Revisiting the Energy Drink Bubble
Two weeks ago, my wife and I drove along the Sea to Sky Highway from Vancouver to Whistler, British Columbia. I had just presented some of my research to attendees of the Agora Financial Wealth Symposium in Vancouver, so we took the opportunity to enjoy some of the legendary natural beauty of the area. Unbeknownst to us, we arrived in the middle of the third annual Kokanee Crankworx Mountain Bike Festival.
This festival can be described as belonging to the “extreme sports” wave that has been growing in popularity among U.S. teens for years. Seeing a part of it provided insight into the world of extreme sports. Elaborate wooden ramps were constructed several feet in the air, presumably for biking’s version of the circus high-wire act. Wikipedia has named this activity “BMX freestyle.” Contestants in this bike stunt contest were walking around with more pads than a football player, for very good reasons.
Perhaps it was related to the fact that this event that was taking place, but dozens of teenagers were walking around Whistler with Monster Energy drinks in hand. This appeared to be the key demographic audience for these drinks. After all, common sense would tell you that those who seek the adrenaline rush of extreme sports are more likely to seek the rush of caffeine. I recognized that the brand name belonged to Hansen Natural, a company I had written about in this space about one month prior. In order to see what the “buzz” was all about, I purchased one.
$2.50 and a headache later, I was convinced that energy drinks are not for me. I’ll stick to old-fashioned coffee if I’m looking for a jolt of caffeine. My personal taste led me to question yet again why a halo surrounded a publicly traded company that was completely focused on the production and marketing of these products. Perhaps this growth trend has staying power, but I wouldn’t expect it to grow beyond its key teenage/young adult demographic.
Therein lies the problem with investors and analysts placing this company in the same category as a sprightly early-1990s version of Microsoft. The sky was the limit for Microsoft’s growth potential. Bill Gates led a management team with a “take no prisoners” view toward competition. The “network effect” reinforced its first-mover advantage. The intellectual property behind Windows became more and more valuable as it grew beyond its initial users to become a standard in the business and home PC markets.
Practically any price was worth paying for such incredibly attractive fundamentals, and early buy-and-hold investors made fortunes. However, now Microsoft is popping up on value investors’ radar screens. Microsoft stock is “cheap” precisely because new threats that can completely undermine its dominance are constantly emerging. Such is life in the Darwinian, short-life-cycle IT business. On Monday, Hansen stockholders reacted as if the company will be the next TASER Intl., not Microsoft circa 1991.
Price Is More Important Than Fundamentals
Buying very expensive stocks with the expectation of cashing out for a quick gain is gambling, not investing. It should be treated as such and speculators have no one to blame but themselves if they attempt this and ultimately get their heads handed to them. I wrote about this theme in “Bubbles in Natural Gas or Energy Drinks?”
In this June 26 Whiskey & Gunpowder essay, I explained how euphoria remained alive and well in many corners of the stock market — even after the painful May-June market decline — and how “speculators trading in Hansen Natural will ultimately be taken to the cleaners.” By “ultimately,” I certainly didn’t have a time frame in mind, but stocks trading at nosebleed valuations have a tendency to randomly get clobbered on even slightly disappointing earnings.
Also back in June, the praise from mainstream analysts regarding Hansen’s attractive, high-ROIC, “asset-light” business model contrasted with their general criticism of Anadarko’s acquisition of Kerr-McGee and Western Gas Resources. No price was too high to pay for Hansen, yet when Anadarko paid reasonable prices for what management considers good long-term investments, it gets criticized for “destroying shareholder value at the top of a commodity cycle.” This indicates that the bull market in natural gas producers is not over and the bear market in energy drinks may have just begun.
An Expensive Education for Hansen Bulls
Monday, after announcing earnings, Hansen Natural stock fell by 35% on 45 million shares in trading volume. This is a stock with a “float,” or shares outstanding minus insider ownership of 60.5 million shares. 74% of the share float trading in a single day is a clear sign that short-term traders bailed out and many short sellers covered their positions. Money flowed from weak hands to strong.
Short sellers get unfairly tarnished as “unpatriotic” or “gaining at the expense of the little guy,” but in the case of HANS trading on Monday, they were the little guy’s best friends. They often add liquidity to markets that would otherwise dry up and go into free fall. Short sellers provided a great amount of buying support for HANS as they bought to close their positions. In fact, short sellers may very well have been the only ones buying.
Hansen bulls were selling “at the market” with little attention to bid/ask spreads, just looking to get out at any price. When buyers leave the market and only sellers remain, prices crash until sellers stop selling or buyers re-enter the market. This was an expensive education for those who didn’t pay attention to valuation and bought above $40 (split-adjusted) in recent months:
Below is a two-year chart for a longer-term perspective. Would you invest in any stock after this extreme two-year run? Apparently, many people did, expecting short sellers to be squeezed in perpetuity. But mean reversion exists for even the fastest-growing, most fundamentally attractive companies:
To appreciate how far the stock has rallied, this long-scale chart shows the stock selling for just $2.50 (split-adjusted) in August 2004:
Hansen Delivered Enviable Quarterly Results
I suggested that a secondary stock offering was a distinct possibility and a threat to current shareholders in my June essay. Hansen has not filed for a secondary offering. Instead, what drove the stock down so mercilessly on Monday was a very slight shortfall below expectations.
So what was all the panic about? After all, most companies envy this kind of fundamental performance: year-over-year sales growth of 78%, diluted EPS growth of 75%, and a return on invested capital of 71% (second quarter annualized). Such numbers, if maintained and compounded over multiple years, result in the kind of return you see in HANS over the past two years.
The real reason traders bailed out of HANS with reckless abandon was that they finally decided to look “through the windshield,” so to speak, instead of “in the rearview mirror.” You can point to trailing fundamentals to justify the high prices of many stocks, including Google, but don’t allow yourself to blindly extrapolate the past into the future.
On Monday, HANS stockholders finally bothered to look far into the future and they did not like what they saw — the distinct possibility of energy drink demand saturation, aggressive competitive response by Coke and Pepsi, accelerating cost pressures, or a potential break below the 200-day moving average. Whatever reason they had, each individual seller sold first and asked questions later. The two-year chart of HANS exhibits herding, human greed, and human fear all in one great financial drama.
Speaking of drama, many individual investors are enjoying the pre-Fed meeting handicapping as I write (before the Fed’s decision on how it will interfere in the free market price of short-term credit). Will it be the “pause that refreshes” or the hike that sends the economy into a tailspin? I personally don’t think it matters very much, because other than in the context of a financial or banking crisis, the Fed’s influence on the credit market is far more bark than bite.
The aggressiveness of lenders and borrowers ultimately determine the price and volume of credit transactions, not the magic wand of central bankers. American consumers, homeowners, and governments must constantly roll over staggeringly high debts, so demand for credit is not as much an issue as supply. Major creditors around the globe are increasingly wary about looking to invest in U.S. markets. Foreign central bankers have been making a lot of noise about diversifying out of dollars.
As veteran market watcher Ray DeVoe said, “Liquidity is a coward, there’s always too much when it’s least needed and it’s nowhere to be found when needed the most.” “Liquid” or “orderly” is not how you would describe the market for Hansen stock on Monday, and “illiquid” is how many may describe credit markets when creditors ultimately balk at financing overstretched U.S. governments and consumers. The end result will be less credit available at a higher price.
Many borrowers and lenders will get what they have coming. But the Fed will team up with Congress to clean up the mess with another round of inflation. The absence of the gold standard’s discipline has led to ever larger cycles of credit bubbles inflating, popping, dealing with the fallout, and inflating yet again. But I digress. I’ll wrap up with the consequences of obsessive focus on quarterly results.
Earnings Season Is Good for TV Ratings, Not Analysis
Considering that the widely quoted reason for Hansen’s blowup was its quarterly earnings report, it’s important to consider what drives long-term returns. Hansen’s quarter merely served as a catalyst that vented underlying anxiety. To use an analogy, it served as a lit match after the room had already filled with gas. The match without the gas is not nearly as dramatic. The point to take away from the case of Hansen is not to get caught up with the minutia of “missing or beating by a penny,” but to understand the fundamentals, risks, and assumptions underlying the quoted price of a stock you are considering for investment.
Earnings season stands out as an important time for the financial media’s ratings. It also generates a great deal of excitement among short-term traders. But this quarterly event normally has little influence on long-term stock market returns. Stocks are claims on the free cash flow a company can generate over a very long future time frame, normally spanning decades. If you want to analyze a stock, do it from this perspective and pay little attention to quarterly earnings.
By free cash flow, I’m referring to operating cash flow minus maintenance-level capital expenditures (or the level of capital expenditures necessary to maintain existing production levels and replace depreciating capital). Capital for a gold mining company includes drilling equipment, managerial expertise, and mineral rights. Capital for a software company includes offices, copyrights, and its employees’ code-writing ability. In both cases, accumulated capital is the reason a company can charge a profitable price for its product and how a company differentiates itself from the competition.
This goes to the heart of the capitalist enterprise, which seeks profits through the production of goods or services that consumers value more highly than they value the component raw materials. In the case of Microsoft, consumers assign Windows a value that far exceeds the capital costs of years of software development and the operating costs of CDs, shrink-wrapped cardboard boxes, and programmer salaries. The result is very high profit margins and free cash flow that can be distributed to shareholders.
My approach to earnings season is to look for any indications that the company’s intellectual or physical property is losing value at a rapid rate or the company’s competitive edge is losing ground. Quantitative measures (like profit margins, free cash flow, and backlog) and qualitative measures (like management changes, product obsolescence, and new product development) are both crucial in evaluating the company’s long-term free cash flow-generating ability.
In the case of Hansen, the market is beginning to have doubts about the trajectory of free cash flow. The market is now assigning a higher probability that free cash flow will decay rapidly, rather than trend steadily upward. Make sure you acknowledge the assumptions behind your stocks and act appropriately before the market forces you to do so under much more painful circumstances.
Dan Amoss, CFA
August 9, 2006