As a value investor, I typically have the idea that let’s assume that nothing happens. Okay, if nothing happens, what kind of cash flows are coming in and what kind of returns can we get? That really doesn’t make too much sense. 

However, Google, or at least if you do that, you will realize the devaluation right now is supposed to be overpriced. What I then did was I used a two stage growth model in terms of expecting how much growth can we get over a relatively short period of time, and then slowly see a decline after that. Again, it all depends on the assumptions that you put in. 

If you assume a 15% growth over the next five years annually, and then actually just cut it off, and then have a 3% perpetuity growth after that, then you will come up with a valuation right now around at 7.5% expected return.  

I’m very curious to hear from the group right now what kind of thoughts you have about on Google. If I can throw it over to Hari first, I’m very curious to hear your thoughts because you know Google better than most. I want to know what you have to say about devaluation but also Google in general.

Hari Ramachandra  6:00  

This is a great topic and probably timely, based on the current events. I think you highlighted some of the key points, which are very significant. 

As you said, I guess 85% of Google’s revenues are still from advertising. Just to put things in context, they are still massively dependent on advertising as a form of revenue, whether it is search, YouTube or other properties that they have. 

However, they have a lot of bets that are going on. To me, Google represents optionality in the sense that they sell *inaudible*. They have their Google platform. Then they have other initiatives that are going on, some of which we don’t even know at this point of time. That’s number one. 

For me, number two, I’m hitting on some of the qualitative aspects here. Toby and Preston probably know better with regard to the valuation aspects. I’m going to leave it to them. 

The second thing that I feel in the Valley or in the tech industry, one metric I look for, which is usually not in their balance sheet, is their ability to attract talent. 

In the pecking order of Silicon Valley, for now ignore some of the really hot startups, just among the bigger companies, or even the mid-sized companies. Google is the top contender. I think, if an engineer is coming out of Berkeley or MIT, except for Facebook, they most likely will [go to Google.]

Preston Pysh  7:45  

Stig, I’m going to talk about the valuation part that you were saying because I like the way that you went about valuing it. I’m a fan of this pick. I think, out of all the picks that we’re going to be talking about on today’s show, I like this one the best.

When we look at how the company’s performed over the past 10 years, what I did is I went and looked at the top line, what was the growth rate of that revenue over the last 10 years. When you look at that, it’s around at a 19% growth rate for the last 10 years annually.

If we start with that as our foundation, saying, “This is what they’ve done in the past and what they’ve done in the past is unbelievable. Can they do that moving into the future?”

If we start with that as our foundation for valuation, if they made 19% annually in their top line and they continue to make 19% in their top line, what kind of valuation comes out, starting with that as our baseline? Then we can adjust from there to kind of determine whether we think that can be sustained or not sustained.

So if we start with that valuation, and we say that it’s going to continue to grow at 19% for the next 10 years, and then after that, we’ll just use inflation at the current price, you’re going to get around a 9% return. 

Now, the question then becomes, “Well, do you think it can keep growing at 19%?” I don’t think that we’re going to hit those kinds of numbers. Maybe I might be wrong, but I would say maybe 10% or maybe half of what they’ve done in the past is what maybe they’ll do in the coming 10 years. 

Then let’s look at what that number kind of produces as far as evaluation goes. When we plug in 10% growth into the future for the next 10 years, we’re getting more around a 4% return. If it’s less than that, well, then you’re right where the rest of the markets are priced at. I think it’s priced better than the market, in my personal opinion, because I don’t think that 10% for them in the next 10 years is out of the question, especially with where they’re at with AI.

However, I think there’s a lot of unknowns. Those are big numbers to produce in the coming 10 years. I think that no one’s going to argue with that. [Therefore], I agree with everything that Hari said, specifically on the tensorflow stuff, cloud computing, and the way that they’re going to be basically outsourcing resources and also storage on their platform, because I think everyone’s going to want access to their open source AI. 

I say open source with quotes around it, but I’m a fan. I’m definitely a fan, especially when you look at some of the other stuff that’s out there.

Tobias Carlisle  10:16  

Yeah, I think I agree with you that Google is a phenomenal business. The growth rates are just astonishing, how big it is to market caps. It’s like $866 billion enterprise values about $770, which means that it’s got roughly $100 billion in cash and investments sitting around. 

The thing that I run into the problem that I have with it is I think it’s expensive. PE is like 54. If I look at the metrics on Acquirer’s Multiple, 25. Enterprise multiples are 20. If you look at any of the quality metrics, it scores off the charts. They’re those quality metrics. I think it’s one of those companies that it’s very hard to lose much money in something like this, because it will likely be a bigger company 10 years from now. The question is how much bigger over the 10 years and therefore does it justify the price currently?

It’s not a company that I would invest in, because just the valuation turns on the growth. The growth has been extraordinarily high. It has to continue to be extraordinarily high. If it does that, then you get a pretty good return, but not a phenomenal return because if it disappoints in any of those metrics, then the return is going to be much more subdued. However, I don’t think it’s a stock that you’ll lose money on.  

I think that the risk reward is interesting. Like the downside is very little that the question that you have is how much money can you make? For that reason, that’s not a bad pick.

Preston Pysh  11:41  

I want to talk about risks as well, too, because we saw recently with Mark Zuckerberg going up on the hill and testifying in front of Congress. They were asking their questions, which were absolutely hilarious. 

You can quickly tell that there’s a major gap in what I would say, the majority of Americans or anyone around the world who really kind of understand about tech, and what Silicon Valley understands about tech. 

Until that gap gets shored up, I don’t necessarily know that you’re going to have the regulations kind of take hold, but I think that that day is coming. I think that what the focus is going to eventually turn to from legislators is a focus on making your data history more accessible and easier for you to adjust. 

As soon as they get on that narrative and as soon as they start forcing that into some type of regulation where, let me give you an example. You go on Facebook, and it’s required by law that in the navigation bar. There’s a button you can click that goes into your entire history of every single thing that they’ve collected on you. Then you can go in there and amend and tweak that at ease. 

I think that that’s where the legislation is going to change is that it’s very easy somehow that the spirit of that is built into the law that they have to make it very easy for people to go in and amend their history and what’s being collected on them. 

Once that happens, the ad revenues for Google, Facebook, whatever drastically changes in my personal opinion, because if I can go in there and see every single piece of data that Company X is collecting on me, and I can delete it with one click, boy, the whole game changes. The money that these companies are making are going to be drastic. 

The problem that I think you got right now is an education problem from legislators. They know there’s a problem. I think most people don’t like not being able to control that. I think if you interviewed 100 people and asked them you wish you could control the data that’s being collected on you with a couple clicks, every single person is going to say yes. 

What the problem is, is you don’t have legislators that can basically orate that or basically say that that’s what the issue is: the control of the history of data. Instead, they’re asking silly questions like, “Are you collecting on my text messages?” and not really talking about what the fundamental problem is. 

The fundamental problem is that people don’t have control of the data that’s being collected on them from a historical context. As soon as they figure that out, I think it’s going to be a bad thing for Silicon Valley.

Tobias Carlisle  14:25  

I’ve got a question for you. In that sort of scenario, would you rather be Google? Or would you rather be Facebook? 

Preston Pysh  14:31  

I think both of them are going to be punished extremely hard on this, but to answer your question, if I had to pick I would probably say Google.

Tobias Carlisle  14:40  

I don’t think that people realize how much data Google collects on them. Whereas you sort of feel like you’ve shared a lot with Facebook, which is why there’s a lot of enmity towards Facebook at the moment. I think it’s even showing up in some, like their daily average use has dropped pretty significantly or less than 10%.

Preston Pysh  14:58  

I completely agree with you. To your point, how often are you on Facebook? Whatever number you come up with. How often are you using a web browser? Okay and what’s going through the web browser?  

I’ll even take it a step further. I’ve got Google routers at my house. It doesn’t take a genius to figure out real fast who’s collecting more information on you.

Tobias Carlisle  15:21  

As you can, if you look into the Google page, and you can see it tracks cell phones. It can see everywhere you’ve been for years. That’s pretty scary.

Preston Pysh  15:31  

I think that’s when you get to the crux of the issue, as soon as legislators figure out that what I just described is the issue, the question then becomes okay, well, they were making this much money per person, when they had full open access to pretty much anything that they wanted, and people couldn’t delete anything.

However, if that would change and you got, let’s just say 10% or 30% of the population literally wipes their entire history clean and we’re making a very strong assumption that something like that would ever exist. If it would exist, what happens to their numbers? I think it’s going to be brutal.

Stig Brodersen  16:07  

Yeah. I completely agree with your concerns about the valuation. It is hard to bring growth picks or whatever you want to call Google into a group of value investors, I guess. I completely agree with you guys. It looks really, really hard. Whether or not you would use my 15% for five years or Preston’s 10% for 10 years, I think it’s really really difficult. 

I like Preston’s approach about saying what the top line is, which is basically also what I did. I subtracted some. It’s not really a scientific art whenever it comes to predicting crazy growth rates because you have to come up with something and argue for why you think it should be 15 x 5, or 10 x 10, whatever you want to come up with. 

I think when it comes to Google, one thing that is unknown and I know that I am talking like a growth investor right now, and not as a value investor. I would like to be, I think the future of AI is going to be very interesting. I think that Google right now is probably best positioned. 

Again, I’m not the right person to ask. It’s probably better to talk to Hari and someone who knows what they’re talking about. 

What I know, with a little knowledge I have about Google, with tensorflow, for them more or less being the standard. If you look at the numbers and the dollar value of the acquisitions and AI, Google… They’re buying up more AI priority than anyone else combined, which in itself pretty crazy when you think about it. 

To me, that part looks appealing. I think in terms of digital advertising, I don’t think that we will see a dramatic slowdown, even though of course, a recession wouldn’t be too good. 

There is a lot of room to grow for digital advertising right now. It’s hard for me to see that Google And Facebook won’t continue to be the emerging winner. I also do want to say if you look at the valuation right now, and if we look at you know, compared to the past 13 years. I like to look at the EBIT, it’s not too different from when Toby’s talking about the cost multiple. 

We have a median of 18 and slightly above right now. In a historical perspective, it’s not good. 

The last thing I just want to say before throwing it over to the group is just full disclosure, I am long Google. I bought some time ago, not a decade ago like I should, but I am actually now considering whether or not I should add more to that position at the price it is. Again, I am almost blinded by how a great company this is and I’m probably too optimistic with the growth rate. 

Preston Pysh  18:45  

I wanted to throw one thing out there, Stig. So we’re following this ticker AIEQ, which is this artificial intelligence ETF. Berkeley PhDs are the guys that have stood this thing up, this thing scouring the entire web. 

It’s number one pick out of its entire portfolio of every single stock on the market is Google. There’s no analysis to that as far as valuation growth, but I can tell you that this bot that’s using machine learning, has selected Google as its number one. 

I also want to say that the risk that I highlighted with respect to the legislators and stuff like that, I don’t see that happening anytime soon. I think that although we talk about it, could it happen? Yeah, I mean, it might be years out there, but from what I’m seeing, and what I saw on that last thing with Mark being on the Hill testify… They’re nowhere close to stand some type of policy up or anything that’s going to limit this.

Stig Brodersen  19:45  

Hari, I would like to ask you about this AI piece. I know it’s always horrible to say this time is different. I think we tried that so many times in financial markets and we are usually always wrong. 

It is, however, astonishing to see what Google can do with only 89,000 employees. It’s incredible what kind of growth rates to have considering the size. It shouldn’t be able to produce a much revenue and produce much profit with the amount of people they have. Will AI completely wash out the conventional metrics, in many ways, with an exponential growth even for something as big as Google, in your opinion.

Hari Ramachandra  20:21  

One of the things I find very troubling is the way AI is being used as a buzzword for everything nowadays. That’s the risk and IBM Watson is famous for just slapping AI on everything they do. It’s actually an automated checklist, for the most part. 

I think that’s where we have to be careful in buying into the hype. For Google, it actually is more relevant in search and YouTube, which we don’t seem to notice. In fact, their AI and machine learning stands out from their search background because they perfected it with their search engine. 

The way they can predict what you want to type and all that stuff… We should not forget YouTube.

What I’ve learned is YouTube’s mission is to take over your living room. I feel among all the companies, Google has the most hold. I think Preston kind of gave a very nice overview of how his life is now being captured by Google. 

I think Google is in our living room with Google Home. Then we have YouTube on your TVs, the Android TVs, as well as Google search. With the self driving car, I think you will be pretty much living a Google life.

Stig Brodersen  21:45  

Okay, guys, thank you so much for the feedback. Let’s move on to the next pick. That would be Hari. 

Hari Ramachandra  21:53  

Okay, continuing on the same theme. I thought it would be timely and interesting to bring up Facebook. The reason I want to bring up Facebook is it has been in a lot of news for not really good reasons. Due to the recent guidance and quarterly result, their stock has taken a beating. Now it’s kind of recovered a little bit. 

At the same time, I want to just cover some of the key aspects and then I’ll come to the risks later. I wanted to get your opinion on the pick. 

An average user of Facebook, spends around 41 minutes every day on Facebook and around 25 minutes on Instagram. So pretty much one hour on Facebook properties. 

Across North America they have like 72% of the population on Facebook. Asia where they’re growing really fast, they have 17% of the population. This is minus China. In Europe, they’re around 41%. 

At the same time, Instagram is also growing very fast. Instagram now has 800 plus million members and close to a billion so they’re growing very fast over there as well. That makes it very interesting. 

Now getting to their business, I think it is fair to say that they’re a one trick pony, even today. All the revenue comes from advertising. In terms of Facebook’s revenue, they were growing at a pretty hefty rate so far. They announced the recent changes in terms of what they’re doing and based on GDPR and other compliance issues, they said that they might slow down in terms of their revenue and in terms of their margin. 

In fact, in the latest quarter, the second quarter of 2018, the revenue was $13 billion, which was an increase of 42% year over year. However, even without regulation risks, it is fair to say that, at some point, they will allow big numbers to catch up with them so they cannot go at these rates.

Kind of what I would like to highlight here is that even if we consider that their margins are going to go down, their operating margin today is around 49%. That is unheard of.

To give you some context. If you look at the margins of the average, S&P 500, or a medium, the margin is around 19%. Considering that you’re not going to capitalize their R&D and content, which I think you should, and if we do that, their margin will come up to 57%. We can assume that their margins will go down because of all the changes. 

Preston, Stig, and Toby, you guys are much more the right people to talk about valuation than me so but I wanted to make the case for Facebook. On the other side, there is a lot of bad news, there might be value. I’d like to know your opinion. 

Stig Brodersen  25:03  

Hari, I think it’s a very interesting pick. There might be value. I guess you have to like factor in a ton of growth, but I do want to say that right now, if you look over the past eight years, really since the time that they went public, the lowest *inaudible* has been 18.4. Right now it’s 20. The median is 41.  

From a historical perspective, it is interesting. Then you can always argue, is it just chronically overvalued? Because then you can use these numbers for really anything, but it is interesting.

To get a decent return, we have the same problems that we have when we’re talking about Google. You have to factor in some very generous double digit growth rates. You have to come up with a short run college, five, seven years,on something like 15-20% annually or something like that. 

I’m not saying it’s not possible the way Facebook is growing their revenue, I think it’s been so impressive. 

One worry I do have before throw it to the guys in terms of evaluation, one worry I have is, what is the backup plan to the *inaudible* plan 98.5% of revenue to construct digital advertising? Then they have 1.5% from other bets, which is primarily the payment processing system. 

Preston and Toby, what are your thoughts on the valuation?

Tobias Carlisle  26:25  

I think this is a very similar situation to Google in that the business is spectacular. The balance sheet is pristine, market caps are $520 billion. Enterprise value is 480. So it’s sort of net cash and investments. PE is 27 high, which is about half what Google is, so it’s interesting. 

If you put Facebook on the same PE as Google, it becomes another trillion dollar company. 

I’ve spoken to Hari about this offline before because it’s something that I have observed for a while too that if you look at as opposed to sort of the late 1990s dot-com boom, where things were just crazy overvalued without sort of any underlying business. 

The FAANG stocks now aren’t sort of crazy overvalued, if you believe that the historical growth rates persist. Facebook’s been growing at 40% plus for five years. That’s on the top line. EBITDA growth is 60% plus. It’s so explosive, like 196% compound over five years, kind of an amazing number. 

If you assume all that holds, then it’s probably half price. If you assume that it slows down or runs into some headwinds, then it’s probably expensive. But I get to the same point that I did with Google, I don’t think there’s very much downside, and it’s probably a much bigger company in 10 years than it is today. 

The question is just, you know, how much bigger does it continue to grow and therefore,  is the valuation justified? For me, it’s my bias always to be more wary of growth rates, but that hasn’t been a great strategy for the last five years or so.

Preston Pysh  27:56  

I think that you get a winner when people hate your platform and then go on your platform to talk about how much they hate your platform. 

Hari, what I really captured from everything that you said was everyone’s mad. Everyone wants this to be fixed. Everyone wants their privacy to be protected. Facebook’s going through some really rough times from a PR standpoint, but the numbers are telling us a different story. 

That’s what I got out of what you said. I think you’re kind of right. I think the numbers are pretty much saying that everyone’s still using the platform and they’re not as upset as what they’re basically what the media is making it sound like. 

I do the same thing as you, Toby. I went back and looked at the top line growth and I got a very high number, like way higher than Google’s. That’s something else.. I mean, to have 40% to almost 50% growth rate on your top line for the time it’s been a publicly traded company is pretty insane.

Tobias Carlisle  28:52  

You’re getting a much higher growth rate and you’re paying a much lower multiple. I think between Facebook and Google probably, Facebook is cheaper than Google at the moment.

Preston Pysh  29:02  

Yeah and from the valuation standpoint, I completely agree with you because when I go and I dropped the growth rate down into the coming 10 years at 10%, I mean, I’m coming up with a 5.5% return on the free cash flow of the business. It’s a hard one. 

I personally can’t stand Facebook. I despise Facebook. I just think that it’s the ultimate time trap and I think that one of their challenges is there was some study I read. This was a while ago that when people go on and they use Facebook, they feel worse about themselves after they’re done using the platform. 

I think when you look at why was Mark Zuckerberg testifying in front of Congress versus Larry Page, Sergey Brin and some of these other folks, why Mark? I really think it comes down to this idea that most people can’t stand Facebook deep down inside. They hate it. It probably makes them feel like they’re back in high school again or whatever. 

They just can’t stand the platform where Google, I think most people, if you ask a person, “Hey, how does Google make money?”

They’d say, “Oh, advertising,” because people just know that it’s advertising. 

At the end of the day, Google is so much slyer in what they’re doing, and so much further under the radar at what they’re doing. I don’t mind Google. I like Google because think about it, if I go onto a search engine. I’m trying to find something and Google gives me the first result. I don’t have to search around for it. I like that. 

It’s not like some person that I met 10 years ago is bugging me with messages on Facebook. That’s annoying. People don’t like that. 

I think that that’s their challenge moving forward is how they manage this from a social standpoint, from a psychological standpoint with their users, and from a regulation standpoint, who’s going to come down on them.

However, from the number standpoint, I’m with you, Hari. I think that the numbers look pretty good. I don’t own this. I don’t want to own it for some reason. Maybe these are all my biases coming during the show is probably more of what it is. Anyway, those are some of my thoughts. 

Okay, Toby, let’s hear your pick.

Tobias Carlisle  31:20  

I’ve got the highest tech pick of the day. It’s Pilgrim’s Pride, PPC. They’re a chicken distributor. 

As you can imagine, it’s not as exciting as Facebook or Google. I don’t make as much money. Chicken production is basically a very fragmented industry and very cyclical. 

If it gets too cheap, then that hurts the chicken process. It’s not a great industry. It’s not one you buy as a compounder. Pilgrim’s Pride has been hurt because they’re not really sure what’s going to happen with the tariffs. It’s something that can’t get hurt because it distributes internationally. 

The reason that you might want to own it  is I think it’s very, very cheap. Market cap is about $4.4 billion, enterprise value is 6.4, which means that it’s got some debt on its balance sheet. However, you get it on PE of a little bit over 7. The Acquirer’s Multiple on it is a little bit under seven as well. 

It’s fine on all of the health metrics that I look at. *inaudible* is about four, so not great. Altman-Z score, which looks at financial distress is safe, which given its debt load is something that I wanted to look at. Finish-M score. 

This looks at whether they’re manipulating their earnings or not. This is sort of on the fringe at negative 1.5. Negative 2.2 is the cut of it. 

It has a pretty reasonable return on invested capital at around 20%. If I do a reverse DCF on it, you are sort of assuming a negative growth rate of about 1% at the current price. I think that you’re already compensated at this price for all the risk that’s in this stock.

In December, it was trading at $37. It’s currently trading at $17.70, off about 50%, so it’s got about 100% headroom. I think DCF valuation has been growing pretty consistently over the last five or so years, about 5% or 6%. So if you assume roughly 5% growth, I get to about $27-30 for these stocks.

Margin of safety, where it trades now, not a great business, as I say, because it’s very cyclical. However, I assume that the tariff situation will sort of scare markets for a while. When that goes away, it’ll sort of go roughly back where it was. I think $27-30 is a reasonable estimate for this stock.

Preston Pysh  33:42  

Toby, let’s talk about your position on the whole tariff thing, because I think that that’s a really important part to understand this company. How do you see a lot of that playing out or kind of how are you positioning yourself with respect to the risk of it?

Tobias Carlisle  33:55  

I don’t know how it plays out. It’s one of those things that I’m just trying to take advantage of the situation as it presents itself now. I think a lot of these stocks are priced as if the worst news are the tariffs coming in. These things are targeted.

I think that that’s the time to buy when you have that uncertainty. Once the uncertainty is gone, I think this is going to be trading at a higher level.

Preston Pysh  34:16  

From the numbers standpoint, I’m assuming, Stig, you got very good numbers on this as well. I got great numbers on this.

Stig Brodersen  34:22  

Yeah, I have something like 9% even without growth. I always love whenever Toby is  pitching something, because it’s always cheap. I like that.

To what you said, Toby, yeah, we are probably not looking at a lot of moats here. It is a pure play on chicken, which can be quite vulnerable. It goes a little under the radar, because of the environment issues compared to beef. Of course you have the animal welfare thing. You do see a shift, as little as it is, when it comes to that. 

There were a few things that I found really interesting about this company. First of all, they have like this *inaudible* shareholder of over 78%. I also think a diligent shareholder, the way that the debt is financed, is payable off 2025. 

Whenever I look at the landscape of companies, I can’t really fathom why so many are doing short term loans right now, when they can secure something more, I wouldn’t say for free, but take a lot of the risk off.

I really like that. It is creeping up because of the acquisition it did last year. They do have a bad history of too much debt when… Well, actually, they went bankrupt in 2008, but it’s a very different company now. If some of you would look at the company, you might think this is not good. 

When there’s a recession, that really becomes something else. It’s been restructured since. 

I think the main concern I have is the fear of overproduction. You also hit on that, Toby, in terms of the cyclicality of the business. It really looks like evaluating something on the very low multiple, something that is probably, call it leveraged earnings, whatever you want to call it. It seems like we are at the top, not just in the general market, but really like in the chicken business. 

What are your thoughts on that? Is that something you fear and sense that it is already very cheap so you can withstand some adversity or some headwinds?

Tobias Carlisle  36:13  

Chicken prices, a pretty big number at the moment relative to the last three years, is sort of below its five year range. The stock is about where it was about five years ago, but it’s considerably bigger than it was then. 

I think that people continue to eat chicken into the future. I don’t see chicken consumption going away. How much that benefits Pilgrim’s Pride? I don’t know. But it’s not a bad business. They’ve got pretty good scale, pretty good efficiency. They are one of the big ones around. Sanderson Farms being the other one in the industry. Next is  *inaudible* and the next one is Tyson Foods.

Their acquisitive so once a year they do an acquisition, which is the reason for some of the debt. So I think that these guys have done a pretty good job over the last period of time sort of working through what is a tough industry. I think if there’s some weakness in the industry, it’s to their benefit.

Preston Pysh  37:01  

Toby, that’s where I was gonna come at this where you guys were saying there’s not much of a moat. Is the moat just purely the market share that they already possess? So I’m looking at the last 12 months, they’ve done $11 billion in sales, which I think is quite a bit. I’m kind of curious what that market size is and what some of their competitors are.

Tobias Carlisle  37:19  

It’s a sort of business that you are really only competing on price. I think anybody walks into… They sell through supermarket chains, restaurants and other places like that. You’re basically competing on price. The only way you expand market share really is you buy competitors, or you lower your prices, but the prices are pretty low at the moment. 

Preston Pysh  37:38  

All right, well, I guess I’m the last one to go here. The reason I’m the last one that goes is because about 10 minutes before we started recording, I said I’ve got to change my pick. I’m changing it to this. I gave these guys no time to prep so they could pepper me with any kind of questions so I’m just going to leave with that. 

The company that I selected was H&R Block. The ticker is HRB. This is not nearly as sexy as some of the other picks. It’s probably about as sexy as the chickens we were just talking about. As far as Google and Facebook, it’s definitely not there. 

Just to kind of give you a little bit of an overview, their top line is about $3.1 billion per year on their revenues. Their free cash flow hovers around… it’s a little lumpy, but it’s not really growing and it’s not contracting. In fact, 2018 was some of the best free cash flow that they’ve had in the last 10 years and it was at $751 million for the year. 

I look at this company really not taking more market share. I don’t see them really losing any market share. I think that their competitive advantage is in the fact that when people go on to do their taxes, their tax information from the previous year is loaded into the cloud on their system. You know how to use their software. It auto flows all your information over the coming year so if you use H&R Block this year, you’re very likely to use it again in the coming year because it’s just ease of use. 

I think that there’s a competitive advantage there for anybody that it was in this space to begin with. I think it’s very difficult for newcomers to come into this space and kind of take market share. I like that. 

From the numbers standpoint, I am pretty much keeping the growth really flat. Maybe around a 2%-3% growth just to keep up with inflation. I also accounted for in my model about a 20% chance that you’d see a negative 5% growth going into the future. 

With those numbers and the price that the stock is currently trading at, it’s trading around $25-26 right now, I’m coming up with a 14% return. I’m looking at this, just like if it was a fixed income bond is how I’m really kind of valuing the business. I think it’s just going to continue to be pretty consistent moving into the future. I feel like that’s a pretty large yield considering where the rest of the markets are today.

I’m curious to hear everyone’s thoughts now that you guys had 10 seconds to hear my pitch and to prepare for this. Let me hear what you got, Toby.

Tobias Carlisle  40:08  

I like this pick for a few reasons. It’s cheap on Acquirer’s Multiple, basis 6.9 times. When I look at the balance sheet and the ratios, it’s really safe like if I just go through *inaudible* Altman, which is the financial distress. It says it’s very safe. For Beneish, which looks for manipulation, it says it’s not a manipulator. Market cap is 5.3 billion. Enterprise value is about the same. PE is about 9, which is probably too cheap for something like this. 

We’re going to reverse DCF. It’s assuming you get a fair value for around 33 bucks, and it’s trading about a 25 growth rate. I assume very, very modest where it’s been growing pretty rapidly 7.8% over the last five years in a revenue versus 7% EBIT *inaudible*. 

I think it’s a good combination. It’s pretty good business at a pretty low valuation. I guess the qualitative questions are does the IRS ever get its house in order and send out those much simplified forms, which means that people don’t have to do anything, they just sign off? Or do it sort of the scrapers that the kids like to use, like Mint? 

The way I do my taxes, I use Intuit product, which just collects all of my data through the year. I have a little app on my phone that I kind of direct to business expenses, and so on. Then that pre-populates the tax that I then give to my accountant at the end of the year. 

Is there some sort of intermediary step in between these guys or do these guys work with an intermediary? That’s not an issue for them. It’s sort of a question for you. 

Preston Pysh  41:42  

I think most of their customers and I could be wrong about this, but I think most of their customers are people who get a W2 at the end of the year. No really other investments. They’re intimidated by the IRS forms. AThey log on to this thing and it’s literally a click through screen, but they input the number and write off their W2 and it just walks them through every step to make sure that they have that sense of fear removed, that they’re going to get audited. All those kinds of concerns. 

Those people are the ones that are not going to be getting audited because the money’s already been taken out of their W2, but I think it’s a sense of not knowing what you’re doing and kind of using their software. That’s my impression. I could be dead wrong about that. 

I don’t know what the market share of their revenue is that person that I just described, but I just think that there’s a very large moat around the fact that they have the history in the cloud of everyone’s previous returns and all their information.

Tobias Carlisle  42:36  

It’s a funny stock that hasn’t sort of  gone anywhere for a really long time. It’s trading roughly where it was 10 years ago. It is trading at 25 bucks and here it is… basically 25 bucks but it’s cheap. Is it the fear of the IRS doing that? What’s keeping the price down?

Preston Pysh  42:53  

I want to caveat with what Toby just said, because I completely agree with him, but when you look at the payout ratio, the payout ratio in this company right now is 80%. 

Whatever they’re bringing in on earnings, they’re paying 80% of that out to people in a dividend, which I think is great. If the price doesn’t move, so what? You’re making a decent return on the dividend. I don’t know. 

I think that you get some of these companies that just continually trade it and have a lower multiple relative to everything else. I think maybe the reason you might see it trading at a lower multiple simply because there’s no growth whatsoever. I think everyone’s growth hungry these days. They’re always growth hungry. What am I saying?

Tobias Carlisle  43:35  

You know, what is funny? The growth isn’t that bad. It’s growing faster than the GDP growth rate for the last five years. It’s about 7.8%. Last 10 years was about 2%. That’s on a revenue line, but the EPS has been 10 years at 5.7%. That’s pretty good. 

Preston Pysh  43:53  

Yeah, I don’t know. I liked how ordinary it was and how kind of it’s under the radar and I think the numbers look good. Anyone else, Stig? I know you had maybe five seconds to prepare because when I started talking to you on Skype, you didn’t even know that I changed my pick.

Stig Brodersen  44:10  

I guess my excuse will be that I didn’t have too much time to come up with being like a really negative person with this pick. The numbers are absolutely amazing. I mean, especially in this market. I don’t see red flags. 

We actually wrote an article on intrinsic value index not too long ago with Kristoff who we’re collaborating with. It is about tax. That was the trigger, which is a very similar company. And so, generally within the industry, I don’t know how much they apply, specifically the services of SRP, but you see more and more optimization, which is also one of the reasons that its SRPs are closing down 400 locations. 

You see a lot of the need for, and this us  just like a general thing about the industry, less than a need for speaking to the customer or the person, one on one, and a lot more cannot be done with computers and different systems. This is really like taking the customer now.

I don’t think I would include a lot of growth. I don’t think that was what you did, Preston. The thing is even  if you see like a small decline, it’s still a very, very decent pick. It sounds crazy when we just talk about Facebook and Google where we came up with 15-20% annually. Now, we’re talking about less, but it’s still okay. It’s a different discussion to have. I think it’s a decent value pick, especially for an income investment.

Tobias Carlisle  45:44  

They’ve been buying back stock pretty consistently so in 2020 years ago, they had 400 million shares on issue and now they’ve got a little bit over 200. They’ve roughly had the shares outstanding of close to 20 years so they’re doing the right thing. The only issue is that the managers don’t own any stock

Preston Pysh  46:00  

Yeah, that’s kind of telling, isn’t it?

Hari Ramachandra  46:03  

Also, Preston, talk about TurboTax *inaudible* and what are some of the risks? Is Intuit or TurboTax cannibalizing a lot of H&R bBock customers? Is there still more room for TurboTax to cause damage?

Another perspective, as I know, Intuit is right here in the Silicon Valley. They’re doing a lot of work to revamp their technical stack. They’re infusing a lot of new methods and methodologies. I can see that they’re reinvesting in the technology in that platform. Their *inaudible* the ratio is like 30% compared to the 80% itself so that means that they will keep investing more than H&R Block.

Preston Pysh  46:47  

My personal opinion is Intuit is a great company. I think that they’re much more developmental, they’re coming up with a lot more products, and they’re in a lot other areas than H&R Block.

However, from a pure numbers standpoint, by saying that Intuit is taking some orTurboTax or whatever, I know TurboTax is one of their divisions and one of their products, but to say that that’s stealing market share from H&R block, I just don’t see it. 

From a number standpoint, looking at the top line, I don’t see it. So if they haven’t done it in the past five years, I guess my impression is they’re not going to do it in the coming five years because I don’t think too much from a technological standpoint has really changed in the past five years. 

However, I think the reason I bring it up is I want people to go out there and check it out. Like I said, the ticker is HRB. Look at some of the numbers. Dig into it a little bit. Tell us on Twitter if you think we’re totally missing something. We always appreciate that. 

Alright, so we really, really enjoy these conversations, Toby, thanks for coming on the show. Give people a quick hand off to where they can find out more about you.

Tobias Carlisle  47:50  

My website is acquirersmultiple.com. That’s got a free screen that shows the 30 cheapest in the top thousand stocks. PPC, my stock pick, came from that screener. I’m on Twitter @greenbackd. I talk to people and interact about stocks and things on Twitter. Finally, my current book is “The Acquirer’s Multiple.” That’s available through Amazon. If you log in there, you’ll see that I’ve also got “Quantitative Value ”, which talks about some of the metrics that are discussed today.

Preston Pysh  48:24  

Thanks, guys. Hari, give everyone a hand off where they can learn more about you as well.

Hari Ramachandra  48:29  

Yeah, my usual place where I hang out is my blog, bitsbusiness.com. Share your comments and give me your feedback.

Preston Pysh  48:38  

Thank you. Well, we really appreciate you guys joining us. If you guys want to just a quick link to that stuff that they mentioned, it’ll be in our show notes. We just always enjoyed doing this. Thanks for joining us, guys.

Stig Brodersen  48:50  

Alright guys, that was all that Preston and I have for this week’s episode of The Investor’s Podcast. We will see each other again next week.

Outro  48:59  

Thanks for listening to TIP. To access the show notes, courses or forums, go to theinvestorspodcast.com. To get your questions played on the show, go to asktheinvestors.com and win a free subscription to any of our courses on TIP Academy. This show is for entertainment purposes only. Before making investment decisions, consult a professional. This show is copyrighted by the TIP Network. Written permission must be granted before syndication or rebroadcasting.