QNST - Still Avoiding QuinStreet Inc.

2023-04-03 14:21:08 ET

Summary

• The most recent financial results were lackluster at best in my view. Revenue is down slightly, gross profit and net income are down massively.
• In spite of this, the shares are between 11%-15% more expensive now than they were a few months ago.
• This investment is made against the backdrop of a 4.6% risk free rate. "TINA" is wrong in this instance, because there very much is a (safer) alternative.

Sometimes there’s a large opportunity cost that comes from taking my advice, and a great example of that is with shares of QuinStreet Inc. ( QNST ). Just after Christmas, I recommended people avoid the name, and the shares are up about 15.7% since, against a gain of about 7.3% for the S&P 500. Since the company has reported earnings since, I thought I’d review the name to see if it’s worth buying at current, higher prices. In addition, because there’s a negative relationship between price paid and subsequent return in my view, I’ll have a look at the valuation here. If the financial results are sufficiently good, for example, the shares may have a much lower valuation, in spite of the fact that they sport a higher price.

Welcome to the “thesis statement” portion of the article. I write one of these near the beginning of each of my articles because I understand that my writing can sometimes be “a bit much.” I write these for people who want to gain access to my thoughts about a given name, but are not comfortable with some of my more infantile turns of phrase. You’re welcome. I think the most recent financial results were a bit of a “trainwreck” as the young people say. While revenue was down only slightly from the same period a year ago, gross profit and net income have collapsed. While the financial results look bad when compared to 2021, they are downright appalling when compared to 2019. Given the very strong balance sheet, this wouldn’t be a problem if the shares were cheaply priced. Unfortunately the shares are between 11%-15% more expensive now than they were a few months ago. That is particularly troublesome in light of the fact that it’s possible to earn about 4.7% in Treasuries at the moment. In that context, why would someone take on the risks associated with this stock? Put another way, I may lose out on some future upside, but I think any upside from current levels will be quickly given back in the event of a market drawdown. What the market giveth, the market can taketh awayeth.

Financial Snapshot

I’d say that the recent financial performance here has been bad when compared to the same period last year. In spite of a mere 2.5% drop in revenue compared to the same period in 2021, operating loss exploded by 289% from a loss of $3.6 million to just over $14 million. Additionally, in spite of a slowdown in the business, product development, and sales and marketing expenses increased by 47.6%, and 9.2% respectively. When we compare the most recent financial performance with the same period pre-pandemic, things look even worse. Compared to the same period in 2019, the most recent period was a catastrophe in my view. While revenue may be higher by about 28% over 2019, gross profit and net income are lower by 28.6%, and 121.5% respectively. I feel a need to remind investors that our rewards come from whatever’s left over after employees, suppliers, and others have been paid. This reward comes in the form of increased book value or sustainable dividends. Rewards from short term price fluctuations are not in and of themselves sustainable in my view.

Not all is terrible, though, as evidenced by the fact that the balance sheet remains one of the strongest I’ve seen. For example, cash represents about 71% of total liabilities. Given that, I’d be willing to buy this stock, but only at a reasonable discount.

The Stock

One of the most important, and most painful, lessons I ever learned is that a company is different from the stock that supposedly represents it. The stock is, in fact, often a poor proxy for the underlying business. I've told and written this story a few times, but I think it's worth repeating because it highlights a mistake that less experienced investors often make. It was the late 1990s, I had bought an irresponsibly large amount of Nokia because I knew the company was going to report rapid growth. They did as I expected, and the stock dropped about 9% in early trading hours. The company delivered very good results, but the market expected very, very good results. Since the company didn't meet the market's expectations, the stock was punished. I learned more from this painful, expensive lesson than I did from every one of my accounting and finance classes in business school. It’s not about how the company does, it’s about the extent to which the company meets, exceeds, or falls short of expectations.

Just because a company delivers great financial results doesn't mean that the stock will go up. If there was that tight a relationship between the two, investing well would be much, much simpler. Ever since this incident, I've drawn a distinction between "stock" and "company", and have realized that a great company can be a terrible investment if you buy it for the wrong price.

The company may sell online marketing services and is affected by the dynamics of that business. The stock, on the other hand, is a piece of virtual traded paper that gets passed around, and rises and falls in price depending on the crowd’s ever changing views about the health of the business. Additionally, the stock may get taken along for the ride when the crowd becomes more or less enamoured of “stocks” as an asset class. Given the above, I want to only ever buy a stock when it’s cheap, because doing so insulates me as much as possible against the vagaries described above.

My regular readers know that I measure whether or not a stock is cheap in a few ways, ranging from the simple to the more complex. On the simple side, I look at the ratio of stock price to some measure of economic value, like sales, book value and the like. Ideally, I want to see a stock trading at a discount to both the overall market and its own history. When I last reviewed QuinStreet, I decided to eschew the shares because they were trading at a price to sales and price to book value of 1.345 and 2.651 respectively. Fast forward to the present, and the shares are between 11% and 15% more expensive per the following:

My regulars know that I think ratios can be instructive, but I want to confirm (or not) what they’re “saying” by trying to work out what the market is "thinking" about a given investment. If you read my stuff regularly, you know that the way I do this is by turning to 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 some pretty basic math 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 opaque, 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 we can infer what the market is currently "expecting" about the future.

Applying this approach to QuinStreet at the moment suggests the market is assuming that this company will grow earnings at a rate of ~13%. I consider that to be a very optimistic forecast, especially with what we’ve seen over the past while. Given the above, I can't recommend buying at current levels and would recommend continuing to avoid the name. I think there are safer investments out there that offer what I consider to be rather decent returns at the moment. In that context, I'd rather forego a few more dollars of an upside than buy at current levels and risk losing capital.

For further details see: