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Introduction
Are you tired of losing money as the market seemingly continues to decline? Worried that high interest rates will cause a recession? Never fear, there are two ways to win in the stock market and you can try just one.
The past decade of monetary expansion and income growth rewarded with ignored profitability has spawned a slew of public companies with billions of dollars in dubious market capitalization. Many of them have halved or more in the last year, but I think most will drop 90% from their highs, and many will go bankrupt (see the dot.com bubble burst circa 2001- 2002). Today I’m highlighting a company that reported earnings (or lack thereof) this week.
Company history
Based in San Francisco, GitLab (NASDAQ: GTLB) develops software that allows companies to manage their own software development. The company also offers training and related professional services. The company was founded in 2011 and has not been profitable since ($638 million in cumulative losses as of July 2022). Its venture capital backers picked the right time in October 2021 to go public, and the stock has fallen more than 40% since then.
Financial overview
For the first quarter of 2022, the company generated revenue of $101 million, up 74% year-on-year. Operating profit was a loss of $65.3 million (-65% operating margin) and net profit was a loss of $59 million or $0.40 per share.
The company currently has 148 million shares and a market capitalization of $8.5 billion. It has zero debt and $930 million in cash thanks to its well-timed IPO. It thus has an enterprise value of $7.6 billion, or 19 times its annualized turnover.
Analysts expect the company to continue to grow at a rapid pace, with its losses maintained. The growth is expected to slow to 40% next year, with the company generating nearly $600 million in revenue next year. Profits are nowhere in sight, and the only concession the company has made is to say it’s “committed to growing responsibly.”
Valuation and recommendation
My guess is that GitLab will eventually become profitable and generate an operating margin of 5% from its current and past negative level of 50-60%. An important point is that I am not ignorant of equity compensation. If you don’t think this is a real expense, you can stop reading now! Most management teams still have their heads in the sand thinking that they can reward their employees with as many shares as they want without adverse effects. This presents an opportunity for bearish investors, as employees will constantly sell their stocks.
A 5% margin on current revenue would mean an annualized profit of $20.2 million per year. I value the company at a multiple of 90x on that earnings. That would equate to a multiple of 30x assuming the company size triples, and I think that’s reasonable. A high quality company like Microsoft (MSFT) is trading at 26 times EPS this year. I don’t apply tax rates to profits to be on the safe side, because the company has substantial losses carried forward.
So I value the business at $1.8 billion and add cash for a total value of $2.8 billion. The split by 148 million shares gives a fair value of $19 for the stock, against its current price of $58, for a decline of 67%. I recommend shorting the stock. You can also choose to sell call options or buy put options instead. I think most of this decline will happen over time as employees continue to sell their shares and no new money will enter the market.
Short interest and cost of borrowing
It would be dangerous to short a stock that already has high short interest, with the possibility of a short squeeze driving the price much higher. Nor would it be profitable to pay a high cost of borrowing that potentially absorbs all the downside on the equity side. GTLB has low short interest at 4 o’clock%.
The cost of borrowing for GTLB shares is 1.5% per annum, although your broker may charge a different rate. Depending on your agreement with your broker, you may also get a short discount for the funds generated from the sale of the stocks you borrow (usually a discount of 50 to 100 basis points from the Fed Funds rate, currently at 2 ,25-2.5%). So when interest rates go up, you get more money back! You will be responsible for any dividends the company pays out, but it’s safe to say that no profit = no dividend! The company may attempt to buy back shares with its cash balance, but since it will buy them above intrinsic value, I don’t see any value creation. At some point, he may run out of cash and consider proceeding with a stock issue.
External ratings
The company does not have an SA quant rating, as it has been listed on the stock exchange for less than a year. Wall Street analysts are uniformly positive on the company, although their price targets have tracked the stock’s decline. They have a composite rating of 4.4, which equates to a buy. I don’t imagine they’ll buy all the stock the employees sell (the company’s stock compensation is 30% of its earnings).
The risks are high but manageable
Shorting stocks is inherently risky, since the potential losses are theoretically infinite. I would recommend having a short portfolio only in conjunction with long positions. You can reduce the risk somewhat by selling put options against short positions, at around 20% below the current price, generating income, but capping profits.
If investors fell in love with a company, there could be a short squeeze. However, with the money crunch, I would consider the chances of this happening on an extended basis not very high. The company would also likely issue shares in such a scenario. However, if it issues shares at an inflated value, it increases the intrinsic value of the company.
The company could be acquired at a premium by another company or a private equity fund. This is a risk that can be diversified by holding a large number of short positions, each of which is small.
The gap between the company’s intrinsic value and the stock price could widen over time.
Preventive disclosure
Writing a short thesis on an action on a public forum is an invitation to feedback from the holders of the action. I welcome respectful comments from eponymous readers. If you are a shareholder or employee of a mentioned company, you had better direct your energies towards the profitability of your company.
