The strong disconnect between sales and profits lingers. The more this company sells, the more it loses.
In spite of that, it seems the valuation remains elevated.
My “switch to calls” strategy worked out well for investors last time, and I recommend a similar approach today.
Poike/iStock via Getty Images In the 34 months since I put out my bearish piece on Q2 Holdings Inc. ( QTWO ), the shares are up about 56% against a gain of ~75% for the S&P 500. I thought I’d review the company again, specifically to see if the problems I identified in my first piece have been solved. If so, it might be worth considering an investment here. I’ll make that determination by looking at the most recent financial history, and by looking at the stock as a thing distinct from the underlying business. I’ll also make a comment about options as an alternative to stock ownership.
I know my stuff can be tedious for many to wade through, and so I’ll offer my thesis statement at the start of this article. In my previous article, I noted the strong negative relationship between sales and net income. I suggested that the company was incapable of achieving economies of scale, and that higher growth would simply create higher expenses. When I wrote about this business nearly three years ago, I saw nothing on the horizon that would change this dynamic. Here we are 34 months later, and the dynamic is firmly in place. The more this company sells, the more it loses. The comments section of that article was full of people talking about the “long term” and the need to be patient. It seems that three years of patience has not yet paid off for investors as losses continue to mount. On top of that, the shares are hardly cheap. For those who insist on staying long, though, I would recommend buying calls in lieu of shares. While you may be obliged to share some of your gains with the government, calls represent far less capital at risk than stock ownership. Financial Snapshot
The last time I sat in a business school lecture, I had far fewer lines on my face, and all of my body parts worked as advertised, but I do have a vague memory about “increased sales are generally good because they lead to higher profits.” Sales are good only in so far as they increase “profits” (however we define them) because profits are the only source of long term returns to owners. Employees, suppliers, tax authorities all take their cut from sales, and owners (i.e. stockholders) of the firm get whatever’s left. I’m a little embarrassed that I have to point out this very obvious fact to an audience on a platform dedicated to stock investing, but here we are.
I’ve sacrificed many, many brain cells to various unhealthy activities since I was a bright eyed business student, but one of the skills I picked up back then that sticks with me now is the ability to run a correlation. Specifically, I still remember which buttons on my financial calculator to press and in what order to produce a correlation between two data series. I took the liberty of doing that for you, dear readers, and found that there continues to be a strongly negative correlation between sales and net income here. For the stats nerds among you, the r value is about -.89. This is a very strong negative relationship, demonstrating that the more this company sells, the more net income goes down. For reasons why this is “bad” from the point of view of owners, please refer to the paragraph above.
The reason that profits fall the more this company sells is fairly obvious when you delve a bit deeper into the financials here. While over the past 8 years, Sales have grown at a very impressive CAGR of ~27.7%, the total of Sales & Marketing, R&D, and G&A expenses have grown at a CAGR of ~26%. So the total of these three expenses have ballooned from ~$37.5 million in 2013 to just over $240.5 million in 2020. From where I sit, there’s no way for the various costs associated with running this enterprise to slow. Higher revenue requires higher expenses, which will continue to balloon losses.
One group who has been rewarded by this enterprise have been employees. Stock based compensation expense has climbed from $4.57 million in 2014 to just under $50.7 million in 2020. That […]