Friday File: Buying Risk and Safety

by Travis Johnson, Stock Gumshoe | September 14, 2018 4:26 pm

One new stock for the Real Money Portfolio, plus one for the watchlist -- and three add-on buys for existing positions.

A few purchases to talk to you about today, and a couple other notes as we go… mostly on the theme of risk and safety, as we close out a week with lots of news-driven volatility. Ready?

Innovative Industrial Properties (IIPR) is, in some ways, a fun way to “play” the marijuana boom with less risk (and less potential reward), but what it really is is a Real Estate Investment Trust (REIT) with phenomenal potential for dividend growth… which is why I bought and added to the shares over the first half of this year.

And today they put that promise into reality a bit, with their second dividend increase in a year — the dividend was initiated at 15 cents per quarter when they went public in 2017, jumped to 25 cents last December, and now is bumped up to 35 cents (ex-dividend date is September 27, which means that if you buy on that day or after you don’t receive that dividend… payment date is October 15). That’s $1.40 annualized, which means the forward dividend yield is now about 3.3%.

Dividend growth does a lot of things — it signals to investors that the company is confident about its flow of business, it allows dividend reinvestors to compound their positions more quickly, and, in many cases, it opens up the ceiling for the stock and allows the stock price to rise along with the dividend. People who were happy with the 2.8% yield at $35 might be willing to bid up the stock to get a similar yield now — if you insist on a 3% yield from IIPR, for example, that means you’re now willing to pay up to about $46.67 per share.

That doesn’t guarantee that the stock will rise, of course, and IIPR, despite the dividend, is still a highly risky investment — the value of its assets is an important foundation for the shares, but that value is reliant on regulatory acceptance because these are not necessarily fungible assets. The indoor medical marijuana growing facilities that they own and lease to growers would not be nearly as valuable if medical marijuana legalization was walked back and they had to find new tenants in some other business… they wouldn’t go to zero, and they don’t have any debt so bankruptcy or a fire sale isn’t an issue, but the stock would fall dramatically with a regulatory setback. If they had to sell these customized industrial buildings for other uses, my estimate is that they would be worth 50-70% less than they paid… and that might be optimistic.

And the growth is at risk as well if marijuana gets too legal and too acceptable, and too many growers crop up and drive prices down, sending IIPR’s tenants into bankruptcy or forcing them to come on bended knee to IIPR to lower rents or offer other forbearance. A real estate company, particularly one with long-term triple net leases of customized buildings, can’t succeed if its tenants don’t succeed.

Further legalization on the Federal level in the US could also depress IIPR’s growth potential, because marijuana growers who have access to conventional bank financing or, for the bigger ones, the bond markets, do not need to do creative and lucrative real estate deals just to finance their growth like IIPR’s current clients do. So they walk a fine line… but as long as that line persists and they can keep signing up new tenants to long-term deals at 15% cap rates, the dividend growth potential is enormous. Remember, this is still a small company that should become more efficient as they scale up… and the current cap rates for more conventional industrial buildings are down in the 5-8% range, which shows the cash flow leverage that IIPR enjoys (without having to borrow money) and also reminds us of the risk.

But IF it keeps working, as might be reasonable for quite a while given our conflicted politics and the general tendency of things to evolve gradually, it’s worth owning because dividend growth like this doesn’t come along very often. We haven’t seen any big new deals for deploying IIPR’s capital in recent weeks, which is a shame, but the dividend increase now, before they had any real pressure to increase it, signals some confidence in their cash flow and ability to keep deploying their capital profitably… so I’ll raise my buy price to adjust for the new dividend.

I think IIPR can now be bought below $45, but do note that the risk is rising as the price goes up — it is less supported by asset value now, and more supported by the operating business and the sustainability of the business model (and the financial health of IIPR’s tenants, still a pretty concentrated group of major tenants and still, obviously, in a high-risk industry), so the downside risk I guess at is now more like 60-70%, not the 50% downside risk I had penciled in when the stock was at $35. Still, I’ll put my money where my brain is and add just a little bit to the position here — the risk is real, but dividend growth like this is too good to pass up, especially when it looks to me like it might be sustainable for years given the high cap rate on their deals and the long-term nature of their leases. I’m not going to risk any meaningful amount of money on the big pot stocks that trade for more than 100X sales in a market where we don’t know where (or if) any pricing power or brands might emerge, but here, at least, I can take a little more risk with a medical marijuana landlord. The price actually dipped a bit on the news this morning, so I bought at about $42, increasing the size of my position by about 15%.

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Speaking of dividend growth, though in a somewhat less dramatic and far safer situation, I also boosted my holdings in Starbucks (SBUX) this week by about 20%, and set up a bullish options position that might substantially increase my holdings over the next few months (I sold $50 puts, with protection at $40, and bought $60 calls, all for January expiration, roughly at break-even — I’d be willing to buy a lot more at $50 if it drops that far, so used that conviction to get “free” exposure to anything above $60 if the stock happens to soar… the real risk is that the stock falls into the $40s and stays there, and then I’m still obligated to buy at $50, and I can live with that risk for five months since I’d be wanting to add more if we get back to $50 anyway).

Starbucks remains at risk partly because of the huge bet they’re making on growth in China to offset the pretty stagnant same-store-sales growth numbers they’re seeing now in the United States, but I continue to believe that their balance sheet transformation is being underestimated — big buybacks and substantial dividend increases overe the next few years, fueled partly by starting to use some meaningful leverage, should please shareholders… and a huge and dominant brand like Starbucks can afford to use leverage, even though they haven’t done so much in the past because their massive profit margins have made it unnecessary. Once people stop worrying about whether Starbucks will ever again be a massive top-line growth company like it was five years ago, they’ll probably begin to appreciate the cash-gushing nature of the business… and the dividend has quietly grown to be significant, with a current yield of about 2.6%, and has almost tripled over the past five years and been consistently boosted by an average of about 20% a year.


And I’ve got two more small buys in the portfolio this week, one safe and one risky…

Safety, Income & Growth (SAFE) has been on my watchlist for a while, mostly because it’s a new kind of REIT that went pubic about a year ago and I think it has some interesting potential… but I haven’t rushed into buying the shares, since they don’t seem likely to be a real “growth” REIT and they are very tied to interest rates and inflation… probably more so than most conventional REITs… which means there should be opportunities to build a position in small bites if one is so inclined.

And the price is getting a little more appealing now thanks to a recent decline, so I thought I’d take another look today.

SAFE is an externally managed REIT (managed by iStar, for a 1% fee) that specializes in ground leases, and they’re trying to modernize the ground lease business and turn it into a more conventional form of financing for building owners… and a more standardized asset class for investors.

Ground leases are just what they sound like — SAFE buys the land, and leases the land… they don’t build or have anything to do with any buildings or other improvements on the land. Lease rates are very low, but lease terms are extremely long and they include inflation protection to at least some degree, so it’s kind of like the real estate has been chopped up into a couple pieces and you own just the AAA part that has a much higher level of safety and a much lower return than the risky building operator might provide. The goal is to make the ground lease be about a third of the value of the property — so if the total value of a piece of real estate is $1.2 million, then they’d buy the land underneath for $400,000 and lease it back to the owner or operator at a cap rate of 3-5% (average right now is about 4.25% for the first year, so at that rate the $400,000 investment would yield SAFE $17,000 in that first year in rent, with periodic inflation adjustment and/or rent increases per the individual agreement, and that $1.2 million property perhaps reverting back to SAFE in 99 years). They explain it pretty well in their basic investor presentation here[1].

The company likes to pitch this idea as somewhat akin to investing in inflation-protected bonds, and there is a potential occasional “windfall” return if their tenants ever get into so much trouble that they default on or fail to renew their ground lease. That’s not likely, and most of the leases run for at least 30 years and often 99 or more… but it’s possible, and if the tenant defaults then the landowner also gets ownership of the building and any other improvements. In their presentations, they call that the “Value Bank” — basically, that’s the capital appreciation potential at lease expiration, but we shouldn’t take it too seriously… in a lot of cases, tenants will have the right to extend leases, or to flatten the building if they want to, or purchase it at the end of the lease. But it is a “maybe” windfall opportunity that, for the most part, exists way off in the hypothetical future.

The challenge, over the very long term, might be that to some degree this ends up being an interest rate arbitrage business — they own land on which they collect ground leases, and their leases are mostly very long (30-99 years) and all have some sort of escalator built in, whether that’s a CPI escalator or a fixed annual increase, so the lease payments should come close to keeping up with inflation as long as inflation doesn’t go crazy (which it might, of course). But the returns are low because ground lease rents start pretty low, so financing for those assets is partially through debt so they can boost the returns enough to pay a decent dividend — they have $227 million in fixed-rate debt secured by $340 million worth of their portfolio (they have some other debt, too, including some specifically tied to their Hollywood properties that are a little different, but we’re ignoring that for simplicity’s sake). That’s all well and good, and they have it plotted out and know that they can make a profit on that land while they’re paying service on that debt… but what do they do when the debt comes due?

The ground leases they’ve signed may, on average, provide rent increases of 2% a year for the next decade… but then the debt matures in 2027, and they are still obligated to provide these ground leases for another 20-90 years at the same rate, and it could be that interest rates are dramatically different in 2027, which could have a big impact on the profitability of those leases. So although this is relatively safe in terms of asset value, largely because the ground lease is secured by both the land AND all the improvements, there is some longer-term interest rate arbitrage going on that you’ll have to be confident about. iStar is very experienced in real estate, and has been doing this kind of thing and innovating in new REIT sectors for decades, so I expect them to be attentive to those kinds of funding risks, but it is a real risk and we don’t get to see the internal deals and exactly how those risks are accounted for — I’m particularly interested in learning to what degree the CPI adjustments will actually protect against inflation. They say that their hedging against interest rate risks covers a weighted average of more than 10 years, so there is no immiment danger — but this is an investment that only really makes sense if you think of it as a multi-decade asset allocation, so the risk is real.

So I remain a little bit skeptical, particularly as they’ve just past their first year, which means the year of “free management” is over and they’ll begin paying the management fee… and because I think they’re likely to be very close to coming back to the market to sell more shares so they can grow the portfolio, which investors usually react negatively to even though it’s a necessity for REITs — but with the price drop, I still think it’s worth entering a small position and watching for any dips in the future that might be driven by shifting interest rate expectations or by any potential secondary offerings.

The management fee won’t show up as huge, since they’ve already been recording it in the income statement, but they’ll no longer be getting a corresponding credit for the fee in their balance sheet. From here on, both the 1% management fee and the reimbursable expenses (accounting, bookkeeping, tax prep done by iStar) will be actually paid — the fee in new SAFE stock, the reimbursables in cash. That would have totaled about $1.25million last quarter, and it will rise with the equity value. The other overhead costs are the cash costs they have to bear, mostly listing fees, legal fees, and auditor fees, totaling up to about the same amount, about $1.25 million, and the stock grants to outside directors, which are a non-cash expense… so the difference won’t be huge, but it’s still a small company so every bit counts.

Right now, SAFE is on pace to have enough in adjusted funds from operations (AFFO) to cover the 60 cent (annualized) dividend just fine (though the AFFO is amped up by the fact that the management fee is non-cash, it’s paid in new SAFE shares to iStar), but they’re not likely to grow the dividend rapidly in the near future… they do want to grow the dividend over time, but they haven’t indicated whether they plan to begin in this first year. If they do decide to raise, now would be the logical time (their first dividend was paid in late September, 2017, and if they keep to their pattern they should declare their dividend for the current quarter at some point in the next few days).

So to think of the basic valuation, you’re currently getting a 3.5% yield that I expect will keep up with inflation, and perhaps do a little better than that… and the company right now is carrying about half as much leverage as they’ll allow themselves (they are just under 1X debt to equity, they want to stay below 2X), so they will very likely be like other REITs and raise money through a combination of debt and equity offerings going forward. They are trading right now at about 10X their annual rental income, though the non-cash management fee and the debt service do have to come out of that rental income.

I’m hoping they’ll do a secondary offering and drop the shares down to a meaningful discount, or that the shares might get really cheap and languish for other reasons — I think that this could be a case, much like others in the market, where a real 99-year value could be obscured because it’s not necessarily such a dramatic 12-month value. For now, though, I think it’s worthwhile to add this as a small slow-growth and low-risk REIT, partly because the anniversary as a public company is bringing more attention and it looks like they’re making the rounds of investment conferences again so we might see the shares rising for a bit… perhaps that’s more of a caution flag, too, that they will raise more capital soon and the dip will come just after I’ve bought my first nibble, but it’s hard to predict that timing. I don’t think there’s any real rush, there will probably be plenty of opportunity to build a position in SAFE as sentiment shifts back and forth, and there’s essentially no chance that the stock will take off and surge to $20 overnight… but you have to start somewhere.


And now let’s get a bit riskier…

Based on the seasonality of The Trade Desk’s (TTD) earnings, I’m going to go out on a limb and guess that they will do a lot better in the final two quarters of this year than the analysts are expecting — the analysts have been upgrading their forecasts, of course, even though they haven’t quite gotten the average price target updated just yet, but I don’t think they’ve upgraded them enough.

Just going by the seasonal patterns in The Trade Desk’s revenue, which have so far shown a pretty consistent bump in the third and fourth quarters as the advertising budgets boom in those periods, and the likelihood that the company won’t be able to rationally spend money fast enough to bring margins down much more in short order, I think they’re still lowballing the expectations — I think the revenue number for the third quarter is probably about 5% too low, even though the analysts are just using the company’s guidance for that revenue… and for the fourth quarter, I’m guessing that they’re about 15% too low, though, of course, with a stock that has already surged by 50% in a matter of a month or so it could easily be that investors are way out ahead of analysts on this one and already expecting something better. TTD earnings per share might decline sequentially, as analysts are expecting (that did happen last year), but I don’t see any real reason why they should given the new boost from TTD’s new offerings that seem to be a hit with advertisers.

I think analyts are probably also overstating how much The Trade Desk will be spending on SG&A (selling costs and overhead) as their revenue ramps… a lot of their revenue growth is going to come from existing big advertisers dramatically increasing the allocation to The Trade Desk’s platform, I expect, but if you just step back and look at what’s expected, the estimate is that we’re in the middle of a period when the revenue will go from $308 million in 2017 to $605 million in 2019, with growth pretty even (2018 is expected to be $459 million), but that doubling in revenue is only expeted to increase the earnings per share by about 60%. Maybe they will see margins shrink that much and reinvest that heavily, maybe not, but I think they’re in enough of a sweet spot, with the rapid rise in programmatic advertising and the value proposition they offer, combined with the meteoric rise in mobile and streaming video, a place where advertisers seem to be climbing all over themselves to crash more cash into the system, that they could, despite their huge gains recently, still be primed for surprisingly rapid future growth.

Probabilities here have to be guessed at by any one who wants to risk money, of course, and The Trade Desk has disappointed before — not long after I bought shares the first time, back in October, the stock took a beating and dropped from the mid-$60s to the mid-$40s because they issued disappointing fourth quarter guidance, and I bought more in the $40s… so as we close in on that next quarterly report (it will probably come on November 9 this year), I wouldn’t blame you for being cautious and waiting for a dip.

What compels me to pile a little bit more onto the table here is really that The Trade Desk, despite a huge surge over the past month, remains a wee minnow — revenue was only $380 million over the past twelve months, versus Alphabet’s $124 billion or Facebook’s $48 billion (or even WPP’s $21 billion), and the ceiling is wide open. They are gaining share in a sub-sector of the ad market that is also growing faster than advertising overall, and quickly, which means there are a lot of levers that could fuel almost exponential growth if things work out well.

What do I mean by that? Well, advertising in general is a $700 billion busines globally (as TTD calculates it, at least), probably heading to a trillion in a few years. The Trade Desk, as a platform-agnostic technology provider to ad buyers, touches about $1.5 billion of that today, which generates $308 million for them in revenue. That’s an almost infinitesimally small portion of the business, and The Trade Desk’s segment of global advertising spending is also growing much faster than the market — they estimate that a given large multinational advertiser might now spend $8 billion on media for advertising, with $2 billion of that on digital ads… and that the portion of that which is driven by programmatic ad buying, TTD’s business, has quadrupled over the past few years but is still only about 6% of the digital media spend. Big advertisers are growing increasingly comfortable with programmatic buying, and The Trade Desk is bringing programmatic buying to more and more media, particularly mobile and streaming video but also all other forms of digital media. Growth is absolutely everywhere.

So I think there’s a good enough chance of them really surprising over the next year that I put a little more money into TTD shares this week, something I almost never do with stocks that have just had a crazy leap up in value and that trade at nosebleed current valuations… but sometimes the real underlying growth is strong enough to justify more purchases, particularly if the company is small enough to still surprise even itself.

They could also have a “Facebook moment” when they announce that they’re going to dramatically reinvest in the business and cut into profits, of course, and companies often find it easier to “talk down” expectations after the stock has soared like TTD’s has… but I don’t expect that. They have been compressing the operating margin as they reinvest in future growth in recent years, but it has been stable for the past year or so… and a lot will be riding on the fourth quarter, which is understandably their largest quarter and their highest-margin quarter, since advertising picks up pretty dramatically around the holidays.

So summing up, their new services and ad buying platform, launched just in the past few months, should help to increase ad spend by their customers, they’re retaining more than 95% of their customers, and people seem almost desperate for an ad buying solution that doesn’t constrain them to the ‘walled gardens’ of Alphabet or Facebook (or even Amazon)… and the company has such a long possible runway that I’m willing to add on at what is obviously a very rich price — I increased my TTD position by about 20% at $145 a share, bringing my cost basis up to about $70.

I’ll still watch the stop loss closely on this one, because they face existential risk (someone could come up with a better technology and convince more ad buyers to use it, or major ad platforms could presumably block their access, though wouldn’t have much to gain from that), but that stop loss is a long way away (around $87), so it has plenty of room to breathe as the business tries to grow. There is competition in programmatic ad buying, but I don’t see anyone threatening The Trade Desk’s position right now — I judge the competition to be less worrisome than it is for other high-growth darlings like, say, Square (SQ) and Shopify (SHOP) right now (I still like those crazy growers just fine and still hold the shares, but am not adding to them at these prices).

Shopify, for what it’s worth, got another upgrade today (target $177, from Wedbush), though that target is really just the high price the stock saw a couple months ago so it’s not overwhelmingly bullish… and Square’s target was just raised from $78 to $98 by Deutsche Bank after they had a meeting with management, so they’re doing just fine. If you’re wondering what The Trade Desk’s sell-side analysts are thinking, they don’t seem to know what to do — they all raised their targets after the last blowout earnings report, but despite the fact that the consensus is still that TTD will “outperform,” the highest target prices are still, from what I’ve seen, in the $125-130 range… so with the shares in the mid-$140s, there will indeed be a lot riding on the next quarterly report in November.


That’s about it for transactions in the Real Money Portfolio this week… what else is happening?

Also in the relatively “safe” part of the portfolio, Hershey (HSY) is buying another “healthier” snacks company to complement its newish SkinnyPop popcorn business, they’re spending $420 million to buy Pirate Brands from B&G Foods, which is best known for Pirate’s Booty cheese puffs. Which I love — both the snacks and the strategy, since they’re buying another powerful brand and there should be economies of scale with their Amplify division that runs SkinnyPop out of Texas… especially in getting critical mass in grocery stores and giving them some more sales force oomph. We don’t know much about the profitability of Pirate’s Booty, but we’re told that it’s growing sales at 8%, which is impressive in the growth-starved packaged goods industry, and faster than anyone else in the $2.5 billion cheese puff category. B&G came out OK, they bought Pirate for $195 million five years ago so they double their money, and I expect Hershey to have more marketing heft to take Pirate’s Booty to the next level. I doubt it will make a huge difference immediately, but adding another good growth brand to the quiver sounds good to me for an efficient, slow-growth snacks and candy company.


Skyworks Solutions (SWKS) briefly touched a stop loss going into Apple’s next iPhone reveal event, but shares recovered instantly and went sharply higher by the time I did my analysis (every time I hit a stop loss alert level, I take a deeper look at the stock to decide whether or not to actually sell), so I’ve let it ride a bit — Skyworks is cheap if the analysts are at all correct about their earnings potential over the next year, they trade at a forward PE of about 11, but growth in the “internet of things” has been slower than many anticipated and Skyworks remains very much captive to the iPhone so it trades up and down as sentiment shifts about whether or not it will keep the iPhone business, and how many iPhones apple will actually sell.

This is a company that has required a lot of patience in the few years I’ve owned it, and I think they’re doing everything right — using their surplus cash to buy back stock, paying a growing dividend, acquiring a company with a strategic position in one of their growth markets (Avnera last month), releasing 5G designs and solutions for developers to try to exercise leadership in that segment… and still no one wants it, they have become a story that’s all too familiar in the world of semiconductors: Not enough pricing power, and volumes are lower because smart phone sales are seen as plateauing as upgrade cycles extend… so the sexiness is gone.

That may or may not continue, I don’t know. I still think Skyworks is well-positioned and I like the strategy and the rising dividend… but much depends on whether Samsung’s phone sales start to grow again, and on unit growth in smartphones around the world in general, and particularly, at least for the stock in the short term, on the volume of iPhone sales that we see with this launch. Skyworks noted last quarter that they think the delays that plagued iPhone X orders last year will not recur, and that they are primed to be back to “normal” with more of a presence in the iPhone this year, but Apple is always secretive on that stuff and we won’t really know for a while. If we get back through that stop loss level again and I decide to change that stance, I’ll let you know.


Qualcomm (QCOM) is clearly the most popular bet in mobile chips and 5G this week, and they also pay a strong dividend and have a huge buyback program underway (the latest buyback announcement, in particular, helped the stock jump more than 5% on the week), but there’s also a lot riding on the trade dispute with China, which could start to hit the chip stocks if the tariff pool is increased dramatically as President Trump threatened… and there’s also a lot riding on Qualcomm’s various legal disputes, particularly with Apple over royalties. Qualcomm does lose some shine as Apple stops using Qualcomm chips and shifts over to Intel for their modems, despite Qualcomm’s technical superiority and despite the fact that they’ll still end up owing Qualcomm money for royalties on their core mobile 5G and 4G and other patents (though the amount, of course, could change dramatically depending on how the legal battle goes, and both companies have lots to lose and plenty of lawyers so it probably won’t be quick). If the trade war fizzles to nothing much, and Qualcomm has a decent settlement with Apple, this could be a $100 stock in a year… if those things go the other way, we could see it back below $50 in a weak market.

Qualcomm is just an irresistible story, and you can see why the Stansberry folks have been pounding the table on it as their 5G idea in recent weeks[2]: Lots of risk here from China and Apple headlines, but it objectively should be a low-risk, high-margin, cash-rich company with big dividends and a big buyback in the center of a very powerful growth sector. I haven’t done anything with my (still small) QCOM equity position, but I did sell part of my call option position after this latest surge, to take my initial capital off the table… and I can’t resist following this story.


Other news? Last week brought some long-floating worries and rumors to light about Social Capital and its front man, Chamath Palihapitiya. Palihapitiya is an inspiring speaker and Social Capital as a venture capital fund, partially funded by his own Facebook millions (he was one of the first Facebook employees), has had one huge reported success so far in funding Slack, but things appear to be wearing a bit thin right now. There was a story in Axios called What Went Wrong at Social Capital[3] detailing the rift between Palihapitiya and his partners, several of whom have left, and his increasingly odd behavior.

I invested in Social Capital’s blank check company, Social Capital Hedosophia (IPOA), because I thought they might succeed in taking a strong “unicorn” public… and it seemed worthwhile to get a little leverage on a potential big-news event like that by getting the warrants that typically come with a “blank check” offering, mostly because it’s rare to find five-year warrants on a decent growth company. This news doesn’t necessarily change anything on that front, other than pointing the possibility that his declining reputation in Silicon Valley, assuming those stories are real and the news flow is sustained, will make it harder to find an appealing deal. Social Capital may well have trouble attracting big new venture investment money from institutions, but the SPAC isn’t going anywhere and they’ve got another year or so to settle on a deal (or return the investors’ money).

I downsized this exposure a while back, taking off my equity exposure and leaving just the warrants in the Real Money Portfolio. The value of those warrants dropped by about 25% on this latest wave of negative attention for Palihapitiya — and my inclination is to be a little less positive now than I was when first hearing him speak and reading some of his work a year or so ago, but I’m also aware that this is a volatile little side bet on IPOA finding success and I entered into that trade with the full awareness that there is a meaningful risk, much greater than 50/50, of a 100% loss (if the SPAC fails to make a deal, the warrants are worthless… and if they make a bad deal that the market doesn’t initially love, the warrants will lose a lot of their value immediately, despite the big optionality present in the five-year term — investors often underestimate the value of time once you go past a year or two).

So I’m just sitting pat — I don’t have any personal knowledge of Chamath Palihapitiya, but he’s certainly an opinionated and outspoken guy in Silicon Valley, not least because he’s trying to bring more analytics and data to a historically personality-driven and connections-driven venture capital funding process, and it probably shouldn’t be all that surprising that he’s making some people mad along the way… though it’s disconcerting that he has lost his two closest partners. We’ll see how it goes, I won’t rush into a decision on this speculation and I’m still aware that this small speculation is at real risk of a 100% loss.


And since I’m taking SAFE off the watchlist and adding it to the portfolio, perhaps it’s appropriate that I also came across a new stock this week that I want to keep an eye on (I also removed some older watchlist stocks that surged dramatically and were ones that I think I just “missed” when I didn’t buy them over the past year).

Switch (SWCH) is our new watchlist stock — it’s a new data center company that went public almost exactly a year ago. They are small, still, with four campuses either operating or planned and three large data centers in operation, and you can get an idea of the way Wall Street is currently thinking of them by looking at their stock chart compared to the five major US data centers and one European one — InterXion (INXN), the Europe-focused data center owner, and Switch (SWCH) are the only ones that aren’t structured as Real Estate Investment Trusts (REITs — pass-through investment vehicles that are designed to distribute cash flow and all taxable income as dividends and thereby avoid corporate taxes).

SWCH Chart[4]

SWCH[5] data by YCharts[6]

Do note that all of those data center stocks trailed the S&P 500 over the past year, even with their relatively high dividends — that’s partly because they overshot in 2016 and 2017, when most of them did far better than the market (except for QTS), so the market went into that October 2017 IPO predisposed to adore data center owners… even if this new one wasn’t actually a REIT and was at a different point in its development phase. This was one of the bigger tech IPOs of 2017, and it definitely captured the imagination of investors with a big first-day IPO pop (from a predicted $15 a share to $20 or so)… though the valuation was pretty aggressive at that IPO, at least in terms of earnings, and the stock has mostly trended down since.

There are obviously some challenges for Switch, particularly because they need to ramp up capital spending pretty dramatically to get their new campuses built, and because this is an industry where there is a strong network effect and pretty good economies of scale — if you’re a large company and can deal with one data center provider who can get you space in a dozen different places around the country (or the world) to provide fast colocation coverage, then that may be more appealing than dealing with half a dozen different smaller providers. Still, many of the data center companies work with a bunch of the same large-scale customers, and, indeed, in some cases even build their own centers (the big guys like Facebook and Google are on a massive building spree, too)… so there’s no real sign of data centers becoming a “winner take all” category, but there is a pricing advantage for those centers that can get you prime colocation space near major metropolitan areas and major telecom hubs, since that speeds up connections and everyone wants more speed.

So how is Switch different? Well, it trades at a much smaller multiple of sales — about 3X sales, versus more like 8X sales for the bigger players. And it’s focusing on what it calls “hyperscale” centers and is focused on building differently, with their roots not in services or real estate but in data center design and optimization. That hasn’t made a difference yet, they don’t seem to be getting premium prices, but it is still early and they are actively building so if they can continue to get cheap access to capital they may be able to dramatically ramp up revenue over the next few years if they can build quickly. That’s two “ifs”, which perhaps is part of why the stock is not doing very well.

And they do have some potential for strong branding, and at least one well-known building — their “east coast” hyperscale data center is in the Steelcase Pyramid in Grand Rapids, Michigan, so they got a little attention for saving and repurposing that iconic building.

There’s very little institutional ownership of this one so far, because they aren’t in any indices so they don’t have that massive Vanguard/Blackrock/Fidelity etc. share holding at the top of their charts. And I would guess that they’re at least a couple years away from considering a conversion to REIT status — mostly because they aren’t really paying taxes yet, so they don’t have a need to avoid taxes (and conversion is not as “automatic” at 21% corporate tax rates as it was at 35%, I expect, but we’ll see).

So what’s the negative? Well, this is one of those “dual class” stocks, with the founder having overwhelming voting control — and the founder is a bit unpredictable, Rob Roy describes himself as a futurist and a “inventrepreneur” and kept 68 percent of voting control after the IPO (that also would keep SWCH out of the S&P 500, since they’re trying to crack down on these IPOs that don’t actually sell any voting power).

And though the class-action lawsuits that spring up every time a company reports a bad quarter don’t usually end up meaning anything, part of one of the recent ones against Switch does summarize some real recent investor complaints pretty well on the “overpromised” front:

“The complaint alleges that the Company made materially false and misleading statements and/or failed to disclose that: (i) Switch’s Grand Rapids and Atlanta facilities would never be as profitable as its Las Vegas facility, diminishing the yield on Switch’s recent capital expenditures; (ii) Switch spent more than $64 million on unbudgeted capital expenditures during the third quarter of 2017 that was not disclosed to investors until after the IPO; and (iii) Switch overstated fiscal 2017 revenue growth and fiscal 2018 revenue prospects. “

There’s some hair on this one, particularly because outside investor pressure might have no influence on management, but if the stock keeps falling the valuation based just on those existing three data centers and their cash flow could get pretty compelling and make it worth the risk. It’s on the watch list, and I’ll let you know. They downgraded guidance recently because they are finding that their more complex offerings in “enterprise cloud” are requiring a longer lead time for sales and engineering work, so there’s also that uncertainty about how this new segment of the business will perform (they call it the “Enterprise Elite Hybrid Cloud”)… and to my mind, there’s no real hurry. I’ll let you know if my thinking changes.

And that’s about it, Gumshoe friends — have a wonderful weekend, I wish you joyful risks and comforting safety, and we’ll be back to blather at you again on Monday. If you’ve got any thoughts on the stocks above, or anything else that might be of interest, feel free to shout it out with a comment below… don’t worry, I don’t bite.

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  1. investor presentation here:
  2. pounding the table on it as their 5G idea in recent weeks:
  3. What Went Wrong at Social Capital:
  4. [Image]:,include:true,,id:total_return_price,include:false&startDate=&quotes=true&zoom=3&securities=id:SWCH,include:true,,id:COR,include:true,,id:DLR,include:true,,id:CONE,include:true,,id:QTS,include:true,,id:EQIX,include:true,,id:SPY,include:true,,id:INXN,include:true,,id:IRM,include:true&scaleType=&securitylistName=&recessions=&correlations=&partner=&securitylistSecurityId=&maxPoints=850&useEstimates=false&source=&note=&units=&title=
  5. SWCH:
  6. YCharts:
  7. You and I can each earn a free share of stock right now if you open an account!:

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