by Travis Johnson, Stock Gumshoe | March 1, 2019 3:07 pm
I’ve got a couple updated thoughts to share with you on some Real Money Portfolio companies, including answering some reader questions about when to take profits on IIPR (I’ll warn you up front, my answer is wishy-washy), but first I’ve got a quick teaser solution for your Friday edutainment.
Just today I got a teaser pitch from Tyler Laundon for his Cabot Small-Cap Confidential about a “small company disrupting a $300 billion industry” … and it turned out to be an insurance pitch, so that caught my eye.
Here’s a little bit of the tease to get you started:
“While it may not be sexy, stable market demand makes insurance big business.
“Personal lines insurance alone — cars, houses, boats, and health — is a massive $300 billion industry!
“Yet oddly there has been little real innovation in this industry.
“In general, when you need a policy you do the same thing you did decades ago: call around and talk to agents, or a direct-to-consumer carrier like GEICO (owned by Berkshire Hathaway by the way)….
“In these situations, people often devote aggravating amounts of time to dealing with insurance agents, trying to get the coverage they need or the reimbursement they expected.
“All too often insurance agents are more interested in selling new policies than servicing the policies they already sold.Are you getting our free Daily Update
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“In short, this industry is ripe for disruption. And this is the company doing the disrupting!”
So he’s pitching what’s not really an insurance company, but a slightly different model of insurance agency — a service company, not one that underwrites risks itself.
And it’s got what has been the magic word lately, too: “Cloud.” Here’s more from the ad:
“The company’s secret lies in a powerful cloud-based technology platform. As in so many industries, cloud-based technology has the potential to transform the personal lines insurance market. And this company is showing how.
“The short version is that the company has centralized customer service activities on a robust cloud-based, SaaS platform then integrated solutions to handle specific activities like call center, document signing and policy comparison shopping.”
And it has been growing, apparently:
“… while the personal lines insurance market is growing in the low single digits, this breakout stock has been growing by more than 30% annually for the last three years.
“And growth is expected to accelerate to 40% this year!”
He describes this as a “new independent agency model” in insurance, and shares some slides from the company’s investor presentation, so we ought to be able to get you an answer pretty easily. The key seems to be their separation of service and sales functions, and the ability that gives them to provide faster and better service to customers. Here’s one final bit of the pitch:
The effectiveness of this platform shows up in the company metrics:
“Customer retention rate of 88%
“Net promoter score of 87 (about twice that of industry average and better than many leading consumer brands, including Amazon and Apple)
“Average annual organic revenue growth was 35% (last three years — far and away the fastest growth in this industry)
“Expected revenue growth over 40% for next couple of years”
A lot of that growth is expected to come from franchising their model to new agents, helping to dramatically expand their addressable market (they cover less than half the US now), and it’s still fairly small, with a market cap of about $1.2 billion and went public in just the past year.
So who is it? This, dear friends, is Goosehead Insurance (GSHD), which will be reporting earnings next week (after the close on Thursday).
And I’ve never heard of that one before, but it did go public last Spring at about $15 and has doubled (though it’s also down 20% or so from the recent highs), and, at first glance, looks pretty impressive. They have an investor presentation up here from last month (yes, that’s where the screenshots in the ad came from), and they make a good case for their ability to dramatically ramp up their sales volume with new franchise agents… and, importantly, to be as profitable as established insurance agencies while growing much faster.
The problem, of course, is that it’s in aggressive growth mode and spending very heavily, including a lot of stock-based compensation, so they trade at a nosebleed valuation that means you really have to be convinced that they have invented a better mousetrap for a very old industry. Yes, insurance is certainly ripe for new ideas and disruption, and it could very well be that Goosehead has developed the right model… but I don’t really know much about insurance agencies (despite investing quite a bit in insurers), and I expect there are probably other strong and disruptive growth models in the space as well.
Heck, maybe some of the lovely folks out there in Gumshoedom are themselves insurance agents — what do you think? Is it attractive to join on with a firm like this as a franchise agent and pay royalties in exchange for an (arguably) improved back-room service operation for your customers so you can focus more on new sales? If so, and if Goosehead is better than their competitors and can recruit hundreds of agents a year and scale up really quickly, then there’s huge growth potential… if not, if some other competitive model or network (or direct sales operation) takes share and raises selling costs, then maybe this is just a nice-sounding idea that won’t work.
The financials look pretty compelling because of the high growth rate in what should be a high-margin business, but so much of the compensation is running through to employees in the form of stock awards that they may not have a lot of room to maneuver if growth slows. There aren’t many analysts following the stock, which is understandable since it’s small and new, but they expect about 40% revenue growth and even better earnings per share growth in 2019, with estimates for 41 cents in EPS this year… but at $30 a share, that’s still a forward PE of 73. Maybe not too high for a fast-growing cloud services company, but awfully high for an insurance agency.
I find it interesting enough to watch this one, and will pay attention to their earnings report on March 7, but that’s too steep a price for me to pay without knowing a lot more about how insurance agencies work. I’ll let you know if I change my mind.
And now, on to news and answering some questions… starting with IIPR.
The Innovative Industrial Properties (IIPR) price craziness in recent weeks has been driven by index buying and the new debt offering, I expect. Before the debt offering I thought $65-70 would be a reasonable place to take some profit, and we hit that level last week… how about now that the shares have touched $80?
Now, as I noted when I updated my thoughts following the debt offering two weeks ago, I think dividend growth is even more likely to be strong — since the debt offering gives them the potential to ramp up rental revenue without share price dilution in the near term (it will act just like an equity sale in the end and be dilutive eventually, since the debt is convertible, but for now it doesn’t show up in the share count). Their goal is to pay out 75-85% of AFFO (adjusted funds from operations — basically, their favored measure of cash flow) as dividends, and the real question is whether the AFFO for this year is going to be somewhere near the current expected rental income (minus operating/overhead costs), or whether they are able to do enough deals with the new capital to ramp that rental income number up considerably.
The guidance as of January was that the current “base rent” and management fees should be $25.6 million a year (that’s not what it will be, but that’s what it would be if all the current deals were paying full rent, as they will before too long — they often pay less during construction/renovation period or during a “holiday” for a time when the lease begins). Subtract the cash expenses of the corporation of $6.5 million (that’s the high end of their $5.5-6.5 million guidance), and you get roughly $19 million. Thats not precisely “funds from operations,” but it’s close — and 80% of that would be about $15 million, so that’s roughly what a sustainable dividend might be, they think… though that’s the “long term target” for their dividend payout ratio, and it wouldn’t be unusual if they pay out more than that during these early years while they’re getting the portfolio established (and have excess cash on the balance sheet that hasn’t been invested yet). There are 9.78 million shares outstanding, so that would mean that a dividend of about $1.50 a year fits with their general guidance at the moment.
The current dividend is $1.40 per year, so it’s right where it should be… though with any growth there’s room to increase that a little bit, and their surplus cash wouldn’t make that frightening. That guidance was before their latest acquisition, which was a small one ($11.5 million) that brought their total investment up to $179 million, and they should have roughly $250 million available to make more acquisitions (the $125 million they just raised in debt, plus ~$100 million that they raised in October and about $25 million in cash on the balance sheet that isn’t committed to current deals). Once that capital is deployed they should have the potential to double that annual dividend (or more, if they’re more aggressive — I’m just assuming that they invest the $250 million in properties with 14% cash rent returns, and distribute 75% of that rent as dividends since overhead shouldn’t grow dramatically as they add properties, which would allow for another $26 million in annual dividends). I would expect that to take more than a year, but would be disappointed if the dividend does not double from here by sometime in 2021.
So what does that look like? Assuming that they don’t have access to additional nondilutive financing (meaning, that they can’t issue regular nonconvertible bonds at a good price), and that they don’t have a huge share offering (they might, since the stock is at a crazy-high valuation and they probably should raise more equity while the raising is good), that’s a dividend of ~$2.80 in 2021. The lowest rational dividend yield that I can take seriously for a REIT, even a rapidly growing REIT like IIPR, is about 2%… so if the stock doubles the dividend in the next two years and trades at a 2% yield that would be a share price of about $140. That’s about the most I can foresee as possible.
What if, instead, things get a little bit ugly and investors demand a higher dividend yield? What if competition comes in and they can only deploy half of their capital at those 14-15% return rates, or can deploy it all but at a 10-12% cap rate instead of 15%? What if they can’t issue debt and have to sell more equity for future growth? It would still be a strong company, but it would deserve a lower valuation… if the dividend growth in the next two years is “only” 50% in total, for example, for a dividend in 2021 of $2.10, and investors demand a 3% yield, then that’s a $70 share price. If they demand 4%, it’s $52.50. That’s the downside risk, really, that investors stop thinking of this as the only rational US marijuana-related stock that’s easy to buy, and the only one that’s in the big ETFs, and start to think of it like they think of other REITs.
I don’t have a crystal ball, of course, but REITs do usually tend to move with their dividends — the dividend can become an anchor if it stays stagnant, almost as easily as it becomes a rocket booster when it soars. This situation is a little different, and I think we’re still in pretty early days because of the still very clean balance sheet and the fact that IIPR is still the only public player in its space (though competition is assuredly coming, and is already there among non-public REITs), though accelerating movements toward marijuana legalization will open up more financing possibilities for growers and should make the market more competitive as growers get access to traditional bank financing (which is bad for IIPR, but if we assume the process is gradual it’s probably not immediately or catastrophically bad since they are still signing new deals and they do have 15-year terms — what would be worse would be an actual failure of a major tenant).
So what does one do as the stock leaps further into stratospheric valuations? That’s been sucking up some of my brain power of late, and probably for little purpose since we’ll never truly know if we’re at a “top,” but here’s what my thinking has been.
Maybe I should sell some $85-90 calls on part of my position for March 15 to shave off a little profit? Earnings are on March 13, so there’s some demand for these call options… but, of course, they could also announce a dividend increase and a raised forecast when earnings come out, and the stock could surge to $100. I think that’s unlikely, given the optimism already baked into this valuation, but it’s certainly not impossible.
And the stock could easily rise by 100-300% over the next few years IF they are able to keep making new sale/leaseback deals at 15% cap rates and if they don’t run into trouble with any major tenants (they are still concentrated enough that one big tenant bankruptcy, if the market falls apart, would have a major impact — Pharmacann, for example, accounts for something like a third of the capital IIPR has invested).
On the flip side, that doesn’t provide you very much protection. If you sold the $85 call options for $2, for example, then you’d worry little about the stock falling from $80 to $75… but it wouldn’t help much with the pain of a fall from $80 to $50, and in exchange you give up the upside above $87 so anything more than a 9% move higher on earnings would hurt, and anything more than a 4% move lower on earnings would hurt. That seems a little silly, frankly, for a stock that has moved more than 20% in just two weeks.
At some point it could become frightening if investor thinking begins to be rational and asset-based, because the company is trading at a value that dramatically outpaces what they have invested — and we might be at that “frightening” point already, it’s hard to judge sentiment in a wild market like this that’s touched by the speculative marijuana bug. The market cap is now almost $800 million, and while they do have $250 million in unallocated cash that still means you’re effectively paying $550 million for the $179 million or so of investments that IIPR has made so far… a premium is justified given their experience and the “first mover” advantage they have in the sector, but that’s a 200% premium.
If you simplify it down, that’s like if a friend of yours bought a rental house for $100,000 a year or two ago and got tenants lined up to pay 15,000 a year in rent, and then offered to sell you a third of the property for… $100,000. And if the value of the property drops, you have less recourse than you might think because there’s also a $75,000 mortgage on the property that has to be paid first. That’s oversimplified and not really fair, because what you’re buying with IIPR is not just the established property portfolio but also their ability to build on that portfolio… but still, if things go badly it’s the existing portfolio, the cash, and the debt that will matter, not those future deals that haven’t yet been made. It’s always important to keep the downside in mind, particularly for stocks that become a large part of your portfolio.
So I’ve decided to just hold still, even as we tickle $80 a share, but it was a close call and I did consider taking a profit on a little bit of my position now that it has gotten close to 5% of my portfolio — not because of a particular reason why the stock has to fall here, but because the valuation is now pricing in a lot of optimism and I need to be more sensitive to risks as it becomes a more meaningful part of my portfolio. I see some storm clouds gathering, but no real shift in sentiment yet, even the short interest has not changed dramatically since the stock was at $50 a few weeks ago (though it is fairly high)… so I continue to hold, with some trepidation. The low-$50s are a key price area for me now on the downside, since $56 is my new “buy up to” price for this one and $50 is the stop loss I’m watching, and I’ll look at it again in a couple weeks when we have new numbers and commentary from the company — though it’s also possible that I’ll sell a little bit of my position before earnings if we happen to see the stock run up dramatically into the next report (I’ll let you know if that happens, of course).
Speaking of real estate, Kennedy-Wilson (KW) reported this week… no big surprises, they continue to be nimble in selling richly valued real estate in places like Seattle and California and reinvesting in places like Salt Lake City and Boise, while constantly developing new properties and working to increase the net operating income per property. I’d like to add to this position, but would prefer to wait for a weaker market — it’s not going to double this year, so I can wait until it trades down 5-10% or so, which it probably will at some point (I pegged this as a “buy around $20” idea in the annual review, and that still makes sense to me). K-W is much more nimble than a typical REIT (and often carries more debt than most conservative REITs, though it’s not worrisome given their asset turnover and they’ve been deleveraging lately), but it provides a very decent REIT-like dividend yield of 4% and has been growing the dividend at a 10%+ rate. Kennedy-Wilson is much more compelling to me than most of the “standard” apartment or office REITs these days, partly because they’re also using outside capital and joint ventures to make the business less capital-intensive, and I’m still quite confident that management, which also holds a lot of shares, will be able to continue to build per-share value over the long term.
And not that it means anything, but our small holding Safety, Income & Growth (SAFE) changed names — it’s now called Safehold, ticker is still SAFE, and the business remains unchanged otherwise.
And a reader asked about Teladoc (TDOC) following earnings last week, and while I don’t own the stock anymore (I was stopped out of that position near the December lows), I do still like the potential. The earnings report was a disappointment because of the lack of a lusty growth forecast, since the first quarter revenue forecast was 3-4% lower than analysts had been expecting.
If TDOC does manage to maintain its lead in virtual doctor visit software/services, as is certainly possible, this could be a good buying opportunity — last year was very strong, with solid momentum both in revenue and, importantly, in the actual number of doctor visits from patients (which supports the idea that the business can grow, and that virtual doctor visits will be popular with patients). The real issue, I think, is the lack of any big new announcements about insurance partnerships or similar deals — since health care is overwhelmingly dominated by a few big private and public insurers in the US (including Medicare and Medicaid), what happens with them will be a major driver for future coverage of virtual doctor visits.
Teladoc earns money both from visits that are either fee-only or partially paid by insurers or employers, and from the far more important subscription access fees paid by insurers — the core of the business is paid members, who are covered by insurance companies that pay “per member per month” (PMPM) fees, which are rising (over a dollar now), so the rise in paid memberships and the rise in utilization (patients who actually use the service, their measure of utilization is quarterly visits as a percent of paid membership and that went up to over 10% this quarter) are key metrics and both are moving in the right direction.
I was willing to let my shares be stopped out because I lost confidence in the board following their bungled handling of the CEO’s foolishness, but the latest quarter indicates that the business is still growing well and still leading — they just haven’t taken a major leap forward in terms of organic new member acquisition lately, which essentially comes down to their ability to sell the service to insurers. The next sign of positivity would be some sort of deal with another major insurer to expand the membership, and that’s probably what investors were hoping for and didn’t see in the guidance… but that doesn’t mean it’s not coming, it just means that in the short term there’s no excitement, and richly valued momentum stocks are always all about short term reinforcement of the “story” and continued “beat and raise” announcements, so the failure to “raise” this quarter hurt.
The most positive note, for me, was that they forecast paid membership to grow by at least 22% in 2019, which is much stronger than the 11% organic growth in 2018 (or even the 16% growth that includes the Advance Medical acquisition), but they must be pretty cautious in either the cost of acquiring those new paid members or think that the membership growth will come toward the end of the year, because they’re forecasting full-year revenue growth of only about 10% from the annualized quarterly results they had at the end of 2018. My best guess is that this is therefore an overly cautious forecast from TDOC, hoping that they can beat the forecast nicely, but we’ll see. I have not personally bought back into the stock, but I do still watch it.
And that’s all I’ve got for you today, dear friends — enjoy your weekend, and give us a shout in the comment box below if you’ve got an opinion to share on any of this, or a question to ask. Thanks for reading!
P.S. I don’t often write in detail about my trades in small speculative options positions, but I did take profits on my Greenlight Re (GLRE) call option position today, since there was still a nice profit to be had even after a weak earnings report and the time to expiry is shortening. That’s reflected in the Real Money Portfolio, FWIW.
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