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Introduction
Are you getting tired of losing money as the market seemingly keeps going down? Worried about high interest rates causing a recession? Fear not, there are two ways to win in the stock market and you may be trying only one.
The past decade of monetary expansion and revenue growth being rewarded with profitability ignored has spawned a multitude of public companies with billions of dollars in questionable market cap. Many of them have halved or more in the last year, but I believe most will drop 90% from their peaks, with many going bankrupt (see bursting of dot com bubble circa 2001-2002). Today, I highlight a company that reported earnings (or the lack thereof) this week.
Company background
Based in San Francisco, GitLab (NASDAQ:GTLB) develops software that enables firms to manage their own software development. The company also provides related training and professional services. The company was founded in 2011 and has been unprofitable ever since ($638 million in accumulated losses as of July 2022). Its venture capital backers picked a good time in October 2021 to take it public, and the stock is down more than 40% since then.
Financial overview
For the first quarter of 2022, the company generated $101 million in revenue, up 74% YoY. Operating income was a loss of $65.3 million (-65% operating margin), and net income was a loss of $59 million or $0.40 per share.
The company currently has 148 million shares and a market capitalization of $8.5 billion. It has no debt and $930 million of cash thanks to its well-timed IPO. It thus has an enterprise value of $7.6 billion, amounting to 19x its annualized revenue.
Analysts expect the company to continue growing at a rapid pace, with its losses maintained. Growth is expected to slow to the 40% range next year, with the company generating close to $600 million in revenue next year. Profits are nowhere on the horizon, and the only concession the company has made is to say that it is “committed to growing in a responsible manner.”
Valuation and recommendation
I am assuming that GitLab will ultimately become profitable and generate a 5% operating margin from its current and past negative 50 to 60% level. One important point is that I do not ignore stock compensation. If you do not believe this is a real expense, then you may stop reading now! Most management teams still have their head in the sand with their thinking that they can compensate their employees with as much stock as they want with no adverse effects. This represents an opportunity for bearish investors, as employees will be constantly selling their shares.
A 5% margin on current revenue would mean annualized profit of $20.2 million a year. I value the company at a 90x multiple on this profit. This would equate to a 30x multiple assuming the company triples in size, and I believe this is reasonable. A high quality company like Microsoft (MSFT) trades at 26x this year’s EPS. I am not applying a tax rate to the earnings to be conservative as the company has substantial loss carry-forwards.
I thus value the company at $1.8 billion and add back the cash for a total value of $2.8 billion. Dividing by 148 million shares gives a fair value of $19 for the stock, against its current $58 price, for 67% downside. I recommend shorting the stock. You may also choose to sell calls or buy puts instead. I believe most of this downside will be realized over time, as employees keep selling their shares and no new money enters the market.
Short interest and cost of borrow
It would be dangerous to short a stock that already has a high short interest, with the possibility of a short squeeze driving the price much higher. It would also be uneconomical to pay a high borrow cost that potentially eats up all the downside on the stock side. GTLB has a low short interest at 4%.
The borrow cost for GTLB stock is 1.5% a year, although your broker may charge a different rate. Depending on your agreement with your broker, you may also get a short rebate for the funds generated from selling the stock you borrow (usually a discount of 50-100 bps from the Fed Funds rate, currently at 2.25-2.5%). So when interest rates go up, you get more money back! You will be on the hook for any dividends the company pays, but it’s safe to say that no profits = no dividends! The company may attempt to buy back stock with its cash balance, but since it will be buying it above intrinsic value, I see no value creation. At some point it may run out of cash and look to do an equity issuance.
External ratings
The company does not have a SA quant rating, as it has been public for less than a year. Wall Street analysts are uniformly positive on the company, although their price targets have been following the stock lower. They have a composite rating of 4.4 on it, equating to a buy. I do not imagine they will be out there buying all the stock that the employees will be selling (the company’s stock compensation amounts to 30% of its revenue).
Risks are high but manageable
Shorting stocks is inherently risky, since the potential losses are theoretically infinite. I would recommend having a short portfolio only in conjunction with long positions. You may somewhat decrease risk by selling puts against short positions, at about 20% lower than the current price, generating some income, but capping profits.
If investors became enamored of a company, there could be a short squeeze. However, with money getting tighter, I would regard the chances of this happening on an extended basis to not be very high. The company would also likely issue equity in such a scenario. However, if it issues equity at an inflated value, that does increase the company’s intrinsic value.
The company could be acquired at a premium by another company or private equity fund. This is a risk that can be diversified by holding a large number of short positions, with each one being small.
The gap between the company’s intrinsic value and share price could widen over time.
Pre-emptive disclosure
Writing a short thesis on a stock on a public forum is an invitation for blowback from holders of the stock. I welcome respectful comments from eponymous readers. If you are a holder or employee of a company mentioned, you would be better off directing your energies towards having your company become profitable.
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