Disclaimer: I and my funds own common shares in NFLX and HLMN.
TL;DR – Stocks with high current FCF yields benefit from price declines in a way which can materially impact IRRs that is not present for high-growth , no-FCF stocks with similar IRR potential. I consider the current FCF of investments a “bird in hard” versus more speculative longer-dated cash flows, and that’s why I strongly prefer high FCF investments.
To explore this, I want to compare two stocks I think are “B+” type ideas with similar IRRs at present: NFLX and HLMN. Full disclosure, the fund made small long investments in each last week, and I know a great deal more about NFLX than HLMN as I have followed NFLX for over a decade and HLMN only recently came public. I chose HLMN as an example of a high current FCF stock, rather than some of the fund’s larger holdings, to avoid turning this into a stock pitch. I want to talk about the strategy of why I think HLMN is an easier stock to own, rather than a detailed analysis of each business.
Before we begin, I want to talk about how I approach valuing a high-growth, no-FCF investment like NFLX. In my opinion, it is perfectly logical to assume certain growth companies could, either presently or in a reasonable time frame, generate significantly higher operating margins and FCF than their current results if it were not for growth investments. To compare to these stocks to those with more normal operations, I prefer to estimate a reasonable long-term margin and calculate run-rate EPS/FCF. As I am speaking theoretically, I will use EPS and FCF interchangeably. However, the key detail here is that unless the current P/E multiple is so cheap that multiple expansion is probable, the no-FCF stock’s sales growth will roughly equal its IRR potential. I’m assuming a simple model with no financial leverage or share count change. The point I’m trying to show is that for other than truly exceptional high growth companies – say greater than 25% sales growth – the IRR is not materially different than buying stocks that are cheap on current FCF with modestly above GDP sales growth. Further, I’m going to argue that as a significant part of the IRR is driven by a return of capital despite a less competitive, more mature businesses, I believe high current FCF yield stocks are better risk/reward adjusted investments.
So let’s talk NFLX, a popular example of a high-growth, no-FCF stock. To run my theoretical model, I am going to assume NFLX can reach a 35% operating margin. Legacy cable networks, HBO, Starz, etc. typically had 30-40% operating margins with similar business models. There are reasons it could ultimately be higher, such as the ability to lever content costs across more users, as well as reasons it could be lower, such as material EM exposure at lower ARPUs and the lack of advertising revenue, but I think 35% is a fine estimate and it’s not too far from what the Street models NFLX achieving in a few years. This assumption yields roughly $20 in 2022 EPS assuming a 25% tax rate. After a recent 50% drop, NFLX is trading 18-20x earnings, which is roughly in-line with the S&P 500 and a heck of a lot cheaper than the 35x it was trading a few months ago. While NFLX is hitting some growth hiccups, not shocking given the 2020 COVID surge and the sheer size NFLX has already reached – 220MM at quarter end versus 600-800MM people in the world who make over $20k/year, I do not believe its business is in any real trouble and I think it will continue to grow over the next few years. I estimate NFLX will see topline growth of ~15% in the next few years – maybe a bit more, maybe a bit less. However, NFLX has no real near-term FCF, so the rapid decline has no benefit to long-term shareholders and may in fact dilute long-term returns given significant employee stock compensation. Despite the painful decline, NFLX’s revenue growth rate will equal its IRR unless NFLX’s multiple expands, something I am loathe to assume for a stock at market multiples without a clear catalyst. Bulls might argue 20x is too low for a business “this good,” but it’s only in a few recent years that >30x multiples have become acceptable. A 15% IRR is above the Street’s 2022 and 2023 S&P 500 EPS growth rate of ~9%, but we are giving NFLX some credit for things it has not yet achieved and the name has been exceptionally volatile at points, both of which warrant caution. Still, I consider a 15% IRR a pretty good yet not amazing result, hence my feeling that it’s a “B+” type idea.
Now let’s look at HLMN, a stock I picked because I think it’s a solid example of a typical “value stock”: good but not explosive growth, historical stability, and cheap to the market on near-term EPS and FCF with capital return plans. HLMN was written up on VIC in August 2021, and the post does a good job summarizing the story. The company has grown sales at a 6% CAGR over the last twenty years, 10% including M&A, and is currently trading at ~7.5% FCF yield on 2022 numbers. Assuming the organic growth continues and HLMN returns its cash to shareholders, I calculate a 13.5% IRR, a tad below our NFLX IRR. However, let’s explore two different thoughts: what happens if HLMN experiences a 50% drop as NFLX just did and the risk benefit of capital returns.
If HLMN drops 50%, all else equal, our IRR potential jumps to 21%, with 75% of our IRR generated from capital returns. This significant change in IRR is a big reason I favor stocks with significant near-term FCF. On any given day, stock prices can do whatever they want, and sometimes they fall from the sky. All FAANG stocks have experienced a 50% decline since 2010. At least with high FCF stocks I can benefit from that volatility at the investment level via buybacks. Of course, I can benefit from that volatility from purchasing additional shares as well. For NFLX to reach a 21% IRR, we need to assume a multiple expansion to say 26x over five years, which is not wild assumption but not a shoo-in either. But what if we were to assume HLMN could see multiple expansion as well? A 15% FCF yield is a 65% discount to the S&P 500, and we are modeling HLMN to retire or dividend 75% of its market cap in five years. Assuming we reweight backward towards 13.5x at the end of five years, our IRR becomes 39%. For NFLX to match that IRR, we need to assume a 52x exit multiple.
Personally, I have a lot easier time underwriting multiple expansion on a stock where capital returns are front-end weighted than one with years of assumptions in front of it, which is my point about the risk benefit assessment I make to favor high current FCF stocks over high-growth, no-FCF stocks with similar IRR potential. In both cases, we still need to be right about our assumptions. If some competitive threat comes along in year three and blows the business’s fundamentals up, we are going to lose money. However, in the HLMN example, assuming the company does the lowest risk thing and dividends cash, we would have lowered our risk by 15-30% by then. Further, it’s unlikely that a competitive threat would drop FCF to zero overnight, and we could still benefit from capital returns and/or a better exit multiple when we decide to throw in the towel. When the market senses a high-growth, no-FCF stock might never make a profit or is heading for a liquidity issue, the bottom is often down significantly given the elevated multiples these names trade. Finally, I’d add that I think estimating threats a few years out is inherently more challenging in an end market growing 30% or better, such as cloud, than in one growing at closer to GDP rates. The allure of that rapid growth and the potential for massive winners simply attracts far more competition than one finds in the more mature industries.
Putting it all together, I just think it’s an easier risk-adjusted investment strategy to largely limit my ideas to those currently generating significant FCF. Maybe the market will go back to favoring the high-growth, no-FCF stocks – I have no idea and the current selloff could just be a pause in an ever-increasing growth multiple world – but I am still going to keep my investment focus on cash flow. Time will tell.