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• Higher energy prices and Middle East tensions are leading to “risk-off” decisions by institutional and retail investors.
• Momentum names with extremely high multiples are particularly vulnerable.
• Management hubris along with slowing growth metrics are hallmarks of great rollover bearish trades.
• Two particular high-flyers are showing signs of topping and look like explosive short candidates:
- Salesforce.com Inc. (CRM)
- Amazon.com Inc. (AMZN)
The last 18 months have been a great period for momentum traders.
For what has seemed like an eternity, Wall Street momentum bulls have continued to buy the dips, pushing speculative stocks higher – regardless of fundamental valuations. Every time the popular momentum names have sold off for more than a session or two, LOLO investors (long-only, leveraged-outright) have stepped in – and have been rewarded for taking on more risk.
To a certain extent, momentum stories can become self-fulfilling prophecies. At least for an extended period of time…
Higher stock prices lead to investor confidence. The Wall Street marketing machine takes this confidence and justifies buying at ever-increasing multiples. Valuations can be justified by extrapolating a few historical quarters of strong growth. If you believe that a company can grow earnings by 30% year after year, then it’s much easier to make a case for a PE multiple of 50, or 80 – or heck, even triple digits!
The stories all make sense when the economic backdrop is rosy. Even when challenges begin to appear, the “buy the dips” mentality can become self-sustaining. Buyers begin to salivate when their favourite stocks tick lower – just like Pavlov’s dogs responding to a bell.
But at some point, excessive speculation breaks down. It may take months, a number of quarters, or even several years – but eventually, reality will crash the party. When this happens, the ride back down is usually much faster and much more volatile than the climb. Great news for nimble traders, ulcer-inducing for the buy-and-hold crowd.
Today’s environment has a number of the elements necessary for sharp declines in speculative names:
- Momentum stocks are priced with unreasonable multiples.
- Business models are facing increasing competition.
- Growth rates are yielding to the law of large numbers.
- Analysts are beginning to lower expectations.
- Chart patterns are beginning to show topping formations.
Anatomy of a speculative market
You and I have both seen this story dozens of times. A company is launched with a good idea – maybe even a great idea… The IPO is successful and things continue to go perfectly. Products find favour with customers, resulting in higher sales. Scalability kicks in and strong revenue growth results in even stronger earnings growth.
Investors start to get comfortable with the business and fall on top of each other – trying to get in on the action. It seems illogical not to own these speculative names in size… And the stock price rises along with investor confidence.
Sure, there are some nay-sayers along the way, but their words are regularly swept under the rug. Sell-side brokers begin to tout lines like: “Traditional metrics just don’t apply to this situation.” and of course the age-old “This time, it’s different.” When you start hearing these arguments, it’s time to take a good-long look at the risk levels – and at the very least have an escape hatch ready.
Usually the turning point is somewhat difficult to pinpoint. A positive earnings report fails to push the stock to a new high. Or a breakout immediately runs into resistance and pushes the stock back into a trading range. But where wary traders are taking a hard look at risks, LOLO investors simply see another opportunity to buy the dips.
Once all of the speculative buyers have been sucked in, the risk of an extraneous event can become all the more dangerous. A fire alarm in a well-lit restaurant may disrupt dinner, but doesn’t cause panic. A fire alarm in a crowded theatre may be an over-used cliche, but the point is all-too clear:
When everyone decides to hit the exits at the same time, price doesn’t matter. Bids can disappear in a moment’s notice and large institutional desks with massive positions are especially vulnerable.
If you see the danger signs before the “event,” you can bypass a lot of the risk. And if you’re flexible enough to take a short position heading into one of these events, a few good trades can make your year!
The key is to play these situations from a position of strength – entering trades at inflection points. It does no good to understand the fundamental risk in play, if you step into a short position while the speculative buyers are still active. But using price action as a timing mechanism, nimble traders can put their capital to work at specific points along the way – instances where risk is properly controlled, and the opportunity set is most advantageous.
Below are two speculative rollover candidates we are tracking for breakdowns this week:
• PE multiple near triple digits sets the stage for significant disappointment.
• Headline growth numbers are slowing, and behind the headlines the details are much more sketchy.
• Hubris is in full-force, spending capital on Super bowl ads and a luxurious corporate campus.
• Chart pattern suggests bulls are weakening and trend reversal is imminent.
It’s tough to imagine a rational argument for buying CRM. Of course there are two sides to every market, but from a logical perspective, the stock just seems dangerous.
To start with, CRM is trading in the high $120′s while the company’s adjusted earnings for the last year are just a bit over $1.20 per share. (I mention “adjusted” because there are some very big issues with the reported earnings figures – more on that in a minute…) The bottom line is that investors are paying more than 90 bucks for every dollar the company earns.
Now there are situations where a stratospheric multiple like this could make sense. Take for instance, a company that is coming out of bankruptcy, marginally profitable, and on track to return to a more stable business in the next 12 months. Looking forward, the company might have a much more reasonable multiple – even though the PE based on past performance is so high.
Another example would be the small, entrepreneurial company which is currently just a shadow of its future potential. In many cases, investors will pay 100 times earnings – respecting the company’s scalability and long-term growth expectations.
But in the case of CRM, these arguments just don’t carry water. The company is only expected to grow earnings by 13% in 2011, and the expectations for 33% growth in 2012 seem more than a little “academic.” After all, can we really know what the cloud computing business environment is going to be like in two years?
Cooking the Books?
Ok, that phrase may be just a bit too harsh. I’m not actually accusing Salesforce.com of outright fraud (although stranger things have happened), but the way the company reports earnings is misleading at best.
While GAAP earnings figures are required to account for stock options issued to executives and employees, CRM management has created a policy of reporting “adjusted” earnings which exclude these expenses. Stock options are a non-cash expense – but that doesn’t mean they don’t carry economic significance.
In the six years since the company’s IPO, CRM’s share count has ballooned from 111 million to 140 million and is expected to hit 145 million in the next year. A large part of this share increase is due to stock options being awarded. Of course, a higher share count means that each existing share owns a smaller portion of the company. A significant dilution that is glossed over by the “adjusted earnings” practice.
Hubris in Full Swing
When traders achieve success too quickly, they often become a bit cocky. The same can be said about Chief Executive Officers. Unfortunately, early success can lead to decisions that don’t always incorporate proper risk management or efficiency. As Jack mentioned in A Trader’s Mindset, some of the best growth opportunities come out of challenging circumstances.
When it comes to recent strategic decisions out of Salesforce.com, it appears that success has gone straight to CRM management’s head.
In addition to a pair of multi-million dollar super bowl commercials (which by the way were a bit insulting to our intelligence), the company has also spent $278 million for a corporate campus in San Francisco — and that’s just the land! Meanwhile the recent “chatter” product launch is really just a glorified chat room, and the majority of subscribers are not paying customers…
CRM may be able to convert some of these subscribers and generate some revenue from the project, but the approach seems incredibly risky given the amount of competition springing up. Non-paying chat members likely have very little attachment to the Salesforce.com brand, and it would be very easy for these users to gear up with other providers when it comes to making a financial commitment.
CEO Marc Benioff appears to see the stock as fairly risky as well. Honestly, it’s hard to fault him when investors are willing to pay up to 100 times the company’s earnings. In the past year, Benioff has unloaded $220 million worth of stock – this during a period in which the Wall Street Journal notes that the company only earned $64 million in profit.
With the stock apparently running out of steam, and the broad market working back into “risk-off” mode, it’s time to consider adding CRM to the short radar – and pulling the trigger as the stock breaks through support levels.
Amazon.com Inc. (AMZN)
• Recent profit margin declines are challenging analyst growth models.
• Laws regarding collection of sales tax may challenge the business model and create more room for competition.
• A PE multiple north of 50 implies robust growth expectations – despite modest actual EPS growth projections.
• The chart pattern is breaking through support after forming a double-top – a warning sign for trapped momentum bulls.
Amazon.com has come a long way from the late ’90′s internet bubble days…
The company has morphed into a retail powerhouse, offering items to consumers in nearly every corner of the world. With revenue of nearly $13 billion in the fourth quarter alone, the company commands the respect of nearly every retail operation in business.
Investors have been well rewarded for holding the stock recently. Over the last year, AMZN has risen some 80% from the July low to the January peak, and the stock’s premium multiple points to robust confidence in the company’s business model.
But behind the scenes, things haven’t been going so smoothly for the company’s growth plans. Challenges are mounting in a number of areas, threatening to undermine confidence – and potentially send the stock spiraling lower.
During times of expansion, investors can’t get enough risk and speculative opportunity. But at the scent of danger, these speculative buyers can send a growth stock down in a hurry. With AMZN’s out-sized growth rate being called into question, the premium stock price could hit the discount page over the course of a few weeks of trading.
Despite a 36% year-over-year increase in revenue this past quarter, AMZN was only able to generate a 7% increase in earnings per share. The disparity caught the attention of sell-side analysts and portfolio managers as well – and the stock gapped sharply lower following the announcement.
Mass retailers typically have tight profit margins and AMZN is no exception. In the fourth quarter of 2009, the company reported a 4.6% operating margin – healthy but challenging considering the company keeps less than 5 cents for every dollar of merchandise sold. But this past quarter, operating margins dropped to 4.1% – a significant decline – raising significant red flags and punching holes in analysts’ tedious earnings models.
Looking forward, management didn’t give the analysts much hope for a rebound. Overall revenue is expected to grow by 28% to 39% in the first quarter, but operating income will fall below last year’s levels. Not exactly the kind of report you expect to hear from a company that is commanding a PE multiple of 54.
In addition to slowing growth, Amazon is fighting an uphill battle when it comes to assessing sales tax. For its entire existence, AMZN has resisted any regulations that would require it to collect tax. The company’s perspective is that they only offer the conduit for transactions to occur – and are therefore not responsible for assessing various state and local taxes.
But as state budgets become tighter, AMZN’s robust business becomes an appealing target for raising revenues. Amazon has already had to take steps preventing affiliates in certain states from selling products on the company’s site – and more restrictions could have a material effect on the company’s revenue and profit growth.
Expensive, and Rolling…
It’s important to mention once again, that valuation is a horrible timing metric for traders. Just because a stock is expensive doesn’t mean it is ready to head lower. But on the other hand, valuation can give us a clue as to how vulnerable a stock is – and how far it might decline.
In the case of AMZN, the stock is selling for more than 53 times earnings – while at the same time, analysts are revising their growth assumptions lower. The current expectation is for AMZN to earn $3.17 in 2011 – up 25% from last year’s figures. A 25% growth rate coupled with a PE north of 50 is like a cardboard box sitting next to a gas stove… Plenty of danger in plain sight.
On top of the high PE and declining growth rate, we also have significant macro economic risks quickly coming into play. As the Middle East conflict increases in intensity, oil prices are rising and global discretionary spending is falling. Higher food and housing costs in emerging markets simply make this problem worse.
The cumulative effect of all of these pressures are weighing on AMZN’s chart pattern. After gapping lower from the poor earnings announcement in January, bullish traders made one last valiant attempt to push AMZN to new highs – but were turned back at the $190 resistance area. Now the fun begins…
If the stock breaks through the $168 – $170 area, it could trigger a hasty exit for momentum players. A double top and break of support is a pattern even a LOLO investor can recognise.
Taking an objective look at the situation, it would be easy for analysts to revise their models to price the stock at 25 to 30 times earnings – and if they keep lowering their earnings projections we could have a sub-$100 stock in just a few months time.
Of course, price action will dictate our trading – and proper risk management will require us to tighten our risk points along the way. But AMZN represents one of the more appealing “cult-stock” breakdowns which could materially impact our P&L stats over the next quarter or two.