China has had enjoyed unprecedented growth and its citizens have reaped the benefits of a bumper crop harvest, levels that this world has never seen before.
Chinese leverage and government spending in the past decade have been excessive.
Can consumption save the day?
The Rapid Ascent
China has been a fascinating story for the past few decades. As a country its citizens have reaped the harvest of unprecedented wealth creation, leading to a relative increase in quality of life the world has never seen.
China is now home to the 2nd largest amount of billionaires (213), second only to the United States (536). China also laid claim as the country with the 2nd largest nominal GDP in world, and just recently, and relatively quietly, in 2014, became the country with the largest GDP by PPP standards (arguably a more accurate measure of true production, includes adjustments to account for exchange rate and cost of living differences).
Yet it seems that the castle is about to come crumbling down. Fueled by lax lending rules and excessive government spending, China's debt levels have exploded.
A report from McKinsey published in 2015 can summarize better than me:
China's debt is rising rapidly. Fueled by real estate and shadow banking, China's total debt has quadrupled, rising from $7 trillion in 2007 to $28 trillion by mid-2014. At 282 percent of GDP, China's debt as a share of GDP, while manageable, is larger than that of the United States or Germany.* Several factors are worrisome: half of loans are linked directly or indirectly to China's real estate market, unregulated shadow banking accounts for nearly half of new lending, and the debt of many local governments is likely unsustainable. *Includes debt of the financial sector.
Purchasing a house is one of largest and most important transitions in your lifetime.
Macroeconomic factors are favorable for purchasing real estate.
High asset prices are fueling capital into alternatives assets such as real estate.
Purchasing a house is one of largest and most important transitions in your lifetime. It can also be one of the best investments you ever make. Peter Lynch is famous for saying: "Before you do invest anything in stocks, you ought to consider buying a house… in 99 cases out of 100, a house will be a money-maker".
Before you stop reading, citing the sub-prime mortgage crisis as the greatest financial crisis since the Great Depression, take a moment to review these figures.
You get to leverage yourself 500% by putting only 20% down on a mortgage.
No margin call on your levered bet.
Interest payments on your mortgage are tax deductible.
Local tax payments are deductible from federal income tax.
Tax credit programs for households under certain income levels (surprisingly generous levels, up to $90,000 in many areas).
Non-taxable capital gains on your investment (certain rules apply).
The price of your house will NEVER go down!!!
Yes, number 7 was said in jest, but all other reasons are very real, very beneficial reasons to purchase a home. The federal government is practically begging you to buy a house with the gigantic tax loopholes that they parading around your feet for you to jump through. Let's do a quick hypothetical:
Let's assume your household makes $65,000 a year and assume a worst case scenario, meaning you live in California and have to pay a 12.3% state income tax. After all taxes, federal withholding, social security tax, Medicare tax, SDI (don't ask), your monthly take home pay is $3,710.32.
With this income, given a 30-year fixed rate mortgage at 3.92%, you can afford a $300,000 house/condo making monthly payments at 40% rate of your monthly take-home pay. Your down payment (initial investment) of 20% would be $60,000.
Neustar shares have been battered by negative rumors and headlines.
A high-upside and low-downside creates a unique investment opportunity.
Neustar is a compelling long-term deep value play.
Neustar (NYSE:NSR) is a company that has been troubled by a barrage of rumors concerning its ability to retain its Number Portability and Administration Center (NPAC) contract, which represents around 50% of revenue. The stock price has fallen by nearly 50% in the past 6 months and short interest is at 31.40% as of May 30th, 2014 (Yahoo! Finance). Due to the unique situation of Neustar, I have attempted to calculate a fair market value for the price of Neustar shares. My results and conclusion are below.
Assuming a 2% growth rate, at a price of $24.35, this implies a WACC of 19.93%, and assuming industry averages, an equity required rate of return of 23.02%. For me, as an equity investor, this is more than an acceptable rate of return, considering current yields and market sentiment. Of course, this is assuming Neustar wins the contract and continues to service the NPAC.
Assuming a 2% growth rate, an industry average WACC, and the current price per shares of $24.35 implies FCFF of just $1.37/shares, which represents a loss of 67.87% of FCFF.
Let's assume an absolute worst case scenario of a loss of 75% of cash flow. This means forecasted FCFF of just $1.07 per share. If we assume a 2% growth rate, and an industry average WACC of 7.76%, we arrive at a price per shares of $18.95. This gives us a downside of ~20% and an upside of nearly 100% (assuming a contract win and continuing FCFF).
Keep in mind that with a minimal forecasted growth rate of 2% in perpetuity, these are all extremely conservative estimates, as Neustar's other sectors are still growing at around 10%. In this case, we can't apply a simple FCFF growth model, as the short-term growth rate is too high and it would be foolish to assume that the 10% growth rate continues in perpetuity. Let us perform a (grossly) simple calculation and assume all earnings figures are reduced by 50%. We can then apply the Information Services industry average multiples for EV/Sales of 4.05, EV/EBITDA of 14.48, EV/EBIT of 20.62, and Price/Book of 5.10 to calculate prices of $17.96, $26.93, $24.93, and $24.89, respectively. With an equal weight to each multiple, we get a price of $23.67. Thus on a relative basis, the entire price of losing the NPAC contract appears to have been priced into the stock.
Neustar is a great deep value play that has minimal downside and very large upside. On both a worse case scenario FCFF and an industry-relative basis, Neustar appears to be fairly - perhaps even slightly under-priced. Furthermore, in 2013, the company repurchased $285.3 mm in shares, representing 9% of shares outstanding. Cheap debt helps, but this shows unwavering commitment by management to the operations of the company. To take advantage of this situation, I would recommend purchasing call options, or even going long the stock if you have a long time horizon.
Of course, the market is unpredictable and the stock price could fall further in the short term. But with all of the rumors and headlines in the past couple of months, any potential bad news has already been priced in.
Disclosure: The author is long NSR. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Allow me to disclose to you an industry secret. The mobile games industry is not glamorous. Despite the car-salesman stock pitches, buzzwords such as "mobile gaming", "GaaS", and "cloud gaming", mobile gaming has proven to be an unforgiving and cutthroat industry. With the rare exception of the super-fans of hits like "Angry Birds" and "Candy Crush Saga", players of mobile games are notoriously fickle and terminally lose interest after a couple years. In terms of gaming, Zynga (NASDAQ:ZNGA), as a publicly traded company, has demonstrated that one big hit ("Farmville") cannot fully sustain revenue, cash flow, profits, and share price expectations. It seems that Glu Mobile (NASDAQ:GLUU) has gotten the formula right: to continuously fund a steady war chest of popular hits, which increases their chance of success through as many successful iterations (games) as possible. By being the only publicly traded mobile game company, GLUU has the capability through equity and leverage to acquire and fully capitalize on hits such as the "Deer Hunter" brand (acquired for $5mm in cash in April of 2012).
Glu Mobile is not your traditional value pick. At first glance it is a speculative play on the mobile games industry. However, when you dig deeper it becomes evident that Glu Mobile is a solid long-term growth investment, a company poised to explode into the video game industry as the dominant player.
Making video games is notoriously difficult. However, if history tells us anything, it highlights the Darwinian features of the video game industry, characterizing a bloody, volatile battle that ends with a few key victors; the ultimate result is a market dominated by a few big players. Take current industry leaders, EA (NASDAQ:EA), Activision Blizzard (NASDAQ:ATVI), and Take Two Interactive (NASDAQ:TTWO), players that have won the war by surviving countless battles (through takeovers and acquisitions) since the birth of the video game industry. The truth is, the nature of the business and the difficulty in creating blockbuster games gives larger companies with pools of capital an unfair advantage. And currently Glu Mobile is the only player with the deep pockets, intellectual capital, expertise, and talent to survive the long haul in the mobile gaming industry.
Glu started off as a video game publisher for feature phones. After a series of mergers and acquisitions, Glu has evolved into a cutting edge company publishing smartphone games for nearly every single major platform in the mobile industry. Recent hits include "Deer Hunter 2014", which has consistently made the leaderboards in the iTunes store for the past 2 months, with record setting sales figures and Monthly and Daily Active Users.
In the US, users spend upwards of 12% of content viewing time on a mobile device, while mobile ad spend accounts for only 3% of total spend. Contrast this with traditional internet, which accounts for 26% of content viewing time and 22% of ad spend. Comparatively, TV accounts for 42% of time spent and 43% of ad spend, radio accounts for 14% of time spent and 10% of ad spend, print 6% of time spent and 23% of ad spend. I can only see radio and print ad spend decreasing, with mobile making up the difference.
Glu is also very focused on developing games in the APAC region, citing that APAC business may eventually eclipse US business. APAC business is now over 30% of total revenue. The APAC region is the fastest growing mobile market (and also the market with the most potential) in the world, especially due to the massive user base in China. China Mobile (NYSE:CHL), China's largest carrier, has over 700mm subscribers. Only 180mm are 3g users, and its 4g network was only recently announced. As faster networks develop, widespread use of smartphones and mobile games will proliferate.
Multiple game delays have dragged on financials. Glu just reported Q313 results:
GAAP revenues of $21.7 million; non-GAAP revenues of $22.6 million exceed guidance
Cash balance of $27.7 million and no debt as of September 30, 2013
"Deer Hunter 2014" sets new Glu Mobile download, DAU and single-day revenue records
"Deer Hunter 2014" has been a smashing success, generating $2.4 mm in revenue in Q313. Keep in mind the release date was September 18, 2013 and Deer Hunter 2014 has only contributed a couple of weeks of revenue.
Otherwise, revenue has been steadily declining since Q212, although this can be attributed to the game delays. Although the revenue numbers and profit numbers aren't what we look for in a traditional value play, we need to focus on what's important - building an active user base and establishing scale to increase the likelihood of releasing a big hit. The active user figures are encouraging. In Q313 Daily Active Users and Monthly Active Users were at all-time highs.
Niccolo De Masi and his management team have a solid track record of identifying issues, creating solutions and executing flawlessly. In their 2012 year end conference, they identified monetization as their most significant issue (page 14). The Glu team responded by building out its GaaS (Games-as-a-Service) concept and putting up a record year in revenue (2012).
GLUU has set the bar high with its Q413 guidance. GLUU hopes to begin a path to profitability, predicting 0 to 0.4mm in net income. With Deer Hunter 2013 generating $2.4mm in less than a month's time, I am confident GLUU can reach total revenue forecasted to be $31.5-$32.5mm. With a historical gross margin of around 70%, that gives us $22mm gross profit on the low side, subtracting $20mm (more than in each of the past 3 quarters) in operating expenses and we arrive at a profitable figure. These are very rough estimates, but during the Q32013 conference call GLUU revealed that Q42013 has been profitable thus far (as of October 2013). In short, I find the long awaited turn to profitability to be realistic and a short-term catalyst for what may be a solid long-term investment. Earnings are to come Feb 3, 2014.
All figures were compiled from Glu's investor relations website which can be viewed here.
Disclosure: I am long GLUU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.