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Are FANG Stocks Expensive? A Moat-Analysis Comparing With Sing Tao News Corporation – Alphabet Inc. (NASDAQ:GOOGL)


Jim Cramer has talked regularly about 4 technology stocks: the so-called FANG-stocks. There are Facebook (FB), Amazon (AMZN), Netflix (NFLX), and Alphabet (GOOGL) (NASDAQ:GOOG). Some people dispute Jim Cramer’s stock picking capabilities. I do not think he is consistently wrong. In fact, he was right on these 4 stocks.

These companies are fabulous names but with investing what first matters is price. Fact is that the stocks went up with 40-50% since a year ago. Could this price increase make these 4 stocks expensive?

There are two reference points: price relative to assets and price relative to future cash flows. The FANG companies have very high Price/Book multiples. So maybe their value can be better explained by looking at future cash flows. Unfortunately these companies do not pay out much. None of them pay dividends and they do not repurchase significant amounts of their stock either. So instead we have to take earnings as a proxy for future cash flows.

EV/EBIT multiples

There are two problems with valuations based on earnings. The first is that different companies have different capital structures. Some of them have not so much equity but loans instead. That means part of the profits go to lenders instead of to stockholders. The solution is correcting the market cap for the cash and the dept. Instead of the multiple Price/Earnings it is better comparing with a multiple based on the enterprise value: market cap -cash +debt. Investing in companies with low multiples Enterprise Value/Earnings Before Interest and Tax, or EV/EBIT, is indeed well known to be better than investing in low P/E companies. If we compare the FANG companies based on EV/EBIT we see large differences, however:

Company

Share Price

EV/EBIT

Facebook

148

28.9

Amazon

965

109

Netflix

151

115

Alphabet (Google)

952

22.9

Amazon and Netflix have a much higher EV/EBIT multiple than Facebook and Google. The reason could be that investors expect higher earnings growth from these 2 companies. Recent developments could also be the reason for their higher multiples. If we annualize last quarter’s EBIT Amazon’s EV/EBIT is still about 100. Until 6 quarters ago Amazon has been running break-even, for years. It seems Amazon’s earnings has passed the break-even point after which small amounts of additional revenue could add much to earnings. Netflix’ earnings did go up during the last couple of quarters. But if we annualize Netflix’s EBIT from last quarter the multiple is still 65. The reason for the higher multiple might be that Netflix has more room for international expansion. It’s subscription based business model should also be less vulnerable to economic downtrends.

A moat analysis based on Gross Profit/(Total Assets – excess cash)

The second problem is that earnings can fluctuate a lot. The solution is usually to look at earnings over multiple years and then at trends. Stable or increasing earnings is better than decreasing earnings. See the diagrams below.

Facebook and Alphabet look very good. Both have increasing earnings per share. Facebook’s earnings show the fastest increase but Alphabet’s increase looks more stable. Amazon has also increasing earnings per share but not so much as Facebook and not in a stable way either. Netflix does not have increasing earnings per share and no earnings stability either.

Correcting earnings for replacement capex

Sometimes companies achieve higher earnings but use relatively much capital to achieve the earnings increase. Or, sometimes earnings stay stable but the company has to upgrade its Property, Plant and Equipment to achieve this. In most companies, part of the capex does not contribute to higher earnings but is just needed to keep up with competition. So the earnings overestimate the value of companies because of investments for staying at the same level as the competition. The good companies grow earnings without deploying much extra capital and without needing to spend much on such replacement capex.

Therefore a good measure for a wide-moat company is a high and constant or growing ratio Gross Profit/(Total Assets – excess cash). That ratio includes the “mandatory” capex needed just to keep competitive. I have done the calculations for the FANG stocks, see the diagram below.

The FANG stocks indeed have high ratio’s Gross Profit/(Total Assets -excess cash). To convince yourself also have a look at my previous article with a similar analysis for car manufacturers. In that article there is more background on the ratio as well. With the FANG companies, except for Netflix, the ratios are above 0.6. This level is among the highest in the stock universe. For car manufacturers the ratio is typically below 0.1. Netflix’s ratio shows a large decline but the last 5 years the ratio has been relatively stable at about 0.2. This is above average but nothing special. Compare these numbers also with the recent 0.23 for The Coca-Cola Company with EV/EBIT in the 20-ties. So, again this indicates Netflix might be overvalued.

For Alphabet and Facebook the high ratios are what we expect. It will be very difficult to come up with a competing search engine. The start-up and maintenance cost of a good search engine are just so enormous that it will take too long for a competitor to become profitable. And once a competitor is able to compete with Google’s search engine profits will be depressed because of less economies of scale. Setting up another social network might be easier than setting up a new search engine. However it is difficult to imagine Facebook will have a hard time given its scale. I think with Facebook the value from network effects is larger than with Google.

Despite the higher earnings growth of Facebook I still like Alphabet more. First because of its lower EV/EBIT multiple. Second, because I think there is still lots of room for expansion because the internet is still expanding. Third, it is longer in business and has shown increasing profits for more years. Fourth, more people use it than Facebook.

Surprisingly Amazon is also showing a good Gross Profit/(Total Assets – excess cash). That shows a moat. But you would expect it is pretty easy to switch from book supplier. Apparently not, even I buy books with Amazon. Amazon has build a great platform and it is reusing that experience for other offerings like web services. It is doing that in a profitable way. For me Amazon is a nut too difficult crack and I think its EV/EBIT multiple is too high.

With Total Assets/Book Value at around 4 Amazon and Netflix are also much more leveraged than Google and Facebook. The latter 2 companies are hardly leveraged which reduces risks for stockholders.

Why I do not invest in any of the FANG stocks

With investing there are many ways to earn money. There is momentum, GARP, special situations, events, etc. I like the statistical approach. Research shows stocks with the lowest valuations in terms of Price/book, EV/EBIT and so on have the best returns. So that is what I do. What’s beautiful is that there are deep value stocks that are also wide moat stocks. The safety of stable and/or increasing earnings is still possible with stocks with low EV/EBIT and low P/B. Usually such stocks are not available on the US stock market, but it is prudent to diversify geographically anyway.

Local newspaper stocks are well known for their moats. The internet makes these stocks less attractive than before but they still have stable earnings. If such a stock is cheap enough you are very likely to earn money with it. For example Sing Tao News Corp (HKG:1105). See the table below from my marketplace research on Seeking Alpha:

Ticker,

Piotroski

Share price

Market cap,

EV in millions

EV/EBIT

P/B

(tangible)

Yield

(%)

HKG:1105

4

0.96 HKD

831 HKD

71.4 HKD

2.2

0.4

6.2

Date

cash flows

EBIT, ttm

from mrq

Cash flow

from ops

Free cash

flow

P/FCF

NCAV /

Market cap

2016-12-30

36.3 HKD

103 HKD

-39.4

1.05

Sing Tao News Corporation publishes newspapers, magazines and recruitment media in Hong Kong. Most revenue and profit comes from the free newspaper Headline Daily and the paid quality newspaper Sing Tao Daily. About 25% of the revenue comes from customers outside Hong Kong and the PRC, mainly from the US. The company owns assets with book value of 232 million HKD in the US. See also the annual report for 2016.

Sing Tao News Corp is a wide moat stock with average Gross Profit/(Total Assets -excess cash) equal to 0.41 and a relatively low standard deviation of about 0.03. The ratio has increased but the increase does not look very stable. See the diagram below.

Last year EBIT was only 36.3 million HKD compared to 59.9 million HKD in 2015. Even in 2015 the EBIT was relatively low. The reason for the low profit in 2015 and 2016 was lower revenue because of lower advertising spending in the second half of 2015 and the first half of 2016. See the diagram below for how this translates to earnings per share.

Revenue might restore quickly since in the second half of 2016 EBIT already restored to 32.7 million HKD. Furthermore on March 2017 the company raised the cover price of Sing Tao Daily from 7 to 8 HKD. Without doubt that will help the profit increase again. The company increased the price of this newspaper after price increases from competing newspapers.

The balance sheet is very strong. The stock trades for about the current assets (1.29 billion HKD) net of all liabilities (413 million HKD). The quality of the current assets is very high with almost everything in cash (669 million HKD) and trade receivables (430 million HKD). Among the other assets there are for 42 million HKD of real estate held for investment purposes, for 58 million HKD of “other deposits”, for 15 million HKD of listed securities available for sale and for 77 million HKD of unlisted debt available for sale. In total this is 199 million HKD.

The company is expanding its printing business by building an 8-story building with 33,000 square meters for 311.8 million HKD. For this works the company recently signed another construction contract for 53 million HKD. From 2018, the new building will save rent on the existing premises (lease expires in 2018).

Large shareholders: the executive chairman, Charles Ho Tsu Kwok owns 49.3% of the shares and a former executive director owns 9.47%, see also here. Apart from the executive chairman there is a separate CEO who isn’t a major shareholder.

There is option overhang of 38.8 million options with strike price 1.16 HKD, maybe worth about 15 million HKD (very rough estimate from annual report over 2015). Furthermore there are 45.15 million options with strike price 1.01 HKD. The options at 1.01 HKD have been granted very recently. There are also 5% preferred shares authorized but these have never been issued. So in reality the EV/EBIT is higher than the 2.2 shown in the screener but is still less than 3. Also the yield from the screener seems to be wrong. Because of a special dividend of 0.02 HKD the yield should be over 8%.

The company tries to develop internet business: websites generating advertising revenue, see also here. The company does this partly via related party transactions. Related party transactions can generate money: see page 184 of the annual report over 2016.

Summary

Despite last 12 month’s share price increase GARP investors might still be well off with investing in Alphabet. This company has clearly a wide moat and a reasonable EV/EBIT multiple. The EV/EBIT multiple is lower than that of the other 4 FANG stocks. Aggressive investors might want to combine this position with a short position in Netflix. This pretty leveraged company does not have a big moat and a very high EV/EBIT multiple. If stock markets go down I expect Netflix to go down much more than Alphabet, so short Netflix and long Alphabet should be a good pair trade.

Deep value investors should skip the FANG stocks. I do not recommend them because the chances are slim they are still undervalued much. Instead they should invest in small positions in stocks like Sing Tao News Corp. This stock is much cheaper in terms of EV/EBIT and P/B and also has significant moat. Moreover for Sing Tao News Corp earnings are likely to mean revert and therefore I expect the stock price to go up.

More information on such deep value stocks is available as part of my marketplace research here.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long Sing Tao News Corporation



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