2023-03-24 14:05:16 ET
Summary
- Over the past decade, revenue here has gone up by nearly 10 fold. That is impressive. The problem is that loss growth has been nearly as impressive.
- The shares of this "the more they sell the more they lose" stock remains expensive in my view. That's a bad combination.
- For those who insist on staying long here, I recommend call options in lieu of shares. These have done relatively very well in the past.
It's been just shy of four months since I suggested that people continue to avoid Q2 Holdings Inc. (QTWO) in an article with the very creative title "Continue to Avoid Q2 Holdings Inc.", and in that time the shares have dropped about 16.3% against a loss of 3.2% for the S&P 500. I'd love to spend the rest of this article bragging about that result, but it's been brought to my attention that some of you may find it a bit tiresome to read a screed of pure self congratulation. Because you readers are so self indulgent and think only of your own needs, I'll spend my words trying to work out whether or not it makes sense to buy at current prices. After all, an investment at $22.77 is, definitionally, a less risky investment than the same stock when it's trading at $27.20. I'll make that determination by looking at the latest financial results, and by looking at the valuation. Additionally, in my previous missive on the name, I reported how my "calls in lieu of shares" offered a slight positive return for less capital, while the shares themselves cratered in price. Thankfully I didn't recommend repeating that strategy this past November, but it is a strategy I want to explore again.
It's nearly the weekend, and for that reason time is running short. Because time is at such a premium at the moment, and because people may be nervous about all of the bragging and other odiousness within, I'll offer you the "gist" of my thinking in this, my ubiquitous "thesis statement" paragraph. This is just one more way that I try to make the reading experiences of my readers that much better. You're welcome. I would recommend continuing to avoid these shares. The company continues to build losses as sales rise, which prompts the inevitable question: if growing sales won't lead to profits, what, exactly will? Additionally, while the shares are certainly "cheaper", they're hardly "cheap." I can't get past the combination of perennial losses and expensive stock. For those who want to buy here, I would recommend calls in lieu of shares. These have worked out much better than the stock itself in the past, and I think will do so again. Thus ends my thesis statement. If you read on from here, that's on you. I don't want to read any complaints in the comments section about excessive bragging, or the fact that I spell words like "rumours" correctly.
Financial Snapshot
I think the level of sales growth here has been magnificent over the years. In fact, in 2022, the company generated just under 10x the revenue it did in 2013. For those keeping track, the company has grown sales at a CAGR of about 25.8% over the past decade, which is remarkable. Unfortunately for me, that's where the good news ends. Various expenses have grown hand in hand with the revenue, which has led to ever larger losses in the teeth of these rising sales. So, while revenue has grown at a CAGR of 25.8%, net losses have grown at a CAGR of 20%. This prompts the obvious question: if growing sales don't lead to profits, what does? I think a judicious use of numbers helps highlight the issue, so I'll do that here. I've run a correlation between the revenue and income from operations for your enjoyment and edification, and found that over the past 10 years, there is a very strong negative relationship (r=-.94) between revenue and income from operations. At this point I'm of the view that the company would be better off if it simply stopped selling.
It's not all bad news at Q2, though. The capital structure remains quite strong in my view. For instance, cash on the balance sheet represents about 21.5% of total liabilities. Thus, I don't worry about a credit or a solvency crisis here anytime soon.
Also, one group that has done well over the years as shareholders have generally lost money are the employees. At the end of 2022 the company employed 2,249 people, and stock based compensation for the year was $65.2 million. Using some of the basic arithmetic skills not so lovingly beaten into me by the nuns at Holy Spirit School decades ago, I calculate that the per employee stock based compensation expense is $28,971. I was worried because this figure hit a high water mark in 2020 at $28,944, but then dropped to $27,565 in 2021. Thankfully, happy times are here again, because that pernicious trend has been reversed, and happy times are very much here again. Some of you investors who've lost money in these shares can at least take some small consolation in the fact that employees are being well looked after.
Q2 Holdings (Q2 investor relations)
The Stock
My regulars know that I consider the business and the stock to be distinctly different things. This is because the business generates revenue by selling cloud based digital solutions to regional banks in the United States, which are obviously doing a rip roaring business themselves at the moment. The stock, on the other hand, is a speculative instrument that gets traded around based on long-term expectations about the business, the size of the "TAM" etc.. Given that the financial statement valuation of the business is "backward-looking" and the stock is a forecast about the distant future, there would be an inevitable tension even without the impact of the capricious crowd.
Additionally, this stock, like all stocks, can be affected by changes in the overall market. The crowd may change its views about the desirability of "stocks" as an asset class, and that will impact individual stocks to some degree. I really, really hate to sound like I'm bragging, but I think it fair to say that some portion of the 16% drop in stock price since I recommended people avoid the name may be a function of the fact that the S&P 500 itself lost about 3% since then. Of course it's impossible to prove this counterfactual, but I'm of the view that some portion of the loss can be "blamed" on the reduced attractiveness of equities as a group.
So, to sum up, the business generates revenue and seemingly perennial losses, while the stock bounces up and down based on the crowd's ever-changing views about the future. 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. I like to buy stocks when the crowd is particularly down in the dumps about a given stock, because those expectations are easier to beat.
Another way of writing "down in the dumps about a given stock" is "cheap." I like to buy cheap stocks because they tend to have more upside potential than downside. 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 relationship of price to some measure of economic value, like sales, earnings, and the like. I like to see a stock trading at a discount to both its own history and the overall market. When I last reviewed Q2, the price to CFO per share was 47.5 times, and the price to sales was 2.678 times. Fast forward to the present, and the shares are between 14% and 25% cheaper, per the following:
In my view, though, "cheaper" is still not the same thing as "cheap." I think 35 times cash from operations is still very expensive indeed.
As my regulars also might remember, 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 Q2,, 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 Q2 at the moment suggests the market is assuming that this company will now grow profits at a rate of about 9% from here. Given that the company has been "in the red" for the past decade, I consider this to be a wildly optimistic forecast, and I must therefore recommend continuing to avoid the shares. Additionally, I couldn't live with myself if I didn't take a moment of our time to swipe at the analyst community. Consensus EPS estimates for this business are currently $0.58 this year, and $0.96 next year. I would ask the analysts, what is going to change here to make this thing profitable?
Options
I am old enough to not be a child of the internet age, and so therefore I can accept that someone holds a different view from my own, and is still human. Just because I don't think there's value here, doesn't mean I'm right, and other people may have very smart reasons for wanting to take a long position on this stock. I'm of the view that no matter what you're buying, you should take the least risk possible to do so. In my previous missive on this name, I bragged (I know, more bragging!) about the fact that the "calls in lieu of shares" strategy I recommended turned a small profit, while the shares themselves cratered in price. With that as a backdrop, I would recommend investors who insist on staying long here represent that perspective with call options. These offer much of the upside that the stock would in case it suddenly reverses course, at far less risk.
In particular, if I were long here, I'd manifest that view with the November call with a strike of $25. These are currently priced at $2.60-$5.00, and I would put in a bid to buy at $3.80. Even if an investor hits the ask, though, they'll do well if the shares explode higher on the back of buyout rumours or some such. If the shares continue to languish, obviously the call owner will do badly, but it's quite possible that they'll do less badly than the stockholder. Additionally, since they wouldn't be fully committed, they would have more capital to employ in other investments. Thus, I'm of the view that if you insist on staying long here, you manifest that perspective with calls in lieu of shares.
For further details see:
Though Cheaper, Q2 Holdings Not Yet Cheap Enough