QNST - Avoid QuinStreet Inc.

Summary

• I think the latest financial results are middling at best. Net income so far in 2022 is down significantly from 2021, which was itself hardly a banner year.
• I think the stock has risen on the back of the buyback. In my view, this isn't sustainable, and I think investors who buy at current valuations will be disappointed.
• This is yet another example of the power of selling put options. Short put returns have crushed stock returns since I started writing about this name back in January.

It’s been just under 10 months since I wrote my second article on QuinStreet Inc. ( QNST ), and in that time, the shares are up about 33.8% against a loss of 11.2% for the S&P 500. I was cautious about the name previously, but something may have changed recently, given the performance of the stock. For that reason, I want to check on the name again to see if it now makes sense to buy. I’ll make that determination by looking at the recent financial history, and by looking at the stock as a thing distinct from the underlying business. Also, as is frequently my wont, I will write about the puts I’ve traded on this stock. These have done well, and they did much less badly than the stock when it dropped fairly precipitously in price. If you think that I can’t wait to write about these trades, you think correctly.

My regulars appreciate the fact that I’m self aware enough to know that my writing can be “a bit extra.” I hope you appreciate the spectacle of an old man like me using young people slang. Doing so proves that I’m “with it”, “am not square, daddy-o”, and I’m a “hep cat.” Anyway, given that my articles can be a bit tiresome, I offer a thesis statement at the beginning of each of them, where I give readers the highlights of my thinking up front. That way, they can choose to wander into the deeper wilds of the article or can choose to get out while they can. This is yet one more example of how I try to make your reading experience as pleasant as possible. You’re welcome. Anyway, I think the financial performance here has been less than stellar in my view. The company turned in its first loss in 2021 since 2016 on the back of rising costs. Thus, 2021 was not a particularly hard comparison year. This is why I was somewhat alarmed to learn that net income is down dramatically so far this year when compared to 2021. That written, I really like the strength of the capital structure here, and I think the market will start to pay more attention to balance sheets as companies start to roll debt at higher rates. The problem for me is the valuation. This stock is now very expensive in my view, driven, perhaps by the fairly massive buyback activity we’ve seen over the last several quarters. Finally, the risk adjusted returns on my put options has absolutely trounced the stock return since I started writing about it. If you’re not yet familiar with the risk reducing, yield enhancing potential of these instruments, I would recommend you become so.

Financial Snapshot

Since I last reviewed the name, the company published 2021’s financial results, and they were mixed in my view. The company achieved record revenues, while net income turned negative for the first time since 2016. So the fact that net income during the first quarter of 2022 has swung from a positive $3 million in 2021 to a loss of $4.5 million during the most recent quarter is troublesome.

Additionally, I think it’s worth noting that the company spent $13.4 million on stock buybacks last year, and an additional $3.17 million during the first quarter of 2021 alone. I think it reasonable to assume that some portion of the recent stock price rise was driven by this activity. Whenever a stock moves dramatically in a manner that is disconnected from business results, I get a bit more nervous than usual.

Finally, I’ve written it before and I’ll write it again. I like the capital structure here a great deal. As of the latest report, the company has cash and equivalents that represent about 72% of total liabilities. This gives the company time in my view, which is highly beneficial to shareholders. For that reason, I’d be comfortable buying this business at the right price.

The Stock

I sometimes point out that the phrase “at the right price” is a term that I’ve used to talk myself out of some great investments over the years. QuinStreet is yet another concrete example of this phenomenon. The stock has soared higher, while I worried that the stock valuation just wasn’t compelling enough. I’ve been cautious because I’ve been given many painful demonstrations of the fact that a great company can be a terrible investment. I’ve also learned that a company that is valuable for its great balance sheet alone can be a mediocre investment. This is why I insist on buying cheap.

Additionally, I insist on buying stocks in general “on the cheap” because the performance of a given stock, for example, is a function of the crowd’s ever-changing views about the desirability of “stocks” as an asset class. There’s no way to prove this definitively, as it’s an obvious counterfactual, but a reasonable argument could be made to suggest that QuinStreet stock would have risen even higher since I last wrote about the investment if the S&P 500 hadn’t dropped about 11% since then.

The last thing I want to write about “stocks” in general is that the stock is often a poor proxy for what’s going on at the company, and I think it’s possible to profitably exploit this disconnect. In my view, the only way to successfully trade stocks is to spot the discrepancies between what the crowd is assuming about a given company and subsequent results. What I want to see in this regard is a stock that the crowd is somewhat pessimistic about that goes on to exceed expectations. When the crowd is pessimistic, the shares are cheap, which is why I try to buy only cheap stocks. Given that I considered the shares to be expensive when the shares were trading at $10.46, I’m not optimistic that I’ll find them cheap at $14, but you never know.

In my previous piece, in case you’ve forgotten, I remained cautious about this stock because the shares were trading at a P/E of about 89 times earnings, though that was impacted by a host of non-recurring items. I also fretted that the shares were trading at a price to book and price to sales ratios of 1.97 and 1.012 times. Fast forward to the present, and here’s the current lay of the land. The shares are actually about 33% more expensive on a price to sales basis, and 34.5% more expensive on a price to book basis per the following:

Source: YCharts

Source: YCharts

As my regulars know, in order to validate (or refute) the idea that the shares aren’t objectively cheap, I want to try to understand what the crowd is currently "assuming" about the future of a given company. If the crowd is assuming great things from the company, that’s a sign that the shares are generally expensive. If you read my articles regularly, you know that I rely on the work of Professor Stephen Penman and his book "Accounting for Value" for this. In this book, Penman walks investors through how they can apply the magic of high school algebra to a standard finance formula in order to work out what the market is "thinking" about a given company's future growth. This involves isolating the "g" (growth) variable in this formula. In case you find Penman's writing a bit dense, you might want to try "Expectations Investing" by Mauboussin and Rappaport. These two have also introduced the idea of using the stock price itself as a source of information, and then infer what the market is currently "expecting" about the future.

Anyway, applying this approach to QuinStreet at the moment suggests the market is assuming that this company will now grow profits at a rate of about 15% from here. When I last reviewed the shares, the market was assuming a 9.5% growth rate. Given the above, I recommend continuing to avoid the shares.

Options Update

In my previous two missives on this name, I recommended selling put options in lieu of buying shares. In the first instance, I sold 10 September 2022 puts with a strike of $10 for $0.40 each. In the second instance, I sold 10 November 2022 puts with a strike of $7.50 for $0.55 each. These have expired worthless, which is obviously an acceptable outcome. More interesting still, though, is the fact that the puts did “less badly” than the stock after the shares cratered.

Specifically, after I sold the September puts, the stock dropped and the puts started trading hands at $1.20. This $0.80 loss per contract was obviously not ideal, but it was preferable to the $4.75 loss that shareholders had suffered. This is yet one more example that leads me to conclude that short put options are a great risk adjusted alternative to stock ownership. I think the $0.95 per share that I’ve earned on these is superior to the $1.55 loss the stock has suffered since I wrote my first article on the name back in January of 2022. Although I love to try to repeat success when I can, I can’t in this instance, as the shares are overpriced in my view. The premia on offer for decent strike prices is non-existent, so I see no point in the enterprise. For that reason, I’ll simply wait on the sidelines for what I think is an inevitable price drop from current levels.

For further details see: