lower-paying and less skill-intensive jobs.

• Artificial intelligence and other technological advances will enhance human-to-robot interactions.

• Robot capabilities will include the ability to learn.

• Semi-autonomous mobile machines will increasingly manage tasks in pre-mapped environments. Think vehicles that can drive autonomously in ideal conditions but not totally unassisted; BCG thinks these vehicles will account for 8% of new car sales in 2030.

• Asian robotics companies, currently a small slice of the market, will be competitive with US and European manufacturers. 

The Risks of Robotics

Based on R&D alone, robotics has a future. The trickier thing to forecast is how lucrative that future will be — and who will profit from it. Regarding the latter, robotics — like technology as a whole — is highly competitive and, therefore, susceptible to disruption and product obsolescence. Investing in a thematic ETF like BOTZ spreads your chips across the roulette table, upping your odds of having your number called. 

Still, a lot still has to continue changing for this industry to prosper. There are scenarios in which robotics doesn’t meet its sky-high expectations. The simplest is a lack of social acceptance — if people don’t reach a high enough comfort level with autonomous equipment, scalability isn’t viable. While that’s not much of an issue in non-human-facing settings (like industrials and agriculture), it is a roadblock for an area like driverless cars (ba-dum-tsshh). 

ETF comparison BOTZ vs. Peers 

Investors have no shortage of options when it comes to robotics and AI ETFs. Here’s a side-by-side comparison of BOTZ and a few other funds. 

Highlights

• Each fund is passive but tracks a different index. For instance, ROBO is based on Robo Global’s own index of robotics and automation companies. Further, ROBO holdings are based on a modified equal weighting system, so you don’t have a scenario like NVIDIA for BOTZ. 

• BOTZ is far more concentrated than its peers with only 38 holdings. Naturally, that means the other funds have more exposure to other fields and applications of robotics. 

• From an expense ratio standpoint, BOTZ is right in between its peers.

BOTZ Outlook

The outlook for BOTZ is obviously dependent on the success of the robotics industry — and, more specifically, ten or so large-cap stocks. But that’s not necessarily a bad thing. For instance, assuming automated vehicles graduate from a niche experiment to some sort of standard, NVIDIA would be well-positioned to benefit. 

On the other hand, it’s not exposed to as much of the robotics market, such as the agricultural side. To give you an idea, Deere & Company (i.e., John Deere) is a big player in agricultural robotics — but it’s outside of BOTZ’s investment scope. (John Deere is held by ROBO and ROBT though). 

Regardless, the recent market sell-off of technology stocks has crushed these funds in 2022. In the near term, BOTZ and its peer ETFs could continue to have shaky performances, but now could also be a good entry point if your investment horizon is 2030 and beyond.

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We’re back with another ETF report, except we’re flipping the script and looking at an inverse fund: Tuttle Capital Short Innovation ETF (SARK).

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Without further ado…

What is SARK ETF?

The Tuttle Capital Short Innovation ETF (SARK or “the Fund”) is an inverse ETF — which is a fund that tries to replicate the opposite return of an underlying benchmark. For SARK, that benchmark is Ark Innovation ETF (ARKK). If ARKK sounds familiar, that’s because it’s the flagship fund of Cathie Wood’s capital management firm, Ark Invest (plus, I covered it in November of last year). 

Long story short, if ARKK falls 2%, SARK should go up by 2%. 

How does it accomplish this? By entering into swap agreements. Tuttle Capital strikes a deal with one or more financial institutions to “swap” the returns of ARKK. 

This isn’t a perfect process, for a couple of reasons. First, these swaps typically last one day, so SARK usually has to place a new bet against ARKK each trading day. As a result, the Fund’s returns are unlikely to match the exact cumulative return of ARKK. More importantly, volatility — the rate of price fluctuations — amplifies the variance between these funds’ cumulative returns. (We’ll explore this more later, it’s easier to understand with numbers).

Why bet against ARKK?

Financial news outlets couldn’t get enough of Cathie Wood last year after her funds skyrocketed in both price and popularity. In 2020, ARKK generated a return of 157%. 

Why bet against a fund that’s doing so well?

Because it might be doing too well. 

At any given time, Ark Innovation has between 35-55 holdings — each of which falls under their thematic blanket of “disruptive innovation.” You could simplify this snazzy term to “companies of the future.” These are the stocks Ark thinks will be the driving forces behind human advancement across various walks of life, such as an internet-based business like Twilio or a financial services company that’s setting trends in its industry, such as Robinhood. 

Considering the stock market is forward-looking by nature, it’s not surprising that Cathie’s funds have been so successful, especially during the pandemic’s investing boom. 

But growth-oriented are not without risks; they usually operate at minimal profits (or even severe losses) and can have sizable levels of debt and scalability hurdles. And when broader market turbulence induces sell-offs, companies that are viewed as overvalued can take serious hits. (Just look at what happened after PayPal axed its growth strategy.)

Tuttle’s inverse fund makes it easy to bet against Cathie’s holdings and profit when they take a tumble. 

Who runs SARK?

The man behind Tuttle Capital Management is Matthew Tuttle, who holds the titles of Chief Executive Officer and Chief Investment Officer for his firm. Here’s a quick highlight of his background:

• CEO, CIO of Tuttle Capital Management (2012 – present) 

• CEO of Tuttle Wealth Management (2003 – 2011)

• Fixed Income Sales for Bear Sterns (RIP)(1998-1999)

• MBA in Finance from Boston University

• Author of How Harvard & Yale Beat the Market and Financial Secrets of My Wealthy Grandparents

In September, Tuttle joined the Boardroom Alpha Podcast, Know Who Drives Return, as a guest. He shared that he was appalled by what passed as advice in the brokerage and insurance industries — so he started Tuttle Wealth Management in 2003 and staffed several advisors. As he puts it, these advisors lost his clients’ money during the housing market crisis, which pissed him off. Eventually, he launched Tuttle Wealth Management because, as the adage goes, “the only way to do it right is to do it yourself.”

This led Tuttle and his team to start launching ETFs. Fast forward a decade, Tuttle now actively manages several thematic ETFs, which I’ve outlined below. (Note that blue-highlighted ETFs are sub-advised by Tuttle Capital.)

What does Cathie Wood think of SARK?

Like a true competitor and market participant, she welcomes the shorts. 

At the Dynasty Financial Partners' 2021 Investment Forum, Wood shared her thoughts to Bloomberg:

"This is what makes a market, right? I never worry about anyone shorting the stocks underlying Ark or with this new ETF, because if we are right, they are going to have to cover their shorts and that will be another source of demand for the stocks in the future. I like skepticism, and I feel much better when there’s a good give and take."

Unfortunately for Wood, she’s been on the wrong side of that “give and take” since her comments. 

Return comparison SARK vs. ARKK

From ARKK’s inception in October 2014 through the end of 2020, Cathie and her fellow shareholders experienced stratospheric returns — 559% to be exact. 

Since SARK entered the fray last November, it’s been another story.

Shorting the holdings within ARKK has proven to be quite profitable, as SARK has generated close to a 58% return in less than three months. Naturally, ARKK is in the red in that same timeframe — but we see the impact of volatility, as ARKK is “only” down 42.3%.   

SARK Risks

Shorting is a gamble. It’s riskier to bet against companies than to bet on them. Buying shares of SARK is the equivalent of trying to time market downturns, which isn’t easy. It’s also *unlikely* that each of ARKK’s individual holdings will fail, especially over longer timeframes. In turn, SARK is best used as an aggressive short-term play or hedge — not a long-term investment. 

SARK needs a partner. To short ARKK, Tuttle enters daily swap agreements with another institution. If that institution fails to settle what it owes Tuttle (e.g, in the event ARKK plummets one day and the firm can’t afford to pay up), it could get very messy for Tuttle and holders of its shares. 

Tracking error. Since SARK is a daily bet against ARKK, the Fund is unlikely to produce an exact -100% return of ARK’s performance. This can work for or against the Fund. (Since its inception, this has worked in the Fund’s favor.)

To explain this better, here’s a hypothetical scenario from SARK’s prospectus:

Mary invests $10.00 in the hypothetical Fund after the close of trading on Day 1. During Day 2, the ARK Innovation ETF decreases from 100 to 98, a 2% loss, and Mary's investment rises 2% to $10.20. Mary continues to hold her investment through the end of Day 3, during which the ARK Innovation ETF increases from 98 to 102, a gain of 4.08%. Mary's investment declines by 4.08%, from $10.20 to $9.78. 

For the two day period since Mary invested in the Fund, the ARK Innovation ETF gained 2% while Mary's investment decreased from $10 to $9.78, a 2.20% loss. The volatility of the ARK Innovation ETF affected the correlation between the ARK Innovation ETF's return for the two day period and Mary's return. In this situation, Mary lost more than -100% the return of the ARK Innovation ETF.

As the example points out, volatility is a key player — more volatility, more variance. 

Here’s another example from the prospectus, except this time we see performance stretched out over a 10-day trading period. Although ARKK generates a cumulative 10-day return of 0%, its volatility causes the Fund to generate a -6.62% return. 

SARK Outlook

Once you understand how Tuttle Capital creates an inverse return using swaps and recognize the impact (and risk) of volatility, SARK is pretty straightforward. 

If you think the stocks within ARKK’s portfolio are about to struggle, SARK is a convenient way to profit from that struggle. 

However, it’s certainly not a suitable investment for everyone — only investors with a near-term trading horizon who are open to aggressive short-selling strategies. That said, if you invest in ARKK and want a hedge during periods of turbulence, SARK could be beneficial too. 

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Today, we’re following up on two previous reports: EVBox/TPG Pace and Activision.

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Without further ado…

EVBox + TPG Pace Beneficial (TPGY)

Another SPAC deal bites the dust. 

On December 29, the companies officially announced the termination of their agreement — two days ahead of the deal’s already extended outside date. The potential merger between EVBox and TPG Pace Beneficial is no more, after EVBox failed to provide reliable financials and assuage its buyers’ budding concerns. 

As a result, EVBox will pay TPG Pace €15 million (€12 million for a failed combination and €3 million for failure to deliver 2020 audited financials, as per the agreement). 

But is the deal really dead?

I’ve covered this proposed business combination a few times over the last year, starting with the EVBox and TPGY Due Diligence report in April. Since then, the companies have struggled to move forward. Here’s a timeline of events leading up to the termination:

• In May, TPGY officially notified investors that EVBox is taking longer than expected to complete an audit of its FY20 financials. 

• On June 1, TPGY announced that the companies had agreed to extend the original outside date from June 8 to August 6. 

• On August 6, TPGY announced another extension — this time to December 31, 2021. Within the report, TPG shared that it had received information indicating that EXBox’s existing FY19 audited financials might require restatement prior to the completion of FY20’s audit. As a result, EVBox had to provide a revised business plan and financial forecast. 

• On August 12, within TPGY’s 10-Q for the quarter ending June 30, the company announces its intentions to continue negotiations with EVBox. Per the filing, “In the event that the Company and Engie Seller are able to mutually agree on terms for a renegotiated Business Combination Agreement, the Company and Engie Seller expect to work toward completing the Business Combination in late 2021 or during the first half of 2022.” Emboldened for emphasis.

So, what now? Despite the termination, the two parties could still reach an agreement. Reading the tea leaves, the fact that the outside date has come and gone wasn’t an unexpected outcome. It’s possible that a new deal gets hammered out in the first half of 2022 — it’s also possible that TPGY targets a new company altogether. 

Per the December press release: 

TPG Pace intends to continue to pursue the consummation of a business combination with an appropriate target. With the agreement terminated, TPG Pace, Engie Seller and EVBox Group may (but are not required to) continue to discuss a potential business combination transaction involving TPG Pace and EVBox Group.

So, yet again, we’re in wait-and-see mode. 

Interestingly enough, shares of TPGY have been pretty stagnant since the late December announcement. Perhaps shareholders are still confident something else will come about between now and the SPAC’s deadline for finding an acquisition target (October 2022 — but that could be amended if something materializes). 

Even though eight institutional investors have pulled out of TPGY in the last three or so months, the latest transaction actually represents bullish sentiment. On January 5, Sculptor Capital purchased a 6.63% equity interest in TPGY. 

Shares of TPGY closed at $9.85 on Thursday. 

Activision (ATVI)

Back so soon, ATVI? I mean, c’mon — I couldn’t have scripted it better. 

Last Friday, I shared the Due Diligence report for Activision Blizzard, which outlined the cultural issues plaguing the company — and CEO Bobby Kotick’s role in the matter. One of the oddities of Activision’s mess was that Kotick was still at the helm despite all the turmoil that, reportedly, he had a hand in cultivating. This prompted me and many others to wonder, “Why hasn’t Kotick stepped down?”

Well, now we have an answer.

He wanted to get paid first.

On Tuesday, news broke that Microsoft (MSFT) plans to acquire Activision for $69 billion. Shares of ATVI jumped through the roof in response. It’s believed that Kotick will step down once the deal completes, which is when he’d undoubtedly receive a massive payout. 

Kotick expressed his commitment to staying around to help fix the internal problems — in reality, that probably translated to “I’m staying around until Microsoft inherits my problems.”

Beyond Kotick getting paid and Microsoft boosting its Game Pass product portfolio, what does this mean for Activision?

Although both boards have approved the transaction, it’s still not guaranteed to close. Consummation of the agreement is subject to standard closing conditions and a regulatory review. That latter is the biggest hurdle, as anti-trust concerns could stop this deal in its tracks. Considering Microsoft purchased Activision at a value of $95 per share, the market is clearly hesitant about the transaction going through — ATVI closed at $81.76 on Thursday. 

But, assuming the deal closes, it’s hard to imagine Activision’s financial position worsening under the world’s second largest company by market cap. Further, Activision has a history of acquiring studios and letting them run autonomously — although, one would imagine there will be more oversight from a workplace culture perspective. 

Within Microsoft’s announcement, the company wasn’t reticent about its intentions for Activision IP, stating: 

“This acquisition will accelerate the growth in Microsoft’s gaming business across mobile, PC, console and cloud and will provide building blocks for the metaverse.” (Emboldened for emphasis)

News Roundup

For your reading pleasure:

• Record IPO rush of 2021 led to historically dismal returns for investors with no relief in sight — IPOs are risky investments as it is. Last year underscored that fact as new stocks vastly underperformed relative to historical returns. 

• Walmart is quietly preparing to enter the metaverse — Walmart + NFTs. Who would have guessed that?

• Tom Cruise space movie producers sign deal with Axiom to build studio in orbit — Absolutely nothing to do with investing, but a hard headline to ignore. In the next few years, Hollywood could extend to space. 

  Earnings Call Quote of the Week

“We are seeing unprecedented customer demand across all market segments from both advanced and mature nodes, driving demand across our entire product portfolio.” –Peter Wennink, President and CEO of ASML, via the company’s earnings call on January 19. 

During ASML’s earnings call, the word “demand” was used 36 times. In an effort to meet surging demand and adjust to supply shortages, chipmakers are boosting capacity to produce more computer chips — which are necessary components of things like smartphones, computers, gaming systems, and modern vehicles. And ASML is the only company in the world that makes EUV lithography systems (i.e., the most advanced equipment for building semiconductors). 

That’s good for business. Shares of ASML closed at $706.46 on Thursday.

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Today’s Due Diligence report covers Activision Blizzard. 

The video game industry was a benefactor of the pandemic’s stay-at-home mandates and social distancing. Without human interaction, many people turned to consoles, computers, and mobile games for entertainment. 

Activision is a major player in the gaming space. And the company experimented with a new revenue model at the perfect time. 

But, despite its financial success and franchise acclaim, Activision stock has been a sinking ship — falling 28.7% over the last year. 

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Now, without further ado...

The Business

Activision Blizzard, Inc. (ATVI) is one of the biggest video game studios in the world. It has its hands in just about every facet of the industry, from full-game development to esports and online community management via its proprietary platform, Battle.net. The company’s key franchises (i.e. big money-makers) include Call of Duty, World of Warcraft, Diabo, Candy Crush, Overwatch, and Hearthstone.

Activision lumps its revenue into two categories: (1) product sales and (2) in-game, subscription, and other. Here’s a description of each category and sub-category.

1. Product sales: sales of games, both digitally through online marketplaces and physically through retail stores. Through the first three quarters of 2021, product sales accounted for 25% of total sales. 

2. In-game revenue: downloadable content and microtransactions, which represent the sale of virtual currencies and goods that can be used to enhance the gameplay experience.  

3. Subscription revenue: periodic arrangements primarily from the company’s World of Warcraft title, which is an online-only game and generally sold via subscription.

4. Other revenue: software licensing and licensing of other intellectual property. Collectively, in-game, subscription, and other revenue accounted for 75% of total YTD sales through September 2021. 

Activision Blizzard is the product of multiple acquisitions — the biggest being the 2008 merger between Activision Inc. and Blizzard Entertainment (hence the company’s name). Here’s a timeline of other notable acquisitions:

• August 1997: Raven Software, an early move that spurred a spree of small studio purchases that would help solidify Activision as an industry leader.

• October 2001 & 2003: Treyarch Invention & Infinity Ward, two studios that have played a key role in the development of the Call of Duty franchise — which, as of December 2020, had generated more than $27 billion of revenue since the first series title released in 2003. 

• February 2016: King Digital, a mobile game developer that Activision purchased to enter a new market. 

Activision’s acquisition strategy over the last 20 years has paid off handsomely. Beyond bolstering the development teams behind franchises like Call of Duty (which also helped expedite game rollouts, although that can create problems too), adding development teams to the corporate umbrella paved Activision’s way into the lucrative mobile games market. 

The company operates through three segments: Activision, Blizzard, and King. Their financial contributions are outlined below. Note: the table does not account for non-reportable segments, the net effect of deferred revenue, and intersegment revenue. 

The Activision segment ballooned in FY20 as the company unveiled its rendition of battle royale, Call of Duty: Warzone in March 2020. This game style, which has taken off in recent years, usually leverages a free-to-play (F2P) revenue model.

Video game developers have rapidly incorporated the F2P into their commercialization strategies. Unlike the traditional pay-to-play model (P2P), in which players pay a one-time fixed price upfront, this model grants players free access to a particular game and typically features purchasable in-game content. And, from a revenue perspective, it works well. One study has shown that F2P mobile game players spent an average of $87 while console players spent $92. For comparison, premium P2P console games typically start around $60. 

The Narrative

Activision has been a news headline staple for all the wrong reasons lately. While there are plenty of storylines to dissect, like the delays of Diablo and Overwatch 2 or China’s crackdown on video games, the major plot point in Activision’s narrative relates to cultural issues that could cause the company to implode if left unfixed. 

Strikes, Allegations, Investigations, and Lawsuits galore

“I want Activision Blizzard to be the leader in our industry for workplace culture.” –CEO Bobby Kotick on the company’s Q3 earnings call.

It’s all fun and games until…well…it’s not. You might be surprised to hear that the video game industry is notorious for extreme working conditions and abysmal pay structures — such as unpaid overtime — especially among lower-end employees like quality assurance testers. Activision is no exception. In December, roughly 200 Activision employees reached a breaking point after several QA employees were let go, inciting a labor strike and efforts to unionize. 

Unfortunately, this isn’t the most damning piece of news for Activision in the last few months. 

About a month before the labor strike, the Wall Street Journal published a monumental report, titled: Activision CEO Bobby Kotick Knew for Years About Sexual-Misconduct Allegations at Videogame Giant.

The in-depth story outlines the company’s lengthy history of quietly dismissing internal complaints by female employees, which alleged discrimination and harassment. Last summer, the California Department of Fair Employment and Housing filed a lawsuit against Activision. The company is described as having a “frat boy” culture in which excessive drinking and employee misconduct is encouraged. And there’s plenty of evidence that indicates Kotick knew about these issues and actively suppressed them. Per the report:

[Internal documents] show that he knew about allegations of employee misconduct in many parts of the company. He didn’t inform the board of directors about everything he knew, the interviews and documents show, even after regulators began investigating the incidents in 2018. Some departing employees who were accused of misconduct were praised on the way out, while their co-workers were asked to remain silent about the matters.

As more information has come to light, more signs point to Kotick’s eventual departure. Over the last few months, ATVI’s share price has slumped. Key partners, like Xbox and Sony, are second-guessing their relationship with Activision. A petition for the removal of Kotick has reached almost 1,900 employee signatures. Even Wall Street analysts are calling for Kotick to depart the company. The belief is that only then can Activision right its course and move forward. 

Supposedly, Kotick has told colleagues that he would step down if he can’t quickly fix these piling issues. But it remains to be seen if that’ll happen anytime soon. 

Stock Overview

• ATVI compares favorably to its peers from an earnings metric standpoint. For instance, Take-Two Interactive (TTWO) and Electronic Arts (EA) — two video game competitors — have P/E ratios of 32.38 and 48.86, respectively. That’s well above ATVI’s ratio of 19.17. 

• The same can be said for their price-to-book ratios of 5.19 and 4.72, relative to ATVI’s 2.98. Note: P/B compares a company’s market value to its book value — the net assets of a company (i.e. if a company liquidated its assets and paid off all of its debt, the remainder would be book value). 

The Finances

Revenue Highlights:

• Video game producers are subject to cyclicality thanks to the timing and reception of yearly product slates. 2019 was a prime example. Activision bounced back with a strong 2020, backed by the release of Call of Duty: Warzone, a free-to-play modeled game that’s been quite successful. 

• Activision’s mobile game sales are much steadier than its games for consoles and PCs, which helps insulate the company from some of that seasonal volatility. 

• Through September of 2021, Activision has increased total revenue by 17% year over year — driven by growth and strategy execution across each of its business segments. The King business segment was responsible for much of that growth as revenue rose almost 20% relative to YTD 2020 and Candy Crush was once again the top grossing game franchise in US app stores.

Profit Highlights:

• Management noted on its latest earnings call that it added hundreds of developers to its team in the third quarter, which led to an increase in product development costs. 

• Although Activision’s business model is susceptible to some revenue fluctuation, its margins are consistently healthy. From FY19 to FY20, the company’s operating income margin increased from about 24.8% to 33.8% as a result of increased in-game purchases (again, another benefit of the free-to-play model). The same goes for the first three quarters of 2021, which saw OI margin jump even higher to 38.8%. Couple that with limited interest expenses, and you can see why Activision has pumped out steady profits. 

• Through the first three quarters of 2021, ATVI had already grown it’s net income by 27% relative to the same period in 2020 — a positive sign ahead of the fourth quarter, which is typically a massive quarter thanks to holiday season releases. 

Balance Sheet & Cash Flow Highlights:

• Activision’s balance sheet is in good shape, with cash and debt balances of $9.7 billion and $3.6 billion, respectively. In other words, the company has sufficient liquidity to pay off its debt in full, if it needed to, with plenty left over to fund operations and other initiatives.

• Activision generated $2.8 billion of free cash flow on a trailing 12-month basis — a 45% year-over-year increase — aided by not having a significant need for capital expenditures. 

Earnings Trends

ATVI has a lengthy history of meeting or surpassing its earning guidance, only missing two consensus estimates in the last five years. 

The Primary Strengths

Industry growth. The gaming industry was a winner of the pandemic’s radical new “normal.” So much so that a report estimates that the global games market generated $177.8 billion of revenue in 2020, a 23.1% increase relative to 2019. And the demand for video games hasn’t declined in 2021, at least not in the US. Per The NPD Group’s Q3 Games Market report, overall total consumer spending on video gaming in the US totaled $13.3 billion in the third quarter of 2021 — a 7% year-over-year increase. Considering Activision is one of the largest video game companies, it’s well-positioned to benefit from this broader economic trend. 

Strong franchises. Activision’s product lineup features some of the world’s most well-known and successful franchises in the world, including Call of Duty, World of Warcraft, Overwatch, and Candy Crush. Just as movie sequels can fall short of expectations, success isn’t guaranteed in the video game industry. But it’s safe to say these franchises have massive, global followings. That doesn’t hurt. 

Financial health. Cultural issues aside, the company is in a healthy financial position. Of course, that’s not guaranteed to last if the alleged toxic workplace continues to deter talent and eventually chase away key business partnerships. But as of September 2021, cash balances dwarf debt and the company routinely has healthy income margins.

The Primary Risks

Business disruption. At this point, Activision is embroiled in controversy. Employees are on strike. The SEC is investigating allegations of misconduct. Corporate partners are rethinking their relationship with Activision. People are calling for Kotick to stand down. That’s all very bad for business — and has the potential to get worse before it gets better. 

Talent acquisition and retention. Human capital is a necessity in the gaming industry. If Activision’s cultural issues continue, they’ll have a hard time onboarding and keeping the industry’s best game developers, testers, publishers, and distributors. That would translate to lower quality products and lost customers. Unsurprisingly, this is a pressing issue for Activision. Per the company’s latest 10-Q:

We have experienced challenges in both the retention of our existing talent and attraction of new talent, with our average voluntary turnover rates being higher in the current year as compared to the prior year in many parts of our company. This competition, voluntary turnover and recruiting difficulty, has negatively impacted our ability to deliver future game releases, and if they persist, could continue to negatively impact our ability to deliver content in a cadence that will be optimal for our business.

Franchise concentration. The titles mentioned above comprise over 70% of the company’s revenue. Considering the competitiveness and cyclicality of the video game industry, Activision is subject to revenue swings in the event of underperformance — or product delays— from one or more of these franchises. During the company’s Q3 earnings call, management shared that the upcoming Fall 2022 releases for the Overwatch and Diablo franchises may not hit shelves until 2023. 

The Street’s Opinion

Despite its cultural issues, ATVI registers an “Overweight” consensus rating. The stock’s average price target of $90.40 implies an upside of 40.9%, while the lowest price target implies things could get worse before they get better. Should Kotick step down, Activision’s public perception (and share price) could improve drastically. 

Bullish or Bearish?

From a morality standpoint, it’s easy to make a case against Activision — especially while Bobby Kotick is at the helm. No one wants to be associated with someone who condones such a toxic workplace, whether that’s consumers, talent, or strategic partners. Eventually, such a perception will trickle down to Activision’s plump bottom line. 

That said, from a purely financial and operational standpoint, Activision is in much better shape than its corporate culture. 

• Activision’s IP is established and highly acclaimed. So long as developers stay to oversee them, franchises can continue to churn out desirable and lucrative titles.

• Each reporting segment generates operating income at healthy margins, thanks to strategic execution related to increased in-game purchases across the board. 

• Free cash flow is ample, giving the company plenty of capital to fund future projects and potential acquisitions. 

With these strengths in mind, I’m conditionally bullish on Activision, which currently trades not too far above its 2020 low. The condition being that Kotick is not in place much longer — or the world somehow forgives or forgets the company’s internal transgressions. 

Sources

1. Q3 earnings transcript

2. Latest 10-Q

3. Latest 10-K

Today, we’ve got a stock update for you: Stitch Fix.

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Without further ado…

Stitch Fix (SFIX)

In our August Due Diligence report of Stitch Fix, we asked a playfully worded but semi-serious question:

Is Stich Fix tearing at the seams?

Well, it certainly seems like it is based on its share price performance over the last four months. 

Since August 20, shares of SFIX are down 54%. Woof.

What happened? 

Let’s start with the good (because, believe it or not, there is some good news). 

• September: Within the company’s Q4 earnings release (its fiscal year ends in July), it announced that net revenue increased 29% to $571.2 million; active clients increased 18% year-over-year to 4,165,000. On top of that, earnings exceeded expectations — SFIX even reported a profit in its final quarter of 2021. 

• September: Stitch Fix announced an upgrade to its direct buy platform features, launching Freestyle. In case you don’t recall, Stitch Fix became renowned for its “Fixes,” which are essentially mystery boxes of apparel that are periodically delivered to customers. However, it has since dipped its toes into more conventional retail, offering on-demand shopping options through its website or app (without the mystery). 

• December: The company’s 1Q22 earnings release also shed light on some positive results. Net revenue was up 19% year-over-year to $581.2 million, while active clients were up 11% to 4,180,000. Compared to Q4 of 2021, obviously, these numbers aren’t nearly as impressive. But it was still positive growth. (Again, earnings surprised analysts.)

But good news doesn’t matter if it isn’t perceived as good enough. And, of course, investors are forward-looking, concerning themselves with future performance rather than recent results. 

That’s why shares promptly tanked by 27% after Stitch Fix reported 1Q results — and revised its general guidance for FY22. In September, management expected FY22 revenue to increase by 15% or more year-over-year. By early December, management was less optimistic, downgrading their already vague guidance to “the high single digits.” 

CEO Elizabeth Spaulding attributed the revision to (1) reduced marketing spend (meaning less new clients) while the company optimizes its new Freestyle feature and (2) supply chain issues:

While we continue to add selection throughout the quarter, we did experience delays in receipts primarily due to shipping delays in the global supply chain. We are currently experiencing delays from one to four weeks, and we expect these delays to continue in Q2 and beyond. 

No one is safe from the pandemic’s ongoing supply chain issues. 

Naturally, Wall Street has significantly lowered its consensus price target for SFIX, which now registers at $25. It was $62 in August.

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Today, we’re going to explore a different type of security: exchange-traded funds (ETFs).  

More specifically, ARK Innovation ETF — one of Cathie Wood’s active funds. 

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Without further ado…

What is an active ETF?

Unlike a passive index fund, which typically matches the performance of an underlying basket of assets, active ETFs do what their label implies — they’re actively managed in an attempt to exceed market returns. The fund’s portfolio manager regularly monitors, researches, and trades based on a predetermined investment thesis. 

Several studies have suggested that “active” isn’t really synonymous with “better” though. One such study produced a truly staggering statistic: 86% of US funds underperformed the S&P Composite 1500 index from 2001 through 2020. 

Yet, ARK funds have been in the minority. 

Due Diligence: ARKK 

Ark Investment Management (“ARK” or “Ark Invest”) is a US-based firm that emphasizes tech-enabled innovation, such as electric vehicles and DNA-sequencing. The firm actively manages several ETFs:

• ARK Innovation ETF (ARKK)

• ARK Next Generation Internet ETF (ARKW)

• ARK Genomic Revolution ETF (ARKG)

• ARK Autonomous Tech. & Robotics ETF (ARKQ)

• ARK Fintech Innovation ETF (ARKF)

• ARK Space Exploration & Innovation ETF (ARKX)

Ark Invest also oversees three passive index funds: the 3D Printing ETF (PRNT), ARK Israel Innovative Technology ETF (IZRL), and ARK Transparency ETF (CTRU). Note that CTRU is expected to launch in December 2021. 

Who’s at the helm of Ark Invest? Cathie Wood, who holds the titles of Chief Executive Officer and Chief Investment Officer for the firm. Before founding Ark in 2014, Cathine served as the CIO of Global Thematic Strategies for AllianceBernstein, overseeing $5 billion in assets. Prior to that, she co-founded a hedge fund by the name of Tupelo Capital Management. Collectively, she has 40+ years of investment management experience. 

Her flagship fund, ARK Innovation ETF (ARKK) has generated a 29.7% average annual return since its inception, easily outpacing the S&P 500 in that same timeframe (14%). But 2020 was another animal as the fund posted sizzling gains of 153%, catapulting Cathie and Ark Invest into the investing spotlight. 

How ARK approaches investments

ARK points to four inefficiencies in the market, which it believes can be exploited for long-term capital gains. Here’s an overview:

• The market’s short-term time horizon. Investors tend to hone in on short-term price fluctuations and underestimate the long-term impact of disruptive technology. 

• Passive public markets. The broader shift to passive investing strategies has led to inefficiently priced, yet innovative companies. 

• The solo-ization of Wall Street. Index strategies make it difficult to spot forward-looking growth opportunities.

• The closed-off research and investment mentality. Many institutions and retail investors employ a limited approach to investing research, relying on traditional — but perhaps outdated — sources and metrics as screeners. 

Let’s explore the last point a bit more. ARK is very transparent about its investment philosophy and research process. Cathie and her team use a system that they’ve coined as an Open Research Ecosystem:

Keeping an open mind about investment research sources seems wise in the current market. Companies can achieve astronomical valuations based on the potential to accomplish something rather than actual results and fundamentals. The auto industry is a prime example. Tesla and Rivian are the first and sixth largest auto manufacturers by market cap, yet their production numbers pale in comparison to the likes of Volvo, Toyota, Ford, GM, etc. Rivian hasn’t even delivered a vehicle yet. 

Markets — and the investors that influence them — have detached, in many ways, from conventional wisdom and investing philosophies. ARK seeks to take advantage of that. 

ARKK investment thesis

ARK employs a hybrid investment strategy: a blend of top-down and bottom-up analysis to locate its investments. ARK uses the “top-down” approach for ideation and viability purposes. Then it uses the “bottom-up” approach to fundamentally and quantitatively value a potential investment. 

ARKK’s investment theme is disruptive innovation, which boils down to tech products or services that might change how the world works. More specifically, ARKK narrows its scope to the following segments:

• Genomic Revolution Companies: companies that strive to enhance the quality of life by incorporating genomics into their business model (e.g., genomic sequencing). Examples from ARKK’s portfolio include Exact Sciences (3.21% weight) and Intellia Therapeutics (3.13%). 

• Automation Transformation Companies: companies that could capitalize on the productivity of machines, such as automated processes that would otherwise require human labor. For instance, 3D Systems and its 3D printers.

• Energy Transformation Companies: companies that innovate the way energy is stored, used, collected, and implemented. For instance, the development and production of lithium ion batteries. 

• Artificial Intelligence Companies: companies that leverage robotics, autonomous technology, etc. Tesla (10.18%) and its autopilot program are a prime example. 

• Next Generation Internet Companies: companies that benefit from the broader shift to software infrastructure, such as cloud computing, shared technology, internet-based businesses, etc. (e.g., Twilio). 

• FinTech Innovation Companies: financial companies that are poised to benefit from technological advancements, such as fraud reduction, peer-to-peer lending, or frictionless funding. Robinhood (1.62%) is a prominent example. (Although I’m still not a believer in this particular platform.)

Here’s a technological breakdown of ARKK’s portfolio as of 9/30:

ARKK holdings

Scanning ARKK’s holdings, it’s not hard to see the innovation theme. As of this writing, there are 45 positions in ARKK’s portfolio — Tesla commands the largest position by far at 10.18%. Oddly enough, Elon’s auto manufacturer arguably has the largest physical presence relative to the remaining tech-heavy and digitally-focused companies within the top 10 holdings. 

You can find all 45 holdings here.

ARKK performance

Although ARKK returns vastly exceeded market benchmarks last year, 2021 has been another story. Through yesterday, ARKK has generated an 8.7% loss — a stark contrast relative to the S&P’s 27.1% gain. However, ARKK’s performance since its inception has put the broader markets in the rearview mirror (hence why Cathie Wood and ARK have skyrocketed in popularity).

The bottom three stocks in terms of 2021 performance have been Teladoc, Roku, and Zoom. Note that Zillow wasn’t far behind; ARKK recently sold off almost its entire position in Zillow.

Teladoc

Teladoc Health offers virtual healthcare, which — as you can imagine — was a highly sought service during the pandemic. TDOC is down 59.7% from its 52-week high of $308, closing at $120 on Thursday. Here’s what ARK had to say about TDOC in its latest quarterly report.

Teladoc Health seems to have underperformed because of investor fears that its top-line growth will continue to slow down in a post-pandemic world, especially as other virtual care companies emerge as potential competitors. Investors also seem to be waiting for evidence that Teledoc is integrating with recently acquired Livongo successfully. 

In our view, the pandemic has accelerated the secular shift towards virtual care, a trend in which Teladoc is best positioned among telemedicine providers to benefit thanks to its channel access, service offerings, geography, and data advantage.

Roku

Roku manufacturers digital media players for streaming purposes. (If you haven’t heard of them, I bet you have heard of Amazon’s Fire Stick — Roku is a direct competitor.) ROKU is down 51.9% from its 52-week high of $490.76, closing at $235.85 on Thursday. Here’s what ARK had to say about ROKU in its latest quarterly report

Roku declined after reporting second quarter earnings because the reopening of the economy caused slower than expected user growth. ARK maintains high conviction that Roku is well-positioned to capitalize on the shift from linear TV to connected TVs and streaming.

Zoom

There’s a good chance you’ve used Zoom in the last year and a half. The videotelephony platform was an absolute hit during the pandemic. But, much like Teladoc, its stock has taken a hit as society reemerges from its stay-at-home hiatus. ZM is down 47.5% from its 52-week high of $486.53, closing at $255.75 on Thursday. Here’s what ARK had to say about ZM in its latest quarterly report

Zoom detracted from performance following an earnings report that pointed to a deceleration in the growth of its core Meetings product in the SMB/individual segment. That said, revenues increased a better than expected 54% on a year-over-year basis against a blistering 355% surge during the depths of the coronavirus crisis last year. Moreover, the number of Zoom customers with more than 10 employees increased 36%. 

Meanwhile, with roughly two million seats, Zoom Phone appears to be gaining momentum. While higher churn from lower-end markets is not surprising as the global economy reopens, ARK believes that Zoom is likely to overcome the slowdown with share gains in the massive enterprise communications space as it evolves what appears to be the most technologically advanced offering for video conferencing and PBX. Zoom is a leader in cloud communications, providing solutions for video conferencing, voice, and chat worldwide.

ARK commentary on markets and economic activity

In a recent interview with Barron’s, Wood was asked why her fund was down this year. She pointed to rising inflation as a catalyst, which she believes encouraged investors to shift from growth stocks to value stocks (ARK is considered a growth fund). Despite widespread fears that inflation will run rampant for the foreseeable future, Cathie Wood and ARK Invest believe the opposite is true — arguing that deflation is more likely in the coming months. 

Wood specifically cited the returns of the financial and energy sectors, which have outpaced other areas of the market, as key indicators that investors don’t believe inflation’s torrid pace will continue. 

Here’s additional commentary from ARK’s quarterly report:

In ARK’s view, inflation fears have been overblown and are likely to give way to the risks of deflation. Thanks to both the base effect of collapsing prices during the coronavirus crisis last year and to supply chain bottlenecks that could be causing businesses to double- and triple-order supplies this year, inventories have been building, perhaps not in stores or on dealer lots but in households and garages. During the next six months, if economic growth were to disappoint in response to higher oil prices, lower confidence, and China’s crackdown on technology and financial services, global consumption could hit an air pocket, causing a collapse in commodity prices.

According to our analysis, two secular sources will exacerbate the shift from inflation to deflation, one good and another bad for economic activity. Innovation is the source of good deflation, as learning curves cut costs, increase productivity, and create exponential growth opportunities. Yet, instead of investing to capitalize on these opportunities, we believe many companies have catered to short-term oriented shareholders who demand results “now” and have leveraged their balance sheets to buy back stock, bolster earnings, and increase dividends. Facing the disintermediation and disruption associated with aging products and services, they could be forced to cut prices to service bloated debt, resulting in the kind of deflation that hurts economic activity.

ARKK alternatives

ARK’s theme-based ETFs spurred the creation of several similar funds last year. Each of the below alternative funds originated in fall 2020, as ARKK’s popularity began to spread. 

• Active funds typically have higher management fees, so it’s not a surprise to see ARKK’s expense ratio at 0.75%, which is higher than passive alternatives. 

• ARKK is by far the most concentrated fund of the bunch; its top 10 holdings comprise 54.4% of its portfolio. As a result, it’s far more susceptible to the movement of select companies (e.g., Tesla). Of course, that can work in their favor or against them.

• Although BTEK has a higher expense ratio, it does offer a more attractive price entry point at $38.28. 

• KOMP is the cheapest alternative to ARKK, primarily because it’s a passive fund and there’s less turnover. There’s also the most overlap between ARKK and KOMP — 24 of ARKK’s holdings are within KOMP’s portfolio.

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Sources

• Prospectus

• Quarterly report

Today, we’re going to check in with the go-to platform for spot-checking home values that are way beyond our spending power: Zillow.

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Also, a quick note: I’ll be taking a brief respite from Due Diligence next week, as I’ll be traversing the Bourbon Trail in Louisville. 

Without further ado…

Zillow (ZG)

On March 19, we released our Zillow Due Diligence report. Our analysis came shortly after Zillow ballooned to $212 a share after entering the year a hair under $100 (and up from a pandemic low of $26.49). The recent housing market boom was largely responsible for the share price rally. 

Since then though, Zillow’s share price has shed some weight, dropping to $93.14 as of Thursday. 

There are a number of reasons. Many early holders likely elected to recognize their gains. Recent earnings didn’t wow investors. Lastly, the prospect of rising interest rates hasn’t helped matters either, as this tends to slow home purchases and new mortgages. 

However, a more recent hurdle poses to do more damage to Zillow’s growth trajectory.

Zillow hits pause on home purchases

Zillow’s positioning as a digital solution in a largely physical industry has been appealing for quite some time. From a profitability perspective, advertising has been its moneymaker. But, in 2018, Zillow sought to extend its operations, dipping its toes into the home-flipping business when it released Zillow Offers. 

Per our March report:

Launched in 2018, this program has three stages: (1) Zillow provides cash offers to homeowners; (2) Zillow’s renovation team repairs acquired homes; and (3) Zillow lists and sells the home back on the market for a higher price.

For home shoppers, it’s a convenient service. But, from a business perspective, Zillow is still working out the kinks. 

Earlier this week, Zillow announced its plan to stop buying homes for the remainder of 2021. Instead, management will prioritize clearing its current backlog of house purchases. 

Per COO Jeremy Wacksman: 

"We're operating within a labor- and supply-constrained economy inside a competitive real estate market, especially in the construction, renovation and closing spaces. We have not been exempt from these market and capacity issues and we now have an operational backlog for renovations and closings. Pausing new contracts will enable us to focus on sellers already under contract with us and our current home inventory."

Although Zillow Offers generated $1.4 billion of revenue in the first half of 2021, its business unit had a net loss of $117.8 million. The good news is that Zillow’s IMT segment (i.e., ad revenue) is doing quite well. Through the first six months of the year, Zillow’s IMT segment turned a profit of $277.1 million, more than offsetting losses elsewhere. 

Financials aside, this may shed light on a more concerning aspect: scalability. Even with labor and materials shortages, the fact that Zillow had to halt purchases does not bode well for scaling this service. That’s not to suggest it can’t be done, it’s just something to be wary of going forward. 

Is Zillow undervalued?

Most Wall Street analysts seem to think so (however, the same was true in March). As of today, 14 of 24 analysts covering the company consider it a “buy.” 

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We’ve got a handful of things to cover in today’s installment of Due Diligence:

• A few updates for previously covered companies (Coinbase, Cresco Labs, and ASML)

• Insight into stocks on the Due Diligence radar (for future reports)

• A summary table of DD stock movements dating back to our inaugural report in March

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Without further ado…

DD Updates

Here’s what’s new from a few of the companies we’ve covered. 

Coinbase NFT on the horizon

Coinbase wants to extend beyond cryptocurrencies. On Tuesday, Coinbase announced its very own marketplace for non-fungible tokens (i.e., NFTs). If you aren’t familiar, the “non-fungible” aspect means it’s unique and irreplaceable. It’s like trading old baseball cards, except with virtual assets. NFTs use blockchain technology to publicly validate proof of ownership — hence why it’s popular for items like digital paintings, photographs, videos, and even tweets. 

The new marketplace will allow users to mint, showcase, discover, and purchase this burgeoning digital artform. Presumably, Coinbase will profit from trading activity. For instance, OpenSea — an existing NFT marketplace — receives 2.5% of every NFT sale. Coinbase’s fees will likely be similar. 

Last quarter, NFTs generated $10.7 billion of trading volume. So, the revenue opportunity is there for Coinbase, but we’ll see if its marketplace can gain traction.

Cresco Labs expands market share in Pennsylvania

Cresco Labs continues to scoop up cannabis companies left and right. Today, Cresco announced the acquisition of Laurel Harvest Labs in Pennsylvania. With the purchase, Cresco gains an additional 52,000 square feet of indoor grow/processing space, as well as two dispensaries (one operational, the other in construction) with permits for four more.

This comes after Cresco announced the acquisition of Cure Penn on September 23, which added three operational dispensaries to Cresco’s Pennsylvania retail footprint.

ASML investor day spotlights bright future

On September 29, ASML held a 4+ hour investor day, sharing insights into its various business lines and its expectations for the future of the semiconductor industry. 

During its business model segment, ASML outlined sizable growth expectations from now until 2030. Here’s an excerpt from the presentation:

Based on different market scenarios, we have an opportunity to achieve an annual revenue for 2025 between approximately €24 billion and €30 billion with a gross margin for 2025 between approximately 54% and 56%.

We see significant growth opportunities beyond 2025. Assuming a 1 trillion dollar semiconductor market by 2030, with litho intensity and our market share constant from 2025, we expect an annual revenue CAGR for 2020-2030 of around 11%. 

We expect to continue to return significant amounts of cash to our shareholders through a combination of growing dividends and share buybacks.

The future of ASML is bright (pun 100% intended).

Much of ASML’s growth prediction is derived from more and more lithography unit sales, particularly the release of the next generation of semiconductor equipment (High-NA). Naturally, as ASML sells and installs more lithography systems, its revenue from equipment services and upgrades will grow as well. 

This is already apparent from ASML’s operations over the last decade. In the following chart, focus on the “Installed base management” revenue growth. In 2010, this line item accounted for $0.6 billion; last year, it was up to $3.7 billion. ASML expects Installed base management revenue to be $6-7 billion by 2025.

Stocks we’re eying

Stocks on the Due Diligence radar for upcoming reports:

How wild is it that TMHC closed yesterday at the exact same price it did a year ago? 

Due Diligence Stock Performance

Since launching in March, Due Diligence has deeply analyzed 19 different companies. Here’s how they’ve performed since their respective reports were released. Note that our reports aren’t necessarily “buy” or “sell” recommendations, so don’t take the below list as investment advice or an indication of our stock picking accuracy. 

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Today, we’re going to check in with a budding fintech company with somewhat of a shady past (and present): Robinhood 

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Without further ado…

Robinhood (HOOD)

On July 29, we released our Robinhood Due Diligence report — the day of HOOD’s initial public offering. If you recall, we discussed Robinhood’s litany of legal issues and tenuous revenue situation. We also cautioned about short-term volatility since Robinhood chose to offer early IPO access to its users (a shrewd marketing tactic):

Robinhood’s price could be extremely volatile in the opening days/weeks/months of trading — more so than the usual IPO. 

Well, guess what happened?

HOOD issued its shares at $38, which slipped to $34.82 by the end of its first day of trading. Less than a week later, HOOD spiked to as high as $85. 

Now, it’s back down to $42.08.

What drove the spike and subsequent fall?

Robinhood, the OG platform for meme stock investors, became somewhat of a meme stock itself. The primary catalyst was Cathie Wood, the CEO and CIO of Ark Invest who’s garnered the attention of the masses over the last few years. 

Her firm opened a sizable position in HOOD on July 30 — buying more than 1.8 million shares across several of Ark’s funds. As news of her purchases spread, investors followed suit. (Cathie double-dipped last week, buying even more shares of HOOD when Evergrande concerns incited fear throughout the market and drove prices down.)

However, the “meme” status was short-lived. Robinhood released its first earnings report as a public company on August 18. HOOD retreated back near its IPO price levels. 

Why? 

At first glance, Q2 seemed like a banner quarter. Robinhood’s Q2 revenue was up 131% from 2Q20 and 8% from 1Q21. Operating income was almost $65 million. If you back out a $528 million non-cash expense, net income was up about $3.6 million year over year. 

Then why did shares of HOOD drop by 10.2% once trading opened the next day?

The primary reason was the company’s crypto-trading activity, particularly its reliance on Dogecoin, the joke currency that caught fire earlier in 2021. During HOOD’s Q2 earnings call, management mentioned that Dogecoin accounted for 62% of crypto-trading volume, which was up from 34% in Q1. 

That doesn’t exactly indicate strong, sustainable revenue growth. (One J.P. Morgan analyst thinks the slump will continue, with a price target of $35 a share.) 

The news doesn’t get better since the company’s earnings release. To make matters worse for Robinhood, it may have to contend with another fintech giant: PayPal. 

On August 30, CNBC broke the news that PayPal had hired Rich Hagen, the former president of Ally Invest and co-founder of TradeKing. That comes after PayPal teased adding “investment capabilities” to its platform during its investor day in February. 

That same day, Barron’s released an article in which it shared tidbits of an interview with SEC Chairman Gary Gensler, who was quoted saying that banning payment for order flow is “on the table.” Payment for order flow (PFOF) is the primary way Robinhood makes money, accounting for 80% of total revenue in Q1 and Q2 of this year. (If you need a refresher on PFOF, we outlined this revenue concept in our report.)

During Robinhood’s earnings call, it took pre-submitted questions from shareholders. Naturally, several questions were around this topic — but I’ll share an interesting snippet from one of CFO Jason Warnick’s answers:

We do think because payment for order flow is such a small revenue stream, it's about 2 – 2.5 cents per $100 traded, that it's not a terribly difficult revenue stream for us to replace.

We’ll continue monitoring the situation to see how easy it is for Robinhood to replace $451 million of revenue.

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“Cutting the cord” is just as relevant of a phrase now as it was 15 years ago. Since 2013, the total number of traditional pay TV households has shrunk by about 26 million. 

While many have shunned live TV altogether, a lot of viewers pivoted to more cost-efficient alternatives with fewer channels. 

Like fuboTV. 

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Now, without further ado...

The Business

Founded in 2015, fuboTV is a live television streaming platform that primarily caters to sports fans — although it also offers news and entertainment channels. 

The television distribution industry has a litany of overlapping and confusing labels for its various TV providers, including MVPD, vMVPD, OTT, and CTV. Here’s a quick synopsis:

MVPD stands for multichannel video programming distributor. These are traditional TV providers that rely on satellite and cable to deliver programming. Think Comcast, DirecTV, and DISH. 

vMVPD stands for virtual multichannel video programming distributor (what a horrible acronym). The key difference between MVPD and vMPVD is how the content is delivered — vMPVDs deliver content via the internet. fuboTV is av vMPVD, as is YouTube TV and Hulu TV. While these providers don’t offer nearly as many channels as traditional MVPDs, they’re usually much cheaper as a result. vMVPDs ballooned in popularity as consumers wanted more cost-efficient alternatives to their traditional cable packages. Hence the phrase “cutting the cord.” 

OTT stands for over-the-top television (another confusing acronym). This simply means content that’s delivered via existing internet services, such as fuboTV. If you already pay for internet, you can access OTT content. As you can piece together, there’s overlap between vMVPD and OTT. 

CTV stands for connected television. This is a subcategory of OTT — it refers to consuming content through TVs that are connected to the internet. Think of smart TVs and attachable streaming devices (Fire Sticks, Rokus, Apple TV). 

Why do these terms matter? Simply defining them gives you a pretty good indication of where the industry has been trending and why. People want television — that hasn’t changed. How they consume it has changed. The typical consumer is more likely to have a Fire Stick or a smart TV than a satellite dish.  

fuboTV’s goal is to be at the forefront of that change in their particular niche — it’s positioned as a more affordable alternative to traditional cable and satellite TV packages for sports content.

fuboTV merger

In April 2020, fuboTV merged with Facebank Group; upon completion of the business combination, Facebank Group changed its name to fuboTV Inc., which eventually went public on the NYSE in October 2020. Facebank’s history is a little complex due to acquisitions and subsequent name changes, but here’s a good summary. This isn’t totally relevant to evaluating fuboTV as an investment, but it sheds light on how FUBO came to be a public company with international aspirations. 

fuboTV offerings

FUBO offers multiple TV packages with varying levels of content access across sports, entertainment, and news; prices range from $64.99 per month to $79.99 (or $32.99 for Spanish channels). The company also upsells “attachments” like feature upgrades (e.g. Unlimited Screens) and premium add-ons (e.g. Starz, Showtime, Epix).  

Most of fuboTV’s content is only available in the U.S. and related territories — there’s also some availability in Canada and Spain. 

fuboTV customers

fuboTV’s primary customers and revenue-generators are subscribers. According to the company’s latest earnings call, fuboTV’s subscriber base skews male and the average subscribe is 42 years old with an annual income of $85,000. 

From December 2017 to June 2021, fuboTV increased its subscriber base from 132,000 to 681,721; it also steadily increased its monthly average revenue per user from $42.77 to $71.43 during the same time span. And that growth doesn’t appear to be slowing down, as management estimates between 910,000 and 920,000 subscribers by the end of 2021. 

The Narrative

fuboTV’s first year as a public company has been active. Here are three big storylines to follow:

1. Can fuboTV tap deeper into other sports markets? 

2. Cord-cutting benefits fuboTV in more ways than one

3. Sports betting is on the rise. Is fuboTV ahead of the curve?

Can fuboTV tap into other sports markets? 

Much of fuboTV’s subscriber growth can be attributed to soccer fans. For instance, during the second quarter, fuboTV provided the exclusive streams of the South American Qatar World Cup qualifying matches (CONMEBOL). Unsurprisingly, this exclusivity helped drive net subscriber additions of 91,291. The company’s subscriber base could see a similar boost next year during the World Cup. 

Soccer is arguably the world’s most popular sport, but that’s not the case in the U.S. While soccer is growing in popularity, it typically ranks as the fourth or fifth most popular sport. That’s significant because most of fuboTV’s content is only available in the U.S. and related territories — so there’s a smaller market to gain subscribers from. 

The third quarter marks the beginning of the NFL’s season, which fuboTV subscribers can stream. It’ll be worth monitoring whether new subscriptions taper off relative to last quarter or continue trending upward. 

Cord-cutting benefits fuboTV in more ways than one

fuboTV’s total addressable market increases as more people realize they don’t want to pay for thousands of channels and “cut the cord.” The benefits of this trend are two-fold. For starters, as a cable TV replacement service, fuboTV could gain more paying subscribers. Second, fuboTV also benefits from the broader consumer switch to OTT platforms in the form of additional advertising revenue. Ad money flows to where the consumers are. 

Here’s fuboTV’s advertising revenue growth since the beginning of 2020.

Sports betting is on the rise. Is fuboTV ahead of the curve?

During its exclusive stream of CONMEBOL matches earlier this summer, fuboTV launched new product features to a select cohort of users — FanView and free-to-play predictive gaming. FanView enabled users to view scores and stats in real time on the FUBO app, while predictive gaming involved predicting certain aspects of soccer matches for a chance to win cash prizes. According to management, FanView improved engagement by 25% to 37%, depending on the content. The underlying goal was to test these features and gather data on usability ahead of fuboTV’s launch of Fubo Sportsbook.

In February 2021, fuboTV acquired Vigtory, a sports betting and interactive gaming company. Since the acquisition, fuboTV has announced plans to rollout Fubo Sportsbook, a “frictionless betting experience” for fuboTV’s customers. 

The rollout will be gradual, as fuboTV has market access agreements in only four states thus far (Pennsylvania, Indiana, New Jersey, Iowa). However, on the latest earnings call, CEO David Gandler expressed the company’s goal to increase market access to 50% of fuboTV’s total subscriber base by the end of 2023:

We are looking to develop a business unit that’s going to deliver 50% gross margins. Our goal in terms of market access is to be able to provide access to our subscriber base by the end of 2023 of up to 50% of our total sub-base. So you can imagine at 915,000, which is our guidance for the end of this year, that becomes a pretty sizable cohort. 

The move is well-timed, as sports betting has surged in the U.S. ever since the Supreme Court repealed the Professional and Amateur Sports Protection Act of 1992 in May 2018. 

Stock Overview

• No matter how you spin it, FUBO is expensive by conventional valuation standards. But, then again, these are rarely relevant or appropriate for growth companies since value is attributed to what could be rather than what is.  

• Note: P/S essentially calculates the amount investors are willing to pay for $1 of a company’s sales. This is a common valuation metric for unprofitable companies to compare to peers and broader industry and index benchmarks. 

• Note: P/B compares a company’s market value to its book value — the net assets of a company (i.e. if a company liquidated its assets and paid off all of its debt, the remainder would be book value). 

The Finances

The merger-via-acquisition between fuboTV and Facebank made for some complex financials in 2020 — primarily due to John Textor’s (the former CEO of Facebank) transition out of the company. 

On July 31, 2020, John Textor stepped down from the company’s board and took over as Head of Studio for Facebank’s legacy business (human animation and digital likeness). Shortly after, he resigned (amicably); as a result, fuboTV had to recognize an impairment of the Facebank reporting unit. These assets aren’t integral to fuboTV’s operation, nor do they generate revenue, but they’re still involved within the entity’s consolidated finances. 

Long story short, the impairment wasn’t significant to fuboTV’s operations, but it made FY20 look horrible. 

Additionally, since the “new” fuboTV Inc. (that is, the post-merger entity) commenced operations in April 2020, the company’s latest public filings don’t include the operating results from January 2020 through March 2020. So, I pulled first quarter fuboTV results (the pre-merger entity) from FUBO’s 2020 prospectus and combined the two to estimate “YTD 2020” in the below table. Otherwise, we’d be comparing six months of 2021 operations to three months of 2020 operations. 

Lastly, the merger and subsequent IPO triggered several fair value adjustments within fuboTV’s non-operating results. We’re going to focus on fuboTV’s operating results (losses) instead:

Revenue Highlights:

• fuboTV’s burgeoning subscriber base spurred significant sales growth over the last few years. fuboTV has already surpassed FY21 revenue in the first six months of 2021. 

• That growth is also driven by increasing advertising revenue, which has also surpassed FY20 totals. 

• Management increased its revenue guidance to a range of $560-570 million for FY21, up from $520-530 million. 

• Note that “other” revenue represents software licensing sales from Facebank operations, which are irrelevant to fuboTV’s operations.  

Profit Highlights:

• Subscriber-related expenses primarily refer to the distribution rights fees the company must pay to be able to air its content offerings — for instance, fuboTV does not own ABC or its intellectual property, the company must pay for the right to air related channels/content. 

• Advertising expenses were $48.2 million in FY20. Sales and marketing expenses have increased over the last two years as the company expands its subscriber base. 

• Prioritizing growth initiatives and marketing campaigns is normal, but the implied cost to acquire net new subscribers is something to keep an eye on. Over the last three quarters (4Q20, 1Q21, 2Q22), we can roughly estimate fuboTV’s individual subscriber acquisition cost to be $319, $520, and $236 by dividing its sales and marketing spend by net new subscribers. fuboTV’s sales department’s marketing efficiency will play a role in whether the company can eventually turn a profit. 

• This underlines the significance of FUBO driving additional revenue per subscriber as well as expanding its other revenue streams — advertising and sports betting. 

Balance Sheet & Cash Flow Highlights:

• fuboTV operations burned through $149 million of cash flow in FY20 and $87.4 million in the first half of FY21. While that’s not surprising for a growth-oriented company that’s investing in marketing campaigns and product features, it’s something to monitor. 

• The company Issued $402.5 million of convertible notes in February 2021; this will help fund the company’s ongoing cash burn. As of June 30, fuboTV had $406.7 million of cash on hand.

Earnings Trends

Since FUBO is in growth mode, EPS results are exceedingly negative. It still remains to be seen whether FUBO can generate any profits, let alone sustainable profits.  

The Primary Strengths

Growth trends. If the company hits its targets for FY21, paid subscribers will have grown by 593% since 2017 and total revenue will have more than doubled relative to FY20. 

Positioning with sports betting. In May 2018, the Supreme Court axed the Professional and Amateur Sports Protection Act of 1992, which opened the door for sports betting to expand to other states beyond Nevada. From May 2018 to May 2020, more than $20 billion flowed through U.S. sportsbooks. With its new sports betting feature, fuboTV will be uniquely positioned to take advantage of this industry trend. 

Untapped international markets. This is less of a strength and more of an opportunity. To date, fuboTV’s growth has been predominantly spurred by soccer enthusiasts thanks to content like the CONMEBOL qualifiers. While soccer is growing in the U.S., it’s the fourth or fifth most popular sport behind the big three of football, baseball, and basketball. If fuboTV can expand internationally and tap into markets in which soccer is the premier sport, their subscriber growth could experience exponential growth.

The Primary Risks

Growth concerns. There’s no doubt that fuboTV’s in growth mode — but there are still concerns about its ability to generate sustainable and profitable growth. fuboTV spends a lot of money to acquire new customers and retain them with enticing, relevant content.

Liability potential. Entering the betting sphere could be lucrative but also opens the doors to litigation, pricing and trading risks, liability management, etc. There’s overlap between live sports broadcasting and sports betting, but there are also unique risks. 

Competition. fuboTV competes across multiple phases, including for customer eyes, distribution rights, and advertisers. Although fuboTV is oriented to sports fans, it’s not the only platform that offers live sports. For instance, if you’ve ever seen a Hulu TV commercial, you know that Hulu also has live sports. 

Material weaknesses in internal controls. In 2020, the company identified material weaknesses in its internal controls environment, specifically related to non-routine transactions (such as mergers and acquisitions). Here’s the statement from the company’s 10-K:

We did not have appropriately designed internal controls in place at the time the Merger was consummated on April 1, 2020 with respect to the accounting for the business combination and the allocation of consideration to the acquired assets and assumed liabilities, including deferred income taxes; and

Our internal controls over the review of accounting considerations for non-routine transactions and events were not appropriately designed with respect to the timing and consistency of performance.

What does this really mean? 

The company didn’t have proper reviews and appropriately documented approvals in place to ensure accurate reporting and asset valuation. fuboTV’s remediation plan included a lengthy list of corrective actions, such as hiring an experienced tax specialist, hiring a valuation specialist, implementing additional supervision and review activities, and hiring a third-party to function as the company’s internal auditor.

According to a CPA I spoke with, who works in audit, material weaknesses in internal controls are more common for newly public companies; however, the primary concern going forward is the company’s ability to “not lose their shirt” when evaluating non-routine transactions like acquisitions. That said, KPMG tested the financial statements and found that they were fairly presented in all material respects. 

In other words, the material weakness didn’t impact its bottom line or cash flows. 

The Street’s Opinion

FUBO registers a “Buy” consensus rating thanks to six buys and one hold. The stock’s average price target of $43.86 implies an upside of 59.2%, while the lowest price target implies an 8.9% upside. 

Bullish or Bearish?

FUBO has several industry trends working in its favor:

1. Cord-cutting 

2. Ad dollars flowing into streaming

3. Ballooning demand for sports betting

But I think there’s a simpler way to evaluate the company. 

Do you pay for fubo? Do you know anyone that does? 

One advantage of evaluating a B2C company is access and perspective — we can look at the company from their customers’ perspective because, well, we could be their customers. 

What’s stopping you from subscribing? If you do, what’s keeping you attached to the platform? 

I actually subscribed to a free trial of fuboTV a few years ago. I don’t remember exactly why, but I think it was to watch something I couldn’t access otherwise. Then I canceled my subscription. 

As a paid TV provider, churn will remain an obstacle (the rate at which people unsubscribe), especially since sports are seasonal. Price-conscious consumers will question the need to pay for a subscription if they’re only using it three to six months out of the year. However, the entertainment, news, and premium channel add-ons help insulate the company from this. More importantly, the sports betting aspect could drive revenue and add some stickiness to the platform — I estimate that people will feel less inclined to stop their subscriptions if they’re routinely using this feature. 

An investment in FUBO is an investment in the long-term future of its platform. Because, today, the company burns through money. The long-term potential is appealing though. For now, I’m interested to see how the company performs in Q3, particularly the impact of NFL content on subscriber growth. If more (American) football fans flock to the platform, that could bode well, especially once the company’s sports betting functionality launches. 

While it’s impossible to predict the stock’s short-term volatility, I still think there could still be a good price-point entry after we get more insight into this quarter’s results. 

For that reason, we’re bullish from a long-term potential — but holding off until we see more. 

Thanks for reading. Don’t forget to hit the heart button if you enjoyed today’s report.

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Sources

1. Q2 earnings transcript

2. Latest 10-Q

3. Latest 10-K

4. Prospectus

Good morning investors!

Today’s Due Diligence report covers Palantir. 

Palantir has ballooned in popularity ever since it was listed on the NYSE at $10 per share last September.

Yesterday, Palantir closed at $26.51 — a 165% increase from its opening price, but a 41% decline from its 52-week high. 

What’s going on?

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Now, without further ado...

The Business

Palantir Technologies Inc (PLTR) uses software to help government agencies and commercial companies make better decisions. That’s the simplest description of Palantir. 

Do you know the origin of the Palantir company name? It’s a nod to the Lord of the Rings series — a “palantir” in this fantasy world is an omnipotent seeing stone that’s used by Saruman to watch his enemies. Despite the cheekiness, it’s actually an apt name. 

Now, let’s dig a little deeper.

When it was founded in 2003, Palantir worked exclusively with the Central Intelligence Agency, designing software to help the government’s counterterrorism operations. The CIA was even responsible for some of the company’s initial funding through its nonprofit venture-capital arm, In-Q-Tel. 

Peter Thiel, the co-founder of PayPal and one of the founders of Palantir, injected the remaining capital necessary to develop Palantir’s first platform, Palantir Gotham (“Gotham”), for customers in the intelligence sector. In essence, Gotham is a central operating system that enables government entities to screen and analyze massive databases in order to identify patterns. The platform then helps its users plan and execute real-world responses to threats. For instance, one of the initial uses was helping protect soldiers from improvised explosive devices (IEDs). 

Gotham was and is primarily used by U.S. government agencies and its allies, however, Palantir also offers this platform to companies in the financial services industry — particularly for fraud investigations. That said, Palantir extended its offerings to the commercial space in 2016 when it launched its second platform, Palantir Foundry (“Foundry”). 

The system that powers these platforms is known as Apollo. As Palantir describes it, it’s “the layer that sits between our applications and the underlying infrastructure.” 

Apollo, our continuous delivery platform, helps to ensure that our software works wherever our users are and under a variety of conditions: on oil rigs and submarines, on disconnected laptops in Humvees in theater, and on more than 9,000 aircraft around the world.

During its last earnings call, Palantir announced its latest software product: meta-constellation. This software integrates with satellites and enables users to answer time-sensitive questions across the globe. For instance, meta-constellation can help target wildfire indicators or the movements of naval fleets.  

Palantir customers

As of June 30, Palantir had 169 customers — up from 137 customers a year prior. Palantir divides its business into two customer segments: 

1. Government: agencies like the U.S. Food and Drug Administration, Centers for Disease Control and Prevention, and National Institutes of Health.

2. Commercial: large corporations across 40 industries. More recently, Palantir launched Foundry for Builders, which caters to startups. 

As you can probably infer from its platforms, Palantir’s primary source of revenue has historically been government agencies, dating back to its founding. That has shifted ever since Palantir launched Foundry in 2016, as its commercial business has grown significantly. 

• From FY19 to FY20, commercial revenue grew 22%. 

• Through the first six months of 2021, Palantir’s commercial customers accounted for 39% of total revenue. 

• U.S. commercial revenue alone grew 90% year over year in Q2. 

The Narrative

Let’s highlight some of the ensuing events that have led to Palantir’s rapid ascension. 

• Tons of interest from retail investors. So, is Palantir a meme stock?

• Metaphorical truckloads of outstanding shares. Is shareholder value diluted?

• Palantir is funneling money into SPACs (and...gold?). Could it pay off?

Is Palantir a meme stock?

Many people like to slap the “meme stock” label on Palantir due to its popularity among retail traders. If you scroll through Reddit threads, it doesn’t take long to find plenty of anonymous posts about certain aspects of Palantir’s past, present, and future. 

Coupled with earnings metrics, it’s easy to wonder if Palantir is a meme stock that’s inflated by retail investor interest. 

While retail investors are partially responsible for the company’s share price appreciation over the last year, it’s not like the rise has been totally unwarranted. Despite being nearly two decades old, Palantir still aligns with the characteristics of a growth stock. It’s even adding to its sales team and upping marketing spend.

We hired more than 100 salespeople in the first half of the year and expect hiring to continue at a strong clip in the second half of 2021. Marketing spend nearly doubled in Q2 compared with Q1 as we continue to build out both brand and performance marketing to drive both sales and recruiting funnels.

Plus, it expects to grow revenue by 30% each of the next five years (including 2021). 

So...many...shares

Palantir has lots and lots of outstanding shares (with even more unexercised options), which ultimately dilute shareholder value. 

How many? Almost 1.9 billion.

That doesn’t even include options. As of June 30, there were 417.6 million options outstanding, which are expected to be exercised over the next 8-9 years; this represents an unrecognized expense of approximately $1 billion.

For reference, here are a few outstanding share totals from other software companies:

• Salesforce: 979 million

• Alteryx: 67 million

• Splunk: 163 million

From a compensation standpoint, Palantir rewards its executives and employees with shares. That’s not necessarily a bad thing. Employees receive assets with the upside of potential appreciation, while Palantir keeps cash in its bank accounts (since stock-based compensation is a non-cash expense). Of course, there’s a flipside: by consistently issuing loads of shares, individual shareholders get a smaller slice of the pie — in other words, value is diluted. 

However, the significance of the dilution depends on how rapidly the company grows. If Palantir outpaces its rate of dilution, then issuing additional shares isn’t as impactful. 

For being a SaaS company, Palantir is really a people business. Each aspect of its operation (and each expense on its income statement) includes people and their compensation expenses, from personnel for Operations and Maintenance (O&M; flows into Cost of revenue) to the salespeople who execute on pilots and customer growth activities (flows into Sales and marketing) and software developers (flows into R&D). 

Glassdoor reviews should always be taken with a grain of salt, but just look at these compensation estimates for FDEs. Does Palantir need a writer?

Beyond a comfortable base pay, take a look at the cash bonus and stock bonus. Palantir pays its employees well — and it shows in its financial statements. 

Palantir gets its foot in the door early

In July, Palantir launched Foundry for Builders to target startups and help them develop their operating systems from the get-go. It’s clear that the company wants to get involved early, but this new initiative only scratches the surface. 

In its quarterly report, Palantir shared that it had invested in a lengthy list of companies, including SPACs: 

In essence, Palantir bet on a diverse selection of industries like air taxis (Lilium), digital health (Babylon), and biotech (Celularity). But Palantir also benefits through longer-term partnerships with these companies — they entered into commercial contracts with Palantir, ranging from three to ten years. According to the company’s 10-Q, the maximum potential revenue from the highlighted commercial contracts is $428 million, including options. 

While those investments are intriguing, they weren’t the most...unusual. Palantir also bought $50.7 million worth of 100-ounce gold bars. Is Palantir predicting doomsday?

Probably not. More likely, they’re simply prepping for economic uncertainty surrounding the pandemic. 

Stock Overview

• Based on traditional valuation metrics, Palantir is expensive at $26.51 per share. Since it isn’t profitable, we have to shift to price-to-sales and price-to-book ratios. PLTR’s P/S of 31.93 and P/B of 24.97 are quite high relative to peers. For reference, Salesforce’s respective ratios are 10.58 and 4.66; Alteryx’s are 9.58 and 11.68. Of course, these metrics aren’t perfect. At the end of the day, it boils down to what investors are willing to pay. 

• Note: P/S essentially calculates the amount investors are willing to pay for $1 of a company’s sales. This is a common valuation metric for unprofitable companies to compare to peers and broader industry and index benchmarks. 

• Note: P/B compares a company’s market value to its book value — the net assets of a company (i.e. if a company liquidated its assets and paid off all of its debt, the remainder would be book value). 

The High-Level Finances

Revenue Highlights:

• Palantir’s customer growth rate has directly translated to higher revenue, which grew 47.2% from FY19 to FY20 after growing 24.7% from FY18 to FY19. 

• Through two quarters of 2021, revenue is up 49% year over year. Relative to last year, management expects FY21 revenue to increase by approximately 30%, which would ballpark to around $1.42 billion. 

Profit Highlights:

• Despite the growth, Palantir operations have generated significant losses — thus, the concern about scalability and profitability. During the first half of FY21, the company’s operations incurred a net loss of $260 million. 

• Palantir’s expenses tell two notable stories. First, the company is beefing up its sales staff, which contributed to the sizable increase in clients (and revenue). Second, Palantir invests in its employees, who ultimately sell, design, deliver, and maintain the end-user’s product. We’ll expand on this more below in the “Adjusted Finances” section

Balance Sheet & Cash Flow Highlights:

• As of June 30, Palantir had $2.3 billion of cash and equivalents, which absolutely dwarf its total liabilities of $1 billion. 

• Speaking of liabilities, Palantir had no outstanding debt as of June 30 — although it does have an undrawn $400 million revolving credit facility. 

• Palantir’s operations generated $139.6 million of cash flow — a welcome sign that, despite the losses, the company’s business is generating cash. See the advantage of stock-based comp?

Adjusted finances

In Palantir’s case, I think it’s helpful to view their operations without their stock-based compensation expense. While you can’t just get rid of this expense (since it does impact the business in the form of additional shares), excluding it sheds more light on the company’s progress toward operating profitability. 

For instance, Palantir went public last fall, which naturally leads to an outrageously high expense for share-based compensation — in PLTR’s case, $1.2 billion. If you remove this expense, Palantir’s operating income has improved each of the last three years — and actually turned positive last year.

In the following table, I’ve removed stock-based compensation from each expense item, which is summarized in the second table by line item. 

Assuming the company can reach its revenue expectations, profitability doesn’t seem like a farfetched concept.

Earnings Trends

Palantir’s EPS results are likely to remain unimpressive and unappealing, at least for the foreseeable future. Palantir’s staggering number of outstanding shares is the culprit. The company would need to generate huge profits and/or institute a share-buyback program — the odds of that are low considering the company is in growth mode and prioritizing R&D.

The Primary Strengths

Commercial growth. Targeting the private sector (i.e. not solely government agencies) is a gamechanger for Palantir’s growth potential. Even IBM, a competitor in this space, is leveraging Foundry. Management expects revenue to increase at an annual rate of 30% over the next five years (including FY21). 

Market positioning. Foundry is the company’s path to additional scale, but let’s not forget about Palantir’s bread-and-butter strength: it’s the undisputed leader in the government space for its services. It has unique government access thanks to its long history with government agencies (highest access among commercial companies). 

Financial health. Palantir has no outstanding debt and it’s sitting on more than $2 billion of cash. The company generates solid levels of adjusted free cash flow. Tack on the stock-based compensation approach, and you've got a cash-flushed business — hence the ability to make sizable investments in other budding industries. 

The Primary Risks

Hefty personnel expenses. Ultimately, this is what’s responsible for Palantir’s inability to generate a profit. It puts a lot of resources into outfitting its customers with the right data platform, which is expensive and calls into question the ability to scale. 

Customer concentration. Although Palantir has increased its customer base over the last few years, its top three customers still account for a significant percentage of total revenue — 25% as of FY20. That figure is down slightly from 28% in FY19. Palantir’s customer growth initiatives have helped reduce its customer concentration so far in FY21, as its top three customers represented 19% of its total revenue through six months — compared to 29% in the first half of 2019. 

Diluted value. While this isn’t an operational risk, it is something investors have to consider. If Palantir’s outstanding share total outpaces its earnings growth, its share price will suffer from downward price pressures. 

The Street’s Opinion

PLTR registers an “Underweight” consensus rating, indicating that analysts think the company is overvalued. PLTR’s average price target implies an 8.7% downside, while the lowest price target suggests an even steeper fall of 25.7%. 

Bullish or Bearish?

There are a lot of reasons to like Palantir, the company, even as a finance-minded person (as opposed to a software developer). 

• Revenue growth from both a historical and future perspective

• Unique positioning with government agencies

• A cash-flushed balance sheet with improving operating results

• Profitability seems feasible 

• Clearly values its employees and compensates them with plenty of shares, which should aid talent acquisition and retention

However, Palantir, the stock, muddies the waters with its extremely high share count and ties to meme traders. So, it’s much harder to set a price target. 

For that, we’re bullish about PLTR from a long-term perspective (3-5+ years), but we’re hesitant at its current share price for any shorter of an investment timeline. 

Sources

1. Q2 earnings transcript

2. Latest 10-Q

3. Latest 10-K

4. Prospectus

Today, we’re going to check in with a few of the stocks we’ve covered: ChargePoint, Pfizer, and EVBox. 

If this is your first time with us, feel free to subscribe here. If you enjoy today’s newsletter, please hit the heart button at the end of the report.

Without further ado…

ChargePoint (CHPT)

On June 11, we released our ChargePoint Due Diligence report. If you recall, we viewed ChargePoint as a risky short-term play. At the time of release, CHPT traded for $28.07. As of yesterday’s close, CHPT is down to $21.36. 

What happened?

EV stocks have taken a beating over the last few months — broadly due to a pullback on steep valuations. Keep in mind, EV manufacturers and EV infrastructure companies don’t generate a ton of earnings yet (relatively speaking, of course). ChargePoint generated $146.5 million of revenue in FY20; the company expects revenue to land between $195 - $205 million this year. Nevertheless, ChargePoint’s market cap is $6.9 billion. 

To give you an idea of how that stacks up against an arbitrary company, Ralph Lauren Corp did $1.4 billion of revenue last quarter — and their market cap isn’t proportionately higher at $8.6 billion. Not even close. 

That shows how jazzed up the world is about EVs. 

Beyond the general retreat for EV stocks, ChargePoint also issued more shares, which didn’t help matters. 

On July 12, ChargePoint announced its plan to issue an additional 12 million shares. Investors generally don’t like that, even when the proceeds go toward something useful like acquisitions or general capital expenditures — because it dilutes existing shareholder value. In this case, “certain stockholders” received all of the proceeds. Investors tend to really not like that. The issuance was priced at $23.50 per share, well below its stock price at the time ($28.84). 

Naturally, CHPT took a beating shortly thereafter. But seven out of eight analysts still rate ChargePoint a “buy.” The average price target sits at $36 per share. 

Things working in ChargePoint’s favor

However, there have been positive developments too. 

On July 20, ChargePoint signed a definitive agreement to acquire has·to·be (what an odd company name), an e-mobility provider with a leading European charging software platform. 

Founded in 2013, has·to·be has 125 employees in Austria and Germany, as well as approximately 40,000 networked ports and over 250,000 networked ports through open roaming agreements.

On August 11, ChargePoint acquired ViriCiti, an eBus and commercial vehicle management provider, to help accelerate fleet electrification over the next decade

Founded in 2012, ViriCiti today has more than 50 employees in the Netherlands and United States, and established market share in North America and Europe with approximately 150 fleet operators, 3,500 connected vehicles and 2,500 networked ports under management. 

Lastly, and more importantly, earlier this month, a bipartisan group of senators hammered out the details of a $1 trillion infrastructure package, of which roughly $7.5 billion would be earmarked for electric charging stations. The House has until September 27 to vote on the bill. 

Keep an eye out for the vote’s results as well as Chargepoint’s upcoming earnings announcement for Q2, which will take place on September 1. 

Pfizer (PFE)

Can you believe it? The biopharmaceutical behemoth’s share price finally experienced some upward momentum. 

On May 14, we released our Pfizer Due Diligence report — we thought PFE was a safe long-term play. At the time of release, PFE traded for $40.10 As of yesterday’s close, PFE is up to $47.38. 

What happened?

The initial catalyst was strong Q2 earnings results. On July 28, Pfizer announced that non-vaccine revenue grew 10% year over year — plus, it raised full-year EPS guidance to $3.95 - $4.05 per share, which was significantly up from its previous expectation of $3.55 - 3.65. 

It’s been tough for analysts to value the COVID-19 vaccine aspect of Pfizer’s business because the jury is still out on whether this source of cash flow will be recurring (for the sake of humankind, hopefully not). In other words, will COVID be an indefinite issue that warrants constant vaccinations? If so, Pfizer will continue to make a fortune. 

On August 10, Reuters reported that Pfizer had hit a record high for the first time in over 20 years. (It peaked at $51.86 on August 17.) Here’s a snippet from the article that quotes one portfolio manager’s opinion:

“I think they are finally getting credit for the vaccine," said Jeff Jonas, a portfolio manager at Gabelli Funds, which owns Pfizer shares.

While investors had treated the vaccine before as "a one-time cash infusion ... it is really going to be a durable business, unfortunately," Jonas said, adding that Pfizer should be able to leverage the vaccine's technology for use against other types of disease as well.

As icing on the cake, Pfizer’s vaccine (BNT162b2) received full approval from the FDA on August 23 — the first COVID-19 vaccine to do so. Since the announcement, Pfizer investors have seemingly cashed in on this news, considering shares of Pfizer are down 6.6% since the approval. 

Analysts collectively view PFE as a “hold” with an average price target of $45.32. 

EVBox (TPGY)

On April 2, we released our EVBox Due Diligence report — we suggested a “wait-and-see” approach. At the time of release, TPGY traded for $20.31 As of yesterday’s close, TPGY is down to $10.30.

What happened?

Of course, TPG Pace Beneficial Finance Corp (the SPAC that’s presumably going to merge with EVBox) has — like the rest of the industry — experienced a significant pullback. But there’s more to this story.

Well, more of the same that is. 

We recently covered TPGY’s tumble in an issue of Market Movers; here’s what we reported:

In May, TPGY officially notified investors that EVBox is taking longer than expected to complete an audit of its FY20 financials. Who knows what the hold-up is, but a delay is not a good sign. 

On June 1, TPGY released another official announcement, which stated that the companies had agreed to extend the original outside date from June 8, 2021 to August 6, 2021. If the deal still hasn’t closed by then, either company is free to terminate the agreement. In other words, the proposed business combination could fall apart.

Well, it’s August 26, and EVBox still hasn’t delivered its FY20 audit to the folks at TPG Pace Beneficial — a prerequisite of the proposed business combination. 

On August 6, through a current report (8-K), TPG and EVBox announced the extension of the outside date to December 31, 2021. Within the report, TPG shared that it had received information indicating that EXBox’s existing FY19 audited financials might require restatement prior to the completion of FY20’s audit. As a result, EVBox has to provide a revised business plan and financial forecast. 

The report continues (emboldened for emphasis):

As a result of the foregoing, TPGY does not consider the previously released financial and operating guidance for EVBox Group for future periods to be reliable indicators of EVBox Group’s expected future financial performance (specifically, the financial and operating guidance filed by TPGY as part of its Current Report on Form 8-K filed on December 10, 2020 or any subsequent reproductions of such guidance).

That’s not exactly a peachy prognosis. I guess we’re still “waiting and seeing.”

I feel bad for the auditors charged with helping EVBox prepare its financials. By the time they finish FY19’s and FY20’s audits, they’ll have to turn around and do this year’s audit. 

What a world.

Shares of TPGY closed at $10.30 on Thursday, well below its 52-week high of $34.28.

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Today’s Due Diligence report covers a former meme stock that’s plummeted back to reality: Stitch Fix. 

In January, shares of Stitch Fix peaked at $113.76.

Yesterday, SFIX closed at $39.59. 

Can the digital retailer stitch itself back together? 

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Now, without further ado... 

The Business

Founded in 2011, Stitch Fix is a digital retailer that caters to men, women, and kids in the U.S. and U.K. The company has employed a uniquely modern approach to retail for the last decade. Combining data science and stylistic recommendations, Stitch Fix delivers boxes of clothing and accessories to its customers. Each box (or “Fix”) contains five items, which are selected based on Stitch Fix’s algorithm and a stylist’s input. 

When customers first join the platform, they take a Style Quiz, which then feeds into Stitch Fix’s robust database and assists the algorithm. I took the quiz (this is Due Diligence after all), and I must say — it’s an extensive assessment. 

In essence, customers receive a mystery box of goods that are expected to be perfectly tailored to their size (based on data) and style preferences (based on data). The keyword is data. The company is constantly collecting feedback to improve its algorithm and the customer experience.

Customers can schedule automatic shipments or order a Fix on demand; regardless, there’s a $20 “styling fee” per box. If the customer elects to purchase one or more items, the $20 fee is applied to the order. If the customer doesn’t like any of the five items, they forfeit the $20 styling fee. 

More recently, the company has rolled out new features called Direct Buy and Fix Preview.

What is Stitch Fix Direct Buy?

In 2019, Stitch Fix added direct-buy functionality to its platform: instead of ordering a random assortment of clothes, customers could buy previously purchased items in different colors, sizes, or prints. This feature has since evolved to allow customers to shop for personalized clothing based on their style profiles. This month, Stitch Fix announced that new customers can buy clothing directly from the company’s website without being active Fix subscribers. (There aren’t any styling fees for direct purchases.)

What is Stitch Fix Preview?

Before the rollout of Fix Preview, customers simply had to trust that the company’s stylists and algorithm would supply a worthwhile selection of desirable clothing. Now, Stitch Fix is allowing shoppers to preview their Fix before it ships. 

Subscribers have 48 hours to review their Fix before it ships; if they don’t like an item, they can remove it and a stylist will add a replacement. 

Does Stitch Fix have its own clothing line?

Yes, Stitch Fix offers third-party branded merchandise as well as its own “Exclusive Brands.” Naturally, the company’s clothing line has higher margins relative to other third-party brands. The ever-shifting merchandise mix, which is based on customer demand, can cause gross margin to shift from period to period.

Stitch Fix client growth

Although Stitch Fix has struggled to maintain profits, the company has continually increased its client growth. As of May 2021, Stitch Fix had 4.1 million active clients, good for 20% year-over-year growth relative to Q3 2020. 

The Narrative

Thanks to a short squeeze, shares of SFIX soared to triple-digit heights in January (at its peak, SFIX was up 867% from its pandemic low). However, the digital retailer’s stay in the clouds was short-lived. Over the last six months, Stitch Fix has faced a number of obstacles, shrinking its share price to a more modest $39.59 as of Thursday; those obstacles include:

• In March, Q2 sales results fell short of expectations.

• In April, Katrina Lake announced she would step down as CEO.

• This month, reports surfaced about stylist departures and culture concerns under new CEO, Elizabeth Spaulding. 

We’re going to focus on the latter two because the sales miss wasn’t significant. The following quarter (Q3), net revenue increased 44% year over year and the company projects at least 20% year-over-year revenue growth for the fiscal year. 

Earlier this month, according to one report, Stitch Fix expressed that it would emphasize live one-on-one styling sessions. To accomplish this, the company imposed new scheduling requirements for its hourly stylists. Stitch Fix offered a $1,000 voluntary severance payout to stylists who did not want to continue with the company. The report references a Wells Fargo analyst who covers Stitch Fix; according to the source, Stitch Fix likely underestimated the number of departures. Although job review boards tend to attract more grievances than praises, Stitch Fix has accumulated a growing stack of negative feedback on Glassdoor this month.

We won’t know the headcount impact until the next earnings release in September, but, for reference, the company had roughly 6,200 stylists as of May. 

While a silver lining could be reduced overhead, we’ll have to see if this impacts Stitch Fix’s ability to consistently deliver high-quality, personalized clothing recommendations. One could argue that this is a sign that the company is leaning more on its algorithm, which has accumulated a decade of data, for style recommendations going forward. 

Stock Overview

• Last week, SFIX’s 50-day moving average fell below its 200-day moving average, which is a negative signal known as a “death cross.” SFIX is down 10% over its last five trading days. Note: many investors use the relationship between these averages as a technical indicator to gauge price trends.

• Since Stitch Fix is not profitable, it does not have a P/E ratio. For companies that generate losses, it’s more appropriate to look at price-to-sales ratios; Stitch Fix’s P/S ratio is 2.2. For comparison, the Apparel and Shoes industry’s P/S ratio is 0.80 — so investors are willing to pay quite a lot more for Stitch Fix. Note: P/S essentially calculates the amount investors are willing to pay for $1 of a company’s sales. This is a common valuation metric for unprofitable companies to compare to peers and broader industry and index benchmarks. 

• Stitch Fix’s consensus price target relative to its last close implies a 57% increase. 

The High-Level Finances

Revenue Highlights:

• Stitch Fix had a fantastic third quarter (its fiscal year ends in July) partially thanks to the scaled availability of Fix Preview to the entire U.K. client base and to over half of its U.S. clients. 

• Management expects to surpass $2 billion of net revenue in FY21 (which would imply 21% year-over-year growth). 

Profit Highlights:

• At first glance, Stitch Fix’s bottom line is headed in the wrong direction. However, despite a decade of existence, Stitch Fix is still in growth mode — it’s not unusual to operate at a loss while expanding. 

• At second glance, while Stitch Fix’s $84 million operating loss through three quarters looks bad, the company has $95 million of non-cash expenses within its SG&A line item, including depreciation, amortization, and share-based compensation. 

• Another tidbit about the growth aspect: advertising expenses represented $142 million of that $766 million SG&A line item for YTD 2021. And I think I’m entitled to a percentage of that for outlining their business model to you fine people. 

Balance Sheet & Cash Flow Highlights:

• From a balance sheet perspective, Stitch Fix is healthy — the company has no outstanding debt, so interest expense isn’t eating away at its cash flow. (Stitch Fix does have access to a revolving line of credit though if it ever needed the capital.)

• Stitch Fix had $124.7 million of cash on hand as of May 2021.

• Historically, Stitch Fix has generated positive free cash flow on an annual basis: $12.7 million in FY20, $47.8 million in FY19, and $55.6 million in FY18. 

• Through three quarters of operations in FY21, free cash flow was negative $58.8 million — although it was negative $39.1 million last year at this point and they still wound up with positive FCF for the year. (Free cash flow is an important measurement because it shows how much money a company generates after general business expenses.)

Earnings Trends

SFIX’s EPS results have been all over the place for the last couple of years. As I mentioned above, that’s not uncommon for growth-oriented companies. So far this year, Stitch Fix has exceeded consensus estimates in each quarter. 

The Primary Strengths

Customer growth. Stitch Fix has added roughly 1,400,000 active clients since the end of FY18. That’s impressive.

New features. Stitch Fix’s new features — Direct Buy and Preview — add diversity to the platform, which could help client acquisition, client retention, client lifetime value, and, ultimately, its bottom line.

Financial health. No debt? No problem. The company has historically generated positive free cash flow and doesn’t rely on debt to fund its business. That’s a plus.

The Primary Risks

(Un)profitability. Here’s the bottom line — the bottom line still matters. Growth is great, but can the company grow profitably? And then maintain those profits if it reaches that point? The next year will be telling. 

Competitive market. Seizing market share is tough in the retail industry. Plain and simple. Stitch Fix’s customer growth is compelling, but maintaining an active client base isn’t guaranteed. 

Consumer spending concerns. As a consumer goods company, Stitch Fix is susceptible to macroeconomic downturns since consumers often limit their spending when budgets are tight. A subscription for trendy clothes is a likely candidate for a personal budget cut. 

The Street’s Opinion

SFIX registers a “Hold” consensus rating thanks to some starkly contrasting opinions of the company. SFIX’s average price target implies roughly 57% upside, while the lowest price target suggests that the stock has darker days ahead of it. 

Bullish or Bearish?

At Due Diligence, we think long-term — we like companies that are well-positioned to be staples of their industries in the future. From a long-term perspective, we’re bullish on Stitch Fix. Its business model appears to be working, as it continues to appeal to (and acquire) active customers. Speaking from experience, the platform does its job, presenting personalized recommendations and streamlining the shopping experience. 

In the near term, we’re cautious. On one side, the company could continue benefiting from pent-up demand and consumer eCommerce spending. If the company exceeds estimates in its next earnings release (scheduled for 9/21), don’t be surprised by a price bump. On the other side, concerns about stylist departures and operating efficiency make us wary. Any signs of Fix inaccuracy from customer feedback or customer activity declines would solidify our concerns. 

Although SFIX appears to be trading at a discount relative to its 52-week high, keep this in mind: that peak was driven by a sudden burst of interest from meme stock chasers. It’s still up roughly 63% from a year ago. 

Sources

1. Q3 2021 earnings release

2. Investor presentation

3. Latest 10-Q

4. Latest 10-K