Growth Meets Value

[leaderoftheback]

Zoom.

https://cloudedjudgement.substack.com/p/clouded-judgement-52…
I scanned these charts for growth companies with one criteria, apparently not important in some valuation models but still important in mine, and that is operating margin…as in “do they actually make money.”

The general mood surrounding ZM seems negative (for those who would be most interested in ZM in the recent past). Earnings tomorrow may or may not move the needle, but I promised myself that if my CAPS pick filled, that I’d look closely. The closer I look, the more I like.

What are ZM’s growth prospects in an atmosphere of deteriorating capital markets? A ZM meeting is less productive and less satisfying than an in-person meeting, but if my company is looking to keep costs down for a year or two, then three Zoom meetings to every in-person meeting seems like a good idea. In other words, I don’t think ZM is gonna fade away.

So back to the charts…the chart says I can’t go wrong even at current valuation. If their “Rule of 40” measure drops to 30? Horror of horrors. If they don’t get as many $100k subscribers? I dunno, my $150 subscription isn’t gonna offset that but I’m pretty disinclined to stop paying that $150 any time soon. Maybe there are more $150 (or $50) customers than they imagine?

The other name that jumps out is VEEV. Another criteria of mine: do I understand, at least in principle, what it is that they do and is what they do of real value in the real world? Seems to be an affirmative in both cases re ZM and VEEV. Also ADBE and perhaps DDOG (which is not losing money at least, so worth watching for another quarter or two).

I think that all four of those, ADBE, DDOG, VEEV and ZM fit Value Hounds models.

-Randy

[earslookin]

Randy,

One challenge for valuation nowadays is that US firms invest close to two times more in intangibles
than tangibles. This is the reverse of the situation forty years ago. Most investments these days
must be expensed on the Income Statement whereas forty years ago most were capitalized on the
Balance Sheet. This means GAAP earnings can be quite misleading. A brick and mortar retailer forty
years ago would reach break-even much faster than a Web retailer today, even though they both had
identical cash flows!

Analysts are grappling with this change by exploring ways to quantify these intangible investments
and determine their useful life – a major challenge. Meanwhile, it’s helpful to understand that
GAAP earnings are becoming less and less reliable as a filtering tool.

Here’s a provocative article on the subject called How to Distinguish Between GAAP Losers and
Real Losers: https://www.stern.nyu.edu/experience-stern/faculty-research/…

Slide 10 of this study shows the divergence of intangibles and tangibles over the last 60 years:
https://www.wilsoncenter.org/sites/default/files/media/docum…

Best to you,
Ears

[leaderoftheback]

Thank you for these links, Ears, and I have been studying this revaluation effort.

For me, value means “risk-out”. Like everything else in investing, it’s often tough to tell whether the risk has come off a particular company, or if the risks are just less visible and deeper.

The title of this post “Growth Meets Value” is essentially that.

Take SNOW for instance: highly regarded and now below its IPO price. So how exactly is The Market valuing it? Contrast with ZM or ADBE (thanks, MisterFungi!). Hammered, yes. Because they have been valued in a similar way to SNOW. But there is a difference and that difference is that ZM and ADBE have GAAP earnings. So sure, intangibles are often expenses, and still ZM and ADBE show GAAP earnings. To me, that is what risk-out means.

For thirteen years of a secular bull market, the new valuation models have not been tested. That test may be going on right now. ZM and ADBE are now in my portfolio and I expect I’ll add VEEV.

I think we are still in the tradable rally phase of a secular bear market. All of the best stocks will go on sale again when capitulation finally occurs. How low will SNOW go? No idea, but if it is viewed as something equivalent to ADBE and ZM (as in “reasonable valuations in a dinosaur’s model”), then it’s headed a LOT lower (I’m gonna put a marker down for future readers and suggest about $40, depending on how long capitulation takes). Since the day SNOW launched, few would ever suggest that it would sell for $112; the longer it flies high, then higher still, keeping it’s growth promise in tact (and even improving on it), it would be a brave soul to bet on $112 ($40 anyone?).

So I’m down with the idea that there may be a new valuation paradigm, but until that paradigm is stress-tested, it’s best to leave them all for those with longer timelines.

-Randy
long ADBE and ZM, though just with “nibbles” because as previously noted by others, both are still pretty richly valued…by dinosaur metrics.

[kelbon]

Here’s a provocative article on the subject called How to Distinguish Between GAAP Losers and
Real Losers: https://www.stern.nyu.edu/experience-stern/faculty-research/……

Snip:

To give you an idea of the impact on corporate earnings of the massive expensing of intangibles, we added back to annual reported earnings the R&D expense, and one-third of SG&A (sales, general and administrative expenses)—the latter representing other-than-R&D intangibles, such as IT and brands reported in SG&A. After these additions, the percentage of loss reporting companies drops from 45% to around 30%, a substantial drop to be sure. Tesla is a case in point. For 2018, it reported a loss of $976 million. But capitalizing its 2018 R&D of $1,460 million would have turned this loss to a profit.

Nuance to your heart’s content, but there’s no denying that if a company spends money, it is an expense. The notion of moving R&D from the minus column to the plus (In the example cited, turning Telsa’s loss into a profit for 2018) masks and muddies a company’s financials more than any of the other accounting practices the author feels unjust.

It’s bad enough that there’s already one clear expense—at least for shareholders—that should be in the minus column, but rather appears in the plus column in cash-flow statements, which is: stock based compensation. Let’s not have another expense magically become revenue.

[earslookin]

Nuance to your heart’s content, but there’s no denying that if a company spends money, it is an expense.

The authors would fully agree with you. The issue is not whether it’s an expense, but when to
recognize the expense.

Let’s not have another expense magically become revenue.

Free cash flow remains the same whether you expense intangibles or capitalize them.

Ears

[kelbon]

Free cash flow remains the same whether you expense intangibles or capitalize them.

My immediate thought on this (I may be missing something) is that “No, it doesn’t”.

Because: the first line of the cash-flow statement is Net Income.
If you expense Intangibles then Net Income is less than if you capitalize them.

(R&D is a line item in Operating Expenses; Operating Expenses are deducted from Gross
Profit to calculate Operating Income; and so on, until Net Income is determined.)

[kelbon]

Further, the only way (I see) that Free Cash Flow would remain the same is if R&D, rather than being accounted for as an expense in calculating Net Income, was if R&D was accounted for as an expense as a component of Capital Expenditures. Either way, an expense.

[earslookin]

I may be missing something

You are. Let’s take intangibles out of the equation for just a moment.

Think about what happens when you capitalize an expenditure on a tangible asset like a new store or
factory. What sections of the cash flow statement are affected and how is free cash flow determined?

Then think about what would happen if accounting rules were different and you were forced to
recognize the full expenditures for a new store or factory in the year incurred rather than being
able to capitalize them. How would that affect the cash flow statement? What happens to the Cash
from/to Operations section and the Cash from/to Investing Section? Granted the numbers in the two
sections would change, but would free cash flow be any different if you had to fully expense a new
store vs capitalizing it?

Ears

[pauleckler]

Kelbon, welcome back. Its been a while. Your last post on this board was in 2019.

Folks, you’ve done a good job peaking his interest. He is selective in subjects he posts about.

A committed value investor.

[kelbon]

I may be missing something

You are.

Yes, I was. Semantics.

I was making an assumption as to precisely what was meant by “capitalize” in this context. After looking it up as strictly accounting speak I now have a better handle on what exactly it means. So, I’ve learnt something; which can only be positive. —Needless to say, I’m not an accountant, or trained in, nor ever worked in, finance.

[kelbon]

Kelbon, welcome back. Its been a while. Your last post on this board was in 2019.

Thanks. Has it been that long? Seems I’m a bit rusty …

[buynholdisdead]

I think discussing all of this is interesting and educational, but in the end it is a progression of a company from Non-Gaap negative, to Cash flow positive, to Gaap positive, is the most important thing. The rules of what is an expense and what is an expense is really immaterial as long as the company is showing a progression to profitability and FCF positive.

Andy