As interest rates go up and the tide of easy money recedes, companies that grew at any cost are taking it on the chin. The era of profitless prosperity is coming to an end. In the last few months, I have highlighted a number of these, from WeWork (WE) to GitLab (GTLB).
Company managements faced with a halving of their stock price and a restive workforce watching their holdings lose value have a choice. They can focus on profitability by cutting costs, and showing the market that they really are providing some economic value to their customers. Or they can use the cash balance they stockpiled during the good times to do a bit of financial engineering and buy back their stock. Alas, the latter is just a temporary fix. At some point, the cash balance will be depleted, and the focus will once again be on profits. This is the path that Guidewire Software (NYSE:GWRE) has chosen, with the announcement of a $400 million share repurchase.
Usually when a company announces a buyback, it’s an opportunity to buy the stock as you know the company will be a buyer for a while. In this case, I believe a contrarian approach of selling or shorting the stock will pay dividends (although I’m pretty sure the company won’t).
Based in San Mateo, CA, Guidewire develops software products for property and casualty insurers. The company also provides related implementation and professional services. The company is trying to move towards a subscription model from license sales. It has been unprofitable for the last three years, with losses increasing every year. The stock is down more than 40% in the last year, compared to a 15% drop in the S&P 500.
For the latest quarter ending July 31, 2022, the company generated $245 million in revenue, up 7% YoY. Operating income was a loss of $32 million (-13% operating margin), and net income was a loss of $31 million or $0.37 per share. This quarter was also the end of its fiscal year, and the company showed revenue of $813 million, up 9% YoY. Operating income was a loss of $199 million (-24% operating margin) and net income was a loss of $180 million or $2.16 per share.
The company currently has 84 million shares and a market capitalization of $5.1 billion. It has $358 million of debt and $1.16 billion of cash for net cash of $0.8 billion. It thus has an enterprise value of $4.3 billion, amounting to 4.6x its annual revenue.
Analysts expect the company to continue growing at a 10% rate, with its losses maintained. The company’s guidance is for approximately $900 million in revenue for the coming year. The company has not offered a path to GAAP profitability.
Valuation and recommendation
Consistent with the conservative way I value loss-making companies, I assume that Guidewire will ultimately become profitable. I am modeling a 10% operating margin, moving up from -24% in its last fiscal year. One important point is that I do not ignore stock compensation. If you do not believe this is a real expense, then you may stop reading now! Most management teams still have their head in the sand with their thinking that they can compensate their employees with as much stock as they want with no adverse effects. This represents an opportunity for bearish investors, as employees will be constantly selling their shares.
A 10% margin on $900 million of annual revenue would mean annualized profit of $$90 million a year. I value the company at a 28x multiple on this profit. I believe this is reasonable. A high quality company like Microsoft (MSFT) with a similar growth rate trades at 24x this year’s EPS. I am not applying a tax rate to the earnings to be conservative as the company has an accumulated deficit of $284 million that can shield a few years’ profits.
I thus value the company at $2.5 billion and add back the net cash for a total equity value of $3.3 billion. Dividing by 84 million shares gives a fair value of $39 for the stock, against its current $61 price, for 35% downside. I recommend selling or shorting the stock. You may also choose to sell calls or buy puts instead. I believe most of this downside will be realized over time, as employees keep selling their shares and no new money enters the market.
Short interest and cost of borrow
It would be dangerous to short a stock that already has a high short interest, with the possibility of a short squeeze driving the price much higher. It would also be uneconomical to pay a high borrow cost that potentially eats up all the downside on the stock side. GTLB has a low short interest at 5% of outstanding shares.
GWRE stock is easy to borrow with a minimal borrow cost. Depending on your agreement with your broker, you may get a short rebate for the funds generated from selling the stock you borrow (usually a discount of 50-100 bps from the Fed Funds rate, currently at 3-3.25%). So you could make 2% a year on any short proceeds.
Seeking Alpha’s artificial intelligence warns that GWRE is at high risk of performing badly based on its quant ratings. It has a composite rating of 1.64, equating to a sell. Not surprisingly, Wall Street analysts are more positive, with a combined rating of 3.6, in between a hold and buy. Their price targets have been following the stock lower.
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 may somewhat decrease risk by selling puts against short positions, at about 20% lower than the current price, generating some income, but capping profits.
If investors became enamored of a company, there could be a short squeeze. However, with money getting tighter, I would regard the chances of this happening on an extended basis to not be very high. The company would also likely issue equity in such a scenario. However, if it issues equity at an inflated value, that does increase the company’s intrinsic value.
The company could be acquired at a premium by another company or private equity fund. This is a risk that can be diversified by holding a large number of short positions, with each one being small. At a $5 billion market cap, an acquisition here is certainly feasible.
The gap between the company’s intrinsic value and share price could widen over time.
The company could drive up its share price by buying back its stock. However, I believe this will be just temporary as it will be buying its shares above their intrinsic value.
Writing a short thesis on a stock on a public forum is an invitation for blowback from employees and holders of the stock. I welcome respectful comments from eponymous readers. If you are a holder or employee, you would be better off directing your energies towards having your company become profitable.