QNST - QuinStreet: Taking A Speculative Position (Rating Upgrade)

2023-08-11 22:12:03 ET

Summary

• QuinStreet Inc. shares have dropped 36% in price in the past four months, making them cheaply priced.
• The company's financial performance has been poor, with a significant drop in net income and rising costs.
• Despite the negative financials, the strong balance sheet and potential for improvement make it a speculative investment opportunity.

It’s been a little over four months since I announced to the world that I’m still avoiding QuinStreet Inc. ( QNST ) in an article with the mind bogglingly original title “Still Avoiding QuinStreet.” Since then, the shares have dropped about 36% in price against a gain of about 8.35% for the S&P 500. An investment priced at $10 is, by definition, less risky than the same investment priced at $15.64, so I thought I’d review the shares again to see if it makes sense to finally pull the trigger here. I’ll make that determination by looking at the most recent financial picture, and by comparing it to the valuation. After all, even the “hairiest” of businesses can be a decent investment if you can acquire it cheaply enough.

As you may know if you’ve read my stuff previously, I write a thesis statement near the beginning of my articles. I do this in order to save you time. You’re welcome. While I’m not impressed with the most recent financial performance, I will admit that the balance sheet remains strong, and offers the company time to improve results. I think this optionality is being excessively discounted by the market, given that the shares are trading very near multi year low valuations. Additionally, there are some potential bright spots here, for example, the company expects uptick in auto insurance spending into the second half of the year . Given the above, I’ll be taking a small, speculative position in the stock this morning. I’m of the view that things can’t get much worse, that the shares are quite cheap, and that the balance sheet gives the company much needed time to improve. To be clear, this is a rather small, speculative position on my part. I’m using capital that I can afford to tie up for years, and I can afford to lose it. While I wouldn’t put “serious” capital to work here, I’m comfortable taking a “flyer” on QuinStreet at current prices.

Financial Snapshot

I’m not in the mood to sugarcoat anything, so I’m just going to come out with it. The most recent financial result here was stupendously bad in my estimation. While revenue was down by about $1.475 million from the prior year, net income absolutely cratered, down about $63.6 million. Now, I’ll admit that much of this drop in net income comes from the fact that last year the company was a beneficiary of government largesse to the tune of $514k, while this year the provision for income tax ballooned to $47.5 million. That’s hardly the whole picture, though. In spite of a relatively small drop in revenue of about $1.475 million, loss before tax cratered by about $15.6 million from last year to this. This is because the cost of revenue was higher by about $3.7 million. Additionally, product development, sales and marketing, and general and administrative expenses climbed by 32%, 13.6%, and 9.4% respectively. These three added $10.89 million to costs in 2023. So, we have a company that costs rise in spite of a slowdown in revenue. This is not a great state of affairs in my view.

I’ve pointed out in the past that the balance sheet is quite strong here, and I think it remains so, though the trend is not great in my estimation. For instance, last year, cash represented 72% of total liabilities, while it represents “only” 68.6% of total liabilities at the moment. While I don’t think there’s reason to be alarmed at this point, I think the trend is noteworthy. That written, I’ve reviewed far worse balance sheets recently. I’m of the view that the company is not at risk of bankruptcy or similar anytime soon, but I’d need the shares to be very cheaply priced to get me excited by them.

The Stock

The reality is that the more you pay for $1 of future earnings, the lower will be subsequent returns. This is as much of an iron "law" as you’re going to find in investing. For that reason, I'm loathe to overpay for an asset. My skittishness sometimes costs me gains, but as in the case of QuinStreet, my insistence on not overpaying for hope can help me sidestep losses. In my view, losses of a certain size hurt much more than gains of the same size make me happy, so I’d rather miss out on a few gains than lose capital.

As my regulars know, I measure the cheapness of a stock in a few ways, ranging from the simple to the more complex. On the simple side, I look at the ratio of price to some measure of economic value, like earnings, free cash flow, and the like. I like to see a stock trading at a discount to both its own history and the overall market. I decided to continue to avoid these shares when they were trading at a price to sales ratio of 1.497 and a price to book of about 3.052 times. Additionally, the market seemed to be assuming a growth rate of just over 13%, which I considered to be wildly optimistic. Here’s the current state of the world:

The shares are between 24% and 41% cheaper, and on a price to sales basis they are now trading very near multi year lows. I’m not going to argue that history needs to repeat, but the last time they were this cheap on a price to sales basis, they went on to do well.

While I think ratios can be helpful, I also want to try to work out what the market is "thinking" about a given investment. The way I do this is by employing methods described in books like Professor Stephen Penman's "Accounting for Value" and Mauboussin and Rappaport's "Expectations Investing." Each of these uses the stock price itself as a rich source of information. Penman, in particular, shows investors how they can employ a bit of high school algebra to isolate the "g" (growth) formula in a standard finance formula to work out what the market expects from a given company. Applying this way of thinking to QuinStreet at the moment suggests the market is assuming that this company will grow earnings at a rate of about 4% from current levels. While this is still a bit rich, it’s come down massively from earlier forecasts.

Given the above, I’m going to “pull the trigger” here, as the kids say, and buy a few shares. I think the company has expressed some confidence about the coming year during its most recent earnings call, and the current valuation lines up with decent subsequent returns in my view. Even if I’m wrong in my bullishness, and it takes the company longer to execute, the very strong balance sheet gives them a great deal of time. I consider this to be a speculative investment at this point, and I wouldn’t risk capital that you can’t afford to lose, or tie up for significant periods of time. For the speculative side of your portfolio, though, I think you could do far worse than QuinStreet at the moment.

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