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Our regular readers know that most dividend stocks are bad investments. They are not the safe-havens that investors think. We recently hosted live training sessions on two dangerous types of dividend stocks:

• Fake Dividend Stocks
• False Dividend Stocks.

Last week, we published “Red Alert: Beware False Dividend Stocks” to keep clients away from stocks where dividend cuts could ruin their income portfolio.

In this report, we’re here to warn about a third, less obvious yet dangerous dividend stock:

Dividend-Trap StocksDividend-trap Stocks look good on the outside. They pay a dividend, and the underlying business is solid enough to afford the dividend. The problem is not the cash flows. It’s the nosebleed valuation of the stocks.

No matter how healthy the dividend is, if the stock is priced to perfection, it’s likely to go down and wipe out any gains you hope to get from the dividend payout. Dividend-trap stocks do not offer very high dividend yields (close to the 5-year zero coupon bond) because the stock price is so rich. So, the upside potential from the dividend payout is small compared to the downside risk from the overvalued stock.

In other words, Dividend-trap Stocks are good companies, but bad stocks, and they don’t pay a yield large enough to make them worth the risk.

You don’t want your “income stock” to crater due to a bad earnings report because the stock is priced for perfection, when you could collect the same yield in a far less risky security.

The only way to avoid Dividend-trap Stocks is to do proper due diligence to accurately assess companies’ cash flows and stocks’ valuations. As we’ve proven many times, investors must do their homework to get the truth about any business.

Below, we break down just how prevalent Dividend-trap Stocks are in the current market.

Pinpointing the Dividend-Trap RiskTo find Dividend-trap Stocks, we first screen our entire coverage universe for stocks that pay a dividend.

Of the ~3,300 stocks under coverage, 1,416 stocks, or 43%, pay a dividend. Only 44 stocks, or 1% of the universe qualify as Good Dividend Stocks and earn a spot in one of our dividend model portfolios: Safest Dividend Yield Stocks and Dividend Growth Stocks.

Figure 1: Dividend Paying Stocks in Coverage Universe – As of June 10, 2025

Sources: New Constructs, LLC and company filings

After we’ve identified the dividend stock paying universe, we then parse out the Dividend-trap stocks. Specifically, Dividend-trap Stocks have:

• A Neutral stock rating,
• An Unattractive or Very Unattractive rating for market-implied growth appreciation period(GAP), which indicates all good news is priced into stock, and
• A dividend yield equal to or below 4.0% (current risk-free-rate).

Per Figure 2, there are 181 Dividend-trap Stocks as of June 10, 2025.

Figure 2: Dividend Stocks with Low Yields – As of June 10, 2025

Sources: New Constructs, LLC and company filings

The Dividend-Trap StocksBelow, we reveal three of the 181 Dividend-trap Stocks. These stocks earn a Neutral rating and are so expensive that we see far more downside risk than upside potential. From an income perspective, the yield is very low, below the risk-free rate. From the capital appreciation perspective, downside risk dwarfs upside potential.

Figure 3: Three Dividend-Trap Stocks: As of June 10, 2025

Sources: New Constructs, LLC and company filings

WD-40 Company (WDFC: $244/share): 1.5% Dividend YieldWD-40 earns its spot on the Dividend-trap Stocks list due to its strong earnings but overvalued stock.

In the trailing twelve months (TTM), WD-40 generated $82 million in net operating profit after-tax (NOPAT) and earns a top-quintile return on invested capital (ROIC) of 21%. Economic earnings, which account for changes to the balance sheet and represent the true profits of the business, are $55 million over the TTM. Additionally, the company generated $60 million in free cash flow (FCF) over the TTM. By all measures, WD-40 meets the criteria of a “good business.”

However, it also meets the criteria of “bad stock”. At its current price of $244/share a WDFC’s price-to-economic book value (PEBV) ratio is 3.1. This ratio implies the company will grow profits over 3 times TTM levels. Furthermore, in the default scenario of our reverse discounted cash flow (DCF) model, WDFC has a market-implied Growth Appreciation Period (GAP) of greater than 100 years.

The company’s current economic book value, or no growth value, is just $80/share, a 67% downside to the current price. In other words, $244/share embeds a rather large amount of future growth in profits. The 1.5% dividend yield does not compensate for the risk of the stock trading sideways or even falling closer to its economic book value. As a result, WDFC finds itself on the Dividend-traps Stocks list.

See Figure 4 for our detailed Stock Rating on WDFC.

Figure 4: WD-40’s Stock Rating Details: Good Company, Bad Stock

Sources: New Constructs, LLC and company filings

Automatic Data Processing (ADP: $312/share): 2.0% Dividend YieldAutomatic Data Processing is also a Dividend-trap Stock due to its positive economic earnings and strong ROIC, but overvalued stock price.

In the TTM, Automatic Data Processing generated $4.1 billion in NOPAT and earns a top-quintile ROIC of 41%. Economic earnings are $3.3 billion over the TTM, and the company generated $1.8 billion in FCF over the same time. Automatic Data Processing certainly looks like a “good company” by all fundamental metrics.

The reason for its landing a spot on the Dividend-trap Stocks list is the high future cash flow expectations baked into its stock price. At its current price of $312/share ADP’s PEBV ratio is 2.5. This ratio implies the company will more than double its profits from TTM levels. In the default scenario of our reverse DCF model, ADP has a market-implied GAP of greater than 100 years. In other words, Automatic Data Processing, must achieve the default revenue growth and margins in our DCF for >100 years to justify its current price.

The company’s current economic book value is just $127/share, a 59% downside to the current price. As with WDFC, the expectations for future profit growth in ADP at $312/share are so high that we think all the good news and then some is baked into the current stock price. Downside risk in this stock dwarfs upside potential.

See Figure 5 for our detailed Stock Rating on ADP.

Figure 5: Automatic Data Processing’s Stock Rating Details: Good Company, Bad Stock

Sources: New Constructs, LLC and company filings

SBA Communications Corporation (SBAC: $225/share): 2.0% Dividend YieldThe third stock for today’s report, SBA Communications Corporation, is like the prior two.

In the TTM period, SBA Communications Corporation generated $1.5 billion in NOPAT and earns a second-quintile ROIC of 12%. Economic earnings are $669 million over the TTM, and the company generated $1.3 billion in FCF over the same time. SBA Communications Corporation, just as with WDFC and ADP, could certainly be called a “good company.”

Its valuation is not nearly as “good” though. At its current price of $225/share SBAC’s PEBV ratio is 3.1. This ratio implies the company will more than triple its profits from TTM levels. In the default scenario of our reverse DCF model, SBAC also has a market-implied GAP of greater than 100 years.

The company’s current economic book value is just $73/share, a 68% downside to the current price. The expectations for future profit growth baked into SBAC at $225/share leave no room for cash flow expectations to improve from current levels. As a result, there is little to no upside in the stock, and the 2.0% dividend yield is not enough to offset the downside risk in owning SBAC at this price.

See Figure 6 for our detailed Stock Rating on SBAC.

Figure 6: SBA Communication’s Stock Rating Details: Good Company, Bad Stock

Sources: New Constructs, LLC and company filings

More Dividend Training SessionsAfter years of digging into Wall Street’s accounting tricks, we know firsthand that many so-called “dividend plays” are traps for Main Street investors.

To help investors of any kind avoid these pitfalls, we recently hosted a training showing you exactly how to spot a False Dividend Stock. Watch the replay here.

As a follow-up, we hosted another training discussing the exact topic of this report: Dividend-trap Stocks. You can watch the replay here.

No matter how good the dividend, investing in a bad stock can cost you much more than the dividend pays.

Want to know where to get good dividend stocks? We hosted a separate live training on June 17at 1pm ET. In this training, we not only cover the dangers of dividends, but also show you which dividend stocks are worth owning. Watch the replay here.

This article was originally published on June 16, 2025.

Disclosure: David Trainer, Kyle Guske II, and Hakan Salt receive no compensation to write about any specific stock, style, or theme.

Questions on this report or others? Join our online community and connect with us directly.

Click here to download a PDF of this report.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Red Alert: The Dangers of Dividend-Trap Stocks.

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Dividend stocks are not the safe-haven that investors think. Anyone thinking that dividend stocks are a good strategy to succeed in these turbulent markets needs to think twice and read on.

We recently hosted a live training session warning investors about the dangers of fake dividend stocks. Fake Dividend Stocks might pay a nice dividend, but the risk of significant decline in stock price more than offsets any potential gains investors might expect from the dividend. In other words, if a stock pays a 5% dividend but drops 20%, then investors lose a lot of money on that stock despite the 5% dividend.

In this report, we’re here to warn you of another type of bad dividend stock:

False Dividend StocksFalse Dividend Stocks pay a dividend, but the company doesn’t generate enough cash flow to afford the dividend. Therefore, the high risk of seeing the dividend cut along with the likely drop in the stock price due to the dividend cut more than offsets the potential gains investors might expect from a False Dividend Stock.

Successful dividend investing is not about finding companies that pay dividends. It’s about finding companies that can afford to keep paying and, hopefully, grow their dividend. A dividend is only good if the company generates the cash flows to afford it.

You don’t want your “income stock” to stop paying dividends because the company can’t afford it. Investors need to know if past dividends have been funded by taking on more debt or spending down cash balances.

The only way to avoid False Dividend Stocks is with diligent fundamental research on cash flows. As we’ve proven many times, investors must do their homework to get the truth about cash flow.

Below, we break down just how prevalent False Dividend Stocks are in the current market.

Pinpointing the False Dividend RiskTo find False Dividend Stocks, we first screen our entire coverage universe for stocks that pay a dividend. Of course, if a stock does not pay a dividend, it cannot be a False Dividend Stock.

Of the ~3,300 stocks under coverage, 1,416 stocks, or 43%, pay a dividend. Only 44 stocks, or 1% of the universe qualify as Good Dividend Stocks because they earn a spot in one of our dividend model portfolios: Safest Dividend Yield Stocks and Dividend Growth Stocks.

Figure 1: Dividend Paying Stocks in Coverage Universe – As of June 4, 2025

Sources: New Constructs, LLC and company filings

After we’ve identified the dividend stock paying universe, we then parse out the False Dividend Stocks, i.e. companies with negative free cash flow (FCF) in the trailing-twelve-month (TTM) period.

Per Figure 2, there are 344 dividend-paying stocks with negative FCF in the TTM period as of June 4, 2025.

Figure 2: Dividend Stocks with Negative TTM FCF – As of June 4, 2025

Sources: New Constructs, LLC and company filings

The False Dividend StocksBelow, we reveal three of the 344 riskiest False Dividend Stocks. These stocks earn our worst rating, Very Unattractive. Not only are the dividends false, but the stocks are also very expensive and overvalued.

Worse yet, there’s higher risk that these three companies will have to cut their dividend because their dividend payments exceed cash flows not just in the TTM but over the past five years. In other words, these companies have been burning cash to pay dividends for an extended period.

These companies are digging themselves quite a hole here. See the last column in Figure 3, the Dividend Deficit as a % of TTM Revenue. This shows how much dividend payments have exceed cash flows over the past five years as a percent of revenue. This metric shows how high the risk that these companies will have to cut their dividend is because they do not have the revenues, much less the income, to fund dividends.

Figure 3: Three Very Unattractive Rated False Dividend Stocks

Sources: New Constructs, LLC and company filings

CTO Realty Growth (CTO: $18/share): 8.3% Dividend YieldCTO Realty Growth earns its spot on the False Dividend Stocks list with -$189 million in FCF over the TTM period. CTO Realty Growth’s Dividend Deficit (FCF minus Dividends) as a % of TTM Revenue is -438% as dividends paid ($160 million) exceeded FCF (-$419 million) by $579 million over the last 5 years. From 2020-1Q25, CTO Realty Growth’s cumulative Dividend Deficit is -$661 million. See Figure 4.

*Figure 4: CTO Realty Growth’s Dividend Deficit: FCF Minus Dividends: 2020-1Q25*

Sources: New Constructs, LLC and company filings

The shareholder dilution required to fund this huge dividend deficit should make management blush.

Specifically, CTO Realty Growth’s total debt increased 116% from $273 million in 2020 to $603 million in the TTM ended 1Q25. The company’s shares outstanding increased 86% from 17.7 million to 32.9 million over the same time.

Making matters worse, CTO Realty Growth earns a low return on invested capital (ROIC) of just 1% and has a 2 yr avg free cash flow (FCF) yield of -10%. CTO’s price-to-economic book value (PEBV) ratio is -1.4 due to its negative economic book value, or no growth value, of -$13/share. Furthermore, in the default scenario of our reverse discounted cash flow (DCF) model, CTO has a market-implied Growth Appreciation Period (GAP) of greater than 100 years. Poor fundamentals and an expensive stock price earn CTO a Very Unattractive Stock Rating.

The AES Corp (AES: $10/share): 6.9% Dividend YieldThe AES Corp is also a False Dividend Stock due to its negative $719 million in FCF over the TTM. AES Corp’s Dividend Deficit as a % of TTM Revenue is -88% as dividends paid ($2.1 billion) exceeded FCF (-$8.5 billion) by $10.6 billion over the last 5 years. From 2020-1Q25, AES Corp’s cumulative Dividend Deficit is -$11.5 billion. See Figure 5.

*Figure 5: AES Corp’s Dividend Deficit: FCF Minus Dividends: 2020-1Q25*

Sources: New Constructs, LLC and company filings

Similar to CTO Realty Growth, the shareholder dilution required to fund this huge dividend deficit is scary. The AES Corp’s total debt increased 57% from $20.3 billion in 2020 to $31.9 billion in the TTM ended 1Q25. The company’s shares outstanding increased 7% from 665.4 million to 711.9 million over the same time.

The AES Corp also generates a ROIC of 2% and a 2-yr Avg FCF yield of -4%. The AES Corp’s PEBV ratio is -0.7 with an economic book value of -$14/share. Furthermore, in the default scenario of our reverse DCF model, AES has a market-implied GAP greater than 100 years. Poor fundamentals and an expensive stock price earn AES a Very Unattractive Stock Rating.

Edison International (EIX: $56/share): 5.9% Dividend YieldEdison International burned $1.1 billion in FCF over the TTM, and the cash burn is even worse over the past five years. Edison International’s Dividend Deficit as a % of TTM Revenue is -60% as dividends paid ($5.6 billion) exceeded FCF (-$4.7 billion) by $10.4 billion over the last 5 years. From 2020-1Q25, Edison International’s cumulative Dividend Deficit is -$12.1 billion. See Figure 6.

*Figure 6: Edison International’s Dividend Deficit: FCF Minus Dividends: 2020-1Q25*

Sources: New Constructs, LLC and company filings

As with the two stocks above, investors should note the shareholder dilution required to fund this huge dividend deficit. Total debt increased 35% from $37.3 billion in 2020 to $50.4 billion in the TTM ended 1Q25. The company’s shares outstanding increased 2% from 378.9 million to 384.8 million over the same time.

Edison International’s earns a bottom quintile ROIC of just 3% while its 2 yr avg FCF Yield sits at -4%. Edison International’s PEBV ratio is 3.5, with an economic book value of just $15/share. In the default scenario of our reverse DCF model, EIX has a market-implied GAP of 5 years, which indicates the stock may not be as overvalued as the two above. However, the company’s poor fundamentals and high PEBV ratio still earn EIX a Very Unattractive Stock Rating.

Upcoming Dividend Training SessionsAfter years of digging into Wall Street’s accounting tricks, we know firsthand that many so-called “dividend plays” are traps for Main Street investors.

To help investors of any kind avoid these pitfalls, we recently hosted a training showing you exactly how to spot a False Dividend Stock. Watch the replay here.

As a follow-up, we hosted another training discussing the exact topic of this report: Dividend-trap Stocks. You can watch the replay here.

No matter how good the dividend, investing in a bad stock can cost you much more than the dividend pays.

Want to know where to get good dividend stocks? We hosted a separate live training on June 17at 1pm ET. In this training, we not only cover the dangers of dividends, but also show you which dividend stocks are worth owning. Watch the replay here.

This article was originally published on June 9, 2025.

Disclosure: David Trainer, Kyle Guske II, and Hakan Salt receive no compensation to write about any specific stock, style, or theme.

Questions on this report or others? Join our online community and connect with us directly.

Click here to download a PDF of this report.

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Senior Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Red Alert: Beware False Dividend Stocks.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Fake Dividend Stocks.

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With the recent downgrade of the U.S. credit rating adding to market uncertainty, safeguarding your investment portfolio is crucial.

Leveraging high-quality fundamental data makes this task far more manageable. Through our rigorous research, we gain insight into the true earnings and cash flows of companies – enabling us to identify overvalued firms with weak business fundamentals, a.k.a. our Danger Zone picks.

This week’s Danger Zone pick highlights a company with a large cash burn, unprofitable business model, misleading earnings metrics, and a valuation that requires far too optimistic growth rates. For instance, the stock’s current price implies the business will simultaneously achieve huge profit margin improvement and grow revenue at twice the industry rate.

Below is a free excerpt from our latest Danger Zone report, published today to Pro and Institutional members. You can buy the full report a la carte here.

We’re not sharing the name of the company because that’s for our paying clients. However, we think you’ll greatly enjoy the research because it provides insights into how hard we work to give you the best ideas and warnings. Feel free to share with friends and family, and we hope your portfolio stays safe from stocks like this one.

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This stock could fall further based on:* declining take rates, * consistent cash burn, * falling economic earnings, * persistent unprofitability in a profitable industry, and * a stock valuation that implies the company will become one of the largest in the industry.

Deteriorating Take RatesThis company generates revenue when consumers make transactions on its payment cards. The percentage of revenue the company generates from each transaction is known as its take rate. If the company’s take rate is steady, or ideally rising, growing TPV would result in higher revenues.

However, despite growing its TPV, this company’s take rate has been declining YoY since 2019 (even before the company’s IPO). The company’s take rate fell from 0.66% in 2019 to 0.17% over the TTM ended 1Q25. See Figure 2. In 1Q25, the company’s take rate was 0.16%, which is down from 0.18% in 1Q24.

Figure 2: Take Rate: 2019 – TTM ended 1Q25

Sources: New Constructs, LLC

Profits Are Less Than They Would Have You BelieveThis company’s management provides a misleading view of the company’s profitability when it directs investors to its “Adjusted” EBITDA. From 2019 to the TTM, the company’s Adjusted EBITDA improved from -$34 million to $40 million. Similarly, the company’s GAAP net income rose from -$122 million in 2019 to $55 million in the TTM.

However, over the same time, the company’s economic earnings, the true cash flows of the business, fell from -$75 million to -$278 million. It is a big red flag when the company’s preferred non-GAAP and GAAP metrics are rising while its economic earnings are declining.

The discrepancy between metrics should come as no surprise as the company openly admits in earnings releases that its adjusted EBITDA calculation excludes “share-based compensation expense, executive chairman long-term performance award, restructuring costs, due diligence and transaction costs related to potential or successful acquisitions” and more. We further detail the issues with Adjusted EBITDA here.

Figure 3: Adjusted EBITDA vs. Net Income vs. Economic Earnings: 2019 – TTM

Sources: New Constructs, LLC and company filings.

…there’s much more in the full report. You can buy the report a la carte here.

Or, become a Professional or Institutional member – they get all Danger Zone reports.

I’ll keep sending information on low quality sectors, industries, or specific companies until you’re ready to start your membership, but know that we expect this Danger Zone pick to underperform.

Interested in starting your membership to get access all our Danger Zone picks? Get more details here.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Investors Shouldn’t Pay This Price.

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Markets soared on the news of a preliminary de-escalation in the tariff war between the U.S. and China, with the main indices jumping between 2-3%.

This development had investors screaming buy buy buy, which could indicate a renewed willingness to allocate capital to equities. However, caution remains warranted. The markets could turn on a dime, as they have many times this year. A number of fundamentally weak and overvalued companies continue to trade at unjustifiable valuations, posing serious risks to unsuspecting investors.

This week’s Danger Zone pick highlights a company with a large cash burn and a valuation predicated on highly unrealistic expectations. For instance, the stock’s current price implies the business will simultaneously achieve unprecedented profit growth and a sevenfold increase in market share. This stock represents a material risk to any portfolio.

We originally put Freshpet Inc. (FRPT: $80/share) in the Danger Zone on February 2, 2022 and most recently reiterated our bearish opinion on the stock in October 17, 2022. Since our original report, FRPT has outperformed as a short by 37%, falling 10% while the S&P 500 is up 26%.

Despite falling 44% YTD, we’re here to remind you: this stock remains dangerous.

Freshpet’s stock could fall further based on:* persistently high operating costs, * large cash burn, * lagging market share, * more profitable competitors, and * a stock valuation that implies Freshpet will grow its market share 7x while also growing profits to levels never seen before.

Figure 1: Freshpet Outperformance as a Short From 2/3/22 Through 5/9/25

Sources: New Constructs, LLC

What’s WorkingFreshpet has successfully grown its retail presence and increased its total store count (stores that sell Freshpet products) by 380 from the end of 4Q24 to the end of 1Q25. Similarly, the company’s revenue increased 18% YoY in 1Q25, mainly driven by volume gains of 15% and favorable price/mix of 3%.

Additionally, Freshpet’s adjusted EBITDA increased from $31 million in 1Q24 to $36 million in 1Q25, though we show below why this metric is misleading.

What’s Not WorkingRetail improvements and top-line growth aside, Freshpet’s fundamentals remain in very poor shape. The company missed earnings estimates in its 1Q25 report and lowered full-year adjusted EBITDA guidance to the range of $190-$210 million, compared to prior guidance of “at least $210 million”.

Adjusted EBITDA Misleads InvestorsFreshpet’s management provides a misleading view of the company’s profitability when it directs investors to its “Adjusted” EBITDA. From 2019 to the TTM, Freshpet’s Adjusted EBITDA improved from $29 million to $167 million, while its GAAP net income rose from -$1 million to $16 million.

Over the same time, the company’s economic earnings, the true cash flows of the business, fell from -$11 million to -$88 million. It is a big red flag when the company’s preferred non-GAAP metric is rising while its economic earnings are declining, or even worse, when its GAAP net income gets outpaced as well.

The discrepancy between the metrics comes largely from the company removing $8.8 million in non-cash share-based compensation when calculating 1Q25 adjusted EBITDA. For reference, Freshpet’s 1Q25 GAAP net income was -$13 million. The discrepancy should come as no surprise as Freshpet openly admits in earnings releases that “the non-GAAP measures are not and should not be considered an alternative to the most comparable U.S. GAAP measures”. We further detail the issues with Adjusted EBITDA here.

Figure 2: Freshpet’s Adjusted EBITDA vs. Net Income vs. Economic Earnings: 2019 – TTM

Sources: New Constructs, LLC and company filings.

Operating Costs Remain ElevatedFreshpet’s total operating expenses, which include cost of goods sold and selling, general, and administrative expenses have remained high for years. For instance, over the last five years, total operating expenses averaged 106% of revenue.

More recently, Freshpet’s total operating expenses rose from 96% of revenue in 1Q24 to 104% of revenue in 1Q25. The increase was driven by SG&A expenses rising from 36% of revenue to 44% of revenue over the same time.

Consistently Burning CashConsidering the company’s high operating costs, it should come as no surprise that Freshpet has been and continues to burn cash.

Freshpet’s free cash flow (FCF) has been negative on an annual basis every year in our model (dating back to 2017). On a quarterly basis, Freshpet’s FCF has been negative in 34 of the 36 quarters in our model. The only two quarters with positive FCF occurred in 4Q16 and 2Q18.

From 2019 through 1Q25, Freshpet has burned through a cumulative $1.2 billion (29% of enterprise value) in FCF excluding acquisitions. See Figure 3.

Figure 3: Freshpet’s Cumulative Free Cash Flow Since 2019

Sources: New Constructs, LLC and company filings.

Despite its cash burn rate, we did not make Freshpet a Zombie Stock because its cash on hand can support its TTM cash burn rate for 34 months (more than the 24 months cut off) from the end of May 2025.

Note that Freshpet was a Zombie Stock before Jana Partners, in 4Q22, took a 10% stake in Freshpet and boosted the company’s cash on hand enough to extend its cash burn runway past 24 months. Jana Partners exited its position in Fresphet in 2Q24. Consequently, FRPT is at risk of going back on the Zombie Stock list should its cash burn runway fall below 24 months.

Small Market Share in an Industry Dominated by GiantsFreshpet faces direct competition from both larger companies like Nestle (NSRGY), Mars Inc., General Mills (GIS), Colgate-Palmolive (CL), and Chewy (CHWY), as well as smaller, lesser-known start-ups. Additionally, the company faces heavy competition from private label pet food brands.

In the most recently available comparable public data (Mars is privately owned and doesn’t disclose pet business sales every year), the pet food market was dominated by Nestle and Mars. In 2023, Nestle (32%) and Mars (29%) combined to make up 61% of the global pet food market. Hill’s Pet Nutrition (owned by Colgate-Palmolive) General Mills (GIS), The J.M. Smucker Company (SJM), rounded out the top five. Freshpet held just over 1% market share. See Figure 4.

Figure 4: Freshpet’s Market Share Compared to Peers

Sources: Research And Markets

Importantly, these companies have significant competitive advantages in the form of larger manufacturing scale, a more extensive distribution network, and other business lines that generate cash to re-invest in the business.

If we analyze estimated market share based on Freshpet’s 2024 sales and the estimated pet food market size in 2024, we find that the company holds just 1% of the estimated market.

Competitors also include general retailers, such as Walmart (WMT), Costco (COST), and Amazon (AMZN), each of which sell their own private label pet brands.

Profitability Is Even WorseFreshpet not only lags the competition in market share, but also in profitability.

Even though Freshpet achieved a record net operating profit after-tax (NOPAT) of $50 million in 2024, profits have fallen to -$10 million in 1Q25, down from $9 million in 1Q24. Similarly, the company’s return on invested capital (ROIC) hit a peak of 4% in 2024, but has fallen to 2% in the TTM ending 1Q25.

Per Figure 5, Freshpet has the lowest ROIC and one of the lowest NOPAT margins in the industry.

Figure 5: Freshpet’s Profitability Vs. Peers: TTM

Sources: New Constructs, LLC and company filings.

Taking market share in an industry already dominated by larger and more profitable companies will be hard to do, especially considering that Freshpet’s revenue is entirely undiversified or 100% dependent on its pet food sales.

Valuation Implies Freshpet Will Grow Its Market Share 7xBelow, we use our reverse discounted cash flow (DCF) model to analyze the future cash flow expectations baked into Freshpet’s stock price. Freshpet’s stock is priced as if it will grow profits at accelerated rates while also taking huge chunks of market share. We also present additional DCF scenarios to highlight the downside risk in the stock if Freshpet fails to achieve these overly optimistic expectations.

To justify its current price of $80/share, our model shows Freshpet would have to:

• improve its NOPAT margin to 5.2% (equal to the company’s all-time high margin, compared to 3% margin over the TTM) and
• grow revenue by 28% compounded annually (above consensus estimates of 17% in 2025, 19% in 2026, and 18% in 2027) for the next decade.

In this scenario, Freshpet would generate $11.7 billion in sales in 2034, which is 12x its TTM sales, 3x Colgate-Palmolive’s TTM pet food sales, and 5x General Mill’s pet food sales.

This scenario also implies Freshpet’s NOPAT would reach $608 million in 2034, compared to the company’s all-time high NOPAT of $50 million and TTM NOPAT of $30 million. Contact us for the math behind this reverse DCF scenario.

The implied sales in this scenario equate to 7% of the forecasted global pet food market in 2034, which is far above the company’s estimated 1% market share in 2024.

Furthermore, companies that grow revenue by 20%+ compounded annually for such a long period are “unbelievably rare”, making the expectations in Freshpet’s share price even more unrealistic.

40%+ Downside Even If Market Share Grows 4xIf we, instead, assume Freshpet:

• immediately improves NOPAT margin to 5.2%,
• grows revenue at consensus rates in 2025 (17%), 2026 (19%), and 2027 (18%), and
• grows 24% compounded annually through 2028 – 2034, then

the stock would be worth $49/share today – a 40% downside to the current price. Contact us for the math behind this reverse DCF scenario.

In this scenario, Freshpet would grow sales to $7.2 billion in 2034, which would be around 8x the company’s TTM sales, 2x Colgate-Palmolive’s TTM pet food sales, and 3x General Mill’s pet food sales.

The implied sales in this second scenario would represent 4% of the pet foods market in 2034, which is 4x the company’s market share in 2024.

65%+ Downside If Revenue Grows at Consensus Growth RatesIf we instead assume Freshpet:

• immediately improves NOPAT margin to 4.0% (still above TTM NOPAT margin of 3.0%),
• grows revenue at consensus estimates in 2025 (17%), 2026 (19%), and 2027 (18%), and
• grows revenue at 18% (equal to 2027 consensus estimate) each year thereafter through 2034, then

the stock would be worth just $26/share today – a 68% downside to the current price. Contact us for the math behind this reverse DCF scenario.

The implied sales in this scenario would still represent 3% of the projected global pet foods market in 2034.

Figure 6 compares Freshpet’s implied future revenue in these scenarios to its historical revenue. For comparison, we include the TTM pet food sales of peers Colgate-Palmolive (CL) and General Mills (GIS).

Figure 6: Freshpet’s Historical and Implied Revenue: DCF Valuation Scenarios

Sources: New Constructs, LLC and company filings.

Stock Is Not Worth $1Each of the above scenarios assumes Freshpet grows revenue, NOPAT and FCF without increasing working capital or fixed assets. This assumption is highly unlikely but allows us to create best-case scenarios that highlight the unrealistically high expectations embedded in the current valuation. For reference, Freshpet’s invested capital grew 43% compounded annually from 2019 through the TTM. If we assume Freshpet’s invested capital increases at a similar rate in the DCF scenarios above, the downside risk is even larger.

Given that the performance required to justify its current price is overly optimistic, we dig deeper to see if Freshpet is worth buying at any price. The answer is likely no.

The company has $477 million in total debt, $42 million in outstanding employee stock options, and just $226 million excess cash. Freshpet has an economic book value, or no-growth value, of <$1/share. In other words, we do not think equity investors will ever see anywhere close to the level of economic earnings required to justify anything more than $1/share under normal operations.

This article was originally published on May 12, 2025.

Disclosure: David Trainer, Kyle Guske II, and Hakan Salt receive no compensation to write about any specific stock, sector, style, or theme.

Questions on this report or others? Join our online community and connect with us directly.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Might Need a Waste Bag for This Stock.

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After a weekend marked by Warren Buffett officially announcing his departure from Berkshire Hathaway, investors are reminded of the importance of disciplined, fundamentals-based investing. Now, perhaps more than ever, investors need to be diligent in an increasingly speculative market.

This week’s Danger Zone pick is one stock that, after doing due diligence, is not worth owning. The company is burning cash at zombie stock-like levels, yet its valuation implies massive profit growth and a near quadrupling of the business’ market share. That disconnect is dangerous to any portfolio.

We originally put Rivian (RIVN: $14/share) in the Danger Zone on October 22, 2021 prior to its IPO. We’ve reiterated our bearish opinion on the stock multiple times since then. See all our reports on RIVN here.

Since its IPO, this Danger Zone pick outperformed as a short by 109%, falling 86% versus the S&P 500 up 22%.

Despite the outperformance as a short, this stock remains dangerous. The company’s growth is slowing, yet its stock was up over 50% last year and up 4% year-to-date.

We’re here to remind you, as the market attempts to rally in recent days, that some very unprofitable businesses remain highly overvalued. Rivian’s stock price remains far too expensive at current levels.

Rivian’s stock could fall further based on:* slowing production and deliveries, * dwindling market share, * large cash burn, * more profitable competitors, and * a stock valuation that implies Rivian will quadruple its market share.

Figure 1: Rivian Outperformance as a Short From 11/10/21 Through 5/2/25

Sources: New Constructs, LLC

What’s WorkingRivian’s vehicle deliveries grew 3% year-over-year, from 50,122 in 2023 to 51,579 in 2024. The increase in deliveries helped Rivian grow its revenue 12% YoY in 2024.

Rivian produced 14,611 and delivered 8,640 vehicles in 1Q25, which topped the company’s previous guidance for ~14,000 vehicles produced, and 8,000 vehicles delivered. For the full year 2025, the company guided for a delivery range of 46,000 to 51,000.

What’s Not WorkingWhen we dig below the surface, we find that the company’s fundamentals remain poor and the stock continues to be overvalued, as we’ll show below.

Stagnant Sales and Declining Market ShareBulls have tried to justify Rivian’s large losses by arguing that the company is in its high-growth, ramp up phase.

However, the company’s deliveries (EV’s sold) grew just 3% YoY in 2024, compared to 147% YoY growth in 2023. Going forward, Rivian’s new guidance of 46,000 to 51,000 deliveries for 2025 would, at the high-end, represent a YoY decline in vehicles delivered in 2025. The growth in this “growth-story” simply isn’t there.

On a quarterly basis, Rivian’s U.S. deliveries fell from 13,588 in 1Q24 to 8,553 in 1Q25, a 37% YoY decrease.

Rivian’s production also dropped in 2024. Despite initial production guidance for 57,000 vehicles in 2024 (which would have been flat YoY), the company managed to produce only 49,476 vehicles, which was down 13% YoY.

Rivian is not keeping pace and is losing market share in the U.S. After growing its U.S. market share from 0.4% in 1Q22 to its peak 5.0% in 3Q23 (and in 1Q24), Rivian’s market share has fallen to 2.9% in 1Q25. See Figure 2.

Figure 2: Rivian’s U.S. Market Share: 1Q22 – 1Q25

Sources: Kelley Blue Book EV Sales Reports

Volkswagen Provided a Zombie LifelineWe originally named Rivian a Zombie Stock in August 2022 as the company could sustain its cash burn rate for just 10 months at the time without additional capital or a significant slowdown in cash burn.

However, we removed the stock from our Zombie Stock List in July 2024, after Volkswagen announced an investment of $5 billion, which later turned into nearly $6 billion and a joint venture between the two companies. The large investment, and backing of Volkswagen, diminished the likelihood of a bankruptcy for Rivian.

Fast forward to early 2025, and Rivian still has all the markings of a Zombie Stock even after the recent investment, as we’ll show below.

Zombie-Like Cash BurnSince 2020, Rivian has burned $32.5 billion (159% of enterprise value) in free cash flow (FCF) excluding acquisitions. See Figure 3. Rivian burned $8.1 billion in FCF in the last two years alone.

Not surprisingly, the company’s economic earnings, the true cash flows of the business that take into account changes to the balance sheet, fell from -$692 million in 2019 to -$6.3 billion in 2024.

Despite having $7.7 billion of cash on hand as of December 31, 2024, Rivian can only sustain its 2024 cash burn rate for 22 months from the end of April 2025. Additionally, Rivian’s interest coverage ratio is currently -13.6.

Rivian meets all the criteria of a Zombie Stock, but we aren’t putting it back on the list is because we think Volkswagen is likely to provide additional investment and would not let Rivian go bankrupt.

If Rivian’s business doesn’t improve, and Volkswagen slows its investment in the company, we’ll be ready to add it back to the Zombie Stock list.

Figure 3: Rivian’s Cumulative FCF: 2020 – 2024

Sources: New Constructs, LLC and company filings.

Breakeven Still a Distant DreamNot only does Rivian continue to burn billions in cash, but its operations also remain far from breakeven.

The company’s total operating costs, which include cost of revenue, R&D, and SG&A were 229% of revenue in 2023 and 194% in 2024. We would expect Rivian’s operating costs to remain high as the company continues to build out production capacity and aim to take market share.

With total operating costs nearly twice as high as its revenue, it’s no surprise Rivian is racking up losses.

The company’s net operating profit after-tax (NOPAT) declined from -$399 million in 2019 to -$4.6 billion in 2024. See Figure 4.

Figure 4: Rivian’s NOPAT Since 2019

Sources: New Constructs, LLC and company filings.

Profitability Significantly Lags CompetitionOf the 55 Automobiles & Auto Parts companies under our coverage, only four have a lower return on invested capital (ROIC) than Rivian. Fellow EV manufacturer and Danger Zone pick Nio Inc. (NIO) is one of them.

The legacy car makers have proven their ability to enter and take EV market share. For instance, Ford (F) and Chevrolet (owned by General Motors) hold 7.7% and 6.5% share of the US. EV market in 1Q25. These auto manufacturers generate billions in profits through their legacy and hybrid offerings that they can then pour into EVs to take market share while remaining profitable. The path for Rivian to achieve lasting profitability while also taking market share looks increasingly challenging.

Per Figure 5, Rivian’s NOPAT margin, invested capital turns, and ROIC all rank near industry lows. The gap between the industry leaders and laggards is particularly stark. We don’t think it is a coincidence that the laggards are relatively new EV-focused vehicle manufacturers.

Figure 5: Rivian’s Profitability Vs. Competitors: TTM

Sources: New Constructs, LLC and company filings.

Credit Rating Looks Poor as WellAfter analyzing Rivian’s latest 10-K, it earns a Very Unattractive Credit rating in three of the five metrics that drive our Overall Credit Rating, As a result. Rivian earns an Unattractive Credit Rating. See Figure 6.

With negative EBITDA to Debt, FCF to Debt, and Interest Coverage, it could be more difficult for Rivian to raise additional capital without significantly diluting existing investors, especially given the current uncertain market conditions.

Figure 6: Rivian’s Credit Rating Details

Sources: New Constructs, LLC and company filings.

Valuation Implies Rivian Will Grow Its U.S. Market Share Nearly 4xBelow, we use our reverse discounted cash flow (DCF) model to analyze the future cash flow expectations baked into Rivian’s stock price. Rivian’s stock is priced as if it will significantly improve profitability while nearly quadrupling its market share in the U.S. EV market. We also present an additional DCF scenario to highlight the downside risk in the stock if Rivian fails to achieve these overly optimistic expectations.

To justify its current price of $14/share, our model shows that Rivian would have to:

• immediately achieve a 4% NOPAT margin (equal to Tesla’s, Stellantis’, and Nissan’s TTM NOPAT margin, compared to Rivian’s NOPAT margin of -93% in 2024) and
• grow revenue 37% compounded annually through 2035.

In this scenario, Rivian would generate $124.4 billion in revenue in 2035, which is 148%, 134%, 92% of Nissan’s (NSANY), Tesla’s (TSLA), and Honda Motor’s (HMC) TTM revenue, respectively. It would also equal 25x Rivian’s 2024 revenue.

This scenario also implies that Rivian would generate $5.0 billion in NOPAT in 2035, which would equal 130% of Tesla’s 2024 NOPAT and 153% of Nissan’s TTM NOPAT, compared to the company’s -$4.6 billion NOPAT in 2024. Contact us for the math behind this reverse DCF scenario.

If we assume automotive revenue remains 90% of total revenue, as in 2024, then Rivian would generate $112.3 billion in automotive revenue in 2035 in this scenario. This revenue figure implies Rivian will sell the following number of vehicles based on these ASPs:

• 1.3 million vehicles – Rivian’s 2024 ASP of $87k
• 2.0 million vehicles – ASP of $56k (equal to average new-EV price in Dec 2024)
• 2.3 million vehicles – ASP of $50k (equal to average new-vehicle price in Dec 2024)

Next, we can analyze the implied U.S. market share for the sales volumes above based on the total estimated number of new EV sales in 2035, according to data compiled by Edison Electric Institute (EEI).

The vehicle sales noted above would represent the following implied U.S. market share in 2035:

• 11% for 1.3 million vehicles
• 17% for 2.0 million vehicles
• 19% for 2.3 million vehicles.

The likelihood of achieving any of these market share scenarios is unlikely in such a competitive industry. For reference, at an ASP of $56k, Rivian would have to sell 2.0 million vehicles in 2035, or more than the 1.8 million vehicles Tesla sold in 2024.

For reference, the two best-selling vehicles, not just EVs, in the U.S. in 2024 were the Toyota RAV4 with ~475,000 sales and the Ford F-150 with ~470,000 sales. In other words, to justify its valuation, Rivian must maintain an ASP well above average new-vehicle prices, while, in 2035, selling more vehicles than the two top selling models combined in 2024, while also fending off competition from all other automakers.

Figure 7: Rivian’s Implied Vehicle Sales in 2035 to Justify $14/Share

Sources: New Constructs, LLC and company filings.

70%+ Downside If Revenue Grows at 2x the Projected Industry Growth RateIf we instead assume Rivian:

• immediately improves NOPAT margin to 4% and
• grows revenue by 26% (2x the projected industry growth) compounded annually through 2035, then

our model shows the stock would be worth just $4/share today – 71% downside to the current price. In this scenario, Rivian’s NOPAT would still grow to $2.2 billion, which is 57% of Tesla’s 2024 NOPAT and 67% of Nissan’s TTM NOPAT. Contact us for the math behind this reverse DCF scenario.

At its current ASP, assuming automotive revenue remains 90% of revenue, this scenario implies Rivian will sell over 568,000 vehicles in 2035. In other words, Rivian would sell 20% more vehicles in 2035 than the Toyota RAV4, the most sold vehicle in the U.S. in 2024.

Figure 8 compares Rivian’s implied future NOPAT in these scenarios to its historical NOPAT. For additional comparison, we include the 2024 NOPAT of Tesla (TSLA) and Nissan (NSANY).

Figure 8: Rivian’s Historical and Implied NOPAT: DCF Valuation Scenarios

Sources: New Constructs, LLC and company filings.

Stock Is Not Worth $1Each of the above scenarios assumes Rivian grows revenue, NOPAT and FCF without increasing working capital or fixed assets. This assumption is highly unlikely but allows us to create best-case scenarios that highlight the unrealistically high expectations embedded in the current valuation. For reference, Rivian’s invested capital grew 42% compounded annually from 2019 through 2024. If we assume Rivian’s invested capital increases at a similar rate in the DCF scenarios above, the downside risk is even larger.

Given that the performance required to justify its current price is overly optimistic, we dig deeper to see if Rivian is worth buying at any price. The answer is no.

The company has $5.0 billion in total debt, $447 million in outstanding employee stock options, and no excess cash. Rivian has an economic book value, or no-growth value, of -$39/share. In other words, we do not think equity investors will ever see $1 of economic earnings under normal operations, which means the stock would be worth $0 today.

This article was originally published on May 5, 2025.

Disclosure: David Trainer, Kyle Guske II, and Hakan Salt receive no compensation to write about any specific stock, sector, style, or theme.

Questions on this report or others? Join our online community and connect with us directly.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Growth Story Screeches to a Halt.

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The market had a surprisingly good week last week. Indices and most stocks trended higher, but there’s no guarantee they will continue to go up.

As more reports emerge of a pending supply chain crisis, investors need to be increasingly cautious of stocks that can hurt their portfolios. Our superior fundamental research can be your guide in these times of high volatility and help you avoid the stocks that can blow up a portfolio.

This week’s Danger Zone pick is especially dangerous. The company is burning cash at zombie stock levels, yet its valuation implies massive profit growth.

As a personal protective equipment (PPE) manufacturer, this company saw a massive boost in both its top- and-line during COVID. Since then, the company’s fundamentals have deteriorated dramatically. While multiple acquisitions have artificially boosted revenue, they only accelerate the destruction of shareholder value. Add in lagging market share and an Unattractive Credit Rating to boot, and Lakeland Industries (LAKE: $16/share) is this week’s Danger Zone.

Lakeland Industries’ stock provides bad Risk/Reward based on:* declining profits amidst rising revenue, * value destroying acquisitions, * more profitable competitors, * large cash burn, and * a stock valuation that implies the company will grow profits to levels only seen during a global pandemic.

Profits Declining Despite Revenue GrowthLakeland Industries’ revenue soared 47% year-over-year (YoY) in fiscal 2021 (Feb 2020 through Jan 2021) as it was able to take advantage of the peak demand for PPE driven by COVID. In fact, the company’s disposables segment sales nearly doubled from $53 million in fiscal 2020 to $104 million in fiscal 2021.

Alongside soaring sales, Lakeland Industries benefited from higher prices, which drove the company’s net operating profit after-tax (NOPAT) to $32 million, the highest for the company in any year of our model (dates back to fiscal 1996).

However, the business looks much different now. While the company has been able to increase revenue through acquisitions, its NOPAT has declined YoY in each of the past four years.

Specifically, Lakeland Industries’ revenue rose from $159 million in fiscal 2021 to $167 in fiscal 2025, while its NOPAT fell from $32 million to less than $1 million over the same time. See Figure 1.

Figure 1: Lakeland Industries’ Revenue and NOPAT: Fiscal 2021 – 2025

Sources: New Constructs, LLC and company filings.

Acquisitions Boost Sales, But Destroy Shareholder ValueLakeland Industries’ revenue increased 34% YoY in fiscal 2025, which might have growth investors salivating. However, a deeper look into the source of revenue growth and how well it translates into profits will leave investors unsatisfied . Excluding acquisitions, Lakeland Industries’ organic revenue growth was just 7% YoY in fiscal 2025. In other words, without costly acquisitions, Lakeland Industries’ “high-growth” story is less appealing.

A company can buy revenue via acquisitions, and if it does so at a bad price, it destroys shareholder value in the process. We’ve long highlighted the issues with overpaying for acquisitions, and since late 2023, Lakeland Industries has acquired:

• Pacific Helmets NZ Limited for $6 million,
• Jolly Scarpe S.p.A. and Jolly Scarpe Romania S.R.L. for $9 million,
• Fire and rescue business of LHD Group Deutschland GmbH for $15 million, and
• Veridian Limited for $26 million.

Since fiscal 3Q24 (quarter end October 2023), right before the first acquisition, Lakeland Industries’ TTM revenue increased from $122 million to $167 million in the TTM ended fiscal 4Q25. However, the company’s NOPAT declined from $4.3 million to $0.2 million over the same time.

Worse yet, the company’s return on invested capital (ROIC), which measures how much profit a company generates for every dollar invested into the business, has fallen from 3.5% in the TTM ended fiscal 3Q24 to 0.1% in the TTM ended fiscal 4Q25. See Figure 2.

In other words, the acquisitions did more damage than good to the business. ROIC has been falling since fiscal 2022, even as the top-line increased.

Figure 2: Lakeland Industries’ ROIC: Fiscal 2021 – 2025

Sources: New Constructs, LLC and company filings.

Acquisitions Dilute Existing Investors and Increase Debt BurdenNot only did the acquisitions sink the company’s ROIC, but they were also financed through debt, mainly the company’s revolving credit facility.

After drawing down on its credit facility to pay for the acquisition, Lakeland Industries issued over 2 million shares in January 2025, which after expenses, raised $46 million for the company. This cash was used to pay down the company’s revolving credit facility, though not in its entirety. All told, these transactions:

• increased shares outstanding from 7.4 million in fiscal 2024 to 9.5 million in fiscal 2025
• increased total debt from $13 million in fiscal 2024 to $33 million in fiscal 2025

Meanwhile, cash and equivalents on the company’s balance sheet declined from $25 million in fiscal 2024 to $17 million in fiscal 2025.

With an increase in total debt and a decrease in cash on hand (more on that later), Lakeland Industries currently earns an Unattractive overall Credit Rating, with an Unattractive-or-worse rating in four of the five credit rating criteria. See Figure 3.

Figure 3: Lakeland Industries’ Credit Rating Details

Sources: New Constructs, LLC and company filings.

Even After Acquisitions, Still a Small Player in the Fire MarketEach of the businesses noted above manufacture firefighter protective equipment and showcase Lakeland Industries’ focus on growing its fire business. Lakeland Industries’ management believes firefighter safety equipment provides strong growth opportunities because it is:

• highly fragmented, with only one competitor having more than 10% market share according to the company,
• a higher-margin business, and
• less subject to economic cycles as municipal budgets require annual spending and replenishment.

To its credit, Lakeland Industries has grown it fire related revenue from $9 million (8% of revenue) in fiscal 2020 to $63 million (38% of revenue) in fiscal 2025. The growth in the segment is driven by the acquisitions noted above.

However, Lakeland Industries has a long way to go to become one of the major players in the fire services market. Based on the size of the firefighter PPE market in 2024, Lakeland Industries, with $67 million in fire related revenue in fiscal 2025, holds just 3% market share.

The highly fragmented nature of the market, while certainly creating a growth opportunity, also means companies are in constant competition with one another. Serving municipal governments, with limited budgets, can also mean a race to the bottom when bidding for potential contracts. Both factors make it more difficult to improve margins while also growing the business. Unfortunately for investors, Lakeland Industries’ stock price already embeds expectations for both margin improvement and huge revenue growth, as we’ll show below.

Already Lagging CompetitorsLakeland Industries’ biggest competition comes from larger companies that have more financial resources to spend on product innovations and technological advancements. More specifically, many possess a more comprehensive PPE lineup and/or other business segments that generate significant cash flows. This cash is an advantage and can be reinvested to enhance or scale competing PPE products and make it that much more difficult for a smaller player, like Lakeland Industries, to complete. The company specifically notes in its 10-K, that the barriers to entry in the disposable and reusable garments and glove market are relatively low.

Some of the largest competitors include:

• Dupont De Nemours (DD)
• Ansell (ANSLY)
• MSA Safety (MSA)
• 3M (MMM).

It’s worth noting that other large firms have recently exited the PPE business. Kimberly-Clark (KMB) sold its PPE business to Ansell in 2024, while Honeywell (HON) reached an agreement to sell its PPE business to Protective Industrial Products (owned by private equity firm Odyssey Investment Partners), with the deal expected to close in the first half of 2025. Companies tend not to exit businesses when they are good.

Lakeland Industries also faces competition from more specialized manufacturers including Bullard, Fire-Dex, Seyntex, Iturri Group, and Lion Protects.

In other words, taking share while improving margins will remain a challenge moving forward in such a competitive industry. Over the TTM, the company already has the lowest NOPAT margin and ROIC out of its publicly traded peers. See Figure 4.

The company’s NOPAT margin fell from 20% in fiscal 2021 to 0% in fiscal 2025, while its invested capital turns fell from 1.7 to 1.0 over the same time. Falling NOPAT margins and invested capital turns drive Lakeland Industries’ ROIC from 33% in fiscal 2021 to 0% in fiscal 2025.

Figure 4: Lakeland Industries’ Profitability Vs. Peers: TTM

Sources: New Constructs, LLC and company filings.

Lack Of ScaleLakeland Industries has built a name in the global PPE market, with operations, including manufacturing and distribution, around the globe, but it remains a small player in a large market. Most of the segments within the broader PPE industry are highly fragmented, with no one single company that dominates in all segments.

Overall, Lakeland Industries fiscal 2025 revenue accounts for just 0.2% market share in the global PPE market.

For comparison, 3M’s PPE business accounts for 3.8% and MSA Safety accounts for 2.1% of the global PPE market.

Cash Burn Is Getting WorseLakeland Industries generated an all-time high (dating back to fiscal 1996) free cash flow (FCF) of $26 million in fiscal 2021. However, recent years have seen record lows.

Lakeland Industries’ FCF has been negative on an annual basis over each of the last three fiscal years. From fiscal 2021 through fiscal 2025, Lakeland Industries has burned through a cumulative $64 million (36% of enterprise value) in FCF excluding acquisitions. See Figure 5.

Figure 5: Lakeland Industries’ Free Cash Flow: Fiscal 2021 – Fiscal 2025

Sources: New Constructs, LLC and company filings.

Nearing Zombie StatusLakeland Industries doesn’t qualify as a Zombie Stock because it has a positive interest coverage ratio. However, the company is burning cash at a Zombie Stock-like rate. The company can only support its fiscal 2025 FCF burn for less than three months from January 2025, based on its cash on hand at the end of fiscal 2025.

It could only support its 2-year average FCF burn for five months from the end of January 2025.

Without a large turnaround in the business, additional share issuances or capital raises could be necessary.

Weak Internal Controls Are Another Big Red FlagEven after we adjust the company’s numbers to get the truth about its profits, we don’t know if we can trust the financials because the company’s auditor identified a material weakness in internal control over financial reporting in fiscal 2025.

Specifically, the weakness in internal controls related to Lakeland Industries’ “controls over the completeness and accuracy of the company’s foreign reporting packages which are the basis preparation of our consolidated financial statements”.

The company’s management is enacting multiple solutions to remediate the weakness in internal control, including the implementation of an enterprise resource planning (ERP) system, establishing a technology committee, and migrating substantially all of the company’s operations to a common accounting system and utilizing a common chart of accounts.

Management has not completed and tested all of these remediation efforts to determine if the weakness in internal controls has in fact been remediated.

Investors should be wary of this disclosure, because weaknesses in internal controls increase the risk that the company’s financials are fraudulent and/or misleading.

Risk of Manufacturing in China Is GrowingThe majority of Lakeland Industries’ products are manufactured in Vietnam and China, which could spell trouble as the ongoing tariff/trade war continues.

Lakeland Industries discloses in its fiscal 2025 10K that it has operations in 16 foreign countries, and that the risks of doing business in foreign countries “could affect our ability to manufacture or sell our products, obtain products from foreign suppliers, or control the costs of our products.”

The good news for the company is that 60% of its sales in fiscal 2025 were in geographies outside the U.S. However, that leaves potentially 40% of sales caught up in the ongoing trade war, which could have material consequences for global manufacturers like Lakeland Industries.

Don’t Fall for the Non-GAAP Metrics EitherLakeland Industries’ preferred metrics are misleading, especially in the last three fiscal years. From fiscal 2023 to fiscal 2025 the company’s Adjusted EBITDA improved from $10 million to $15 million, while its GAAP net income fell from $2 million to -$18 million. Over the same time, the company’s economic earnings, the true cash flows of the business, fell from $0 million to -$11 million.

It is a big red flag when the company’s preferred non-GAAP metric is rising while its economic earnings and GAAP net income are both declining.

Figure 6: Lakeland Industries’ GAAP Net Income vs. Economic Earnings vs. Adjusted EBITDA

Sources: New Constructs, LLC and company filings.

Valuation Implies Lakeland Industries Will Grow Twice as Fast as the IndustryBelow, we use our reverse discounted cash flow (DCF) model to analyze the future cash flow expectations baked into Lakeland Industries’ stock price. Lakeland Industries’ stock is priced as if it will more than double its record high revenue and grow profits to levels only seen during a global pandemic. We also present an additional DCF scenario to highlight the downside risk in the stock if Lakeland Industries fails to achieve these overly optimistic expectations.

To justify its current price of $16/share, our model shows Lakeland Industries would have to:

• improve its NOPAT margin to 3.4% (equal to the 10-year average prior to COVID and above Lakeland Industries’ 0.1% fiscal 2025 and 1.9% fiscal 2024 NOPAT margin) and
• grow revenue by 10% compounded annually (2x projected PPE industry growth through 2033 and 2x projected firefighter PPE industry growth through 2032) for the next decade.

In this scenario, Lakeland Industries would generate $434 million in revenue in fiscal 2033, which is 2.6x the company’s all-time high revenue from fiscal 2025. The company would also grow revenue faster than its organic revenue growth rate in fiscal 2025.

This scenario also implies Lakeland Industries’ NOPAT grows 55% compounded annually over the next decade to reach $15 million in fiscal 2035, which would be the company’s second highest NOPAT (dating back to 1996) compared to $0.2 million NOPAT in fiscal 2025. Contact us for the math behind this reverse DCF scenario.

For context, prior to COVID (fiscal 2021) the highest NOPAT the company had achieved was $9 million in fiscal 2016. In other words, in order to justify its current stock price, Lakeland needs to grow profits to levels only achieved during a global pandemic.

44%+ Downside If Revenue Grows at Projected Industry Growth RateIf we instead assume Lakeland Industries:

• immediately improves NOPAT margin to 3% (still above Lakeland Industries’ 0.1% fiscal 2025 and 1.9% fiscal 2024 NOPAT margin) and
• grows revenue by 5% (projected industry growth) compounded annually each year through fiscal 2035, then

the stock would be worth $9/share today – a 44% downside to the current price. Contact us for the math behind this reverse DCF scenario.

In this scenario, Lakeland Industries would grow revenue to $272 million in fiscal 2035, which would be 1.6x the company’s fiscal 2025 revenue. This scenario also implies Lakeland Industries grows NOPAT 47% compounded annually over the next decade to the company’s fourth highest NOPAT in its history.

Figure 7 compares Lakeland Industries’ implied future NOPAT in these scenarios to its historical NOPAT.

Figure 7: Lakeland Industries’ Historical and Implied NOPAT: DCF Valuation Scenarios

Sources: New Constructs, LLC and company filings.

Stock Is Not Worth $1Each of the above scenarios assumes Lakeland Industries grows revenue, NOPAT and FCF while invested capital grows just 1% compounded annually. This assumption is highly unlikely but allows us to create best-case scenarios that highlight the unrealistically high expectations embedded in the current valuation.

For reference, Lakeland Industries’ invested capital grew 18% and 10% compounded annually in the last five and ten years, respectively. If we assume Lakeland Industries’ invested capital increases at a similar rate in the DCF scenarios above, the downside risk is even larger.

Given that the performance required to justify its current price looks overly optimistic, we dig deeper to see if Lakeland Industries is worth buying at any price. The answer is no.

The company has $33 million in total debt and only $9 million excess cash. Lakeland Industries has an economic book value, or no-growth value, of -$2/share. In other words, we do not think equity investors will ever see $1 of economic earnings under normal operations, which means the stock would be worth $0 today.

Stupid Money Risk is the Best HopeOften the largest risk to any bear thesis is what we call “stupid money risk”, which means an acquirer comes in and buys Lakeland Industries at the current, or higher, share price despite the stock being overvalued. Given our analysis above, the only plausible justification for LAKE trading at its current price is the expectation that another firm will buy it.

However, we think potential acquirers would need a significant discount from current prices to consider acquiring Lakeland Industries.

Stranger things have happened than firms being acquired at unnecessarily high premiums to their intrinsic value. Below, we quantify how high the acquisition hopes priced into the stock are.

Walking Through the Acquisition MathFirst, investors need to know that Lakeland has $33 million (21% of market cap) in total debt that makes it more expensive than the accounting numbers would initially suggest.

After adjusting for all liabilities, we can model multiple purchase price scenarios. For this analysis, we chose MSA Safety as a potential acquirer of Lakeland, given its existing presence in the firefighting equipment market. While we chose MSA Safety, analysts can use just about any company to do the same analysis. The key variables are the weighted average cost of capital (WACC) and ROIC for assessing different hurdle rates for a deal to create value.

Even in the most optimistic of acquisition scenarios, Lakeland is worth less than its current share price if MSA Safety cares about shareholder value.

Figures 8 and 9 show what we think MSA Safety should pay for Lakeland Indsustries to ensure it does not destroy shareholder value. There are limits on how much MSA Safety should pay for Lakeland Industries to earn a proper return, given the NOPAT or free cash flows being acquired.

Each implied price is based on a ‘goal ROIC’ assuming different levels of revenue growth. In the first scenario, we use 5% revenue growth in each year through fiscal 2030, or the projected industry growth rate. In the second scenario, we use 10% revenue growth in each year through fiscal 2030, or two times the projected industry growth rate. We use the higher estimates in scenario two to illustrate a best-case scenario where we assume Lakeland Industries could grow organic revenue faster while being integrated within MSA Safety’s existing larger business.

We optimistically assume Lakeland Industries achieves a 4% NOPAT margin, which is above its pre COVID 10-year average of 3.4%.

We also optimistically assume that MSA Safety can grow Lakeland Industries’ revenue and NOPAT without spending any working capital or fixed assets beyond the original purchase price.

Figure 8: Implied Acquisition Prices for Value-Neutral Deal – Scenario 1

Sources: New Constructs, LLC and company filings

Figure 8 shows the implied values for Lakeland Industries assuming MSA Safety wants to achieve an ROIC on the acquisition that equals its WACC of 8%. This scenario represents the minimum level of performance required not to destroy value. Even if Lakeland Industries can grow revenue by 10% compounded annually for five years and achieve a 4% NOPAT margin, the company would still be worth less than the current share price. However, it’s worth noting that any deal that only achieves an 8% ROIC would not be accretive, as the return on the deal would equal MSA Safety’s WACC.

Figure 9: Implied Acquisition Prices to Create Value – Scenario 2

Sources: New Constructs, LLC and company filings

Figure 9 shows the implied values for Lakeland Industries assuming MSA Safety wants to achieve an ROIC on the acquisition that equals 14%, its current ROIC. Acquisitions completed at these prices would be accretive to MSA Safety’s shareholders. Even in this best-case growth scenario, the implied value is far below Lakeland Industries’ current price. Without significant increases over the margin and/or revenue growth assumed in this scenario, an acquisition of Lakeland Industries at its current price is value neutral at best and destroys significant shareholder value at worst.

Earnings Misses Could Send Shares FallingLakeland Industries has missed earnings estimates in each of the past five quarters, and 7 of the past 10 quarters. Doing so again, especially after acquiring numerous businesses and revenue sources could send shares even lower.

Furthermore, additional clarity on tariffs, particularly that negatively impact products from China and Vietnam, could have an adverse impact on the company’s business, and therefore its stock price.

What Noise Traders Miss with LAKEThese days, fewer investors pay attention to fundamentals and the red flags buried in financial filings. Instead, due to the proliferation of noise traders, the focus tends toward technical trading trends while high-quality fundamental research is overlooked. Here’s a quick summary for noise traders when analyzing Lakeland Industries:

• it is running out of cash,
• intense competition that has greater resources,
• already lagging market share in its key markets,
• valuation that implies profits reach global pandemic levels.

Executive Compensation Plan is Not Creating Shareholder Value – Though it Should BeLakeland Industries’ executives receive both short-term cash incentives and long-term equity awards. The short-term incentives are tied to revenue growth, EBITDA margin, and free cash flow margin goals.

Long-term equity awards are tied to revenue growth, EBITDA margin, and return on invested capital. Despite using ROIC as an incentive to long-term awards, management still undertook the value destructive acquisitions noted above, likely because revenue growth and EBITDA margin are more heavily weighted when determining bonuses.

Using revenue growth and EBITDA margin diminishes the positive impact of including ROIC in compensation plans. Putting more emphasis on ROIC would ensure that executives’ interests are more aligned with shareholders’ interests as there is a strong correlation between improving ROIC and increasing shareholder value.

Despite including ROIC in its executive compensation plan, Lakeland Industries’ ROIC fell from 33% in fiscal 2021 to 0% in fiscal 2025.

Insider Trading and Short Interest TrendsOver the past 12 months, insiders have bought ~163,000 shares and have sold ~21,000 shares for a net effect of ~142,000 shares purchased.

There are currently 162,000 shares sold short, which equates to 2% of shares outstanding and around two days to cover.

Unattractive Funds That Hold LAKEThere are no funds that receive our Unattractive-or-worse rating and allocate significantly to LAKE.

This article was originally published on April 28, 2025.

Disclosure: David Trainer, Kyle Guske II, and Hakan Salt receive no compensation to write about any specific stock, sector, style, or theme.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Gear Doesn’t Protect Margins.

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As the market continues to rollercoaster, Tesla (TSLA: $252/share) would love to get off the ride. The company has been in the headlines for all the wrong reasons, and its stock is down 38% year-to-date (YTD) and 48% from its 52-week high. The near halving in stock price might have investors wondering, is now the time to scoop up shares on the cheap?

No. And, we show below, we do not see an honest argument for owning the stock above $50/share.

As David Trainer discussed in BYD versus Tesla, Tesla lost its first-mover advantage, its profitability and market share are in decline, and there’s no straight-faced argument that the company can reverse these trends.

When we think of Tesla and all the promises Elon Musk has made over the years, we cannot help but think of the lyrics for the Eurythmics classic song: Sweet Dreams (Are Made of This).

“Some of them want to use you

Some of them want to get used by you

Some of them want to abuse you

Some of them want to be abused.”

In our opinion, Mr. Musk has used and abused investors to build his unrivaled fortune and influence. The clear-eyed math that drives our Tesla research leads us to the inescapable conclusion that TSLA is worth less than $50/share or 80%+ below the current price. We welcome your questions and feedback on this unique take. We have no ax to grind here. We’d love nothing more than to fall in line with all the staunch believers in Mr. Musk’s ability to change the world. But, math is math. And, the numbers in this report paint a very clear picture. Sell TSLA now.

Whether you think Tesla is just a car company, or a combination of robot, solar, battery, insurance, FSD, space exploration, and satellite companies, its stock is terribly overpriced. For starters, Tesla’s current stock price implies that the company will become the world’s largest automaker, not just electric vehicle (EV) maker, even as the company is losing market share, seeing revenues flatten, and continually misses its delivery goals.

Below, we address the many reasons why Tesla does not (and hasn’t ever) deserve its lofty valuation.

Pipe Dream #1: First Move Advantage Will Last ForeverMarket Share Is Declining Rapidly. Tesla’s total vehicle deliveries fell YoY for the first time in 2024, and despite rising deliveries prior to 2024, the company has not been keeping pace with the overall EV market.

Based on sales data from the International Energy Agency, Tesla’s share of global EV sales, which include battery-electric vehicles (BEV) and plug-in hybrid electric vehicles (PHEV), fell from 17% in 2019 to 10% in 2024.

For comparison, BYD’s share of the global EV sales, including BEV and PHEV, increased from 10% in 2019 to 22% in 2024, which makes BYD the global leader in EV sales. Wuling had the third highest market share at 4%, and the rest of the main competitors (BMW, Li Auto, Geely, Volkswagen, and more) followed close behind at market shares ranging between 3% and 2%.

As a battery-electric vehicle manufacturer only, we can also compare Tesla’s share of the BEV industry. Per Figure 1, Tesla’s BEV market share, based on number of vehicles sold, fell from 25% in 2019 to 17% in 2024.

Figure 1: Tesla’s Share of Global BEV Sales: 2019 – 2024

Sources: New Constructs, LLC, Statista, and IEA

Market Share Losses Are Steepest in the More Mature EV Markets. Tesla has been ceding the most share in more mature EV markets, as multiple competitors (old and new) bring numerous, compelling new models to market.

China is the largest EV market in the world with 64% of global EV sales in 2024.

BYD is #1 in China by a wide margin. Its sales were 32% of the EV market, while Tesla was just 6% in 2024. Tesla is not even in second place in China. According to Autovista24, BYD’s EV sales were 5.2x higher than the second-best EV brand Wuling, and 5.3x higher than Tesla’s EV sales in China in 2024.

As David discusses in a recent webinar “BYD vs Tesla”, we expect BYD to widen its lead on Tesla as it rolls out new charging technologies and a wider range of EV models to meet many different price points.

Figure 2: Best-Selling EV Brands in China in 2024

Sources: New Constructs, LLC and Autovista24

Tesla’s market share in Europe is trending down, too. Tesla’s European sales declined 45% in the first two months of 2025, despite overall EV sales in the region rising 37% over the same time.

Tesla’s market share in Europe fell from 21% in 1Q23 to 9% in 1Q25 according to EU-EVs.com. Volkswagen leads the market with 14% share in 1Q25. See Figure 3. On a monthly basis through February 2025, Tesla’s sales in Europe fell YoY in 10 of the last 12 months.

Figure 3: Europe BEV Market Share: 1Q23 ­– 1Q25

Sources: New Constructs, LLC and EU-EVs.com

In the U.S. Tesla still enjoys leading market share. However, we’re not sure how long that will last given that its market share fell from 82% in the first half of 2020 to 44% in 1Q25.

Around the world, the market share trend is not Tesla’s friend. As we stated long ago, competition would erode Tesla’s once-leading market share.

While Tesla is counting on its redesigned Model Y to boost sales, we think that goal looks less and less likely to be met due to production pauses at factories around the world.

Can’t Regain Market Share with Delivery Misses Piling Up. Not only is Tesla losing market share, but it is increasingly missing consensus estimates for vehicle deliveries. Tesla’s deliveries in the first quarter of 2025 missed the consensus estimate by 12% or 40,909 deliveries, which was one of the largest misses to date.

Longer-term, Tesla has missed the consensus estimates for deliveries in 7 out of the last 10 quarters per Figure 4. Such misses add further evidence to Tesla’s ongoing struggles.

Figure 4: Tesla’s Quarterly Delivery Beats & Misses: 4Q22 ­– 1Q25

Sources: New Constructs, LLC and CNBC

Pipe Dream #2: Profits to the MoonProfits Are Headed Down. No doubt, Tesla deserves credit for proving the EV market, but that doesn’t mean EVs are a good business. Tesla briefly boasted high margins and soaring sales, but as inevitably happens in free markets, a flood of competition has forced revenue growth and margins down.

Tesla saw impressive revenue growth for many years, but that trend has stopped in its tracks. Total revenues, excluding automotive regulatory credits, were down ever-so-slightly from $95 billion in 2023 to $94.9 billion in 2024, while automotive revenue, the large majority of the business (more on that topic below), excluding regulatory credits dropped more precipitously (8%) from $80.6 billion in 2023 to $74.3 billion in 2024. Worse yet, Tesla’s net operating profit after-tax (NOPAT) fell 39% from $7.2 billion to $4.4 billion over the same time. See Figure 5.

Tesla’s NOPAT margin fell from 13% in 2022 to 5% in 2024, while the company’s invested capital turns fell from 2.3 to 1.6 over the same time. Falling NOPAT margins and invested capital turns drive Tesla’s ROIC from 30% in 2022 to just 8% in 2024.

Figure 5: Tesla’s Revenue and NOPAT: 2022 – 2024

Sources: New Constructs, LLC and company filings

Tesla’s declining profitability is a window into the competitive dynamics of the EV industry. When Tesla faced less competition, it earned high margins. As companies entered the market, pricing became more competitive, and consumers had greater choice in EVs, Tesla’s profitability declined. For example, Tesla’s return on invested capital (ROIC) was nearly 4 times higher than the average ROIC of its incumbent peers[1] in 2022. However, in 2024, Tesla’s 8% ROIC is equal to the average trailing twelve-month (“TTM”) ROIC of its incumbent peers.

Still Burning Cash Like There’s No Tomorrow. Surprise! Despite showing positive EPS and even a decent ROIC, Tesla has been a major money loser over its life. It doesn’t qualify as a Zombie Stock, due to its large cash balance (Mr. Musk is really good at selling stock), but it continues to burn cash at a zombie-like pace.

Tesla’s free cash flow (FCF) has been positive in just one year out of the last 14 years.

Since 2014, Tesla has burned $29.0 billion, excluding acquisitions. In the last three years alone, the company burned through $10.2 billion.

Figure 6: Tesla’s Free Cash Flow: 2014 – 2024

Sources: New Constructs, LLC and company filings

If Tesla could not sustain positive cash flows in the good times, we’re not sure how it ever will, considering the declines in market share, technological advantage and profits.

Pipe Dream #3: Technological Advantages Will Last ForeverNo More Range Advantage. Tesla once boasted a large range advantage in the EV market, particularly at a time when consumers weren’t sure about the feasibility of EVs as replacement to ICE. That advantage has all but disappeared.

In 2014, Tesla owned the #1 and #2 longest-range EVs in the world and had a big lead of the next closest competitor. Specifically, at #1, the 85 kW-hr version of Model S reported a range of 265 miles, and, at #2, the 60 kW-hr version of Model S reported a range of 208 miles. The next closest vehicle, the BYD e6, reported a range of just 127 miles. With such a big lead over the competition, we can understand why investors might believe Tesla would retain its range advantage for the foreseeable future.

Fast-forward to 2025, and the range discussion looks a lot different. Car And Driver tested many popular EVs to determine a real-world range, rather than the range reported in marketing materials. Through this testing, Car and Driver found that four vehicles have longer “real-world” ranges than Tesla’s Model S. See Figure 7.

Figure 7: Highest Range EV Models in 2025 – Top 5

Sources: Car and Driver

As you move lower down the list, the differences in range get less significant. For example, the Rivian R1T, which ranked 14th in Car and Driver’s testing, had a range of 280 miles, or just 40 miles less than Tesla’s #5-ranked Model S. In other words, Tesla has fallen behind in range and more firms are catching up to it.

Lagging Behind in Charging Speed. The time it takes to charge an EV is one of the main pain points that make consumers hesitant to purchase an EV. After all, it only takes a few minutes to put gas in a vehicle and be on your way. If EV charging takes 30+ minutes, it’s not be as an attractive alternative.

China’s BYD, the world’s largest EV maker in 2024, recently unveiled new chargers that could erase this concern altogether. BYD’s new 1,000 kW chargers can add almost 250 miles of range to an EV in just 5 minutes.

Tesla’s most powerful charging stations can add 200 miles of range in 15 minutes; so the new BYD charging stations are almost 4 times as fast and make charging time the same as filling up a regular gas car, maybe even faster. BYD aims to install 500 of these new chargers in April

Tesla is “planning” to roll out 500 kW chargers this year, though these charging stations appear to be just half as powerful as BYD’s new chargers.

Autonomous Driving Technology Is Stagnating. Tesla bulls have long maintained the company’s autonomous driving technology, Full Self Driving (FSD), will be best-in-class. The company has marketed that its FSD technology will allow all its vehicles to drive autonomously and create a massive robo-taxi ride hailing service that would instantly convert Tesla vehicles into money-making machines that work while their owners sleep. However, real world data would show that Tesla’s latest FSD, v13, is nowhere close to being fully autonomous. ~3 months after v13 was released, data shows the system can go, on average, 495 miles between critical disengagement. Previously, Tesla has stated that it needs to achieve 700,000 miles between critical disengagement to be safer than humans.

While Tesla is struggling to improve its FSD technology, Waymo, a robotaxi company that is now a subsidiary of Alphabet (GOOGL), already has 700+ fully autonomous cars on the road that provide 200,000 rides a week. And, these cars are not just fully autonomous for arguments sake, they actually have no humans behind the wheel.

According to Guidehouse Insights, Tesla ranks dead last out of the top 20 competitors in autonomous driving technology. The top three companies in the autonomous driving technology race are Waymo, Baidu, and Mobileye. The top 10 are below:

1. Waymo
2. Baidu
3. Mobileye
4. Nvidia
5. Aurora
6. Plus
7. WeRide
8. Zoox
9. Gatik
10. Cruise

As noted in Electrek, Elon Musk has promised unsupervised FSD “by the end of the year” in each of the last six years. Tesla keeps promising, but not delivering.

Robotaxis Must Pass Many Legal Hurdles. Even if the technology was more competitive, Tesla must secure a series of approvals from several state regulators to put robotaxis on the road. The company has received only the first approval (of many required) for operation in California. Given the issues detailed in the sections before and after this one, we do not think Tesla will have much success in securing the approvals needed to put its robotaxis, in their current state, on the road.

Safety Issues Present Huge Risk to the Stock. The National Highway Traffic Safety Administration (NHTSA) continues investigations into Tesla’s FSD and autopilot features. Most recently, NHTSA opened a safety probe for up to 2.6 million Tesla vehicles in January 2025. Since 2019, Tesla’s automated driving features have been linked to over 700 hundred crashes and at least 19 deaths. Tesla’s largest ever recall happened at the end of 2023, where the company was forced to recall 2 million vehicles to fix the software related to its Autosteer driver assist feature.

If the NHTSA discovers defects in Autopilot or FSD, Tesla could be on the hook to fund the expenses of a massive recall not to mention the liabilities related to the deaths and injuries from the crashes. Furthermore, any design flaws discovered in the investigation could leave Tesla open to more class action litigation.

Competitors Are Better Equipped to Improve Technology. As Telsa’s vehicles fall behind in range, charging speed, and autonomous driving, incumbent auto manufacturers continue to outspend the company in research and development (R&D). Per Figure 8, Tesla’s R&D spend in 2024 ranks far behind the likes of Ford (F), Toyota (TM), General Motors (GM), Mercedes-Benz, and Volkswagen.

As has long been the case and a key point in our bear thesis on Tesla, one of the most overlooked advantages for incumbent manufacturers is their profit-generating legacy operations that can fund larger R&D budgets.

While Tesla must continue to simultaneously develop new technology and add production capacity from scratch, incumbents can leverage cash flows from existing profitable operations to build new technologies and leverage existing distribution advantages to sell more EVs, if and when the market is ready.

Figure 8: Tesla’s R&D Spend Vs. Major Competitors in 2024

Sources: New Constructs, LLC and company filings.

How could we expect Tesla to regain its first-mover advantages when it is falling behind and its R&D budget is so much lower than its competition?

And, given the major drop in profits and consistently negative free cash flow, we see no reason to believe Tesla will ever have competitive R&D budgets.

Pipe Dream #4: Tesla Is Not a Car Company, Should Be Valued based on Other BusinessesOther Businesses Aren’t Material. Bulls have long argued that Tesla is not just an automaker, but it’s a technology company with multiple verticals including insurance, solar power, space exploration (Mars anyone?), full self-driving, robotaxis, and, yes, robots. We’ve long refuted these pipe dreams. Regardless of the promises of developing multiple non-auto businesses, Tesla’s revenues remain heavily concentrated in automobiles.

After a steep decline in 2024, auto revenue was 79% of Tesla’s total revenue. In 2023, auto revenue was 85% of total revenue. Energy generation and storage accounted for just 10% of total revenue in 2024. The rest of the company’s revenue comes from the “services and other” segment, which includes insurance, non-warranty maintenance and collision, sales of used vehicles, and retail merchandise sales.

Figure 9: Tesla’s Segment Revenues as a Percentage of Total Revenue in 2024

Sources: New Constructs, LLC and company filings

Energy Generation and Storage…Solar Power Segment Is Still Weak. Tesla’s energy generation and storage segment includes the design, manufacture, installation, sales and leasing of solar energy generation and energy storage products and related services and sales of solar energy systems incentives.

As of the first half of 2024, 8 of the top 10, including all of the top 5, solar panel manufacturers were Chinese companies. We don’t think Tesla has any competitive advantages in the solar power space. It is hard to believe that Tesla will be able to take material market share from the dominant Chinese manufacturers.

Services and OtherServices and other revenue consist of sales of used vehicles, non-warranty maintenance services and collision, part sales, paid supercharging, insurance services revenue and retail merchandise sales.

Insurance Business Is a Nothing Burger. Elon Musk once claimed that the insurance could be 30-40% of the value of Telsa’s car business. Today, it’s so small its bundled within the services and other segment. In 2024, Tesla’s insurance operations generated upward of $1 billion (~1% of revenue) in premiums while accumulated at least $69 million in underwriting losses.

Robots Are Way Behind the Competition. At its “We, Robot” event in October 2024, the company showcased its autonomous Optimus robots walking around, dancing, mixing drinks, and talking. Sounds impressive. However, the robots were actually controlled remotely by humans. Not so groundbreaking after all.

Tesla’s remote-controlled robots are multiple generations behind the industry leaders, and we do not see reason to expect that to change anytime soon.

For example, Boston Dynamics’ humanoid Atlas robot is already fully autonomous and requires no remote controls or pre scripted movements. This video from October 2024 shows Atlas successfully moving engine covers between supplier containers and a mobile sequencing dolly after being provided with only a “list of bin locations to move parts between”. Atlas showcases dynamic movements as well as fully autonomous operational capabilities.

Boston Dynamics’ Spot robot can fully navigate its way through factory floors, construction sites, research labs, etc. while also monitoring and collecting data. Spot can do all the mentioned functions either by remote control or autonomously following a predefined route.

Boston Dynamics is one of many companies that are way ahead of Tesla in the development of robots.

Cybertruck Is a Money Loser. Tesla’s Cybertruck hit the market with lots of fanfare. Mr. Musk was able to secure more than a million reservations to buy the vehicle before one ever hit the road. It quickly became the best-selling electric pickup truck in the U.S. However, this demand quickly stalled when consumers actually saw what they were getting. Now, Tesla is struggling to sell its inventory.

U.S. Cybertruck sales fell over 32% between January and February 2025. Cox Automotive estimates that Tesla sold around half the number of Cybertrucks in February 2025 than its best ever month, September 2024. Estimates put Tesla’s inventory of new Cybertrucks at ~2,300 in early April. One would expect with over one million reservations, Tesla would be delivering Cybertrucks as fast as they could build them, not holding increasing numbers in inventory.

In the latest hit to the pent-up demand bull thesis, Tesla is reportedly trying to boost sales by converting its more expensive foundation series trucks to the base model (which costs $20,000 less), by having the special badging buffed off.

Early on, Mr. Musk said the Cybertruck might generate positive cash flow within a few years, once volumes reached certain levels. It appears those volumes have not and will not ever be met.

Other Businesses Are More Liabilities Than Assets. Mr. Musk has his hand in many pies outside of Tesla, and some of them appear to be very promising businesses. However, it is important to note that these businesses are not part of Tesla, and they do not contribute to the profits or losses of Tesla.

Many would argue that these other businesses, such as Neuralink, SpaceX, Starlink, xAI, Boring, DOGE, and more do more to hurt Tesla because they take Mr. Musk’s valuable attention away from Tesla. Or worse, they compete directly with Tesla not just for Musk’s attention but also the attention of key Tesla personnel. For example, in June of 2024, Tesla shareholders sued CEO Elon Musk for a breach of fiduciary duties based on comments he made about poaching Tesla employees for the xAI and using Tesla resources for his private companies.

The lawsuit remains unresolved. However, it stands as one of many examples where Mr. Musk’s interests are not aligned with those of Tesla shareholders. No matter how talented a CEO might be, if he or she engages in self-dealing on the regular at the expense of the company he/she runs, we raise a big red flag.

Pipe Dream #5: Tesla’s Stock Valuation Makes SenseDespite the challenges above, Tesla’s stock is still priced for extraordinary profit growth, while incumbents are priced for the exact opposite.

While Tesla’s market cap is more than double the combined market cap of incumbents, the company’s economic book value (EBV), or no growth value, is -$11 billion. Meanwhile, each of the other legacy automakers has an EBV that is higher than its current market cap. In other words, the price-to-economic book value (PEBV) ratio of Tesla’s competitors ranges from 0.2 to 0.6. In each of these instances, a below 1.0 PEBV ratio implies the market expects profits for these legacy automakers to permanently decline. See Figure 10.

Figure 10: Tesla’s Valuation Compared to Incumbent Peers*: TTM

Sources: New Constructs, LLC and company filings.
*As of market close on April 15, 2025.

Current Valuation Implies Tesla Will Own 31%+ of the Global EV MarketTesla selling 1.8 million cars in 2024 is no small feat. However, that number is minuscule compared to the 22 million to 38 million vehicles [depending on average selling price (ASP) assumptions] that Tesla must sell to justify its very expensive stock price. For reference, Toyota, the world’s largest overall (EVs and everything) automaker for the fifth straight year, sold 10.8 million vehicles in 2024. Does anyone believe, after what we covered above, that Tesla will ever sell twice as many cars as Toyota?

To provide the details behind this implied vehicle sales analysis, we show our reverse discounted cash flow (DCF) model’s output so investors can decide for themselves whether or not Tesla’s valuation is too high.

Quantifying The Expectations in the Current Share Price. To justify ~$250/share, our model shows Tesla would need to:

• immediately achieve a 15% net operating profit after-tax (NOPAT) margin (1.5x Toyota’s TTM margin, compared to Tesla’s 2024 margin of 5%) and
• grow revenue by 28% compounded annually through 2035.

In this scenario, Tesla would generate $1.4 trillion in revenue in 2035, which is 1.3x the combined TTM revenues of Toyota, General Motors, Nissan (NSANY), Ford, Honda Motor Corp (HMC), and Stellantis (STLA). Contact us for the math behind this reverse DCF scenario.

In this scenario, Tesla would generate $204.5 billion in net operating profit after-tax (NOPAT) in 2035. At $204.5 billion, Tesla’s NOPAT would be 3.1x all incumbent peers’ combined TTM NOPAT and 1.9x Apple’s (AAPL) TTM NOPAT, which, at $109 billion, is the highest of all companies we cover. Additionally, Tesla’s ROIC would rise to 331% (nearly 4x Apple’s TTM ROIC of 81%) in 2035.

If we assume automotive revenue remains 79% of total revenue as in 2024, then Tesla would generate $1.1 trillion in automotive revenue in 2035 in this scenario. This revenue figure implies Tesla will sell the following number of vehicles based on these ASP levels:

• 22.4 million vehicles – ASP of $50k (equal to average new-vehicle price in Dec 2024)
• 25.9 million vehicles – Tesla’s 2024 ASP of $43k
• 38.2 million vehicles – ASP of $29k (equal to Toyota in fiscal 2024)

Next, we can analyze implied market share of such sales volume based on the estimated number of new EV sales in 2035, according to data compiled by Autovista24.

In this scenario, the vehicle sales noted above would represent the following implied market share in 2035:

• 31% for 22.4 million vehicles
• 36% for 25.9 million vehicles
• 53% for 38.2 million vehicles

The likelihood of reaching any of the above-mentioned market share scenarios is extremely unlikely in such a competitive industry. For reference Toyota, the world’s largest automaker, held an 11% share of the global automobile market in 2024.

Figure 11: Tesla’s Implied Vehicle Sales in 2035 to Justify $252/Share

Sources: New Constructs, LLC, company filings, and Statista

TSLA Has 65%+ Downside Even If the Company is the World’s Largest AutomakerIf we instead assume, Tesla’s:

• NOPAT margin immediately improves to 10% (equal to Toyota’s TTM NOPAT margin),
• revenue grows at consensus estimates in 2025 (11%) and 2026 (19%), and
• revenue grows 22% each year thereafter from 2027 to 2035, then

our model shows the stock would be worth just $87/share today – 65% downside to the current price. In this scenario, Tesla’s NOPAT would still grow to $72.8 billion, which is 16x Tesla’s 2024 NOPAT. Contact us for the math behind this reverse DCF scenario.

At its current ASP, assuming automotive revenue remains 79% of revenue, this scenario implies Tesla will sell 13.8 million vehicles in 2035 at an ASP of $43k, or 19% of the projected global EV market in 2035. 13.8 million vehicles is more nearly 30% higher than the 10.8 million vehicles sold by Toyota, the world’s largest overall automaker, in 2024.

TSLA Has 81%+ Even If Tesla Grows Sales Volume by Over 4xIf we estimate more reasonable (but still very optimistic) market share achievements for Tesla, the stock is worth just $49/share. Here’s the math, assuming Tesla’s:

• NOPAT margin immediately improves to 10%,
• revenue grows at consensus estimates in 2025 (11%) and 2026 (19%), and
• revenue grows 14% compounded annually from 2027 to 2035, then

our model shows the stock would be worth just $49/share today – an 81% downside to the current price. Contact us for the math behind this reverse DCF scenario.

In this scenario, assuming automotive revenue remains 79% of revenue, Tesla would sell 7.5 million cars (10% of the projected EV market in 2035) in 2035 at an ASP of $43k. Given the required expansion of plant/manufacturing capabilities and formidable competition, we think Tesla will be lucky to sustain a margin as high as 10% from 2025-2035. If Tesla fails to meet these expectations, then the stock is worth less than $49/share.

Figure 12 compares the firm’s historical NOPAT to the NOPAT implied in the above scenarios to illustrate just how high the expectations baked into Tesla’s stock price remain. For additional context, we show Apple’s, Toyota’s, and the combined incumbent peers’ TTM NOPAT.

Figure 12: Tesla’s Historical and Implied NOPAT: DCF Valuation Scenarios

Sources: New Constructs, LLC and company filings

Each of the above scenarios assume Tesla grows revenue, NOPAT, and FCF without increasing working capital or fixed assets. This assumption is highly unlikely but allows us to create best-case scenarios that demonstrate the high level of expectations embedded in the current valuation. For reference, Tesla’s invested capital has grown 29% compounded annually since 2014. If we assume Tesla’s invested capital increases at a similar rate in the DCF scenarios above, the downside risk is even larger.

This article was originally published on April 16, 2025.

Disclosure: David Trainer, Kyle Guske II, and Hakan Salt receive no compensation to write about any specific stock, sector, style, or theme.

Questions on this report or others? Join our online community and connect with us directly.

[1] Incumbent peers under coverage include Toyota (TM), General Motors (GM), Ford (F), Stellantis (STLA), Honda (HMC), and Nissan (NSANY).

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Pipe Dreams Are Made of These.

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As market volatility reigns, there’s no better time than now to share our Zombie Stock List. Originally, available only to Pro or higher members, we decided to release this model portfolio to the public to help more investors.

Successful investing is as much about avoiding zombie stocks as it is finding good stocks. Just one blowup could upend years of winners.

We launched our Zombie Stock list in June 2022. Of the 33 stocks added to the list, only 12 remain. These stocks could legitimately go to $0/share because they have flawed business models that will likely never generate enough cash pay equity investors a penny.

The damage these stocks could do to your portfolio is not hypothetical. Since our first Zombie Stocks report on June 23, 2022, the Zombie Stocks short model portfolio (up 3%) has outperformed the shorting the S&P 500 (down 29%) by 32%. See Figure 1.

Figure 1: Performance of Zombie Stocks List Through 4/7/25

Sources: New Constructs, LLC and company filings.

The most recent update to the Zombie Stock list was the removal of Trupanion (TRUP) due to it extending its cash runway beyond 24 months.

When we first named Trupanion a Zombie Stock it had enough cash to sustain its cash burn for another 23 months.

Trupanion slowed its FCF burn from -$109 million in 2023 to -$46 million in 2024. The lower, yet still negative, FCF means Trupanion no longer qualifies as a Zombie Stock because it has enough cash to sustain its 2024 FCF burn for 78 months from the end of March 2025.

Trupanion remains in the Danger Zone, and its stock is still very dangerous. Below we show why TRUP remains a very risky investment, and then we present the full Zombie Stock list in Figure 5 and 6. Figure 5 includes which stocks remain on the list. We’re always looking for more Zombie Stocks to add to the list. Stay tuned for updates.

Adjusted EBITDA Misleads InvestorsIf one only listened to Trupanion, you would get a misleading view of the company’s profitability. From 2019 to 2024, Trupanion’s Adjusted EBITDA improved from $11 million to $46 million, while its GAAP net income fell from -$2 million to -$10 million.

Over the same time, the company’s economic earnings, the true cash flows of the business, fell from -$21 million to -$77 million. It is a big red flag when the company’s preferred non-GAAP metric is rising while its economic earnings are declining, or even worse, when its GAAP net income is declining as well.

The discrepancy between the metrics should come as no surprise since Trupanion openly admits in earnings releases that its non-GAAP metrics may “exclude expenses that may have a material impact on Trupanion’s reported financial results.” We further detail the issues with Adjusted EBITDA here.

Figure 2: Trupanion’s GAAP Net Income vs. Economic Earnings vs. Adjusted EBITDA: 2019 – 2024

Sources: New Constructs, LLC and company filings.

Cash Just Keeps on BurningDespite positive and increasing Adjusted EBITDA, Trupanion hasn’t achieved a positive free cash flow (FCF) in any full year since 2015 (earliest data available). In fact, the company has only achieved a positive FCF in one quarter (3Q18) out of thirty-six in our model. Trupanion has burned $508 million (34% of enterprise value) in free cash flow (FCF) excluding acquisitions since 2015. See Figure 3.

Figure 3: Trupanion’s Cumulative Free Cash Flow Since 2015

Sources: New Constructs, LLC and company filings.

Valuation Implies Trupanion Will Nearly Double its Market ShareBelow, we use our reverse discounted cash flow (DCF) model to analyze the future cash flow expectations baked into Trupanion’s stock price. Trupanion’s stock is priced as if the business will instantly reach profitability, continue to grow revenue, and nearly double its market share, a feat that is highly unlikely. We also present an additional DCF scenario to highlight the downside risk in the stock if Trupanion fails to achieve these overly optimistic expectations.

To justify its current price of $35/share, our model shows Trupanion would have to:

• improve its NOPAT margin to 3% (equal to Prudential and Cigna’s 2024 NOPAT margin and above Trupanion’s -1% 2024 NOPAT margin) and
• grow revenue by 26% compounded annually (1.5x projected industry growth through 2032) for the next eight years.

In this scenario, Trupanion would generate $8.0 billion in revenue in 2032, which is more than 6x the company’s 2024 revenue, and grow its market share in the global pet insurance industry from an estimated 12% in 2024 to 21% in 2032. This scenario also implies Trupanion’s NOPAT would reach $272 million in 2032 compared to -$19 million in 2024. Contact us for the math behind this reverse DCF scenario.

Furthermore, companies that grow revenue by 20%+ compounded annually for such a long period are “unbelievably rare”, making the expectations in Trupanion’s share price even more unrealistic.

49%+ Downside at Industry Growth RatesIf we instead assume Trupanion:

• immediately improves NOPAT margin to 3% and
• grows revenue by 17% (projected industry growth) compounded annually each year through 2032, then

the stock would be worth $18/share today – a 49% downside to the current price.

This scenario still implies Trupanion’s revenue would reach $4.5 billion in 2032, which is 3.5x higher than the company’s 2024 revenue. In this scenario, Trupanion’s NOPAT would reach $144 million in 2032, which is well above the company’s best ever NOPAT of -$2 million in 2018. Contact us for the math behind this reverse DCF scenario.

Should the company fail to improve margins and grow revenue at a rapid pace, the stock could be worth $0.

Figure 4 compares Trupanion’s implied future NOPAT in these scenarios to its historical NOPAT.

Figure 4: Trupanion’s Historical and Implied NOPAT: DCF Valuation Scenarios

Sources: New Constructs, LLC and company filings.

Stock May Not Be Worth $1Each of the above scenarios assumes Trupanion grows revenue, NOPAT and FCF without increasing working capital or fixed assets. This assumption is highly unlikely but allows us to create best-case scenarios that highlight the unrealistically high expectations embedded in the current valuation. For reference, Trupanion’s invested capital grew 20% compounded annually in the last decade. If we assume Trupanion’s invested capital increases at a similar rate in the DCF scenarios above, the downside risk is even larger.

Given that the performance required to justify its current price is overly optimistic, we dig deeper to see if Trupanion is worth buying at any price. The answer is no.

The company has $129 million in total debt, $2 million in deferred tax liabilities, $6 million in employee stock options, and no excess cash. Trupanion has an economic book value, or no-growth value, of -$7/share. In other words, we do not think equity investors will ever see $1 of economic earnings under normal operations, which means the stock would be worth $0 today. Though TRUP is no longer a Zombie Stock, it remains very dangerous.

The Full Zombie Stock ListWhen we select companies to add to the Zombie Stock list, we look for companies that have:

• less than 24 months of cash to sustain their high cash burn, and
• a negative interest coverage ratio (EBIT/Interest expense).

While being on the Zombie Stocks list, companies may no longer meet these criteria. We review such instances to decide if we believe the company has truly improved its business, or if the results look more like a blip while the issues with the business model remain in place.

For the companies we believe have improved their standing, we remove them from the Zombie Stock list. In fact, we’ve removed companies from the list because:

1. they have extended their cash runway before running out of cash,
2. their stock prices are near $0,
3. they have been acquired, thereby saved from going to $0, or
4. they have turned their businesses around and look like they will avoid bankruptcy.

See Figure 5 for all stocks currently on the Zombie Stocks List.

Figure 5: Current Zombie Stocks List – 4/7/25

| Company | Ticker | Sector | Market Cap ($mm) | Economic Book Value ($mm) | | Affirm Holdings | AFRM | Technology | $11,949 | ($2,456) | | AMC Entertainment | AMC | Consumer Cyclicals | $994 | ($7,930) | | Beyond Meat | BYND | Consumer Non-cyclicals | $221 | ($2,409) | | BILL Holdings | BILL | Technology | $4,083 | ($2,382) | | Carvana | CVNA | Consumer Cyclicals | $35,784 | $763 | | Compass | COMP | Technology | $4,188 | ($1,369) | | DoorDash | DASH | Technology | $69,862 | $2,270 | | Peloton Interactive | PTON | Consumer Cyclicals | $2,008 | ($3,486) | | RingCentral | RNG | Technology | $2,021 | ($1,624) | | Sunrun | RUN | Energy | $1,486 | ($18,871) | | Sweetgreen | SG | Consumer Cyclicals | $2,372 | ($1,237) | | Wayfair | W | Consumer Cyclicals | $3,482 | ($7,482) |

Sources: New Constructs, LLC and company filings.

Of course, the risk of running out of cash within 24 months makes a stock risky. But what makes Zombie Stocks particularly dangerous? Low and negative economic book values.

For the few companies that currently generate positive earnings or net operating profit after-tax (NOPAT), they have liabilities that more than offset the positive earnings. In other words we do not think equity investors will ever see $1 of economic earnings under normal operations, which means the stock would be worth $0 today.

Making matters worse, the disconnect between market cap and economic book value increases risk. These stocks trade so far beyond the no growth value of the business that should the stock price correct, as we’re seeing in the current market, it could create a contagion where confidence in the business follows suit and pushes the company towards bankruptcy even quicker.

All Zombie Stocks – Current and RemovedFigure 6 shows all 33 Zombie Stocks. We mark those that have been removed from the list with an asterisk.

Prior reports where we removed stocks from the Zombie Stock List are here, here, here, here, here, here, here, here, here, and here.

Figure 6: Zombie Stock Reports: With Performance Since Publish Date Through 4/7/25

| Company Name | Ticker | Date Added | Return Since Add Date | Return as Short Vs. S&P 500 | | Freshpet Inc. | FRPT | 6/23/22 | -16% | 9% | | Peloton Interactive | PTON | 6/23/22 | -53% | 83% | | Carvana Co. | CVNA | 6/23/22 | 433% | -403% | | Snap Inc. | SNAP | 7/22/22 | 9% | 36% | | Beyond Meat, Inc. | BYND | 8/1/22 | -91% | 115% | | Rivian Automotive | RIVN | 8/8/22 | -61% | 94% | | DoorDash, Inc. | DASH | 8/10/22 | 114% | -93% | | Shake Shack, Inc. | SHAK | 8/10/22 | 112% | -75% | | AMC Entertainment | AMC | 8/15/22 | -99% | 116% | | GameStop Corporation | GME | 8/15/22 | -68% | 69% | | Chewy Inc. | CHWY | 8/17/22 | -55% | 57% | | Uber Technologies | UBER | 8/17/22 | 146% | -112% | | Robinhood Markets | HOOD | 8/22/22 | 307% | -261% | | Tilray Brands | TLRY | 9/7/22 | -49% | 92% | | Affirm | AFRM | 9/19/22 | 70% | -38% | | Sunrun | RUN | 9/21/22 | -79% | 116% | | Blue Apron * | APRN | 9/26/22 | -79% | 95% | | RingCentral | RNG | 10/3/22 | -48% | 81% | | Allbirds Inc. | BIRD | 10/17/22 | -71% | 89% | | Wayfair | W | 11/14/22 | -35% | 62% | | Atlassian | TEAM | 11/16/22 | 43% | -32% | | Bill.com | BILL | 11/16/22 | -66% | 94% | | Okta | OKTA | 11/16/22 | 47% | -2% | | Oatly | OTLY | 11/21/22 | -62% | 71% | | Twilio | TWLO | 11/23/22 | 39% | 4% | | Ceridian | CDAY | 11/23/22 | -3% | 11% | | Redfin | RDFN | 11/30/22 | 107% | -68% | | Five9 Inc. | FIVN | 12/5/22 | -37% | 72% | | Opendoor | OPEN | 1/30/23 | -9% | 50% | | Compass Inc. | COMP | 2/6/23 | 91% | -70% | | Sweetgreen Inc. | SG | 3/13/23 | 189% | -160% | | Lucid Group | LCID | 4/10/23 | -23% | 31% | | Trupanion | TRUP | 5/1/23 | 4% | 34% | | Overall Portfolio Return | -3% | 29% |

Sources: New Constructs, LLC and company filings.
*Stocks removed from the Zombie Stock List. Performance tracked through the date each was removed. Linked report goes to the report in which the stock was removed.

This article was originally published on April 8, 2025.

Disclosure: David Trainer, Kyle Guske II, and Hakan Salt receive no compensation to write about any specific stock, style, or theme.

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Our IPO research provides an alternative to the popular narratives on IPOs. This alternative deserves attention as it has warned and saved investors from losing big money on many of the worst IPOs over the last decade, such as Beyond Meat (BYND), WeWork (WE), Peloton (PTON), Robinhood (HOOD), Allbirds (BIRD), Didi Global (DIDI) and more. Investors should keep our track record in mind as they read this latest IPO warning.

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March Madness is nearing its end, but stock market madness is not letting up. Upsets might be exciting in basketball, but not so much in the stock market. No one wants a stock they own to blow up.

Our Danger Zone picks are specifically meant to help you avoid a portfolio upset. Only the worst of the worst stocks, ETFs and mutual funds get put in the Danger Zone.

Our proven-superior fundamental research gives us an edge in finding the worst and the best stocks. Diligence is the name of the game and can be the difference in feeling like you’re heaving up half court shots as the clock hits zero or methodically executing a strong game plan.

We originally put Gitlab Inc. (GTLB: $48/share) in the Danger Zone on October 8, 2021 prior to its IPO. Since the company’s IPO, it has outperformed as a short by 79%, falling 53% while the S&P 500 is up 26%.

Despite the outperformance as a short, this stock remains dangerous. After analyzing GitLab’s fiscal year 2025 10-K, our short thesis still stands. The company is dwarfed by its competition, remains unprofitable, and its stock price is too expensive and offers much more downside risk than upside potential.

GitLab’s stock could fall further based on:* the inability to convert free users into paying ones, * slowing recurring revenue growth from its paying customer base, * more profitable competition, and * a stock valuation that implies GitLab will grow its market share nearly 5x in an industry dominated by much larger and stronger companies.

Figure 1: GitLab Outperformance as a Short From 10/14/21 Through 3/28/25

Sources: New Constructs, LLC

What’s WorkingGitLab grew its total revenue 31% year-over-year (YoY) in fiscal 2025. Additionally, in fiscal 2025, the number of customers that generate:

• more than $5,000 of annual recurring revenue (ARR) increased 15% YoY.
• more than $100,000 of ARR increased 29% YoY.
• more than $1 million of ARR increased 28% YoY.

The company also beat on both the top- and bottom-line when it reported fiscal 4Q25 results.

What’s Not WorkingJust focusing on top-line growth, rather than trends, would be short-sighted. For instance, the customer segments noted above all grew at lower YoY growth rates in fiscal 2025 than in fiscal 2024. Slowing top-line growth is just one of the concerns of investing in GitLab at current levels, as we’ll show below.

Conversion Rate Is Not Nearly High EnoughThe freemium business model has been around for many years, and industry analysis estimates that most software-as-a-service (SaaS) companies have a 2%-5% freemium conversion rate. Conversion rate refers to the percentage of free users converted into paying users.

There’s no doubt GitLab has successfully attracted users. Its total registered users have increased from an estimated 30 million in fiscal 2024 to “more than 50 million” in fiscal 2025. Over the same time, GitLab’s base customers, which are the customers that generate more than $5,000 in ARR, increased from 8,602 to 9,893. In other words, in a time when the company’s reported estimate of registered users increased 20 million, its base customers increased by 1,291, much less than the average 2-5% conversion noted above.

The number of customers that generate higher ARR is also still a small portion of the company’s base customers. In fiscal 2025, the number of customers that generate more than $100,000 and more than $1 million in ARR were 1,229 and 123, respectively.

GitLab’s revenue is largely dependent on converting free users into paying users. The fact that the company converts so few continues to be alarming.

Figure 2: GitLab’s Revenue and NOPAT: Fiscal 2020 – 2025

Sources: New Constructs, LLC and company filings.

Existing User Upsells Are Slowing TooAs GitLab converts fewer free users to paid users, the recurring revenue generated by existing users is growing at slower rates in recent years.

The company measures its ability to retain and expand revenue generated by its existing customers in the form of dollar-based net retention rate, which is calculated by the dividing the current period ARR by the previous period ARR derived from its customer base at a point in time.

GitLab’s dollar-based net retention rate fell from over 145% in fiscal 2021 to 123% in fiscal 2025. See Figure 3.

Figure 3: GitLab’s Dollar-Based Net Retention Rate: Fiscal 2021 – Fiscal 2025

Sources: New Constructs, LLC and company filings.

Small Market Share Dwarfed by Industry LeadersGitLab’s closest competition comes from industry giant Microsoft (MSFT), which owns GitHub after acquiring the company in 2018. Other competitors include large tech/cloud players such as Amazon (AMZN), Alphabet (GOOGL), Oracle (ORCL), International Business Machines (IBM), and Atlassian Corp (TEAM). The broad cloud services market is dominated by established tech companies that are consistently looking to take market share.

More specifically, GitLab operates in the DevSecOps (development, security, and operations) market, which is a segment of the infrastructure as a service industry. The global DevSecOps market size was estimated to be worth $8.8 billion in 2024, which would give GitLab an approximate market share[1] of 9% based on revenue. On the user front, Gitlab’s estimated 50 million registered users would still be half of the 100 million users GitHub reported in 2023.

Not only do industry incumbents have more users and resources than GitLab, but they are significantly more profitable. Even though GitLab’s net operating profit after-tax (NOPAT) has improved, it is still negative. Per Figure 4, GitLab has the lowest NOPAT margin and return on invested capital (ROIC) in the industry.

Figure 4: GitLab’s Profitability Vs. Peers: TTM

Sources: New Constructs, LLC and company filings.

Taking market share in an industry mainly occupied by behemoths will be hard for GitLab, especially considering that GitLab’s revenue is 100% dependent on its DevSecOps operations, while its competitors have many other revenue streams and are more profitable.

Cash Burn Continues OnwardOn top of negative NOPAT, GitLab is burning cash.

Since fiscal 2021, GitLab’s free cash flow (FCF) has been negative on an annual basis every year except one (it generated $7 million in FCF in fiscal 2024). On a quarterly basis, Gitlab’s FCF has been negative in 11 of the 12 quarters in our company model.

From fiscal 2020 through fiscal 2025, GitLab has burned through a cumulative $1.4 billion (16% of enterprise value) in FCF excluding acquisitions. See Figure 5.

Following the same trend, the company’s economic earnings, the true cash flows of the business that take into account changes to the balance sheet, fell from -$163 in fiscal 2020 to -$194 in fiscal 2025.

Figure 5: GitLab’s Cumulative Free Cash Flow Since Fiscal 2021

Sources: New Constructs, LLC and company filings.

Valuation Implies GitLab Will Grow Its Market Share 5xBelow, we use our reverse discounted cash flow (DCF) model to analyze the future cash flow expectations baked into GitLab’s stock price. GitLab’s stock is priced as if it will grow revenue at accelerated rates and will 5x its current market share in the DevSecOps industry. We also present additional DCF scenarios to highlight the downside risk in the stock if GitLab fails to achieve these overly optimistic expectations.

To justify its current price of $48/share, our model shows GitLab would have to:

• improve its NOPAT margin to 17% (equal to IBM’s 2024 NOPAT margin, compared to GitLab’s -12% fiscal 2025 NOPAT margin) and
• grow revenue by 33% compounded annually (2.5x projected industry growth through 2030) for the next decade.

In this scenario, GitLab would generate $13.1 billion in revenue in fiscal 2035, which is 17x the company’s fiscal 2025 revenue. This scenario also implies GitLab’s NOPAT would reach $2.2 billion in fiscal 2035, compared to the company’s -$93 million NOPAT in fiscal 2025. Contact us for the math behind this reverse DCF scenario. For reference, ServiceNow (NOW), a much larger and profitable SaaS company, generated $1.2 billion in NOPAT in 2024.

The implied revenue in this scenario would be 40% of the estimated global DevSecOps market in 2034[2], which is far above the company’s estimated market share of 9% in 2024.

Furthermore, companies that grow revenue by 20%+ compounded annually for such a long period are “unbelievably rare”, making the expectations in GitLab’s share price even more unrealistic.

38%+ Downside If Revenue Grows at 2x Projected Industry Growth RateIf we instead assume GitLab:

• immediately improves NOPAT margin to 17% and
• grows revenue by 26% (2x projected industry growth) compounded annually each year through fiscal 2035, then

the stock would be worth $30/share today – a 38% downside to the current price. Contact us for the math behind this reverse DCF scenario.

In this scenario, GitLab would grow revenue to $7.7 billion in fiscal 2035, which would be over 10x the company’s fiscal 2025 revenue. This scenario also implies GitLab achieves a NOPAT of $1.3 billion in fiscal 2035, which is still far above the company’s NOPAT in fiscal 2025. $1.3 billion in NOPAT would be almost 3x higher than Workday’s (WDAY) fiscal 2025 NOPAT.

The implied revenue in this second scenario would represent 23% of the DevSecOps market in 2034, which is still nearly triple the company’s market share in 2024.

75%+ Downside If Revenue Grows at Projected Industry Growth RateIf we instead assume GitLab:

• immediately improves NOPAT margin to 17% and
• grows revenue by 13% (projected industry growth) compounded annually each year through fiscal 2035, then

the stock would be worth just $12/share today – a 75% downside to the current price. Contact us for the math behind this reverse DCF scenario.

Figure 6 compares GitLab’s implied future NOPAT in these scenarios to its historical NOPAT. For additional comparison, we include the TTM NOPAT of profitable SaaS companies ServiceNow (NOW) and Workday (WDAY).

Figure 6: GitLab’s Historical and Implied NOPAT: DCF Valuation Scenarios

Sources: New Constructs, LLC and company filings.

Stock Is Not Worth $1Each of the above scenarios assumes GitLab grows revenue, NOPAT and FCF without increasing working capital or fixed assets. This assumption is highly unlikely but allows us to create best-case scenarios that highlight the unrealistically high expectations embedded in the current valuation. For reference, GitLab’s invested capital grew 23% compounded annually from fiscal 2020 through fiscal 2025. If we assume GitLab’s invested capital increases at a similar rate in the DCF scenarios above, the downside risk is even larger.

Given that the performance required to justify its current price is overly optimistic, we dig deeper to see if GitLab is worth buying at any price. The answer is no.

The company has $45 million in minority interests, <$1 million in deferred tax liabilities, $140 million in outstanding employee stock options, and no excess cash. GitLab has an economic book value, or no-growth value, of -$5/share. In other words, we do not think equity investors will ever see $1 of economic earnings under normal operations, which means the stock would be worth $0 today.

This article was originally published on March 31, 2025.

Disclosure: David Trainer, Kyle Guske II, and Hakan Salt receive no compensation to write about any specific stock, sector, style, or theme.

Questions on this report or others? Join our online community and connect with us directly.

[1] To calculate GitLab’s estimated current market share, we divided the company’s fiscal 2025 revenue (ending January 31, 2025) of $759 million by the global DevSecOps market size at the end of 2024, which was $8.8 billion.

[2] To estimate the global DevSecOps market size in 2034, we assume the industry continues to grow at the projected 2025-2030 industry CAGR of 13.2% from 2031-2034 to calculate a projected market size of $33.2 billion.

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Senior Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: IPO Report: Valuation Rotten to the Core.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: One Stock Most Likely to Miss 3Q24 Estimates.

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Picking out the one stock most likely to miss the Street’s estimates for next quarter’s earnings is something one can only do with a superior earnings measure of the entire market. Only we provide such a measure. Without our proprietary footnotes data, other analysts are flying blind. They are forced to estimate earnings without the full picture of a company’s financials, including the material information hidden in footnotes.

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Every quarter, we comb through thousands of footnotes to find the one stock we think is most likely to miss the Street. We think this stock will miss because Street Earnings are artificially increased by non-operating income that we remove when we calculate our proven-superior Core Earnings.

You probably won’t be surprised to learn that Street Earnings overstate profits for the majority of S&P 500 companies. In this report, the second of our two earnings season preview reports, we show:

• the frequency and magnitude of overstated Street Earnings in the S&P 500 and
• the S&P 500 company most likely to miss 3Q24 earnings.

Our Robo-Analyst technology allows us to compare Core Earnings to Street Earnings across the entire market.

Street EPS Are Higher Than Core EPS for 369 S&P 500 CompaniesFor 369 companies in the S&P 500, or 74%, Street Earnings are higher than Core Earnings in the trailing twelve months (TTM) ended 2Q24. In the TTM ended 1Q24, Street Earnings were overstated for 373 companies.

The more interesting trend, however, is in the percentage of the S&P 500 where Street Earnings overstate Core Earnings by more than 10%. That number equals 42% (210 companies), which is slightly lower the 212 companies in the TTM ended 1Q24.

Those 210 companies make up 26.9% of the market cap of the S&P 500 as of 9/23/24, which is down from 27.4% of the market cap in 1Q24, measured with TTM data in each quarter. See Figure 1.

Figure 1: Overstated Street Earnings by >10% as % of Market Cap: 2012 through 9/23/24

Sources: New Constructs, LLC and company filings.

The 369 companies with overstated (by any amount) Street Earnings make up 66% of the market cap of the S&P 500 as of 9/23/24, which is down from 71% in 1Q24, measured with TTM data in each quarter.

Figure 2: Overstated Street Earnings as % of Market Cap: 2012 through 9/23/24

Sources: New Constructs, LLC and company filings.

Note that this analysis is based on our team analyzing the financial statements and footnotes for ~3,000 10-Ks and 10-Qs filed with the SEC after earnings season. We estimate that the cost of this work for most firms would be over $2 million each quarter. To say the least, there is tremendous value in our rigorous analysis of these filings across so many companies so that our clients can discern the best and worst stocks with unrivaled diligence.

….there’s much more detail in the full report, including the one S&P 500 company we think is most likely to miss Street Estimates for 3Q24 earnings.

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Buy this Danger Zone reportThis week we are removing stocks from the Danger Zone in a similar fashion to what we recently did for our Long Ideas.

As we explain below, these stocks no longer provide the same risk/reward as when we first put them in the Danger Zone. In some cases, the stock prices have almost reached $0. In others, the business has reached profitability. We’re closing the below Danger Zone positions.

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Senior Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Position Close Updates: Closing Danger Zone Picks in September 2024 and Position Close Update: Zombie Stock Up in Smoke.

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All eyes are on The Fed this week, but we want to bring your attention to a dangerous spot in the market. As expectations for a rate cut have increased, so too has this stock. In fact, shares are up over 90% in the past six months.

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Why are we brining this to your attention now? Because the company continues to struggle as much now as when we first put it in the Danger Zone in September 2022. Since then, the stock has outperformed as a short by 90%, falling 38% while the S&P 500 is up 52%.

The recent 90% stock run-up is untethered from the fundamentals of the business, and the stock looks exceedingly expensive, again. In fact, the no growth value of the business is less than $0/share, yet the stock trades ~$19/share.

Below is a free excerpt from our latest Danger Zone report, published today to Pro and Institutional members. We hope you enjoy it. Feel free to share with friends and family, and we hope your portfolio stays safe from stocks like this one.

This stock is risky because of:* rising cash burn resulting in short cash runway, * high expenses relative to revenue, * increasing debt balance, * a stock valuation that implies the company will grow 2x faster than projected industry growth.

What’s WorkingThe company grew its customer base 13% year-over-year (YoY) in 2Q24 and increased storage attachment rates on installations to 54% in 2Q24, which is up from 18% in 2Q23. Meanwhile, megawatts hours of storage capacity installed increased 152% YoY over the same time.

What’s Not WorkingThe company’s growth has come to a halt. Revenue was down 11% YoY in 2Q24, which represents the fourth straight quarter of YoY decline. Customer additions were also down 33% YoY in 2Q24. Beyond the topline, the company’s fundamentals are deteriorating too, as we’ll detail below.

Profits Trending LowerThe company’s Core Earnings declined from $139 million in 2017 to -$256 million in the trailing-twelve-months (TTM). Note that the company’s revenue increased from $533 million to $2.1 billion over the same time.

In the TTM period, the company generated a -33% NOPAT margin and a -3% return on invested capital (ROIC).

Consistently negative Core Earnings and ROIC highlight the business’ inefficient revenue growth and operations.

Figure 2: Revenue and NOPAT: 2017 – TTM

Sources: New Constructs, LLC and company filings

Zombie Stocks Are Inherently RiskyUnprofitable companies with fast-depleting cash reserves are risky investments in any market. These risks are higher when the cost of raising capital is higher. When we first named this company a Zombie Stock, we noted it had just two months until running out of cash (or needing to raise additional capital). The company has been able to prolong this runway by taking on more debt. However, taking on additional leverage has not fixed cash-burning operations.

One Month of Cash LeftGiven the company’s current cash balance, it can only support its TTM free cash flow (FCF) burn for one month from the end of August 2024. More details in Figure 3 in the full report. The fact remains that, without a significant improvement in operations, the company will need to take on additional debt and raise capital, else it run out of cash.

Unabated Cash BurnThe company’s FCF has been negative on both an annual and quarterly basis throughout the history of our model. In fact the company’s cash burn has been increasing each year since 2018. Since then, this company has burned through a cumulative $13.9 billion (78% of enterprise value) in FCF excluding acquisitions. In the TTM, the company’s cash burn sits at -$2,959 million.

….there’s much more in the full report. You can buy the report a la carte here.

Or, become a Professional or Institutional member – they get all Danger Zone reports.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Dark Clouds Closing In.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: The Most Overstated Street Earnings in 2Q24.

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While everyone else was cheering Nvidia’s (NVDA) stock back to new heights this week, I called the top for the stock first thing Monday (August 26th) morning on Chuck Jaffe’s MoneyLife show. You can listen to the whole interview here – my part starts at the 23:12 mark. If you want just my part, you can get it here.

In this letter, I am going to show you my secret weapon for calling the top in NVDA, the most important stock in the market. My secret weapon works for other stocks, too. I’m going to show you how to use it to call the top for another very popular stock. The video tutorial for this report is here.

I’m not guaranteeing that either stock won’t go back up like a crazy meme stock. These days anything is possible. But, I went out on a limb to say I think NVDA is headed down, way down for two reasons:

1. Liquidity is drying up – as detailed in this letter (see the section titled “Why Is the Yen Carry Trade A Big Deal?”).
2. My secret weapon raised red flags.

I needed to see liquidity dry up before I could apply my secret weapon. As one of my favorite hedge fund clients told me many years ago, the “only thing that causes a bubble to pop is a liquidity pinch.” And, that’s exactly what we saw on August 5th.

Figure 1: NVDA Price Movements

Sources: Google Finance

When I saw how much that liquidity pinch affected NVDA, I, along with many other folks, noted that much of the money pouring into NVDA was leveraged capital from the yen carry trade. Lots of investors were shorting the yen and putting that money into NVDA. In other words, investors were “speculating” not “investing” in NVDA, they were looking to make a quick buck with cheap capital.

Next, I needed to be sure that the liquidity pinch would continue and that neither the U.S. Federal Reserve nor the Bank of Japan were going to pull strings to re-ignite the yen carry trade. When they did not, I knew it was time to pull out my secret weapon for finding the most overvalued stocks in the market.

I first learned how to use this weapon back in 1996 when I started as an equity research analyst for Credit Suisse|First Boston, and I have been perfecting my techniques ever since. My mentors, Michael Mauboussin and Paul Johnson, were the first Wall Street analysts to put this weapon to work on stocks. Michael and Paul published a seminal report on the weapon in January of 1997 titled: Competitive Advantage Period “CAP” – The Neglected Value Driver. I liked the report so much that I printed out extra copies and handed it out to every analyst at the firm. Michael went on to co-author an entire book on the weapon with Alfred Rappaport called Expectations Investing, which is in its second edition.

My favorite quote from the Expectations Investing website is:

“Investors who use Expectations Investing will have a fundamentally better way to evaluate all stocks, setting them on the path to success.”

I agree 100% with that quote. I believe my clients and I get a huge edge from using this weapon. While the concept of expectations investing is rather easy to understand, it is very difficult to apply in the real world, especially at scale. When I started New Constructs, one of the first things we built into our technology was the ability to mass produce this weapon.

So, you’re probably wondering what this “weapon” is. I’m going to tell you what it is, and then I am going to show you how I use it.

The weapon is a reverse dynamic discounted cash flow model (DCF). Our clients will tell you that it is not just any discounted cash flow model, it is the best in the world for two reasons:

1. It’s driven by our proven-superior fundamental data. Models are only as good as the data that drives them, and we have the best data in the world.
2. It is super easy to use.

What the heck is a “DCF” model?The Discounted Cash Flow (DCF) model is a popular valuation tool that analysts use to determine the value of stocks.

From Google: “A Discounted Cash Flow (DCF) model is a financial model that estimates a company’s value by forecasting its future cash flows and discounting them to the present value. The model’s basis is that a company’s value is determined by its ability to generate cash flows for its investors.

DCF models are based on the belief that the value of an asset is equal to the present value of the cash flows it generates now and in the future. “Present” value means that the future cash flows are discounted to today’s value. This discount is necessary to account for the fact that cash in hand today is worth more than cash in hand a year from now, i.e. “time value of money”. The value of future cash flows is lowered by (1) inflation and (2) risk that those cash flows do not materialize.

Traditional DCF models rely on the analysts to forecast the future cash flows of a company, which determines the value of the company. In other words, they require analysts to predict the future of a company.

Most DCFs Are NOT Easy To UseWhen I first started using the reverse dynamic DCF back in 1996, everything was in an excel model, a very big and complicated model. When I rebuilt the model for the Value Dynamics Framework business that I ran for Credit Suisse|First Boston, I worked hard to simplify and make it easier for my clients (research analysts and portfolio managers) to understand. But, there’s only so much you can do to make a complicated excel model easier to use.

And, even worse, I had to create and build a new DCF model for every new company we wanted to cover. That meant reading lots of 10K filings, entering lots of data and building out lots of forecasts. Talk about a lot of very complex and complicated work. For those that really want to learn how models work, it makes sense to build at least a couple of these models by hand. After that, you have to be a special kind of nerd to want to do more. You’re probably not surprised to learn that there are not many people on this planet that want to know how these models work enough to invest the time to learn how to build one. Even fewer, who want to build more than the minimum number needed to learn how they work. Trust me, I saw, first hand, the apathy for building good models on Wall Street during the tech bubble – as detailed in this e-letter.

I did not share that apathy, and I probably built over a thousand dynamic DCF models. My team built another couple of thousand of these excel models. Yes, I admit that I am a nerd. Just don’t tell my buddies at Renzo Gracie Nashville that – haha.

The Robo-Analyst: Necessity is the Mother of InventionWhen I wrote the business plan for New Constructs, I knew we needed to automate the creation of these models because they are honestly too much very complicated work for just about any investor to undertake.

I believed we could build technology that would automate the creation of the models. And, if we were successful, we could give everyone access to this superior analytical weapon for analyzing stocks. Giving everyone access to this weapon meant everyone would be empowered with “a fundamentally better way to evaluate all stocks” – that’s what New Constructs is about. For those of you that already know me, you probably remember that the mission for New Constructs is “to improve the integrity of the capital markets.”

Those of you who already know me also know we succeeded in building that technology, which is known in the industry as the Robo-Analyst. It’s been featured in multiple top-tier publications including the Harvard Business School Case 118-068: “New Constructs: Disrupting Fundamental Analysis with Robo-Analysts”. If you email me and promise to take the case for personal use only, I’ll send you a copy.

Now, let me show you how I used this weapon to call the top in NVDA.

What the heck is a “reverse” DCF model?First, a quick note on the key concept behind how the “reverse” dynamic DCF model works. The first question I like to ask our new analyst trainees is: would you rather be a fortune teller or a critic of a fortune teller? I think it’s much easier to be a critic of someone trying to predict the future than to predict it myself. And, our reverse DCF models work the same way. These models do not attempt to predict the future. Instead, they reverse engineer the future cash flows required for the model to produce a value equal to the stock price. In other words, we start with the stock price and figure out what the future cash flows have to be to justify that stock price. Ok, now let’s get into the details.

How to Load the WeaponWARNING

Buckle up because I’m about to take you deep into nerdland when it comes to valuing stocks.

I logged into our Robo-Analyst website and opened the model for Nvidia. The first thing I saw: our Default scenario in our DCF model showed that it would take Nvidia over 100 years to grow into the profits needed to justify its stock price. The Default[1]scenario is based on:

1. Consensus estimates for revenue growth
2. Future NOPAT margins are roughly the same as past margins
3. Capital efficiency improves pretty aggressively.

Given that few investors want to think in terms of a hundred-year forecast horizon, I created two new scenarios for Nvidia’s future cash flows: Optimistic and Pessimistic. Here’s a summary of what I changed versus the Default scenarios:

1. Optimistic scenario: higher revenue growth and higher profit margins
2. Pessimistic scenario: lower revenue growth and lower profit margins

How To Aim the WeaponLet me show you exactly what all that means. Figure 2 is a picture from the Decision page in our company models. The purpose of the Decision page is to summarize the reverse dynamic DCF into a table and a few charts so clients can get a quick and easy read of the results of the model. Now, there’s still a lot of information to digest here – haha, I told you to buckle up – so I am breaking the Decision page into three parts: 1. the summary table (Figure 2), 2. the implied stock price charts (Figure 3) and 3. the implied future revenue and ROIC (Figures 4 & 6).

Figure 2, from left to right, what the model is showing:

1. The grey section presents the key variables over recent history.
   1. Revenue CAGR (“CAGR” stands for Compound Annual Growth Rate)
   2. ROIC – WACC = Return on Invested Capital minus Weighted Average Cost of Capital
   3. GAP (Growth Appreciation Period) = our term for CAP (Competitive Advantage Period). They are exactly the same thing.
2. Forecast 1 section shows the future performances required to justify the current price based on the Optimistic scenario.
3. Forecast 2 section shows the future performances required to justify the current price based on the Pessimistic scenario.

A key benefit to this table is that it allows for easy comparison between past performance of key variables to implied future performance.

Figure 2: Summary Tables for the Reverse Dynamic DCF for NVDA

Sources: New Constructs Company Valuation Models

To keep things simple, I am going to focus on explaining the tables based on the current stock price ($117.59), or the sections in red boxes.

1. In the Optimistic scenario, to justify $117.59, Nvdia must grow revenue at 47% CAGR while achieving an average ROIC-WACC spread of 513% for the next 8 years.
2. In the Pessimistic scenario, to justify $117.59, Nvdia must grow revenue at 29% CAGR while achieving an average ROIC-WACC spread of 486% for the next 16 years.

What is a “dynamic” DCF model?One last explanatory point here. The difference between a dynamic DCF and a traditional DCF model is in the forecast horizon. Traditional DCF models typically have one forecast horizon, e.g 5 years. Dynamic DCF models use multiple forecast horizons so that the user can solve for the GAP or CAP. A shortcoming in traditional DCF models is that they require an assumption on how much the cash flows after the forecast horizon (e.g. 5 years) grow. This future cash flow growth assumption can have a very large impact on the value of the stock. Dynamic DCF models do not require that assumption because their forecast horizons can be extended for as long as necessary to capture all the future cash flow growth.

How To Fire the Weapon: Part 1As an investor, the question you must answer is whether or not you believe that Nvidia can achieve the performance implied by the stock price. That question is the entire point of Expectations Investing. The beauty of Expectations Investing is that it relieves the investor of having to predict the future. Instead, the investor gets to be a critic of the future implied by the stock price. Now, a key point here is that the only way to be a well-informed critic is to quantify the expectations embedded in the stock price. And, that is exactly what our reverse dynamic DCF models do for clients.

Another way to pose the questions is: the market, via the stock price, is predicting that Nvidia can grow revenues and reach the ROIC-WACC spread for the respective GAPs. Do you agree?

1. If your answer is yes, then the stock is fairly valued.
2. If you think Nvidia will do even better, then the stock is cheap.
3. If you think Nvidia will do worse, then the stock is expensive.

Next, I am going to show you how our models can make answering this question easy.

First, our dynamic DCF quantifies the market’s expectations based on common-sense operational metrics (e.g. revenue growth and ROIC) that you can compare to the historical performance of the business and to your own expectations about the future performance of the business. Valuation doesn’t have to be done through a multiple that’s difficult to understand.

Figure 3 shows the implied share prices over multiple Growth Appreciation Periods so you can see how the different scenarios affect the valuation of the stock. Not surprisingly, the slope of the Optimistic line is steeper than the Pessimistic line because of the faster revenue CAGR assumptions in the Optimistic scenario. I want you to see this chart because it shows how we find the market-implied GAPs. It shows how we run scenarios over as long a time frame as needed for the DCF model to get to the current stock price. The year in which the DCF model produces a stock value equal to the current stock price is the market-implied GAP. The market-implied GAP is important for many reasons, but, in particular, it is important for creating charts like what we show in Figure 4.

Figure 3: Summary Tables for the Reverse Dynamic DCF Scenarios for NVDA

Sources: New Constructs Company Valuation Models

How To Fire the Weapon: Part 2Now, where this gets fun is using charts to compare historical revenues, ROIC and cash flow to the future levels implied by each scenario. Check out Figure 4, which shows how Nvidia’s past revenue compares to the future revenues implied by each scenario. This chart shows us that Nvidia’s revenue will reach $1.3 trillion at the end of its GAP for the Optimistic scenario[2]. And, its revenue will reach $3.7 trillion at the end of its GAP for the Pessimistic Scenario. The chart also shows the magnitude of the improvement in revenue compared to where the company has been in the past. Just look at how low and flat the revenue line is going back to 2010. The future implied revenues make the past revenue look tiny.

Figure 4: Comparing Historical Revenue to Implied Future Revenue

Sources: New Constructs Company Valuation Models

Still, when I saw $1.4 and $3.7 trillion, I was stunned. Seems like a big number. How big?

We need some context on how big $1.4 and $3.7 trillion in revenue is. Let’s start with the fact that Apple’s revenue at the end of its 3Q24 was $385.6 billion, less than 1/3rd of $1.4 trillion and about 1/10th of $3.7 trillion. Hmm, that makes those revenue expectations seem pretty big. Here’s another perspective: $3.7 trillion in revenue would make Nvidia as big as India, the 5th largest GDP in the world in 2023. See Figure 5.

Revenues of $1.355 trillion would make Nvidia bigger than Turkey, the #17-ranked country in the world based on 2023 GDP. After seeing that, I decided I thought the future performance expectations for Nvidia might be too high, way too high.

Figure 5: GDP of Largest Countries in 2023

Sources: Google Search

How To Fire the Weapon: Part 3Next, I wanted to see what the implied future ROICs looked like because companies can grow revenues and take market share if they slash prices and margins, which means ROICs usually come way down. In other words, revenue growth at any level, but especially large revenue growth like that in the Optimistic and Pessimistic scenarios, is next to impossible to achieve while also increasing ROIC. So, I ran the same comparison for ROIC as I did for revenue, and you can see the results in Figure 6.

“Wow” was my reaction. Like Figure 4, Figure 6 shows the magnitude of the improvement in ROIC compared to where the company has been in the past. Nevertheless, more contact on how those implied ROIC compare to the best ROICs in recent history would be helpful.

Figure 6: Comparing Historical ROIC to Implied Future ROIC

Sources: New Constructs Company Valuation Models

We need more context here to really understand how reasonable or unreasonable it is to believe that Nvidia will achieve an 839% or 975% ROIC while also growing revenue at the rates shown above. Fortunately, New Constructs is the perfect system to research ROIC stats.

First, Nvidia’s current ROIC is 195%, which is 6x higher than 2023 and much higher than the 130% it achieved in fiscal year 2024.

Next, I looked at the number of times over the last 5 years that a company in the S&P 500 achieved an ROIC greater than 100%. Here are the results.

1. 100%: 11 times
2. 200%: 7 times
3. 300%: 3 times
4. 500%: 2 times
5. 600%: 1 time
6. 700%: none

Over the last 5 years, only one company in the S&P 500 averaged more than 100% ROIC.

Lastly, I reviewed two of the highest ROIC businesses of all time in technology: Apple and Microsoft. Figure 7 plots their ROICs from 1998 to present. Apple’s ROIC peaked at nearly 400% and is now well under 100%. Microsoft peaked at 200% and is now well under 30%.

The takeaway for me is that it’s more likely that hell will freeze over than Nvidia will get to an ROIC over 800%.

Figure 7: ROIC Trends for Apple and Microsoft from 1998- Present

Sources: New Constructs Company Valuation Models

I Love the Smell of Napalm in the MorningNeedless to say, I think it’s even less likely that Nvidia will grow revenues at 47% or 29% while also achieving such huge increases in ROIC as detailed in the scenarios above.

And given the liquidity pinch, I decided to call the top for NVDA.

How You Get an EdgeNow, my secret weapon is no longer my secret. It’s yours, too.

I hope this report shows you why I think the New Constructs reverse dynamic DCF model, along with our research platform, is a weapon that can give you “a fundamentally better way to evaluate all stocks, setting on the path to success.”

Having the ability to quantify market expectations with precision and based on the best fundamental data in the world is a huge competitive advantage for investors. Add the ability to compare the performance track records of thousands of companies over the last 25+ years, and I think it’s fair to say we have a pretty powerful weapon that gives us and our clients a large proprietary edge.

With the GAP rating as a core component of our Stock Ratings, every one of our clients from the Stock Tracker 50 to the Institutional user gets to use this weapon.

As for the other stock I mentioned at the beginning of this letter. It’s Super Micro Computer, Inc. (SMCI). I mentioned it on air on Tuesday as like Nvidia – a very expensive stock with lots of downside risk. I also pointed out that we suspended the rating for a major red flag we found in the footnotes. Needless to say, we were not surprised at all to see the stock take a huge hit this week.

As you can see from Figure 8, the company’s Valuation metrics are flashing red. They were even more red before the stock tanked. When we ran the reverse DCF model on SMCI last week, we saw similar signs of over valuation as we saw with Nvidia. Same story, different stock.

Figure 8: Rating for Super Micro Computer, Inc. (SMCI)

Sources: New Constructs Ratings page

If you’d like to see some live action use of our reverse DCF model, join our private online community (use this form to sign up for free) and check out Reverse DCF case studies.

Want more details on New Constructs?

As always, we are 100% transparent in all of our research, reports, ratings, and models. We regularly review our work and research on Long Ideas and Danger Zone Ideas with clients. We want you to know how much work we do! Here’s some ways to keep in touch with us:

1. Free live Podcast every month. The next one is on Friday, September 13th, register here. The last one was August 9th. Get free replays in our online community.
2. Join our online community (use this form to sign up for free). Ask questions and make friends! Lots of humble investors talking to each other is a good thing.
3. Monthly Let’s Talk Long Ideas webinars where we do deep dives into our research, analytics, reverse DCF models and ideas for our Professional and Institutional clients. Our next one is on August 14th at 5:00pmET. Replays are here for our Professional and Institutional clients.

If this message resonated with you and you want to start your investing future with us – schedule a meeting with us here.

Diligence matters,
David

This article was originally published on September 3, 2024.

Disclosure: David Trainer, Kyle Guske II, and Hakan Salt, receive no compensation to write about any specific stock, sector, style, or theme.

Questions on this report or others? Join our online community and connect with us directly.

[1] The same is true for the Default scenario in most of our models.

[2] We use a no-growth terminal value in our DCF models. The formula is NOPAT(t+1)/WACC. Note that we believe a no-growth terminal value is necessary for a reverse dynamic DCF model to have integrity.

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Reddit, (RDDT: $5 billion valuation), should start trading as a newly public company sometime in March. At this reported valuation of $5 billion, Reddit earns an Unattractive Stock Rating.

While Reddit’s expected $5 billion valuation is half of its $10 billion private market valuation seen in 2021 when interest rates were zero and money was cheap, it remains much too high.

Reddit reminds us of the fast-growing, but highly unprofitable IPOs we saw in 2021. Sure, Reddit birthed some of the most volatile meme stocks through the WallStreetBets subreddit, but the company has never been profitable and should not be a publicly traded company. Reddit’s IPO marks the return of the junk IPO. We think the company may never monetize its platform without angering its users and the entire premise of Reddit is user-generated content. This business model is inescapably built on a catch-22: make money or please users.

A $5 billion valuation implies that Reddit will grow its user base to 26x current levels, which would be nearly 5x the size of Snap (SNAP), which is a highly unlikely feat. Reddit looks overvalued, and we think investors should pass on this IPO.

Below, we’ll analyze the risks to the business and use our reverse discounted cash flow (DCF) model to show how expensive the IPO is. Our IPO research aims to provide more investors with more reliable fundamental research.

Return of the Unprofitable IPO?Remember the IPOs of 2020-21, such as DoorDash (DASH), Robinhood (HOOD), Coinbase (COIN), Didi Global (DIDIY), and Rivian (RIVN)? Remember how they performed? Most are on our Zombie Stock list, where Reddit will likely be if it ever goes public.

The first social media company to go public in years will not only test investors’ appetite for the next money-losing operation, but it will also provide some clarity on the IPO market in general. Let’s hope investors aren’t throwing caution to the wind and piling into the latest profitless company. Real diligence reveals that Reddit is not only unprofitable, but also highly overvalued.

Losses Shrinking, But Still LargeReddit has successfully grown its top line, but not the bottom-line. In 2023, the company’s revenue grew 21% year-over-year (YoY). However, Reddit’s net operating profit after tax (NOPAT) was -$131 million in 2023 and it burned $841 million in free cash flow (FCF).

Figure 1: Reddit’s Revenue & NOPAT: 2022 – 2023

Sources: New Constructs, LLC and company filings

Users Are Growing…Reddit has successfully leveraged its brand recognition and community focused platform to gain users. Total daily active uniques (DAUq) have grown from an average of 54.8 million in 1Q21 to 73.1 million in 4Q23. Quarter-over-quarter (QoQ) and YoY, these user growth rates are trending higher, per Figure 2.

Figure 2: Reddit Daily Active Uniques QoQ Growth Rate: 2Q21 – 4Q23

Sources: Company filings

…And Those Users Generate RevenueDespite its smaller (relative) user base, when measured by DAUg, Reddit’s average revenue per user (ARPU) is higher than social peers such as Snap and Pinterest (PINS). See Figure 3. Moving forward, finding a way to translate those revenues to profits is critical to Reddit’s success and ability to justify its lofty valuation.

Figure 3: Reddit’s ARPU Vs. Peers: 4Q23

Sources: New Constructs, LLC and company filings

Projecting Strong Growth OpportunitiesThose only skimming the S-1 could believe that Reddit is poised for significant growth in the coming years. However, a more thorough examination reveals many risks and red flags that could challenge such growth.

As Reddit tells it in its S-1, its growth opportunities include advertising, data licensing and artificial intelligence, and adding additional commerce and digital goods/services to the platform. From the S-1, each of these markets boasts strong expected growth rates:

• S&P Global Market Intelligence forecasts the Global Advertising market will grow 8% compounded annually through 2027.
• International Data Corporation (IDC) forecasts the broader AI market will grow 20% compounded annually through 2027.
• IDC forecasts the “user economy” market will grow 12% compounded annually through 2027.

Nevertheless, the problem is not growth. As we have seen with so many Zombie Stocks, spend enough money, and anyone can grow revenues. The problem is profits.

Not All Growth is ProfitableWhile growing users is key to any social media or community platform, not all growth is profitable.

Reddit is attracting users, but not those that can be monetized. In its S-1, Reddit notes that from July 2023 through December 2023, 75% of the incremental users added were “logged-out users”. These users (emphasis added) “typically come to Reddit via search engines, spend less time on the site, and do not monetize at the same rate as logged-in users.”

In other words, Reddit is growing, but it is attracting a type of user that won’t make the company any profit.

*Heavily Concentrated Revenue Adds Risk to Growth Potential*98% of Reddit’s revenue in 2023 came from third-party advertising on the site and 28% of all revenue came from ten customers. The high revenue weakens pricing power, and the loss of a large customer would materially hurt the business.

Reliance on Unpaid Moderators Creates Unique RiskReddit’s user-focused communities create a unique experience, one that is generally not available on most social media platforms. However, unlike other platforms, which employ a large quantity of moderation teams, Reddit relies heavily on unpaid moderators (“mods”). These mods are volunteers responsible for key functions such as reviewing content and defining and enforcing community rules.

This unique approach makes the Reddit experience more personal, but it is not without risks. Moderators are extremely important and could leave at any time. From the company’s S-1:

“Redditors who volunteer to be moderators of Reddit communities are an important part of our business’ ecosystem. … Because moderators are volunteers, any moderator can decide to stop acting as a moderator and participate only as a community member, or to leave our platform entirely. “

These key members also hold large influence and power within the community and can actively disrupt the normal operations of Reddit’s business. Again, key quotes from the S-1:

• “[moderators] may be able to leverage their influence within those communities to change the dynamics of the discourse within the communities or to disrupt the normal operation of their communities or other communities on our platform.”
• “Moderators can also band together and, for various reasons, decide to shut down the normal operation of their communities in a manner that degrades the experiences of all Redditors…”

The second risk in those quotes is not just hypothetical. It is real. In June 2023, moderators set subreddit’s that counted millions of users private, thereby making them inaccessible to the public during a 48-hour protest of Reddit’s decision to increase its API pricing. Prior to that, moderators have locked down communities over Reddit’s hiring decisions and hate speech policies. Leaving moderation up to users creates a community that matches its users wants and needs, but it can also create damaging conflicts between the users and the company.

Users Already Seem Unhappy with the IPOIt’s impossible to analyze Reddit without accounting for the power of its users (moderators included). The meme-stock phenomenon traces some of it roots to the WallStreetBets subreddit, and those same users are much less enthusiastic about Reddit as a public company than they were GameStop (GME) back in the day.

Despite providing certain users the ability to participate in the IPO, there are many reports that users are unhappy with the IPO. The overarching question – can a platform built on community and shared interests lose its value proposition when its business is run to meet quarterly sales and profit expectations?

Reddit also warns that the influence of users, such as those in the WallStreetBets community, could increase volatility and uncertainty in its shares. Keeping these users engaged and active will be key to growing the platform but could run counter to why those users use Reddit in the first place.

Low Switching CostsUnlike other social platforms, which are built around friends, family, and meaningful connections, Reddit, alongside Twitter, is arguably the most anonymous platform. Users can enter the platform without investing much time and can leave just as easily. Reddit recognizes as much in its S-1, when it notes “we face intense competition for users with low switching costs.”

For Reddit users, moving to another platform, or finding information elsewhere is trivial. The low switching costs make monetizing users more difficult because they can bolt at the slightest inconvenience and aren’t necessarily loyal to the platform.

Even With Unpaid Contributors, Costs Remain HighUser risk aside, Reddit’s path to profitability requires a significant reduction in expenses, and we don’t see significant cost reduction coming anytime soon. Reddit notes that it is “in the early stages” of monetization efforts. We believe reducing costs in key areas such as sales and marketing or R&D would signal less growth moving forward, not more. Companies that cannot grow without being terribly unprofitable are prime candidates for the Zombie Stock list.

Reddit’s cost of revenue, sales & marketing, general & administrative, and research & development costs were 117% of revenue in 2023, per Figure 4.

To maintain competitiveness, attract new users, and develop new products to engage those users, Reddit must continue this spending. How else can it win the fight for advertising dollars from firms with some of the most resources in the market, such as Facebook and Google?

Figure 4: Reddit’s Operating Expenses: 2022 – 2023

Sources: New Constructs, LLC and company filings

Competition Is PlentifulAs an internet community, Reddit vies for users’ attention against an endless number of competitors. In its S-1, Reddit specifically highlights content and communication services, online marketplaces, and large language models as key competitors. The companies that make up each of these groups range from the largest and most successful to other unprofitable social media companies fighting for users, such as:

1. Alphabet (GOOGL)
   • Google
   • YouTube
2. Meta Platforms (META)
   • Facebook
   • Instagram
   • Threads
   • WhatsApp
3. Wikipedia
4. Snap (SNAP)
5. X (formerly Twitter)
6. Pinterest (PINS)
7. TikTok
8. Roblox (RBLX)
9. Discord
10. Twitch
11. Facebook Marketplace
12. Nextdoor (KIND)
13. Craigslist
14. Poshmark
15. Etsy (ETSY)
16. ChaptGPT
17. Gemini
18. Anthropic

Reddit is Nowhere Near BreakevenReddit is an unprofitable social media company fighting for users. We think it will struggle to gain any advantage over the largest and successful competitors. Per Figure 5, Reddit’s NOPAT margin, invested capital turns (a measure of balance sheet efficiency) and return on invested capital (ROIC) rank in the bottom half of its competition, and nowhere near breakeven. We included Match Group (MTCH) and Bumble (BMBL) in Figure 5 as a reference as they’re business also revolves around social media and communication with others.

Figure 5: Reddit’s Profitability Vs. Competition: TTM

Sources: New Constructs, LLC and company filings

Valuation Implies Seemingly Unrealistic GrowthWhen we use our reverse discounted cash flow (DCF) model to analyze the future cash flow expectations baked into RDDT, we find that shares, even at $5 billion, embed very optimistic assumptions about margins and growth. We think the stock holds downside risk at its IPO valuation.

Reported Valuation Implies Reddit’s DAUq Will Rival FacebookTo justify its reported valuation of $5 billion, our model shows that Reddit would have to:

• immediately improve NOPAT margin to 5% (compared to -16% in 2023 and higher than Pinterest’s 3-yr average margin) and
• grow revenue by 38% compounded annually through 2033.

In this scenario, Reddit would generate $20.7 billion in revenue in 2033, which is almost 26x its 2023 revenue and 4.5x Snap’s 2023 revenue. At its current annual ARPU[1], $12.38 at the end of 2023, this scenario implies the company would have 1.7 billion DAUs. For reference, at the end of 2023, Facebook had 2.1 billion DAUs, Snap had 414 million DAUs and Reddit had 73 million.

This scenario also implies Reddit grows NOPAT to $1.0 billion in 2033, compared to -$131 million in 2023.

We think that it is overly optimistic to assume Reddit will achieve margins anywhere near 5% without a material increase in user monetization, which risks upsetting users that have grown accustomed to the current experience. Reddit’s lack of competitive moat and concerns about advertisers’ willingness to promote on Reddit raise further questions about its ability to improve margins while maintaining revenue growth rates.

Growing DAUq to 1.7 billion also seems overly optimistic as well. The market’s expectations for both margin improvement and DAUq growth look unrealistically high standalone. We think it is even more unlikely that the firm could achieve both at the same time.

There’s 97%+ Downside if Growth Matches 2023Even if we instead assume a newly public Reddit focuses more heavily on monetization, and less on user growth than in the scenario above, and:

• NOPAT margin immediately improves to 8% (double Pinterest’s 3-year average margin) through 2033, and
• revenue grows 21% compounded annually (equal to 2023 revenue growth rate) through 2033, then

the stock would be worth just $141 million today – a 97% downside to the reported IPO valuation. At Reddit’s current ARPU, this scenario implies Reddit has 437 million DAUs in 2033. Even if we assume Reddit can double its ARPU, this scenario implies it has 218 million DAUs in 2033, or 3x its 2023 DAUs.

This scenario also implies Reddit grows NOPAT to $433 million in 2033. Again, for reference, Reddit’s 2023 NOPAT is -$131 million.

Figure 6 compares Reddit’s implied future NOPAT in these scenarios to its historical NOPAT. For reference, we include Pinterest and Etsy’s NOPAT.

Figure 6: Estimated IPO Price Looks Overvalued

Sources: New Constructs, LLC and company filings

Each of the above scenarios assume Reddit grows revenue, NOPAT, and FCF without increasing working capital or fixed assets. This assumption is highly unlikely but allows us to create best-case scenarios that demonstrate the high level of expectations embedded in the reported IPO valuation.

Ignore the Non-GAAPMany unprofitable companies present non-GAAP metrics to appear more profitable than they really are, in hopes of justifying a higher valuation, and Reddit is no different. Reddit provides investors with the popular Adjusted EBITDA metric. Not surprisingly, Adjusted EBITDA gives a more positive picture of the firm’s business than GAAP net income and our Economic Earnings.

For instance, Reddit’s 2023 adjusted EBITDA removes $49 million in stock-based compensation and $14 million in depreciation and amortization. After removing all items, Reddit reports adjusted EBITDA of -$69 million in 2023. Meanwhile, GAAP net income is -$91 million while economic earnings are even lower at -$288 million. See Figure 7.

Figure 7: Reddit’s Adjusted EBITDA, GAAP Net Income, and Economic Earnings: 2022 – 2023

Sources: New Constructs, LLC and company filings

Control Concentrated in the Hands of a FewIn its initial S-1, Reddit disclosed it will go public with dual class shares. New investors will buy the A shares, which receive one vote per share, while existing investors will own shares that receive 10 votes per share. This super voting class gives existing shareholders significant say over corporate governance matters.

Prior to the IPO, large existing shareholders, such as Advance Magazine, FMR LLC, Quiet Capital, Tacit Capital, Open AI’s Sam Altman, Tencent, and Vy Capital, own 75% of the voting power in the company.

While these figures could shift slightly post IPO, and it’s too early to tell given that Reddit’s initial S-1 lacks details around how many shares it will be selling and what that amount will mean in relation to existing shareholders, one thing is clear. New shareholders will not have much say in the corporate governance of the business.

Emerging Growth Company Status Limits TransparencyBy electing to operate as an “Emerging Growth Company”, Reddit is exempt from certain requirements that are beneficial to shareholders.

More specifically, Reddit notes in its S-1 that, as an emerging growth company, it will:

• present only two years of audited financial statements in the S-1,
• not be required to obtain an auditor’s attestation report on the company’s internal controls over financial reporting requirements of the Sarbanes-Oxley Act,
• provide less extensive disclosure about executive compensation arrangements, and
• will not require stockholder non-binding advisory votes on executive compensation or golden parachute arrangements,

Reddit notes in its S-1 that it is continuing to develop and refine its disclosure controls and improving its internal control over financial reporting. Investors need to know if a company’s financials can be trusted, and in this case, there are no assurances given that the reporting procedure are still being built and tested.

No White Knight to Save InvestorsThe expectations baked into Reddit’s reported IPO valuation look highly optimistic. Often, the best hope investors might have in overvalued stocks is for an established company to acquire the firm. However, investors shouldn’t get their hopes up. As noted above the competitors with the most cash already have larger user bases, with better monetization, and robust advertising platforms. Additionally, competition has had many years to acquire Reddit prior to this IPO and have chosen not too. Acquiring Reddit now wouldn’t create all that much value for a competing social platform.

Additionally, Reddit’s economic book value, or no growth value, is -$5.4 billion. Potential acquirers will not likely have interest in paying anywhere close to the lofty IPO valuation for a business that will likely face significant challenges moving forward.

This article was originally published on March 1, 2024.**

Disclosure: David Trainer, Kyle Guske II, and Hakan Salt receive no compensation to write about any specific stock, style, or theme.

Questions on this report or others? Join our Society of Intelligent Investors and connect with us directly.

[1] Calculated as 2023 revenue of $804 million divided by quarterly average DAUq over 2023 (65 million).

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Wall Street analysts are too bullish on first quarter earnings expectations for most S&P 500 companies. Although down from record highs set in recent quarters, the percentage of S&P 500 companies whose Street EPS exceeds our Core EPS[1] remains high at 68%.

This report shows:

• the frequency and magnitude of overstated Street Earnings[2] in the S&P 500
• five S&P 500 companies likely to miss 1Q23 earnings

Get our report on the S&P 500 companies most likely to beat 1Q23 Street EPS estimates here.

Learn more about the best fundamental researchStreet Exceeds Core EPS for 339 S&P 500 Companies339 companies with overstated Street Earnings make up 74% of the market cap of the S&P 500 as of 4/6/23, which is down from 76% in 3Q22, measured with TTM data in each quarter.

Figure 1: Overstated Street Earnings as % of Market Cap: 2012 through 4/6/23

Sources: New Constructs, LLC and company filings.

When Street Earnings are higher than Core Earnings, they are overstated by an average of 19%, per Figure 2. For over a third of the S&P 500 (186 companies), Street Earnings are overstated by more than 10% vs. Core Earnings.

Figure 2: Street Earnings Overstated by 19% on Average in TTM Through 4Q22[3]

Sources: New Constructs, LLC and company filings.

Five S&P 500 Companies Likely to Miss 1Q23 EarningsFigure 3 shows five S&P 500 companies likely to miss calendar 1Q23 earnings because their Street EPS estimates are overstated. Below, we detail the hidden and reported unusual items that caused the overstated Street Earnings in the TTM ended 4Q22 for First Solar (FSLR). Because investors and analysts tend to anchor their earnings projections to historical results, errors in historical Street EPS lead to errors in Street EPS estimates.

Figure 3: Five S&P 500 Companies Likely to Miss 1Q23 EPS Estimates

Sources: New Constructs, LLC, company filings, and Zacks
*Assumes Street Distortion as a percent of Core EPS is the same for 1Q23 EPS as for TTM ended 4Q22.

First Solar: The Street Overestimates Earnings for 1Q23 by 204%The Street’s 1Q23 EPS estimate of $1.06/share for First Solar is $2.16/share higher than our estimate for 1Q23 Core EPS of -$1.10/share. Large gains due to the sale of a business and “other income” drive much of the difference between Street and Core EPS estimates. After removing these non-recurring gains, our analysis of the entire S&P 500 reveals First Solar as one of the companies most likely to miss Wall Street analysts’ expectations in its 1Q23 earnings report.

First Solar’s Earnings Distortion Score is Miss and its Stock Rating is Unattractive, in part due to its bottom-quintile return on invested capital (ROIC) of -2%, 0% free cash flow (FCF) yield, and price-to-economic book value (PEBV) ratio of 74.4.

Below we detail the unusual gains that materially boost and distort First Solar’s 2022 Street and GAAP earnings. After removing all unusual items, we find that First Solar’s 2022 Core EPS are -$1.28/share, which is lower than 2022 Street EPS of -$0.42/share and GAAP EPS of -$0.41/share.

Figure 4: Comparing First Solar’s GAAP, Street, and Core Earnings: TTM Through 4Q22

Sources: New Constructs, LLC and company filings.

Figure 5 shows the differences between First Solar’s Core Earnings and GAAP Earnings so readers can audit our research. Given the small difference between GAAP and Street Earnings, the adjustments that drive the difference between Core and Street Earnings are likely mostly the same.

Figure 5: First Solar’s GAAP Earnings to Core Earnings Reconciliation: 2022

Sources: New Constructs, LLC and company filings.

More details:

Total Earnings Distortion of $0.86/share, which equals $91.8 million, is comprised of the following:

Hidden Unusual Expenses, Net = -$0.59/per share, which equals -$63.3 million and is comprised of

• $63.3 million impairments and net losses on disposal of long-lived assets

Reported Unusual Gains, Net = $2.52/per share, which equals $268.3 million and is comprised of

• $253.5 million gain on sales of businesses
• $31.2 million in “other income”
  • First Solar disclosed in the notes that, in connection with its sale of the Luz del Norte plant, creditors agreed to forgive $30.2 million in loan balances, which was recorded as a gain in “Other Income”
• -$16.4 million foreign currency loss

Tax Distortion = -$1.06/per share, which equals -$113.2 million

Core Earnings are a more comprehensive measure of profits and capture all unusual items to ensure we calculate First Solar’s true profitability.

This article was originally published on April 12, 2023.

Disclosure: David Trainer, Kyle Guske II, and Italo Mendonça receive no compensation to write about any specific stock, style, or theme.

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[1] The Journal of Financial Economics features the superiority of our Core Earnings in Core Earnings: New Data & Evidence.

[2] Street Earnings refer to Zacks Earnings, which are reported to remove non-recurring items using standardized assumptions from the sell-side.

[3] Average overstated % is calculated as Street Distortion, which is the difference between Street Earnings and Core Earnings.

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The post Zombie Stock #32 – Into Thin Air appeared first on New Constructs.

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Senior Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Zombie Stock #32 – Into Thin Air.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Street Earnings Overstated for 74% of S&P 500 in 4Q22.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Street Earnings Overstated for 74% of S&P 500 in 4Q22.

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The post Don’t Get Burned by Poor Holdings and High Fees appeared first on New Constructs.

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Senior Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Don’t Get Burned by Poor Holdings and High Fees.

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The post Zombie Stock #31 – The Grass is Not Greener appeared first on New Constructs.

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Senior Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Calculating True Profits & More from the Real Earnings Season.

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Senior Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Dash to the Death.

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Quarterly earnings season may be winding down, but the real earnings season – annual 10-K filing season – is just ramping up.

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The post Zombie Stock #30 – Headed South appeared first on New Constructs.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Zombie Stock #30 – Headed South.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Zombie Stock #29 – Close This Door.

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Tesla (TSLA: $167/share) reported record earnings on January 25, 2023 and the stock is up over 15% on the news. While the earnings beat may make headlines, a deeper look bolsters our thesis that the stock is worth closer to $25/share – an 85% downside from the current price. See all our reports on Tesla here.

What Happened?Production miss. Tesla failed its 50% annual production growth rate goal as it grew just 47% in 2022. Deliveries were even lower at 40%. Moving forward, Tesla stated it would “grow production as quickly as possible in alignment with the 50% CAGR target” but such a promise looks less reliable after 2022 results.

Additionally, Tesla’s 2023 production guidance of 1.8 million vehicles is just a little higher than the annualized 4Q22 production level of 1.76 million cars. Even Elon Musk’s unofficial goal of producing 2 million vehicles in 2023 is only 14% above 4Q22’s annualized production rate.

Gross margin decline. Tesla’s automotive gross margin fell 466 basis points in 4Q22 to its lowest level in the last five quarters. The automotive gross margin for 2022 fell 82 basis points YoY. These results largely exclude Tesla’s recent price cuts, which put margins at risk of falling even more.

What Does It Mean?Tesla’s stock remains highly overvalued. The company is not immune to higher costs and demand elasticity in a rising rate and slowing economic environment. Worse yet, Tesla’s competition keeps getting stronger and has ample resources and cash flows to invest in the EV market. Tesla faces an increasingly uphill battle to secure its competitive position, which makes its current valuation look even more unrealistic.

This News Supports Our Bear Thesis – Tesla Remains OvervaluedYesterday’s earnings report, coupled with Consumer Reports announcing that Tesla’s Autopilot ranks seventh out of 12 systems tested, affirms our thesis that Tesla’s valuation remains untethered from reality.

While the stock has fallen 28% since our October 2022 report, the downside risk is still substantial. Even if we assume Tesla sells 3.9 million cars (12% of projected global EV passenger market in 2031) at an ASP of $40k (equal to General Motors in 2Q22) in 2031, the stock would be worth just $25/share today – an 85% downside to the current stock price.

As we wrote in October, Tesla’s price ($205/share) implied it would sell 12 million EVs in 2031 at average selling prices (ASP) of $54k, which would equal 37% of the projected global EV passenger vehicle market in 2031.

ASPs, however, have been on a downward trajectory for years. With lower ASPs, Tesla would need to take a 50+% share of the projected EV market in order to reach the targets implied by its valuation.

This article was originally published on January 27, 2023.

David Trainer, Kyle Guske II, Matt Shuler, and Italo Mendonça receive no compensation to write about any specific stock, sector, style, or theme.

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The post Don’t Chase Yield with This Fund’s Poor Holdings appeared first on New Constructs.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Don’t Chase Yield with This Fund’s Poor Holdings.

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Carvana’s (CVNA: $6/share) stock dropped more than 50% on December 7, 2022 and, despite rebounding for a month, fell another 9% on January 19, 2023 and 21% in the past week. Recentnews that the company adopted a “poison pill” to ward off hostile takeover lowers stupid money risk and supports our thesis that CVNA could fall even further to $0/share. We first made Carvana a Danger Zone pick in April 2019 and identified it as a Zombie stock in June 2022. Since our original report, CVNA is down 90% while the S&P 500 is up 35%. See all our reports on Carvana here.

What Happened?On December 6, 2022, Bloomberg reported that Carvana’s largest (70% of outstanding unsecured debt) creditors entered into an agreement to cooperate in possible debt restructuring negotiations.

What Does It Mean?Bankruptcy could be on the horizon. Though Carvana has denied any existing cooperation with creditors, investors have sold shares on the implication that a significant debt restructuring or bankruptcy is imminent.

This News Supports Our Zombie Stock ThesisOur thesis stated that Carvana’s business is undifferentiated and its cash burn, unsustainable. Given the latest developments, it is clear that creditors and investors are taking notice.

Carvana embraced a growth-at-all-costs strategy and could not turn a profit even with COVID tailwinds propelling its top-line forward. The company is now facing a challenging funding environment, softening demand, and fierce competition from incumbents such as CarMax (KMX) and AutoNation. The latest news leads us to reiterate our view: CVNA is a Zombie Stock, and the company’s imminent liquidity issues could take its stock to $0.

This article was originally published on January 20, 2023.**

David Trainer, Kyle Guske II, Matt Shuler, and Italo Mendonça receive no compensation to write about any specific stock, sector, style, or theme.

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The post A Winning Focus List: Short Pick with Further to Fall appeared first on New Constructs.

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The post A Focus List: Short Pick Poised to Pay Off appeared first on New Constructs.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: A Focus List: Short Pick Poised to Pay Off.

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Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Zombie Stock #28 – Please Don’t Stay on The Line.

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The post Zombie Stock #28 – Please Don’t Stay on The Line appeared first on New Constructs.

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Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Zombie Stock #27 – Broker Than Broke.

Learn more about the best fundamental researchThe post Podcast: Why This Real Estate Brokerage Is in The Danger Zone appeared first on New Constructs.

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This company experienced a brief lift in performance as a result of the COVID pandemic, but current numbers paint a different picture.

The post Zombie Stock #27 – Broker Than Broke appeared first on New Constructs.

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The company’s lack of profitability continues to destroy shareholder value.

The post Zombie Stock #26 – Running Out of Resources appeared first on New Constructs.

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This company's fundamentals have never been promising, and it is poised to burn even more cash going forward.

The post Zombie Stock #25 – Expectations and Reality Can’t Connect appeared first on New Constructs.

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This Zombie has earned an Unattractive Rating since its IPO and has never generated a positive NOPAT or FCF.

The post Zombie Stock #24 – Burning Cash Until the Cows Come Home appeared first on New Constructs.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Zombie Stock #24 – Burning Cash Until the Cows Come Home.

The post Podcast: Why This Consumer Food Provider’s Stock Is in The Danger Zone appeared first on New Constructs.

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Heeding these ETF warnings can protect your portfolio from blowups and help you outperform.

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Heeding these mutual fund warnings can protect your portfolio from blowups and help you outperform.

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No matter how you analyze its business, one thing is clear: this company burns through a large amount of cash.

The post Zombie Stock #23 – Access Denied appeared first on New Constructs.

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This Zombie's profitability has been weakening since 2018.

The post Zombie Stock #22 – No One to Pay the Bills appeared first on New Constructs.

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This company will need either a capital raise or a significant change in business operations soon to remain a going concern.

The post Zombie Stock #21 – Don’t Join This Team appeared first on New Constructs.

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W take a closer look at this zombie stock’s current cash burn, lack of profit potential, and how much further the stock could fall.

The post Zombie Stock #20 – Way Further to Fall appeared first on New Constructs.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Zombie Stock #20 – Way Further to Fall.

The post Podcast: Why This Online Retailer’s Stock Is in The Danger Zone appeared first on New Constructs.

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This company’s current fundamentals cannot justify the expectations baked into its stock price, especially in the face of slowing growth.

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The 20% jump in stock price after 3Q22 earnings makes our bear case even more compelling.

The post A Great Time to Sell the Dead Cat Bounce appeared first on New Constructs.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: A Great Time to Sell the Dead Cat Bounce.

The post Podcast: Why This E-commerce Stock Is in The Danger Zone appeared first on New Constructs.

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Traditional fund research would tell you to buy this All Cap Growth fund. Don’t listen.

The post This Fund’s Active Management Does Not Lead to Outperformance appeared first on New Constructs.

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Kyle Guske II sat down with Money Life to talk about our Danger Zone pick: This Fund’s Active Management Does Not Lead to Outperformance.

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Given increased competition, a history of unprofitability, and an undifferentiated product offering, there are no automated profits in this IPO.

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Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: How This Stock’s Outrageous Valuation Could Destroy All Zombie Stocks.

The post Podcast: Why This EV Manufacturer Remains in The Danger Zone appeared first on New Constructs.

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In the current market, investors are searching for real cash flows and sustainable profits, and this company has neither.

The post Zombie Stock #19 – Almost Out of Cash appeared first on New Constructs.

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We revisit this stock's overvaluation, quantify the stupid money risk, and show why it remains in the Danger Zone.

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Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Good Luck Justifying This Acquisition.

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This stock is a bellwether that could destroy all zombie stocks.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: 3Q22 Earnings: Where Street Earnings Are Too High & Who Should Miss.

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Investors are searching for real cash flows and sustainable profits and this Zombie Stock has neither.

The post Zombie Stock #18 – Calling for a Lifeline appeared first on New Constructs.

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Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Zombie Stock #18 – Calling for a Lifeline.

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This electric vehicle (EV) maker is burning cash at an alarming rate and charging to the bottom of the industry.

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We’re taking this stock off the Zombie Stock list but given the company's operational and competitive challenges it remains in the Danger Zone.

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This zombie stock could go to $0 as its cash-burning business deplete limited cash reserves

The post Zombie Stock #17 – Burnt Cash Delivered to Your Door appeared first on New Constructs.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Zombie Stock #17 – Burnt Cash Delivered to Your Door.

The post Podcast: Why This Consumer Food Business is in The Danger Zone appeared first on New Constructs.

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This stock is the 16th addition to our zombie stock list of stocks – all of which are at risk of going to $0.

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The 15th addition to our zombie stock list that could go to $0 as its cash-burning business depletes limited cash reserves.

The post Zombie Stock #15 – Buy Now Suffer Later appeared first on New Constructs.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Zombie Stock #15 – Buy Now Suffer Later.

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We see this restructuring as confirmation that the company has pivoted from growth mode to survival, i.e. avoid bankruptcy, mode.

The post Still a Zombie after Cost Cutting & Layoffs appeared first on New Constructs.

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The 13 stocks we put on our Zombie Stocks list (-13%) have outperformed the S&P 500 (+3%) by 16% as a short portfolio since inception of the list.

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Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Zombie Stock #11 – Chewing Up Cash.

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Taking a closer look at this zombie, its cash burn, and how much further its stock could fall.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Zombie Stock #13 – Democratizing Foolish Investing.

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This company's high cash-burn rate puts its stock at risk of going to $0.

The post Zombie Stock #12 – Running on Empty appeared first on New Constructs.

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This company's cash crunch and challenging competitive environment, puts its stock at significant risk of declining to $0 per share.

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We take a closer look at this zombie stock, its cash burn, and how much further its stock could fall.

The post Zombie Stock #10 – Another Overvalued Meme-Stock appeared first on New Constructs.

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We recommend caution as investors may be feeling FOMO and consider rushing back into some of the meme stocks in the market.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Zombie Stock #7 – More Cash Burners to Sell.

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See the newest addition to our zombie stocks list, a list of companies that will face challenges as easy/cheap access to capital dries up.

The post Zombie Stock #8 – More Cash Burners to Sell appeared first on New Constructs.

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Investors may be feeling FOMO and consider rushing back into some of the meme stocks or once popular “growth” stocks. Instead, we recommend caution.

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The newest addition to our zombie stock list has a high risk of declining to $0 per share.

The post Zombie Stock #6 – Valuation Is Way Overcharged appeared first on New Constructs.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Zombie Stock #6 – Valuation Is Way Overcharged.

The post Podcast: Why This Automaker’s Stock is in The Danger Zone appeared first on New Constructs.

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After another weak earnings report, we continue to believe Wayfair remains significantly overvalued.

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We think it is time to close this successful Danger Zone position.

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Companies with heavy cash burn and little cash on hand are risky in any market, but especially now.

The post Zombie Stock #5 – From Beyond the Grave appeared first on New Constructs.

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Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Zombie Stock #5 – From Beyond the Grave

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Facing bigger competition, mounting losses, and a slow recovery from a pandemic-related decline in demand, we’re keeping this stock in the Danger Zone.

The post Competition Will Run This Company Off the Road appeared first on New Constructs.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Zombie Stock #4 – Snap Out of It or Die.

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Unless the Fed changes course, this company must either dramatically cut costs and lower its cash burn, or it will go bankrupt.

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We're walking away from any increased stupid money risk and taking the gains from this outperforming position.

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Even after falling 86% from its 2019 high and 29% year-to-date, we think the stock has much more downside.

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This stock has outperformed the S&P 500 as a short by 122% since we first put it in the Danger Zone.

The post Expectations for This Stock Are Still High as a Kite appeared first on New Constructs.

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Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: On the Cutting Edge of Transformation.

The post Podcast: Investors Ignoring This Tech Giant Are in The Danger Zone appeared first on New Constructs.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week.

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We’re closing this Danger Zone pick since there is little to stop the announced deal from going through.

The post Position Close Update: Zendesk (ZEN) appeared first on New Constructs.

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Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone picks this week.

The post Podcast: Why These Three Zombie Stocks Are in The Danger Zone appeared first on New Constructs.

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As the Fed raises interest rates and ends quantitative easing, access to cheap capital is drying up quickly.

The post Cash Burn: Stocks That Could Go to $0 As Fed Raises Rates – Part 3 appeared first on New Constructs.

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These “zombie” companies are at risk of going bankrupt if they cannot raise more debt or equity, which is not as easy as it used to be.

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Time is running out for cash-burning companies kept afloat with easy/cheap access to capital.

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Our deep dive into this fund’s holdings reveal a portfolio that is inferior to its benchmark and the S&P 500, which makes future underperformance likely.

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Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Look Beyond Legacy Fund Ratings and Avoid This Mutual Fund.

The post Podcast: Why This Mid Cap Growth Mutual Fund Is in The Danger Zone appeared first on New Constructs.

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Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Street Earnings Overstated for 67% of S&P 500 Companies in 1Q22

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The company’s current fundamentals cannot justify the expectations baked into its stock price, especially given slowing growth and weak guidance.

The post The Music Is Ending For This Once High-Flyer appeared first on New Constructs.

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This company’s current fundamentals cannot justify the expectations baked into its stock price.

The post Stick a Pin in It – This Growth Story Is Over appeared first on New Constructs.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone picks this week: Stick a Pin in It – This Growth Story Is Over and The Music Is Ending on This Once High-Flyer

The post Podcast: Why These Once High-Flyers Are Still in The Danger Zone appeared first on New Constructs.

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The combination of improved profitability and falling stock price mean RKT is no longer a quality short position.

The post Position Close Update: Rocket Companies (RKT) appeared first on New Constructs.

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For years, we’ve been ringing the alarm on dangerous ETFs and mutual funds with poor holdings and expensive costs that offer investors poor risk/reward.

The post Our Fund Picks Outperform Too: Danger Zone Update appeared first on New Constructs.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Our Fund Picks Outperform Too: Danger Zone Update.

The post Podcast: Why Investors Ignoring our Fund Research Are in The Danger Zone appeared first on New Constructs.

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Given the outperformance as a short, UAA no longer offers the same risk/reward and we’re closing this Danger Zone pick.

The post Position Close Update: Under Armour (UAA) appeared first on New Constructs.

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Coinbase’s 1Q22 results and guidance do not bode well for the future, and we think shares are worth as little as $17/share.

The post 1Q22 Earnings Shows Coinbase’s Struggles appeared first on New Constructs.

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Bulls have long argued that data center operators, given their ties to data usage and the internet, deserve premium valuations. We disagree.

The post Data Centers Are Dinosaurs appeared first on New Constructs.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Commodities Trading Like Tech Stocks.

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Given the stock’s fall to just over $1/share, we’re closing this strongly outperforming short position.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick: A Decade of Danger.

The post Podcast: Nearly a Decade of The Danger Zone appeared first on New Constructs.

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This report focuses on a company with particularly poor ROIC and reiterates our warning on its stock.

The post Avoid Low ROIC Businesses in Turbulent Markets – Part 2 appeared first on New Constructs.

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A difficult economic environment and choppy markets are forcing investors to take a closer look at the fundamentals of stocks they own.

The post Avoid Low ROIC Businesses in Turbulent Markets – Part 1 appeared first on New Constructs.

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Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone picks this week: Avoid Los ROIC Businesses in Turbulent Markets

The post Podcast: Why Low ROIC Businesses Are in The Danger Zone appeared first on New Constructs.

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Given the outperformance as a short, we’re closing this Danger Zone pick.

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With the subscriber loss in 1Q22 and guidance for further subscriber deterioration in 2Q22, the weaknesses in Netflix’s business model are undeniable.

The post Netflix Could Fall Another 50% appeared first on New Constructs.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Is the End Near for Tesla and Other Meme-Stocks?.

The post Podcast: Why Elon Musk, Tesla, and Meme-Stocks Are in The Danger Zone appeared first on New Constructs.

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Despite recent gains, investors should consider selling Tesla and other meme stocks now, before institutional money bails.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: 1Q22 Earnings: Where Street Earnings Are Too High & Who Should Miss.

The post Podcast: Why S&P 500 Stocks Likely to Miss Upcoming Earnings Are in The Danger Zone appeared first on New Constructs.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Street Earnings Overstated for Most S&P 500 Companies in 2021.

The post Podcast: Why This Healthcare Company with Overstated Earnings is in The Danger Zone appeared first on New Constructs.

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A popular growth stock with fundamentals that cannot justify its high-flying valuation.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Jack of All Trades, Master of None.

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Our deep dive into this fund’s holdings reveal a portfolio that is inferior to its benchmark and the S&P 500.

The post Don’t Buy This Dip – Legacy Fund Ratings Are Misleading appeared first on New Constructs.

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Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Don’t Buy This Dip – Legacy Fund Ratings Are Misleading.

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The fundamentals of this business simply don’t justify the expectations baked into its stock price.

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Investment Analyst Kyle Guske II sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Book Your Assets Elsewhere and Square Peg Meets Round Hole.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: No Coin to be Made Here and Shop Elsewhere for Realistic Expectations.

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With her flagship ETF, ARK Innovation Fund (ARKK) down 51% from its 52-week high, Cathie Wood, founder of ARK Invest, is franticly attempting to convince investors that her “disruptive innovation” strategy will work again. We disagree. ARKK’s portfolio is filled with cash-burning companies that continue to trade at nosebleed valuations. These companies, along with the ARK Innovation Fund, are in the Danger Zone.

Learn more about the best fundamental research Burning Cash Is Not a Competitive Advantage

Too many companies are built on strategies that assume access to cheap capital is a lasting competitive advantage. Who can blame them? Their stocks have soared on a rising tide of investor ebullience driven by ultra-easy monetary policy. Who can blame investors for their ebullience? For most of the last decade, they’ve seen frighteningly little downside risk in stocks. But times are changing, and as monetary policy tightens, the once high-flying cash-burning “innovation” stocks have much farther to fall.

Figure 1 shows that 28 of the 32 ARKK holdings under our coverage generate negative free cash flow (FCF) and have negative FCF yields over the trailing-twelve months (TTM). ARKK currently holds an additional six stocks not under our coverage.

Figure 1: Free Cash Flow for ARKK’s Holdings Is Poor – as of 2/25/22

Sources: New Constructs, LLC, company, and ETF filings

Innovation Alone Is Not a Good Investment

Of course, ARKK doesn’t look specifically for cash-burning businesses. ARK Innovation ETF’s principal investment strategy is to invest in stocks that fit a “disruptive innovation” theme. ARK Invest believes “disruptive innovation” is the "introduction of a technologically-enabled new product or service that potentially changes the way the world works.”

Changing the world is certainly a bold goal and flashy selling point for raising money, and this approach has garnered ARK Invest a loyal following and $28 billion in AUM at its peak. However, innovation alone does not make a great company or investment thesis. Instead, one must find the companies that match innovation with a real business model – one that generates real FCF at a reasonable price – for investors to see gains.

Otherwise, investors are simply buying hype and hoping that other investors will play the greater fool and buy in at a higher price. We advise against being another investor’s exit strategy and buying stock in companies without a real business model or defensible moat.

Fundamentals Might Not Be Sexy, But You Can Trust Them

Our focus on quantifiable fundamental benchmarks, instead of just using qualitative research and flashy selling points, has already led us to put five of ARKK’s holdings, 23% of the portfolio, in the Danger Zone. See Figure 2.

Without reliable fundamental data to accurately measure both profitability[1] and valuation, ARKK routinely invests in companies with poor profitability at prices that imply unrealistic future profit growth.

Figure 2: ARKK Holdings That are Also Danger Zone Picks – as of 2/25/22

Sources: New Constructs, LLC and ETF filings

Our Fundamental Research on ARRK’s Holdings Reveals a Low-Quality Portfolio

Our Predictive ETF Rating for ARKK is Very Unattractive (equivalent to Morningstar’s 1 Star). Meanwhile, Morningstar gives the ETF a 3 Star rating. Our ETF research is different from legacy fund research because it is forward-looking and based on our risk/reward analysis of each individual fund holding. Most legacy fund research is backward-looking because it is based on past price performance.

ARKK’s Very Unattractive rating means that its holdings have both low profitability and expensive valuations. Our detailed holdings analysis, made possible by our Robo-Analyst technology[2], also reveals that ARKK has a much lower-quality portfolio compared to benchmarks, Invesco QQQ Trust (QQQ) and State Street SPDR S&P 500 ETF (SPY).

Per Figure 3, ARKK allocates 58% of its portfolio to Unattractive-or-worse rated stocks compared to just 9% for QQQ. At the same time, ARKK’s exposure to Attractive-or-better rated stocks is much lower, at 9%, versus QQQ at 29%.

Figure 3: ARK Innovation ETF Allocates to Far Worse Stocks than QQQ

Sources: New Constructs, LLC, company, and ETF filings

Our holdings analysis also reveals ARKK’s portfolio is much lower quality than the S&P 500, or State Street SPDR S&P 500 ETF. See Figure 4 for comparison.

Figure 4: ARK Innovation ETF Allocates to Far Worse Stocks than SPY

Sources: New Constructs, LLC, company, and ETF filings

Expensive Stocks Drive Very Unattractive Risk/Reward Rating

Figure 5 contains our detailed rating for ARKK, which includes each of the criteria we use to rate all ETFs and mutual funds under coverage. These criteria are the same for our Stock Rating Methodology, because the performance of an ETF’s holdings equals the performance of an ETF after fees.

Figure 5: ARK Innovation ETF Rating Details

Sources: New Constructs, LLC, company, and ETF filings

As Figure 5 shows, ARKK is inferior to QQQ (click here for our report on QQQ) and SPY in four of the five criteria that make up our holdings/Portfolio Management analysis. Specifically:

• ARKK’s ROIC is 11%, below the 52% earned by QQQ and 33% earned by SPY
• ARKK’s free cash flow (FCF) yield of -14% is lower than QQQ’s at 1% and SPY’s at 2%
• the price-to-economic book value (PEBV) ratio for ARKK is 9.7, which is greater than the 3.6 for QQQ and 2.9 for SPY
• our discounted cash flow analysis reveals an average market-implied growth appreciation period (GAP) of 86 years for ARKK’s holdings compared to 34 years for QQQ and 25 years for SPY.

ARKK holds stocks that generate inferior cash flows and have significantly higher valuations compared to both QQQ and SPY. The market expectations for ARKK’s holdings are for profit growth (measured by PEBV ratio) that is nearly 10x above current profits and significantly above the profit growth expectations embedded in QQQ’s and SPY’s holdings.

Expectations Investing: Quantifying the Overvaluation of an ARKK Holding

Below we highlight PagerDuty (PD: $33/share), which is one of the five companies in ARKK’s portfolio that have negative and declining FCF over the past three years. PagerDuty provides a perfect example of the overvalued, cash-burning companies that make up ARKK’s portfolio.

While PagerDuty may be the most recent digital operations management platform to hit the market (IPO’d in 2019), its products are, by no means, innovative to the point of changing the world. Larger competitors Atlassian (TEAM) and Splunk (SPLK) offer similar products alongside a larger suite of software solutions. In Atlassian’s case, its competing service can be purchased standalone or is included as a feature of its more robust service management platform.

Given larger and more established competition, it should be no surprise that from fiscal 2019 to fiscal 2021, PagerDuty burned through a cumulative $712 million (26% of market cap) in FCF. Over the nine-months-ended October 31, 2021, PagerDuty burned an additional $35 million in FCF. Figure 6 illustrates PagerDuty’s consistent cash burn.

Figure 6: PagerDuty’s -$747 Million Free Cash Flow Burn Since 2019

Sources: New Constructs, LLC and company filings

Not only does PagerDuty’s business burn significant cash, but it is also becoming even more unprofitable.

PagerDuty’s net operating profit after-tax (NOPAT) has fallen from -$32 million in fiscal 2018 to -$88 million over the TTM. NOPAT margin remains highly negative, at -34% over the TTM, and is down from -27% in fiscal 2021. The company’s ROIC has been negative since its IPO (took place in 2019) and declined from -11% in fiscal 2021 to -14% over the TTM.

Objective Math: PagerDuty is Overvalued

Despite falling 38% from its 52-week high, PagerDuty remains significantly overvalued and priced to be more profitable than Atlassian, its largest competition. Below, we use our reverse discounted cash flow (DCF) model to analyze the expectations for future growth in cash flows baked into PagerDuty’s current share price and show that it could fall 91%+ further.

To justify its current price of $33/share, PagerDuty must:

• improve its NOPAT margin to 10% (double Atlassian’s best ever margin and much higher than PagerDuty’s current -34% TTM margin), and
• grow revenue by 30% compounded annually for the next nine years (above average consensus estimates for a 25% CAGR from fiscal 2022 through fiscal 2024).

In this scenario, PagerDuty would generate $2.3 billion in revenue in fiscal 2030, which is 9x its TTM revenue. At $2.3 billion, PagerDuty’s revenue would be 93% and 90%, respectively, of Atlassian’s and Splunk’s TTM revenue, it two main competitors.

This scenario also implies that PagerDuty’s NOPAT in fiscal 2030 would reach $227 million, up from -$88 million over the TTM. $227 million in NOPAT would be 6x Atlassian’s TTM NOPAT and 2x Atlassian’s fiscal 2021 NOPAT (highest in company history). Splunk currently generates a negative NOPAT.

We think it’s overly optimistic to assume PagerDuty will immediately improve margins that double its larger competition while also growing revenue faster than consensus estimates. Furthermore, companies that grow revenue by 20%+ compounded annually for such a long period are unbelievably rare, which make the expectations in PagerDuty’s share price even more unrealistic. In a more realistic scenario, detailed below, the stock has large downside risk.

79%+ Downside if Consensus is Right

Here’s an additional DCF scenario to highlight the downside risk if PagerDuty’s revenue grows in-line with consensus estimates and the company can achieve margins equal to Atlassian’s highest ever margin.

If we assume PagerDuty’s:

• NOPAT margin improves to 5% (compared to -34% TTM),
• revenue grows at consensus rates in fiscal 2022, 2023, and 2024, and
• revenue grows 24% a year from fiscal 2025-2030 (continuation of fiscal 2024 consensus estimate), then

the stock is worth $7/share today – a 79% downside to the current price. This scenario still implies PagerDuty’s fiscal 2030 revenue is 6x higher than TTM levels and fiscal 2030 NOPAT is over 2x Atlassian’s TTM NOPAT.

If PagerDuty fails to grow revenue at consensus rates, the downside risk in the stock is even higher.

91%+ Downside If Revenue Growth Slows to Industry Expectations

We review a third DCF scenario to highlight the downside risk if PagerDuty’s growth slows to equal the overall IT operations growth rate beyond fiscal 2024.

If we assume PagerDuty’s:

• NOPAT margin improves to 5%,
• revenue grows at consensus rates in fiscal 2022, 2023, and 2024, and
• revenue grows 17% from fiscal 2025-2030 (equal to projected industry CAGR through 2027), then

the stock is worth just $3/share today – a 91% downside to the current price.

Figure 7 compares PagerDuty’s implied future NOPAT in these three scenarios to its historical NOPAT. For reference, we include the TTM NOPAT of Atlassian.

Figure 7: PagerDuty’s Historical and Implied NOPAT: DCF Valuation Scenarios

Sources: New Constructs, LLC and company filings.

Each of the above scenarios also assumes PagerDuty grows revenue, NOPAT, and FCF without increasing working capital or fixed assets. This assumption is highly unlikely but allows us to create best-case scenarios that demonstrate the expectations embedded in the current valuation. For reference, PagerDuty’s invested capital grew 123% compounded annually from fiscal 2018 to fiscal 2021. If we assume PagerDuty’s invested capital increases at a similar rate in DCF scenarios 2 and 3 above, the downside risk is even larger.

Overhyped and Overpriced

Compounding the issues above, ARKK charges investors above average fees for below average portfolio allocation. At 0.83%, ARKK’s total annual costs (TAC) are higher than 88% of the 76 Technology ETFs under coverage. For comparison, the simple average TAC of all the Technology ETFs under coverage is 0.57%, the asset-weighted average is 0.34%, QQQ charges just 0.22%, and SPY has total annual costs of just 0.10%. Why pay higher fees for inferior stock selection?

Get an Edge from Holdings-Based ETF Analysis Based on Superior Stock Research

We offer clients in-depth reports for all the 7,600+ ETFs and mutual funds under coverage. Click below for a free copy of ARKK’s standard ETF report.

Free copy of our ARKK report Smart ETF (or fund) investing means analyzing the holdings of each mutual fund. Failure to do so is a failure to perform proper due diligence. Simply buying an ETF or mutual fund based on past performance does not necessarily lead to outperformance. Only through holdings-based analysis can one determine if an ETF’s methodology leads managers to pick high-quality or low-quality stocks.

Most investors don’t realize they can access sophisticated fundamental research[3] that enables investors to overcome inaccuracies, omissions, and biases in legacy fundamental datasets. Our Robo-Analyst technology analyzes the holdings of all 220 ETFs and mutual funds in the Technology sector and ~7,600 ETFs and mutual funds under coverage to avoid “the danger within.” Our diligence on holdings allows us to cut through the noise and identify potentially dangerous funds, like ARK Innovation ETF, that traditional, backward-looking fund research overrates.

Easily Make Any ETF, Even ARKK, Better

As we showed in The Paradigm Shift to Self-Directed Portfolio Construction, new technologies enable investors to create their own funds without any fees while also offering access to more sophisticated weighting methodologies. If, for instance, investors wanted exposure to ARKK’s holdings, but weighted by ROIC, the risk/reward of this customized version of the fund improves, particularly on the Unattractive-or-worse portion of the portfolio:

• 9% of assets to Attractive-or-better rated stocks (equal to ARKK current allocation)
• 28% of assets to Unattractive-or-worse rated stocks (compared to 58% for ARKK).

Compare the quality of stock allocation in our customized version of ARKK vs. as-is ARKK in Figure 8.

Figure 8: ARK Innovation ETF Allocation Could Be Improved

Sources: New Constructs, LLC, company, and ETF filings

Better Alternatives to ARKK: Attractive Technology Funds

Below we present five Technology ETFs or mutual funds that earn an Attractive-or-better rating, have more than $100 million in assets under management, and have below average TAC.

1. First Trust NASDAQ Technology Dividend Index Fund (TDIV) – Very Attractive rating – 0.55% TAC
2. ETF Series Defiance Quantum ETF (QTUM) – Attractive rating – 0.44% TAC
3. State Street Technology Select Sector SPDR Fund (XLK) – Attractive rating – 0.11% TAC
4. Nationwide NYSE ARCA Tech 100 Index (NWJEX) – Attractive rating – 0.36% TAC
5. iShares U.S. Technology ETF (IYW) – Attractive rating – 0.45% TAC

Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life.**

This article originally published on February 28, 2022.**

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, sector, style, or theme.

Follow us on Twitter, Facebook, LinkedIn, and StockTwits for real-time alerts on all our research.

[1] Only Core Earnings enable investors to overcome the flaws in legacy fundamental data and research, as proven in Core Earnings: New Data & Evidence, a paper in The Journal of Financial Economics written by professors at Harvard Business School (HBS) & MIT Sloan.

[2] Harvard Business School features the powerful impact of our research automation technology in the case study New Constructs: Disrupting Fundamental Analysis with Robo-Analysts.

[3] See how our models overcome flaws in Bloomberg and Capital IQ’s (SPGI) analytics in the detailed appendix of this paper.

Click here to download a PDF of this report.

The post No Ark Can Save These Cash-Burning “Innovators” appeared first on New Constructs.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: No Ark Can Save These Cash-Burning “Innovators”.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone picks this week: Another Falling Knife That Could Cut Your Portfolio – Part 3 and Another Falling Knife That Could Cut Your Portfolio – Part 5.

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Quarterly earnings season may be winding down, but the real earnings season – annual 10-K filing season – is ramping up. Investors ignoring filings, footnotes, and the MD&A are in the Danger Zone.

Why Footnotes Matter – Earnings Are More Overstated Than Any Time Since 2012

Going into the 4Q21 calendar earnings season, Street Earnings were more overstated than any time since 2012. Specifically, the 360 S&P 500 companies that overstated Street Earnings in 3Q21 make up 81% of the market cap of the index, the highest percentage since at least 2012 (earliest data available).

Figure 1: Overstated Street Earnings as % of Market Cap: 2012 through 11/16/21

Sources: New Constructs, LLC and company filings.

Since 2005, we’ve reported how traditional earnings measures are unreliable due to accounting loopholes that allow companies to manage earnings. Our Core Earnings[1] excludes unusual gains and losses to provide a more reliable earnings measure shown to provide a new source of alpha.

The only way to overcome the flaws in Street Earnings, GAAP earnings, and other profit metrics from legacy providers is through rigorous analysis of company filings, especially the footnotes and MD&A[2].

In this report, we provide an example of an unusual item that has a material impact on Amazon (AMZN) and Ford’s (F) 2021 GAAP Earnings. We also highlight a well-known tech company with highly misleading Street and GAAP earnings.

Learn more about the best fundamental research IPO Euphoria Impacts 2021 Reported Earnings for Amazon (AMZN) and Ford (F)

Despite lackluster price performance since its IPO in November 2021, Rivian’s (RIVN) IPO had a material impact on the reported profits of both Amazon and Ford in 2021. Amazon and Ford formed “strategic” partnerships with Rivian prior to its IPO, which we called “arms-length equity investments” in our original report on Rivian.

Reported 2021 earnings confirmed our views on these partnerships and significantly boosted both firm’s reported earnings.

In 2021, Amazon reported GAAP Earnings of $33.4 billion, or $64.78/share. However, included in earnings was $14.6 billion, or $28.41/share in “Other Income” reported on the income statement. Only by reading the footnotes can investors find that $11.8 billion, or $22.91/share, of “Other Income” is actually a valuation gain from the equity investment in Rivian Automotive.

When we adjust for all unusual items in Amazon’s 10-K (details available to all New Constructs members), we find that Amazon’s 2021 Core Earnings are $20.1 billion, or $39.05/share, which is significantly (40%) lower than reported GAAP earnings of $33.4 billion, or $64.78/share.

Ford’s 2021 results present a similar story. In 2021, Ford reported GAAP Earnings of $17.9 billion, or $4.45/share. However, included in earnings was $9.2 billion, or $2.27/share in realized and unrealized gains on cash equivalents, marketable securities, and other investments. We find that $9.1 billion, or $2.25/share of these reported gains are directly related to gains on Rivian’s IPO, information that was only disclosed in the management discussion and analysis section of Ford’s 2021 10-K.

When we adjust for all unusual items in Ford’s 10-K (details available to all New Constructs members), we find that Ford’s 2021 Core Earnings are $8.9 billion, or $2.20/share, which is significantly (51%) lower than reported GAAP earnings of $17.9 billion, or $4.45/share.

These highly overstated earnings mean both Amazon and Ford now earn a Strong Miss Earnings Distortion Score. Without proper diligence of reading the footnotes and MD&A, investors would believe both Amazon and Ford were significantly more profitable in 2021 than they really were.

Block (SQ): Street Earnings Overstated by $1.45/share & GAAP Earnings Overstated by $0.72/share

Of the S&P 500 companies that haven’t yet filed their 10-K and earn an Unattractive-or-worse rating, Block (SQ) has some of the most overstated earnings. Overstated earnings earn Block our Strong Miss Earnings Distortion Score. Our stock rating for SQ is Very Unattractive.

The difference between Block’s 3Q21 Street Earnings of $1.76/share and Core Earnings of $0.31/share is $1.45/share, per Figure 2.

Below, we detail the hidden and reported unusual items that aren’t captured in GAAP Earnings but are captured in Core Earnings for Block. We would be happy to reconcile our Core Earnings with Street Earnings but cannot because we do not have the details on how analysts calculate their Street Earnings.

Unusual gains, which we detail below, materially increased Block’s 3Q21 TTM GAAP Earnings and make profits look better than Core EPS. After adjusting for unusual items, we find that Block’s Core Earnings of $0.31/share are less than one-third of reported GAAP Earnings of $1.03/share.

Figure 2: Comparing Block’s Street, GAAP, and Core Earnings: TTM as of 3Q21

Sources: New Constructs, LLC and company filings.

Below, we detail the differences between Core Earnings and GAAP Earnings so readers can audit our research. Figure 3 details the differences between Block’s Core Earnings and GAAP Earnings.

Figure 3: Block’s GAAP Earnings to Core Earnings Reconciliation: 3Q21

Sources: New Constructs, LLC and company filings.

More details:

Total Earnings Distortion of $0.72/share, which equals $375 million, is comprised of the following:

Hidden Unusual Gains, Net = $0.54/per share, which equals $281 million and is comprised of

• $295 million in the TTM period based on $295 million in gains on revaluation of equity investments in the 2020 10-K
• $5 million in sublease income in the TTM period based on
  • $2.6 million in 1Q21
  • $2.6 million in 4Q20
• -$3 million in losses on disposal of property and equipment in the TTM period based on
  • -$0.9 million in 3Q21
  • -$0.4 million in 2Q21
  • -$0.6 million in 1Q21
  • -$0.6 million in 4Q20
• -$17 million in acquisition related costs in the TTM period based on
  • -$0.3 million in 3Q21
  • -$14 million in 2Q21
  • -$0.03 million in 1Q21
  • -$2 million in 4Q20

Reported Unusual Gains Pre-Tax, Net = $0.17/per share, which equals $89 million and is comprised of

• $307 million in “Other Income” in the TTM period based on
  • -$12 million in expense in 3Q21
  • $76 million in income in 2Q21
  • -$28 million in expense in 1Q21
  • $271 million in income in 4Q20
• -$71 million in bitcoin impairment losses in the TTM period based on
  • -$6 million in 3Q21
  • -$45 million in 2Q21
  • -$20 million in 1Q21
• -$147 million in transaction and loan losses in the TTM period based on
  • -$62 million in 3Q21
  • -$48 million in 2Q21
  • -$20 million in 1Q21
  • -$16 million in 4Q20

Tax Distortion = $0.01/per share, which equals $4 million

Clearly, getting to the truth about Block’s profitability requires going beyond the income statement and balance sheet. We do that work for nearly all U.S. exchange-traded companies.

Technology to Provide Reliable Research at Scale

For humans, performing this level of due diligence (i.e. analyzing filings & footnotes) on just a few companies is a daunting task. Applying this level of rigor to thousands of companies is downright impossible – until now.

We use our cutting-edge Robo-Analyst technology to help automate the analysis of corporate filings. From mid-February through the end of March, our expert team of human analysts will be coming in early and staying late to validate the models built by the Robo-Analyst.

Last year, from February 19, 2021 through March 29, 2021, we analyzed 1,914[3] 10-K and 10-Q filings from which our Robo-Analyst[4] technology collected 219,465 data points. Our analyst team used this data to make 35,498 Core Earnings, balance sheet, and valuation adjustments with a dollar value of $18 trillion.

Figure 4: Filing Season 2021 – The Power of the Robo-Analyst

Sources: New Constructs, LLC and company filings.

The adjustments were applied as follows:

• 13,255 income statement adjustments with a total value of $1.2 trillion
• 14,541 balance sheet adjustments with a total value of $7.5 trillion
• 7,702 valuation adjustments with a total value of $9.7 trillion

This combination of technology and human expertise enables investors to overcome the flaws in legacy fundamental research and make more informed investment decisions. Look for our Filing Season Finds Reports over the coming weeks, which will feature items found during the real earnings season.

Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life.**

This article originally published on February 14, 2022.

Disclosure: David Trainer, and Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, sector, style, or theme.

Follow us on Twitter (#filingseasonfinds), Facebook, LinkedIn, and StockTwits for real-time alerts on all our research.

[1] Only Core Earnings enable investors to overcome the flaws in legacy fundamental data and research, as proven in Core Earnings: New Data & Evidence, written by professors at Harvard Business School (HBS) & MIT Sloan for The Journal of Financial Economics.

[2] Only our “novel database” enables investors to overcome flaws with legacy fundamental datasets and apply reliable fundamental data that analyzes all the footnotes & MD&A in their research.

[3] We analyzed the majority of those filings (1,769) by March 17th.

[4] Harvard Business School features the powerful impact of our research automation technology in the case New Constructs: Disrupting Fundamental Analysis with Robo-Analysts.

Click here to download a PDF of this report.

The post The Real Earnings Season Starts Now: Time to Read Filings & Footnotes appeared first on New Constructs.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: The Real Earnings Season Starts Now: Time to Read Filings & Footnotes.

Learn more about the best fundamental research The post Podcast: Why Ignoring Footnotes Could Land Your Portfolio in The Danger Zone appeared first on New Constructs.

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Affirm (AFRM: $58/share) was trading at about the same level as it is now when we warned investors against owning the stock on January 31, 2022.

Since then, the company’s latest earnings report disappointment confirms our thesis that the stock is overvalued by 80%+.

We are not surprised to see the company guide expectations lower for revenue and profits because the business is losing market share, lacks competitive advantages, is unprofitable, and faces intense competition.

The recent struggles at Peloton (PTON), historically one of Affirm’s largest merchant partners, only bring more pressure to an already struggling business.

We first alerted investors to the risk in Affirm Holdings when we put the stock in the Danger Zone in October 2021. Since then, the stock has outperformed the S&P 500 as a short by 50%.

We think the stock has much farther to fall as we detail below by using our reverse DCF analysis to quantify how the high the future cash flow expectations baked into the stock’s valuation are.

Current Valuation Implies Affirm Will Be Biggest BNPL Firm in the World

Despite facing larger, more profitable competition, Affirm is priced as if it will be the largest buy now pay later (BNPL) provider, measured by gross merchandise volume (GMV), in the world, on top of immediately achieving profitability.

To justify its current price of ~$60/share, Affirm must:

• immediately improve its NOPAT margin to 8% (above Block’s [formerly Square Inc.] 1% and Affirm’s -41% TTM NOPAT margin), and
• grow revenue by 38% compounded annually (nearly 2x expected industry CAGR through 2028) for the next eight years.

In this scenario, Affirm’s revenue grows to $11.4 billion in fiscal 2029, or 13 times higher than the company’s fiscal 2021 revenue.

If we assume Affirm maintains a revenue per GMV rate of just over 10% (equal to fiscal 2021), then this scenario implies Affirm’s GMV in fiscal 2029 is $109 billion, which is 1.6x Klarna’s TTM GMV at the midway point of 2021. For context, Statista estimates Walmart’s 2020 ecommerce GMV was $92 billion. Affirm must process more than double Walmart’s 2020 ecommerce GMV simply to justify its current valuation. We are skeptical of any BNPL firm ever achieving such high merchandise volume.

56% Downside If Consensus Growth is Realized

We review additional DCF scenarios below to highlight the downside risk should Affirm’s revenue grow at consensus rates, or if margins do not improve as much as the scenario outlined above.

If we assume Affirm:

• immediately improves its NOPAT margin to 8%,
• grows revenue by 46% in fiscal 2022 and 43% in fiscal 2023 (equal to consensus), and
• grows revenue by 22% each year thereafter through fiscal 2029 (equal to projected industry growth), then,

Affirm is worth just $26/share today – a 56% downside to the current price

83% Downside If Margins Remain Capped by Competition

If we assume Affirm:

• immediately improves its NOPAT margin to 4%, which equals Block’s highest ever margin,
• grows revenue by 46% in fiscal 2022 and 43% in fiscal 2023, and
• grows revenue by 22% each year through fiscal 2029 then,

Affirm is worth just $10/share today – an 83% downside to the current price.

Figure 1 compares Affirm’s implied future NOPAT in these three scenarios to its historical NOPAT. For reference, we include Block (SQ) and Shopify’s NOPAT.

Figure 1: Affirm’s Historical vs. Implied NOPAT: DCF Scenarios

Sources: New Constructs, LLC and company filings.

Each of the above scenarios assumes Affirm grows revenue, NOPAT, and FCF without increasing working capital or fixed assets. This assumption is highly unlikely but allows us to create best-case scenarios that demonstrate the expectations embedded in the current valuation. For reference, Affirm’s invested capital has grown 4x from fiscal 2019 to fiscal 2021. If we assume Affirm’s invested capital increases at a similar rate in DCF scenarios two and three above, the downside risk is even larger.

Fundamental Research Provides Clarity in Frothy Markets

2022 has quickly shown investors that fundamentals matter and stocks don’t only go up. With a better grasp on fundamentals, investors have a better sense of when to buy and sell – and – know how much risk they take when they own a stock at certain levels. Without reliable fundamental research, investors have no way of gauging whether a stock is expensive or cheap.

As shown above, disciplined, reliable fundamental research shows that even after plummeting, Affirm still holds significant downside.

This article originally published on February 11, 2022.

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, style, or theme.

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Click here to download a PDF of this report.

The post Affirm’s Results Affirm Our Thesis: Sell This Stock appeared first on New Constructs.

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Acquiring Peloton (PTON) anywhere close to its current valuation would be a poor use of capital. Peloton’s fiscal 2Q22 earnings, executive changes, and lowered full-year revenue guidance underscore our thesis that the stock is wildly overvalued and could fall as low as $8/share.

Peloton’s stock price recently soared on news of a potential acquisition by the likes of Amazon (AMZN) or Nike (NKE). However, we doubt Peloton will be acquired because there are far too many competitors that offer a similar product to Peloton, and there is nothing special about Peloton’s technology that make it an appealing acquisition target. Acquisition rumors often temporarily boost a stock to provide an opportunity for professionals to unload it.

Amazon, Nike, or even Apple (AAPL) likely do not want to acquire the equipment and manufacturing headaches that come with Peloton’s business, and the value add of acquiring subscribers is likely low, given the high likelihood that Peloton subscribers/users are also already customers of Amazon, Nike, and Apple.

For Peloton to become an attractive acquisition target, its stock would need to trade below $8/share, which is more than 50% lower than current levels. We believe investors that still own Peloton shares should get out now before the stock drops even lower.

Learn more about the best fundamental research We Remain Bearish on Peloton

We originally added Peloton to our Focus List Stocks: Short Model Portfolio in October 2020, and it outperformed the S&P 500 as a short by 103% in 2021. Even after falling 76% in 2021, Peloton’s valuation remains disconnected from the reality of the firm’s fundamentals and could fall much further.

The Downside of the COVID Bump is Here

After COVID-19-induced lockdowns drove consumers to in-home workout equipment,Peloton’s year-over-year (YoY) revenue comps were always going to be difficult to top. As expected, as economies reopened, interest in at-home exercise equipment fell, and Peloton’s “growth story” unraveled in 2021 as YoY revenue growth continued a downtrend.

Peloton recently cut its full fiscal 2022 revenue guidance to a range of $3.7 to $3.8 billion, down from a previous estimate of $4.4 to $4.8 billion. At the midpoint, such guidance would represent a 7% year-over-year revenue decline. The firm also cut its 2022 guidance for subscribers to 3 million, which is down from prior estimates of 3.35 to 3.45 million.

Such downturn in the business shouldn’t surprise investors. We warned investors in November 2021 that Peloton remained significantly overvalued, and many analysts issued concerning (for bulls) notes about Peloton’s future results. Guggenheim and Raymond James both noted that subscriptions are likely to be lower than expected due to weakening demand. JMP Securities highlighted website visits and page views declined YoY in December.

Competitive Pressure Drives 78%+ Downside

We outline the numerous headwinds Peloton faces in our report here. The biggest challenge to any Peloton bull case is the rising competition from incumbents and startups across the home exercise equipment industry, along with Peloton’s continued lack of profitability.

For instance, Apple has expanded its fitness subscription service, which already integrates with its existing suite of products. Amazon recently announced Halo Fitness, a service for home video workouts which integrates with Amazon’s Halo fitness trackers.

Tonal, which counts Amazon as an early investor, offers a wall-mounted strength training device, and Lululemon offers the Mirror. Brands such as ProForm and NordicTrack have offered bikes, treadmills, and more for years and are ramping up their efforts in subscription workout class offerings. In response, Peloton announced its latest product, “Guide”, a camera that connects to a TV while tracking user movements to assist in strength training. Truist analyst Youssef Squali called the offering “underwhelming” compared to the competition.

Peloton’s struggles also come as traditional gym competitors are seeing renewed demand.

Furthermore, of its publicly-traded peers, which include Apple, Nautilus (NLS), Lululemon, Amazon, and Planet Fitness (PLNT), Peloton is the only one with negative net operating profit after-tax (NOPAT) margins. The firm’s invested capital turns are higher than most of its competitors but are not enough to drive a positive return on invested capital (ROIC). With an ROIC of -21% over TTM, Peloton is also the only company listed above to generate a negative ROIC. See Figure 1.

Figure 1: Peloton’s Profitability vs. Competition: TTM

Sources: New Constructs, LLC and company filings.

Reverse DCF Math: Peloton Is Priced to Triple Sales Despite Weakening Demand

We use our reverse discounted cash flow (DCF) model to quantify the expectations for future profit growth baked into Peloton’s stock price. To justify ~$37/share, Peloton must become more profitable than any time in its history. We see no reason to expect an improvement in profitability and view the expectations implied by $37/share as unrealistically optimistic about the company’s prospects.

Specifically, to justify a price of ~$37/share, Peloton must:

• improve its NOPAT margin to 5% (3x Peloton’s best-ever margin, compared to -8% TTM), and
• grow revenue at a 17% CAGR through fiscal 2028 (more than 2x projected home gym equipment industry growth over the next seven years).

In this scenario, Peloton would generate $12.4 billion in revenue in fiscal 2028, which is over 3x its TTM revenue and 7x its pre-pandemic fiscal 2020 revenue. At $12.4 billion, Peloton’s revenue would imply an 18% share of its total addressable market (TAM) in calendar 2027, which we consider the combined online/virtual fitness and at-home fitness equipment markets. For reference, Peloton’s share of its TAM in calendar 2020 was just 12%. Of competitors with publicly available sales data, iFit Health, owner of NordicTrack and ProForm, Beachbody (BODY), and Nautilus held, respectively, 9%, 6%, and 4% of the TAM in 2020.

We think it is overly optimistic to assume Peloton will vastly increase its market share given the current competitive landscape, and inability to sell existing product, while also achieving margins three times higher than the company’s highest ever margin. Recent price cuts to its products indicate high prices are unsustainable and could pressure margins even more in the coming years. In a more realistic scenario, detailed below, the stock has large downside risk.

PTON Has 51%+ Downside if Consensus Is Right: Even if we assume Peloton’s

• NOPAT margin improves to 4.2% (more than 2x its best-ever margin and equal to Nautilus’ 10-year average NOPAT margin prior to COVID-19),
• revenue falls -7% in fiscal 2022 (midpoint of management guidance),
• revenue grows at consensus rates in 2023 and 2024, and
• revenue grows 14% a year in fiscal 2025-2028 (nearly 2x home gym equipment industry CAGR through calendar 2027), then

the stock is worth $18/share today – a 51% downside to the current price. This scenario still implies Peloton’s revenue grows to $8.8 billion in fiscal 2028, a 12% share of its total addressable market, equal to its share of the TAM in calendar 2020.

PTON Has 78% Downside Even if Profitability Surpasses COVID Highs: If we assume Peloton’s

• NOPAT margin improves to 3.4% (1.5x highest margin in company history) and
• revenue grows 11% compounded annually through fiscal 2028, then

the stock is worth just $8/share today – a 78% downside to the current price.

If Peloton fails to achieve the revenue growth or margin improvement we assume for this scenario, the downside risk in the stock would be even higher.

Figure 2 compares Peloton’s historical NOPAT to the NOPAT implied by each of the above DCF scenarios.

Figure 2: Peloton’s Historical vs. Implied NOPAT

Sources: New Constructs, LLC and company filings.
Dates represent Peloton’s fiscal year, which runs through June of each year

The above scenarios assume Peloton’s change in invested capital equals 10% of revenue in each year of our DCF model. For reference, Peloton’s annual change in invested capital averaged 24% of revenue from fiscal 2019 to fiscal 2021, and equaled 52% of revenue over the TTM.

Each scenario above also accounts for the recent share offering and subsequent cash received. We conservatively treat this cash as excess cash on the balance sheet to create best-case scenarios. However, should Peloton’s cash burn continue at current rates, the company will likely need this capital much sooner, and the downside risk in the stock is even higher.

This article originally published on February 9, 2022.**

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, sector, style, or theme.

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The post Fade the Rumors on Peloton Before the Market Sells the News appeared first on New Constructs.

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We counsel investors not to try and catch falling knives – stocks that have seen steep declines but still have further to fall. As the market rotates away from high-flying growth names to more stable cash generators, investors need reliable fundamental research, more than ever, to protect their portfolios from falling knives.

We continue to post an exceptional hit rate on spotting overvalued stocks. Currently, 62 out of our 65 Danger Zone stock picks are down from their 52-week highs by more than the S&P 500. Figure 1 lists the open Danger Zone picks that are down at least 40% from their 52-week highs. Our Focus List Stocks: Short Model Portfolio, the best-of-the-best of our Danger Zone picks, outperformed the S&P 500 as a short portfolio by 36% in 2021 with 29 out of our 31 picks outperforming the index.

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The post Another Falling Knife That Could Cut Your Portfolio – Part 5 appeared first on New Constructs.

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We counsel investors not to try and catch falling knives – stocks that have seen steep declines but still have further to fall. As the market rotates away from high-flying growth names to more stable cash generators, investors need reliable fundamental research, more than ever, to protect their portfolios from falling knives.

We continue to post an exceptional hit rate on spotting overvalued stocks. Currently, 62 out of our 65 Danger Zone stock picks are down from their 52-week highs by more than the S&P 500. Figure 1 lists the open Danger Zone picks that are down at least 40% from their 52-week highs. Our Focus List Stocks: Short Model Portfolio, the best-of-the-best of our Danger Zone picks, outperformed the S&P 500 as a short portfolio by 36% in 2021 with 29 out of our 31 picks outperforming the index.

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The post Another Falling Knife That Could Cut Your Portfolio – Part 4 appeared first on New Constructs.

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We counsel investors not to try and catch falling knives – stocks that have seen steep declines but still have further to fall. As the market rotates away from high-flying growth names to more stable cash generators, investors need reliable fundamental research, more than ever, to protect their portfolios from falling knives.

We continue to post an exceptional hit rate on spotting overvalued stocks. Currently, 62 out of our 65 Danger Zone stock picks are down from their 52-week highs by more than the S&P 500. Figure 1 lists the open Danger Zone picks that are down at least 40% from their 52-week highs. Our Focus List Stocks: Short Model Portfolio, the best-of-the-best of our Danger Zone picks, outperformed the S&P 500 as a short portfolio by 36% in 2021 with 29 out of our 31 picks outperforming the index.

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The post Another Falling Knife That Could Cut Your Portfolio – Part 3 appeared first on New Constructs.

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We counsel investors not to try and catch falling knives – stocks that have seen steep declines but still have further to fall. As the market rotates away from high-flying growth names to more stable cash generators, investors need reliable fundamental research, more than ever, to protect their portfolios from falling knives.

We continue to post an exceptional hit rate on spotting overvalued stocks. Currently, 62 out of our 65 Danger Zone stock picks are down from their 52-week highs by more than the S&P 500. Figure 1 lists the open Danger Zone picks that are down at least 40% from their 52-week highs. Our Focus List Stocks: Short Model Portfolio, the best-of-the-best of our Danger Zone picks, outperformed the S&P 500 as a short portfolio by 36% in 2021 with 29 out of our 31 picks outperforming the index.

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The post Another Falling Knife That Could Cut Your Portfolio – Part 2 appeared first on New Constructs.

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We counsel investors not to try and catch falling knives – stocks that have seen steep declines but still have further to fall. As the market rotates away from high-flying growth names to more stable cash generators, investors need reliable fundamental research, more than ever, to protect their portfolios from falling knives.

We continue to post an exceptional hit rate on spotting overvalued stocks. Currently, 62 out of our 65 Danger Zone stock picks are down from their 52-week highs by more than the S&P 500. Figure 1 lists the open Danger Zone picks that are down at least 40% from their 52-week highs. Our Focus List Stocks: Short Model Portfolio, the best-of-the-best of our Danger Zone picks, outperformed the S&P 500 as a short portfolio by 36% in 2021 with 29 out of our 31 picks outperforming the index.

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The post Another Falling Knife That Could Cut Your Portfolio – Part 1 appeared first on New Constructs.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone pick this week: Put This Stock in the Doghouse.

Learn more about the best fundamental research The post Podcast: Why This Pet Food Producer Is in The Danger Zone appeared first on New Constructs.

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We continue to warn investors of the dangers of overlooking reliable fundamental research. Our “Falling Knives” reports (see report #1 of 5) illustrate the perils of ignoring these warnings, especially as 62 of our Danger Zone picks are down 40%+ from their 52-week highs.

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Robinhood’s 4Q21 earnings report underscores our thesis that the stock is wildly overvalued and could fall to as low as $6/share.

Robinhood went public at a valuation that implied its revenue would be larger than industry stalwart Charles Schwab (SCHW), but that growth has not materialized, not even close. No matter how management tries to spin the latest results, or the poor guidance going forward, one thing is clear. Robinhood’s growth story is over.

Without COVID-19 tailwinds, the key issues for this stock grow more obvious:

• growth has fallen to near zero and guidance implies negative year-over-year growth in 1Q22
• Robinhood’s main source of revenue is still highly volatile cryptocurrency and more risky (relative to standard equity trading) option trades.
• competitors continue to hold massive scale advantages and profitable businesses outside of a brokerage
• the lack of scale in an undifferentiated market begs the question – will Robinhood ever be consistently profitable?

The stock has fallen 63% from its IPO price and 83% from its 52-week high, yet still has significantly more downside.

Learn more about the best fundamental research Questionable Revenue Model Screeches to a Halt

Robinhood’s use of payment for order flow (PFOF) has been widely criticized, and we touched on the potential regulatory issues in our original report.

More importantly, what was once a growing model for revenue is no more. Per Figure 1, Robinhood’s revenue grew just 14% year-over-year (YoY) in 4Q21, down from 300%+ growth in 1Q21. Management’s guidance for 1Q22 implies a -35% YoY decline in revenue as retail investors/traders look elsewhere (competitors or non-investing activities alike).

Figure 1: Robinhood’s YoY Revenue Change: 1Q21 through 1Q22 Guidance

Sources: New Constructs, LLC and company filings.
*Based on management guidance for $340 million in revenue in 1Q22.

Investors No Longer Flock to Robinhood

In our original report, we noted the impressive growth in customer accounts Robinhood achieved prior to its IPO, but argued its best days were likely behind it. Figure 2 shows how customer account growth stalled in the last three quarters of 2021.

Since rising to 22.5 million accounts in 2Q21, Robinhood’s account growth has stalled, and at the end of 4Q21, total cumulative funded accounts equaled just 22.7 million.

Figure 2: Robinhood’s Cumulative Funded Accounts – 2017 through 4Q21

Sources: New Constructs, LLC and company filings.

Brokerage Assets Stalled Alongside User Growth

We believe that for Robinhood to compete with its much larger competition the company needs to drastically increase its brokerage assets, which Robinhood refers to as Assets Under Custody. Growing assets would provide a base source of net interest revenue if PFOF is banned, trading activity diminished, or both. However, per Figure 3, Robinhood’s Assets Under Custody, at $98 billion at the end of 4Q21, have fallen from the peak of $102 billion in 2Q21.

Figure 3: Robinhood’s Assets Under Custody – 2019 through 4Q21

Sources: New Constructs, LLC and company filings.

Lack of Scale is Still a Critical Business Model Flaw

Robinhood’s lack of scale continues to be a big competitive disadvantage. The firm’s focus on first-time, low-profit investors originally helped the company sign up a high number of client accounts, but the average size of said accounts is much smaller than competitors. Per Figure 4, Robinhood holds less than 1% of the combined assets of larger peers and lacks the scale to generate enough revenue to compete with incumbents without PFOF.

Figure 4: Robinhood’s Client Assets Are Tiny Compared to Peers – 2021

Sources: New Constructs, LLC and company filings. Fidelity data available here.
*Estimate based on $11.1 trillion in customer assets at Fidelity minus $4.2 trillion in “Discretionary Assets” or assets in managed accounts that Fidelity has the discretion of how they’re invested.

Business Model Built On Conflict of Interest

With transaction based revenue, including PFOF, generating 77% of the company’s revenue in 2021, Robinhood has a clear incentive to generate and sell as much order flow as possible. The company has proven it is good – maybe too good – at enticing users to trade. More trading is not always prudent for clients and brokers generating account “churn” is not a new phenomenon for regulators. Notable regulatory issues:

• Robinhood previously agreed to pay a record $70 million settlement after a FINRA investigation into giving options trading to unqualified investors.
• This settlement comes after a lawsuit filed by the family of 20-year-old Alex Kearns, who committed suicide in June 2020 after Robinhood misinformed him about how much money he lost trading options.
• The state of Massachusetts filed a lawsuit against Robinhood to revoke its license to operate in the state based on claims of “gamifying” investing and predatory business practices.

The mounting regulatory risk Robinhood faces makes us concerned that the public may see Robinhood’s stated goal to ‘democratize investing’ as a ruse to lure them into gambling . That said, there are many beautiful casinos in Las Vegas that are tributes to the willingness of millions of people to lose money gambling.

Otherwise Undifferentiated Offering

In prior years, Robinhood stood out amongst its peers as the only brokerage offering commission-free trades. The largest brokerages quickly eliminated this competitive advantage by cutting stock commissions in late 2019.

Generally, there is a lack of differentiation between most brokerage businesses. Not only do they all offer 0% commission on stock trades, most offer ancillary services, such as education, a variety of asset classes to invest in, retirement accounts, personalized wealth management, and options trading. Robinhood is playing catch up in some instances, for example, the firm plans to begin offering retirement accounts later this year.

Robinhood’s most differentiating feature, options trading for new investors, has also been a source of significant legal and regulatory costs and challenges, and led famed investor Charlie Munger to call Robinhood “a gambling parlor masquerading as a respectable business.”

A Niche Player in Crypto

Robinhood continues its push into cryptocurrency and plans to add more coins to its trading capabilities in 2022. However, just like in traditional securities, Robinhood is playing catch up in this market as well. Peers such as Coinbase (COIN) dwarf its brokerage assets and others, such as PayPal (PYPL) and Block (SQ) are looking to take market share in the industry as well.

Valuation Implies 2x Revenue of Interactive Brokers

Below we use our reverse discounted cash flow (DCF) model to show the expectations for future cash flows in HOOD look overly optimistic, given that Robinhood’s growth story unraveled in the second half of 2021 and guidance for 1Q22 is weak.

To justify Robinhood’s current price of $14/share, the company must:

• improve its NOPAT margin to 16% (compared to 8% in 2020 and -355% in 3Q21) and
• grow revenue by 26% compounded annually through 2027, which is over 6x the projected industry growth rate through 2026

In this scenario, Robinhood would generate $4.9 billion in revenue in 2027, which is nearly 3x its 2021 revenue, 2x Interactive Brokers (IBKR) TTM revenue and 4x Coinbase’s TTM revenue. Additionally, Robinhood would generate $784 million in NOPAT in 2030, which is more than 9x its 2020 NOPAT and just under half Interactive Brokers’ TTM NOPAT.

Keep in mind, the number of companies that grow revenue by 20%+ compounded annually for such a long period are unbelievably rare, making the expectations in Robinhood’s share price look unrealistic.

57% Downside Even if Growth is 4x Industry Expectations

Robinhood’s economic book value, or no growth value, is negative $1/share, which illustrates the overly optimistic expectations in its stock price.

Even if we assume Robinhood:

• achieves a NOPAT margin of 16% and
• grows revenue by 15% compounded annually through 2027 (nearly 4x projected industry growth rates through 2026) then

the stock is worth just $6/share today – a 57% downside.

Figure 5 compares the company’s implied future revenue in these two scenarios to its historical revenue, along with the revenue of competitors, such as Interactive Brokers and Coinbase.

Figure 5: Robinhood’s Historical and Implied Revenue: DCF Valuation Scenarios

Sources: New Constructs, LLC and company filings

Each of the above scenarios also assumes Robinhood grows revenue, NOPAT, and FCF without increasing working capital or fixed assets. This assumption is highly unlikely but allows us to create best-case scenarios that demonstrate the level of expectations embedded in the current valuation. For reference, Robinhood’s invested capital increased $1.4 billion (146% of revenue) YoY in 2020. If we assume Robinhood’s invested capital increases at a similar rate in DCF scenario 2, the downside risk is even larger.

This article originally published on February 2, 2022

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, style, or theme.

Follow us onTwitter, Facebook, LinkedIn, and StockTwits for real-time alerts on all our research.

Click here to download a PDF of this report.

The post Robinhood: Still Nothing But a Gamble appeared first on New Constructs.

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We counsel investors to take care not to be cut by falling knives – stocks that have seen steep declines but still have further to fall. As the market rotates away from high-flying growth names to more stable cash generators, investors need reliable fundamental research, more than ever, to protect their portfolios from falling knives.

We continue to post an exceptional hit rate on spotting overvalued stocks. Currently, 62 out of our 65 Danger Zone stock picks are down from their 52-week highs by more than the S&P 500. Figure 1 lists the open Danger Zone picks that are down at least 40% from their 52-week highs. Our Focus List Stocks: Short Model Portfolio, the best-of-the-best of our Danger Zone picks, outperformed the S&P 500 as a short portfolio by 36% in 2021 with 29 out of our 31 picks outperforming the index.

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The post Falling Knife You Don’t Want to Catch – Part 5 appeared first on New Constructs.

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We counsel investors to take care not to be cut by falling knives – stocks that have seen steep declines but still have further to fall. As the market rotates away from high-flying growth names to more stable cash generators, investors need reliable fundamental research, more than ever, to protect their portfolios from falling knives.

We continue to post an exceptional hit rate on spotting overvalued stocks. Currently, 62 out of our 65 Danger Zone stock picks are down from their 52-week highs by more than the S&P 500. Figure 1 lists the open Danger Zone picks that are down at least 40% from their 52-week highs. Our Focus List Stocks: Short Model Portfolio, the best-of-the-best of our Danger Zone picks, outperformed the S&P 500 as a short portfolio by 36% in 2021 with 29 out of our 31 picks outperforming the index.

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The post Falling Knife You Don’t Want to Catch – Part 4 appeared first on New Constructs.

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We counsel investors to take care not to be cut by falling knives – stocks that have seen steep declines but still have further to fall. As themarket rotates away from high-flying growth names to more stable cash generators, investors need reliable fundamental research, more than ever, to protect their portfolios from falling knives.

We continue to post an exceptional hit rate on spotting overvalued stocks. Currently, 62 out of our 65 Danger Zone stock picks are down from their 52-week highs by more than the S&P 500. Figure 1 lists the open Danger Zone picks that are down at least 40% from their 52-week highs. Our Focus List Stocks: Short Model Portfolio, the best-of-the-best of our Danger Zone picks, outperformed the S&P 500 as a short portfolio by 36% in 2021 with 29 out of our 31 picks outperforming the index.

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The post Falling Knife You Don’t Want to Catch – Part 3 appeared first on New Constructs.

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We counsel investors to take care not to be cut by falling knives – stocks that have seen steep declines but still have further to fall. As themarket rotates away from high-flying growth names to more stable cash generators, investors need reliable fundamental research, more than ever, to protect their portfolios from falling knives.

We continue to post an exceptional hit rate on spotting overvalued stocks. Currently, 62 out of our 65 Danger Zone stock picks are down from their 52-week highs by more than the S&P 500. Figure 1 lists the open Danger Zone picks that are down at least 40% from their 52-week highs. Our Focus List Stocks: Short Model Portfolio, the best-of-the-best of our Danger Zone picks, outperformed the S&P 500 as a short portfolio by 36% in 2021 with 29 out of our 31 picks outperforming the index.

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We counsel investors to take care not to be cut by falling knives – stocks that have seen steep declines but still have further to fall. As the market rotates away from high-flying growth names to more stable cash generators, investors need reliable fundamental research, more than ever, to protect their portfolios from falling knives.

We continue to post an exceptional hit rate on spotting overvalued stocks. Currently, 62 out of our 65 Danger Zone stock picks are down from their 52-week highs by more than the S&P 500. Figure 1 lists the open Danger Zone picks that are down at least 40% from their 52-week highs. Our Focus List Stocks: Short Model Portfolio, the best-of-the-best of our Danger Zone picks, outperformed the S&P 500 as a short portfolio by 36% in 2021 with 29 out of our 31 picks outperforming the index.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone picks this week: Falling Knife You Don’t Want to Catch – Part 1, Falling Knife You Don’t Want to Catch – Part 2, Falling Knife You Don’t Want to Catch – Part 3, Falling Knife You Don’t Want to Catch – Part 4, and Falling Knife You Don’t Want to Catch – Part 5.

Learn more about the best fundamental research The post Podcast: Why These Falling Stocks Remain In The Danger Zone appeared first on New Constructs.

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Tesla’s (TSLA) 4Q21 earnings report only underscores our thesis that the stock is wildly overvalued and will fall as low $136/share.

Musk’s promises of riches from non-EV businesses are only getting more and more outlandish. Remember the Roadster, CyberTruck, FSD, paradigm-shifting battery technology, solar panels, and now robots. To date, none of these have produced any meaningful profits. Musk’s claims to the contrary point to an increasingly unstable house of cards.

We disagree that Tesla is like Amazon and will reap profits from multiple businesses. Unlike Elon Musk, Jeff Bezos never tipped his hand about new businesses into which Amazon might move. Amazon Web Services (AWS) had a huge first-mover advantage before most investors knew it existed. And once AWS was well-known, Amazon made the most of its first-mover advantage to become an industry leader.

Tesla has earned its first-mover advantage in electric vehicles, for sure, but it is different from Amazon’s AWS success in two ways:

1. Unlike cloud services, automobile manufacturing is not a new industry, and it is rife with multiple deep-pocketed incumbents with more experience building cars than Tesla.
2. AWS maintains industry-leading market share and capitalized on its first-mover advantage, while Tesla’s manufacturing woes have allowed its competition to catch up and take over the lead in market share in Europe.

Mr. Musk focused on robots instead of Tesla’s record profits because he knows those profits are illusory and unsustainable given the rise of competition in the electric vehicle market from both incumbent car makers and other start-up EV makers.

Nevertheless,Tesla bulls continue to pile into the stock on the hopes that Tesla will revolutionize not just the auto industry, but energy, software, transportation, insurance, and more, despite ample evidence to the contrary as we detail in our report here. The optimistic hopes for these businesses seem to compel investors to buy shares at valuations more suited to science-fiction than investing.

Tesla’s record vehicle deliveries were a major factor in stock performance in 2021. Selling just under 1 million cars in 2021 sounds great and was no small feat. However, that number is minuscule compared to the number of vehicles Tesla must sell to justify its stock price – anywhere from 16 million to upwards of 46 million depending on average selling price (ASP) assumptions. For reference, Adam Jonas, a Morgan Stanley analyst, projects Tesla will sell 8.1 million vehicles in 2030.

Why We Remain Bearish on Tesla: Valuation Ignores Weakening Competitive Position: The headwinds Tesla faces are numerous (such as the recent recall of half a million vehicles) and outlined in more detail in our report here. The biggest challenge to any Tesla bull case is the rising competition from incumbents and startups alike across the global EV market.

Incumbent automakers have spent billions of dollars building out their EV offerings. Indeed, automakers other than Tesla already account for 85% of global EV sales through the first half of 2021. The global EV market is simply not big enough for Tesla to achieve the sales expectations in its valuation unless everyone else exits the market.

The bottom line is that it is hard to make a straight-faced argument that in a competitive market, Tesla can achieve the sales its valuation implies.

Reverse DCF Math: Valuation Implies Tesla Will Own 60%+ of the Global Passenger EV Market

At its current average selling price (ASP) per vehicle of ~$51k, Tesla’s stock price at ~$1,200/share implies the firm will sell 16 million vehicles in 2030 versus ~930k in 2021. That represents 60% of the projected base case global EV passenger vehicle market in 2030 and the implied vehicle sales based on lower ASPs look even more unrealistic.

To provide inarguably best-case scenarios for assessing the expectations reflected in Tesla’s stock price, we assume Tesla achieves profit margins twice as high as Toyota Motor Corp (TM) and quadruples its current auto manufacturing efficiency.

Per Figure 1, a $1,200/share price implies that, in 2030, Tesla will sell the following number of vehicles based on these ASP benchmarks:

• 16 million vehicles – current ASP of $51k
• 21 million vehicles – ASP of $38k (average new car price in the U.S. in 2020)
• 46 million vehicles – ASP of $17k (equal to General Motors over the TTM)

If Tesla achieves those EV sales, the implied market share for the company would be the following (assuming global passenger EV sales reach 26 million in 2030, the base case projection from the IEA):

• 60% for 16 million vehicles
• 80% for 21 million vehicles
• 179% for 46 million vehicles

If we assume the IEA’s best case for global passenger EV sales in 2030, 47 million vehicles, the above vehicle sales represent:

• 33% for 16 million vehicles
• 44% for 21 million vehicles
• 98% for 46 million vehicles

Figure 1: Tesla’s Implied Vehicle Sales in 2030 to Justify $1,200/Share

Sources: New Constructs, LLC and company filings

Tesla Must be More Profitable Than Apple For Investors to Make Money

Here are the assumptions we use in our reverse discounted cash flow (DCF) model to calculate the implied production levels above.

Bulls should understand what Tesla needs to accomplish to justify ~$1,200/share:

• immediately achieve a 17.2% NOPAT margin (double Toyota’s margin, which is the highest of the large-scale automakers we cover), compared to Tesla’s TTM margin of 7.7%) and
• grow revenue by 38% compounded annually for the next decade.

In this scenario, Tesla generates $789 billion in revenue in 2030, which is 103% of the combined revenues of Toyota, General Motors, Ford (F), Honda Motor Corp (HMC), and Stellantis (STLA) over the TTM.

This scenario also implies Tesla generates $136 billion in net operating profit after-tax (NOPAT) in 2030, or 46% higher than Apple’s (AAPL) fiscal 2021 NOPAT, which, at $93 billion, is the highest of all companies we cover.

TSLA Has 44% Downside If Morgan Stanley Is Right About Sales

If we assume Tesla reaches Morgan Stanley’s estimate of selling 8.1 million cars in 2030 (which implies a 31% share of the global passenger EV market in 2030), at an ASP of $38k, the stock is worth just $471/share. Details:

• NOPAT margin improves to 17.2% and
• revenue grows 27% compounded annually over the next decade, then

the stock is worth just $471/share today – 44% downside to the current price. See the math behind this reverse DCF scenario. In this scenario, Tesla grows NOPAT to $60 billion, or nearly 17x its TTM NOPAT, and just 3% below Alphabet’s (GOOGL) TTM NOPAT.

TSLA Has 84%+ Downside Even with 28% Market Share and Realistic Margins

If we estimate more reasonable (but still very optimistic) margins and market share achievements for Tesla, the stock is worth just $136/share. Here’s the math:

• NOPAT margin improves to 8.5% (equal to General Motors’ TTM margin, compared to Tesla’s TTM margin of 7.7%) and
• revenue grows by consensus estimates from 2021-2023 and
• revenue grows 20% a year from 2024-2030, then

the stock is worth just $136/share today – an 84% downside to the current price.

In this scenario, Tesla sells 7.3 million cars (28% of the global passenger EV market in 2030) at an ASP of $38k. We also assume a more realistic NOPAT margin of 8.5% in this scenario. Given the required expansion of plant/manufacturing capabilities and formidable competition, we think Tesla will be lucky to achieve and sustain a margin as high as 8.5% from 2021-2030. If Tesla fails to meet these expectations, then the stock is worth less than $136/share.

Figure 2 compares the firm’s historical NOPAT to the NOPAT implied in the above scenarios to illustrate just how high the expectations baked into Tesla’s stock price remain. For additional context, we show Toyota’s, General Motors’, and Apple’s TTM NOPAT.

Figure 2: Tesla’s Historical and Implied NOPAT: DCF Valuation Scenarios

Sources: New Constructs, LLC and company filings

Each of the above scenarios assumes Tesla’s invested capital grows 14% compounded annually through 2030. For reference, Tesla’s invested capital grew 53% compounded annually from 2010-2020 and 29% compounded annually from 2015-2020. Invested capital at the end of 3Q21 grew 21% year-over-year (YoY). Tesla’s property, plant, and equipment has grown even faster, at 58% compounded annually, since 2010.

A 14% CAGR represents 1/4th the CAGR of Tesla’s property, plant, and equipment since 2010 and assumes the company can build future plants and produce cars 4x more efficiently than it has so far.

In other words, we aim to provide inarguably best-case scenarios for assessing the expectations for future market share and profits reflected in Tesla’s stock market valuation.

This article originally published on January 27, 2022.

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, sector, style, or theme.

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We’ve been bearish on Netflix (NFLX: $380/share) foryears, not because it provides a poor service, but because the firm is a bait fish in a tank filled with sharks.

With the subscriber miss in 4Q21 and weak guidance for subscriber growth in 1Q22, the weaknesses in Netflix’s business model are undeniable. Even after falling 47% from its 52-week high, we think the stock could have a further 66% downside.

As we’ll show, strong competition is taking market share, and it’s becoming clear that Netflix cannot generate anything close to the growth and profits implied by the current stock price.

Learn more about the best fundamental research Netflix Loses Market Share: Subscriber Growth Continues to Disappoint

Netflix added 8.28 million subscribers in 4Q21, below its prior estimate of 8.5 million and consensus estimates of 8.32 million. Management guided for 2.5 million additions in 1Q22, which would represent a 37% year-over-year (YoY) decline in subscriber additions and be the slowest subscriber growth of the past four years.

We expect that such muted growth is the new normal, as noted in our April 2021 report because competition is taking meaningful market share from Netflix and making subscriber growth more expensive. Figure 1 highlights Netflix’s U.S. market share loss in 2021, as well as the clear gains by HBO Max, Apple TV+, and Paramount+.

Figure 1: Netflix Losing Market Share to Competitors

Source: JustWatch

We expect Netflix will continue to lose market share as more competitors enter the market and deep-pocketed peers such as Disney (DIS), Amazon (AMZN), and Apple (AAPL) continue to invest heavily in streaming.

No Longer the Only Game in Town

The streaming market is now home to at least 15 services with more than 10 million subscribers (see Figure 2). Many of these competitors, such as Disney, Amazon, YouTube (GOOGL), Apple, Paramount (VAIC) and HBO Max (T) have at least one of two key advantages:

1. profitable businesses that subsidize lower-cost streaming offerings
2. a deep catalog of content that is owned by the company, rather than licensed from others

Competing against firms that make enough money in other business that they can afford to lose money in their streaming businesses means Netflix may never generate positive cash flows. Netflix also suffers from a “winner’s curse” with its licensed content: as it gains subscribers, the content owners know they can charge more to license content. Netflix has had impressive success with content generation but, until it has a deep content catalogue of its own, it must pay costly licensing fees and spend heavily to build brand cache.

Figure 2: Lots of Competitors in Online Streaming

Sources: New Constructs, LLC and company filings.
Prices represent subscription level with the most similar features across each offering
Represents Amazon Prime members, all of which can use Amazon Prime. Amazon hasn’t officially disclosed Prime Video users.
Pricing based in Yuan, converted to Dollars
Requires subscription to Hulu + Live TV
*Monthly Active Users (MAUs). As a free service, Tubi reports MAUs instead of numbers of subscribers.

Harder to Hike Prices With So Many Low-Cost Alternatives

We underestimated Netflix’s ability to raise prices while maintaining subscription growth. We expected competitors to enter the streaming market sooner but, now that competition is showing up in strength, our thesis is playing out as expected. Netflix’s recent price hike will be a true test of how sticky its user base is.

Consumers have a growing list of lower-cost alternatives to Netflix so a willingness to accept price hikes is not a given. Per Figure 3, Netflix now charges more than every other major streaming service. For reference, we use Netflix’s “Standard” plan and the equivalent packages from competitors in Figure 3.

Figure 3: Monthly Price for Streaming Services in the U.S.

Sources: New Constructs, LLC

Acquiring Customers Has Never Been More Expensive

A combination of rising inflation and increasing competition have left Netflix paying more than ever to acquire subscribers. Marketing costs and streaming content spending has risen from $959 per new subscriber in 2019 (pre-pandemic) to $1,113 per new subscriber in 2021.

For a user paying $15/month in the US, it takes over six years for Netflix to break even. In Europe and Latin America, where average revenue per membership is lower, this break-even is eight years and eleven years, respectively.

Growth or Profits, Never Both

Netflix’s free cash flow was positive in 2020 for the first time since 2010, frequently a positive sign for a company. But, in this case, positive FCF coincides with Netflix cutting content spending during the COVID-19 pandemic. It also coincides with sharply slower subscriber growth (see Figure 4), which is hardly a surprise considering the hyper-competitive, content-driven nature of the streaming business.

Netflix’s management plans to do what the company has always done, spend more on content. But the long-term slowdown in subscriber growth suggests that throwing billions of dollars at content will not be enough to fend off its competition. What 2020 and 2021 showed Netflix was that the wolf is always at their door. Without spending heavily on content and marketing, new subscribers will not show up.

Figure 4: Change in Subscriber Growth & Content Spend: 2014 – 2021

Sources: New Constructs, LLC and company filings.

Limited Ability to Monetize Content Creates a Cash Burning Business

Because of the heavy spending required to produce content, the company has burned through $11.7 billion in FCF over the past five years. Over the TTM, free cash flow sits at -$374 million. Heavy cash burn is likely to continue given that Netflix has one revenue stream, subscriber fees, while competitors such as Disney monetize content across theme parks, merchandise, cruises, and more. Competitors such as Apple, AT&T (T) and Comcast/NBC Universal (CMCSA) generate cash flows from other businesses that can help fund content production and general losses on streaming platforms.

The question then becomes, how long will investors keep fronting cash to support subscriber growth without profit growth. We don't think Netflix’s money-losing, mono-channel streaming business has the staying power to compete with Disney’s (and all the other video content producers’) original content spending ­– at least not at the level to grow subscribers and revenue at the rates implied by its valuation.

Figure 5: Netflix’s Cumulative Free Cash Flow Since 2015

Sources: New Constructs, LLC and company filings.

Lack of Live Content Limits Subscriber Growth

Netflix has historically stayed out of the live sports arena, a stance that looks unlikely to change. Co-CEO Reed Hastings stated in mid 2021 Netflix would require exclusivity that is not offered by sport leagues in order to “offer our customers a safe deal.” For consumers that require live content as part of their streaming needs, Netflix is either not an option, or must be purchased as a complementary service with a competitor.

Meanwhile, Disney, Amazon, CBS, NBC, and Fox (each of which has its own streaming platform) are securing rights to more and more live content, especially the NFL and NHL, giving them a very popular offering that Netflix cannot match.

Netflix’s Valuation Implies Subscribers Will Double

We use our reverse discounted cash flow (DCF) model and find that the expectations for Netflix’s future cash flows look overly optimistic given the competitive challenges above and guidance for slowing user growth. To justify Netflix’s current stock price of ~$380/share, the company must:

• maintain its 2020 NOPAT margin of 16%[1] (vs. TTM of 18.5%, three-year average of 12%, and five-year average of 9% and
• grow revenue 14% compounded annually through 2027, which assumes revenue grows at consensus estimates in 2022-2024 and 14% each year thereafter

In thisscenario, Netflix’s implied revenue in 2027 of $63.1 billion is 4.8x the TTM revenue of Fox Corp (FOXA), 2.4x the TTM revenue of ViacomCBS (VIAC), 1.6x the combined TTM revenue of Fox Corp and ViacomCBS (VIAC) and 94% of Disney’s TTM revenue.

To generate this level of revenue and reach the expectations implied by its stock price, Netflix would need:

• 340 million subscribers at an average monthly price of $15.49/subscriber
• 472 million subscribers at an average monthly price of $11.15/subscriber

$15.49 is the new monthly price for Netflix’s standard U.S. plan. However, the majority of Netflix’s subscriber growth comes from international markets, which generate much less per subscriber. The combined (U.S. and international) average monthly revenue per subscriber is $11.15. At that price, Netflix needs to more than double its subscriber base to over four-hundred seventy million to justify its stock price.

Netflix’s implied NOPAT in this scenario is $9.9 billion in 2027, which would be 5x the 2019 (pre-pandemic) NOPAT of Fox Corp, 2.6x the 2019 NOPAT of ViacomCBS, 1.7x the combined 2019 NOPAT of Fox Corp and ViacomCBS, and 93% of Disney’s 2019 NOPAT.

Figure 6 compares Netflix’s implied NOPAT in 2027 with the TTM NOPAT[2] of other content production firms.

Figure 6: Netflix’s 2019 NOPAT and Implied 2027 NOPAT vs. Content Producers

Sources: New Constructs, LLC and company filings.

There’s 47% Downside if Margins Fall to 3-Year Average

Below, we use our reverse DCF model to show the implied value of NFLX under a scenario with a realistic assessment of the mounting competitive pressures facing Netflix. Specifically, if we assume:

• Netflix’s NOPAT margin falls to 12.1% (equal to its 3-year average) and
• Netflix grows revenue by 11% compounded annually through 2027, (above management’s guided YoY revenue growth rate for 1Q22) then

the stock is worth just $202/share today – a 47% downside. In this scenario, Netflix’s revenue in 2027 would be $52.2 billion, which implies Netflix has 281 million subscribers at the current U.S. standard price of $15.49 or 390 million subscribers at the overall average revenue per subscriber of $11.15/month. For reference, Netflix’s has 222 million subscribers at the end of 2021.

In this scenario, Netflix’s implied revenue of $52.2 billion is 4x the TTM revenue of Fox Corp, 1.9x the TTM revenue of ViacomCBS, 1.3x the combined TTM revenue of Fox Corp and ViacomCBS and 77% of Disney’s TTM revenue.

Netflix’s implied NOPAT in this scenario would be 3x the 2019 (pre-pandemic) NOPAT of Fox Corp, 1.6x the 2019 NOPAT of ViacomCBS, 1.1x the combined 2019 NOPAT of Fox Corp and ViacomCBS, and 58% of Disney’s 2019 NOPAT.

There’s 66% Downside if Margins Fall to 5-Year Average

Should Netflix’s margins fall even further due to competitive pressures for more spending on content creation and/or subscriber acquisition, the downside is even greater. Specifically, if we assume:

• Netflix’s NOPAT margin falls to 9.2% (equal to its 5-year average) and
• Netflix grows revenue by 11% compounded annually through 2027, (above management’s guided YoY revenue growth rate for 1Q22) then

the stock is worth just $131/share today – a 66% downside. In this scenario, Netflix’s implied revenue and subscribers would be the same as in Scenario 2. Netflix’s implied NOPAT in this scenario would be 2.4x the 2019 (pre-pandemic) NOPAT of Fox Corp, 1.2x the 2019 NOPAT of ViacomCBS, 82% the combined 2019 NOPAT of Fox Corp and ViacomCBS, and 45% of Disney’s 2019 NOPAT.

Maybe Too Optimistic

The above scenarios assume Netflix’s YoY change in invested capital is 10% of revenue (equal to 2020) in each year of our DCF model. For context, Netflix’s invested capital has grown 38% compounded annually since 2013 and change in invested capital has averaged 24% of revenue each year since 2013.

Figure 7 shows just how capital-intensive Netflix’s business has been since 2013. Not only is invested capital larger than revenue but the YoY change in invested capital has been equal to or greater than 10% of revenue each year since 2013. It is more likely that spending will need to be much higher to achieve the growth in the above forecasts, but we use this lower assumption to underscore the risk in this stock’s valuation.

Figure 7: Netflix Revenue, Invested Capital, and Change in Invested Capital as % of Revenue: 2013-TTM

Sources: New Constructs, LLC and company filings.

Fundamental Research Provides Clarity in Frothy Markets

2022 has quickly shown investors that fundamentals matter and stocks don’t only go up. With a better grasp on fundamentals, investors have a better sense of when to buy and sell – and – know how much risk they take when they own a stock at certain levels. Without reliable fundamental research, investors have no way of gauging whether a stock is expensive or cheap.

As shown above, by combining more reliable fundamental research with our reverse DCF model, we show that even after plummeting post-earnings, NFLX still holds significant downside.

This article originally published on January 25, 2022.

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, style, or theme.

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[1] Assumes NOPAT margin falls to be closer with historical margins as costs increase from pandemic lows. For example, Netflix’s gross margin fell quarter-over-quarter in all four quarters of 2021.

[2] We use 2019 NOPAT in this analysis to analyze the pre-COVID-19 profitability of each firm, given the pandemic’s impact on the global economy in 2020 and 2021.

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CEO David Trainer sat down with Chuck Jaffe of Money Life to talk about our Danger Zone picks this week: Focus List: Short Winner That Will Fall Further – Part 1, Focus List: Short Winner That Will Fall Further – Part 2, and Focus List: Short Winner That Will Fall Further – Part 3.

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One-year after the reckless meme-stock rally of late January 2021, the valuation of some of the most popular meme-stocks, especially GameStop (GME: $109/share) and AMC Entertainment (AMC), remain untethered from reality. Looking back, here are key takeaways:

• The meme-stock trade grabs fewer headlines than a year ago, but it still affects the stock market today.
• Investing in meme stocks carries reckless and unnecessary risk, which puts an investor’s portfolio in danger of potentially devastating declines.
• We don’t have a problem paying a premium for a company producing strong profits, but that isn’t the case with any of the meme stocks.
• Investors need reliable fundamental research to assess corporate profits, more than ever, as the market rotates away from high-flying growth names to more stable cash generators
• The stock market decline so far in 2022 suggests investors are paying much closer attention to profits valuations than they did in 2021.
• A narrowing gap between valuations and fundamentals is not good news for meme-stock investors, who tend to completely ignore due diligence.
• Meme-stocks like GameStop (GME) and AMC Entertainment (AMC) remain dangerously overvalued and don’t generate anywhere near the profits necessary to justify their current valuations.

Below we highlight how, despite falling significantly from its peak in 2021, GME remains a dangerous stock. We do the math to show how the business must perform to justify its current price. We also look at more realistic scenarios, which show that GME could have upwards of 59% downside.

Learn more about the best fundamental research Meme-Stock Rally Stagnated And Has Farther To Fall

Meme-traders (or self-proclaimed “apes”) threw caution to the wind and piled into GameStop in January 2021, sending the stock soaring to as high as $347/share (based on closing prices). Even after falling 68% from this peak, GME still trades nearly 500% higher than it did at the end of 2020, per Figure 1.

Figure 1: GME Remains 500% Above 2020 Closing Price

Sources: New Constructs, LLC

GME has yet to trade in-line with its actual business fundamentals. This phenomenon remains in place for other popular meme-stocks, such as AMC Entertainment (AMC) and Express (EXPR). Even Koss Inc. (KOSS), which trades 85% below its meme-stock peak, is still nearly 200% higher than its 2020 closing price.

Given that these stocks still trade so much higher than is warranted by their fundamentals, it’s clear that investors and apes alike continue to ignore fundamental research and are taking unnecessary risks with their investments.

Changes Haven’t Fixed a Broken Business

Despite boardroom and executive changes, GameStop remains a lagging brick-and-mortar retailer in an increasingly online world. While the stock got a bump recently from reports that it is entering the NFT and crypto market (a similar playbook to meme-stock companion AMC), these headlines do little to change the underlying fundamentals of the business.

In fiscal 2020 (year ended 2/1/20), before the meme-stock run, the firm’s net operating profit after-tax (NOPAT) margin was 1% and its invested capital turns, a measure of balance sheet efficiency, sat at 1.5, which drove a return on invested capital (ROIC) of just 1%. Over the trailing twelve months (TTM), GameStop’s NOPAT margin has fallen to -2% while its ROIC has fallen to -3% TTM.

Core Earnings[1], a more accurate measure than reported earnings, have fallen from $19 million in fiscal 2020 to -$141 million over the TTM. Despite the clear deterioration of the business, GameStop’s stock price continues to trade as if fundamentals will never matter.

Figure 2: GameStop’s Fundamentals Pre-and-Post Meme-Stock Rally

Sources: New Constructs, LLC and company filings

Quality Research Helps Measure Risk More Clearly

While shorting GME could be a losing proposition, we think it is important to understand the high risk in owning the stock by quantifying the future cash flow expectations in the current stock price.

It’s clear meme-traders have ignored such due diligence, but we’re making it easy for them to have it.

GME is Priced to Generate 150% the Revenue of Activision Blizzard

We use our reverse discounted cash flow (DCF) model to analyze the expectations for future profit growth implied by GameStop’s stock price. In doing so, we find that at $109/share, GameStop is priced as if it will immediately reverse falling margins and grow revenue at an unrealistic rate for an extended period of time.

Specifically, to justify its current price GameStop must:

• improve its NOPAT margin to 3% (equals its three-year average prior to COVID-19, compared to -2% TTM) and
• grow revenue by 15% compounded annually through fiscal 2028 (1.5x the projected video game industry growth through 2027)

In this scenario, GameStop earns over $13.5 billion in revenue in fiscal 2028 or 150% the trailing-twelve-months revenue of Activision Blizzard (ATVI) and 168% the revenue of successful hybrid brick-and-mortar & e-commerce retailer Williams-Sonoma (WSM). For reference, GameStop’s revenue fell by 1% annually from fiscal 2009 to fiscal 2019.

There is a 31%+ Downside If Consensus is Right: In this scenario, GameStop’s:

• NOPAT margin improves to 3%,
• revenue grows at consensus rates in fiscal 2022, 2023, and 2024, and
• revenue grows 10% a year from fiscal 2025 through fiscal 2028 (equal to projected industry growth rate through 2027), then

the stock is worth just $76/share today – a 31% downside to the current price. If GameStop’s growth continues to slow, or its turnaround stalls completely, the downside risk in the stock is even higher, as we show below.

There is a 59%+ Downside If Growth Slows to Achievable Rates: In this scenario, GameStop’s

• NOPAT margin improves to 2% (5-year average),
• revenue grows at consensus rates in fiscal 2022, 2023, and 2024, and
• revenue grows 4.4% a year from fiscal 2025 through fiscal 2028 (continuation of fiscal 2024 consensus), then

the stock is worth just $45/share today – a 59% downside to the current price.

Figure 3 compares the firm’s historical revenue and implied revenue for the three scenarios we presented to illustrate just how high the expectations baked into GameStop’s stock price remain. For reference, we also include the TTM revenue of Activision Blizzard and Williams-Sonoma.

Figure 3: GameStop’s Historical Revenue vs. DCF Implied Revenue

Sources: New Constructs, LLC and company filings

Fundamentals Provide Clarity in Frothy Markets

Wall Street isn’t in the business of warning investors of the dangers in risky stocks because they make too much money from their trading volume and underwriting of debt and equity sales.

With a better grasp on fundamentals[2], investors have a better sense of when to buy and sell – and – know how much risk they take when they own a stock at certain levels. Without reliable fundamental research, investors have no way of gauging whether a stock is expensive or cheap. Without a reliable measure of valuation, investors have little choice but to gamble if they want to own stocks.

Only independent firms are free to provide unconflicted research and navigate Wall Street conflicts and analyst biases. With new technology to cut through the deluge of data in financial filings and overcome the flaws in Wall Street research, self-directed investors are better positioned than ever to make informed decisions.

This article originally published on January 20, 2022.

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, style, or theme.

Follow us on Twitter, Facebook, LinkedIn, and StockTwits for real-time alerts on all our research.

[1] Only Core Earnings enable investors to overcome the flaws in legacy fundamental data and research, as proven in Core Earnings: New Data & Evidence, written by professors at Harvard Business School (HBS) & MIT Sloan for The Journal of Financial Economics.

[2] Our research utilizes our Core Earnings, a more reliable measure of profits, as proven in Core Earnings: New Data & Evidence, written by professors at Harvard Business School (HBS) & MIT Sloan and published in The Journal of Financial Economics.

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The post One Year Later: Meme Stocks Show Investors Ignore Fundamental Research appeared first on New Constructs.

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Our Focus List Stocks: Short Model Portfolio outperformed the S&P 500 as a short portfolio by 36% in 2021 with 29 out of our 31 picks outperforming the index. This is the last of three reports reviewing the biggest winners from this Model Portfolio last year and their potential returns for this year. We reviewed our worst performers from 2021 here.

Buy the Focus List Stocks: Short Model Portfolio Koss Corp (KOSS: $10/share) outperformed as a short in 2021 and we remain bearish on the stock. We also feature two other Focus List: Short stocks that outperformed in 2021, Peloton (PTON) here and Beyond Meat (BYND) here.

Focus List Stocks: Short Outperformed in 2021

The Focus List Stocks: Short Model Portfolio contains the best of our Danger Zone picks and leverages superior fundamental data, as proven in The Journal of Financial Economics[1], which provides a new source of alpha. This Model Portfolio is available in real-time to Pro and higher members, or you can purchase the current version of the Model Portfolio here.

The Focus List Stocks: Short Model Portfolio fell, on average, -16% in 2021 compared to an average return of 20% for the S&P 500, per Figure 1[2].

Figure 1: Focus List Stocks: Short Model Portfolio Performance from Period Ending 4Q20 to 4Q21

Sources: New Constructs, LLC

Because our Focus List Stocks: Short Model Portfolio represents the best of the best picks, not all Danger Zone picks we publish make the Model Portfolio. We published 46 Danger Zone Reports in 2021 but added just 11 of those picks to the Focus List Stocks: Short Model Portfolio during the year. Currently, the Focus List Stocks: Short Model Portfolio holds 28 stocks.

Figure 2 shows a more detailed breakdown of the Model Portfolio’s performance, which encompasses all the stocks that were in the Model Portfolio at any time in 2021.

Figure 2: Performance of Stocks in the Focus List Stocks: Short Model Portfolio in 2021

Sources: New Constructs, LLC
Performance includes the performance of stocks currently in the Focus List Stocks: Short Model Portfolio, as well as those removed during the year, which is why the number of stocks in Figure 2 (31) is higher than the number of stocks currently in the Model Portfolio (28).

Winner: Focus List Stock: Short: Koss Corp (KOSS): Down 54% vs. S&P 500 Up 13% Since Added to Focus List in 2021

We originally added Koss Corp to the Focus List Stocks: Short Model Portfolio in June 2021 and from that point through the end of 2021 it outperformed as a short by 67% in 2021. As the meme-stock rally ages, Koss remains significantly overvalued. We also warned investors of the risks of investing in other meme-stocks such as GameStop (GME), AMC Entertainment (AMC), and Express Inc. (EXPR).

Main Reason for Short Outperformance: Meme-Stock Rally Ran Out of Steam: Koss rose to popularity in January 2021 amongst the Wall Street Bets (WSB) Reddit crowd and was fully swept up in a meme-stock rally that saw its stock rise from $3/share to as high as $64/share. As with all the meme-stocks, Koss’ fundamentals had nothing to do with the stock’s rise. Once the meme-driven surge fizzled, Koss shares fell back to earth.

Why Koss Remains Very Unattractive: Business Cannot Justify Current Valuation: Even though Koss never traded based on its fundamentals, when we analyze its fundamentals, and juxtapose them with the expectations baked into the stock price, we see a large disconnect.

The retail dollar value of global headphone shipments has grown by 30% (vs -8% for KOSS) compounded annually since 2016. Meanwhile, Koss’s revenue has fallen 6% compounded annually over the same time.

Put another way, Koss’ revenue fell 28% while the retail dollar value of global headphone shipments rose 273% over the same time. If Koss can’t grow revenue in such a good environment, one must ask, when will it?

Koss’ revenue has been deteriorating for many years, and its profitably has lagged its competition as well. Of the competitors in Figure 3, Koss is the only company with negative NOPAT margin and ROIC. In fact, ROIC and NOPAT margin have been negative every year since 2016.

Figure 3: Profitability Metrics: Koss vs. Peers: TTM

Sources: New Constructs, LLC and company filings

Current Price Implies Profits 6x Previous Quarterly Record

We use our reverse discounted cash flow (DCF) model to quantify the expectations for future profit growth baked into the current stock price and see what the stock would be worth assuming more reasonable growth.

To justify $10/share, Koss must:

• immediately improve its profit margin to 4% (double its highest ever margin of 2% TTM vs. a 5-year average margin of -2%) and
• grow revenue by 24% compounded annually through fiscal 2027 (which is over 2x the projected industry growth over the same time, vs. Koss’ -6% CAGR over the past five years).

In this scenario, Koss earns $3 million in NOPAT in fiscal 2027, which would be the company’s first ever positive annual NOPAT and 6x its highest quarterly NOPAT ($0.5 million in fiscal 4Q21).

There is a 60%+ Downside If Growth Reaches Industry Average: In this scenario, Koss

• improves its profit margin to 4% and
• grow revenue by 11% compounded annually through fiscal 2027 (which is equal to the projected industry growth over the same time), then

the stock is worth just $4/share today – a 60% downside to the current price. If Koss’s revenue continues to fall, or it is unable to improve margins as assumed in the scenario above, the downside risk in the stock is even higher.

Figure 4 compares the firm’s historical NOPAT and implied NOPATs for the two scenarios we presented to illustrate just how high the expectations baked into Koss’ stock price remain.

Figure 4: Koss’ Historical and Implied NOPAT: DCF Valuation Scenarios

Sources: New Constructs, LLC and company filings

This article originally published on January 18, 2022.

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, sector, style, or theme.

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[1] Our research utilizes our Core Earnings, a more reliable measure of profits, as proven in Core Earnings: New Data & Evidence, written by professors at Harvard Business School (HBS) & MIT Sloan and published in The Journal of Financial Economics.

[2] Performance represents the price performance of each stock during the time in which it was on the Focus List Stocks: Short Model Portfolio in 2021. For stocks removed from the Focus List in 2021, performance is measured from the beginning of 2021 through the date the ticker was removed from the Focus List. For stocks added to the Focus List in 2021, performance is measured from the date the ticker was added to the Focus List through December 31, 2021.

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The post Focus List: Short Winner That Will Fall Further – Part 3 appeared first on New Constructs.