Motley Fool Hidden Gems Investing - Alphabet’s Next Act in Cybersecurity

Episode Date: July 17, 2024

Alphabet eyes its biggest acquisition of all time in Wiz, and a struggling retailer’s outlook gets worse – but it might be a buying opportunity for investors.   (00:22) Jason Moser and Dylan Lewis discuss: - Retirement lessons and a reminder to ignore the exogenous from our colleagues at FoolFest 2024.  - Why Alphabet is eying a $23B cybersecurity acquisition. - Five Below’s stock going on sale, and whether new leadership can put the struggling retailer back on track.  (16:25) Alison Southwick and Brian Feroldi continue their summer school series, running through the financial metrics that can help investors understand a company's valuation and one less common ratio that can tell you a lot about profitability. Companies discussed: GOOG, GOOGL, FIVE, AAPL, NVDA, MSFT Host: Dylan Lewis Guests: Jason Moser, Alison Southwick, Brian Feroldi Producer: Ricky Mulvey Engineer: Tim Sparks Learn more about your ad choices. Visit megaphone.fm/adchoices

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Hump Day, right? Happy Wednesday. Hump Day. Getting over that hump. Yeah. And our first day back from Fool Fest, we are fresh off of our member event. Maybe fresh, not quite the right word. My voice is a little bit raspy from a lot of very fun conversations with members over

the last couple of days. Certainly had a blast. Jason, we were both on stage, but also in the audience for a lot of the day and kind of taking in the insights from our colleagues who were on stage for some of the sessions. Any takeaways, any lessons for you from the event? Yeah, well, I mean, there are always a lot of lessons I think you take away. I mean, we obviously talk with so many members and learn their backgrounds. We learn what they like, what they don't like, things that they feel like we can do better,

things they feel like we're doing really well. So that's always really fun. But yeah, you're right. I was attending sessions when I wasn't helping present them. And in one session that really stood out to me, Robert Brokamp, our bro, as many people might know him by, he had a session called Crucial Retirement Planning Principles. And Dylan, I'm a stock guy. I've been a stock guy ever since I've been here.

That's kind of like what I do. And it's fun. And I love it. But I've always enjoyed Bro's content because it focuses on something that I don't focus on as much. And it helps me, I think, professionally, but also personally. And I know our members really enjoyed it. But there was one particular part of his presentation that I thought was just really, really noteworthy. And he was talking about when you're retired, typically you're going to have multiple streams of income, right? I mean, when we're working, we're getting

paid, you're subject to that tax there, your ordinary income tax. But when you have these multiple streams of income when you retire, you have to consider a little bit more. He's talking about Social Security, pension or retirement accounts, dividends, interest, Roth accounts, and whatnot. The list goes on depending on who you are. His point was, they're each taxed differently. And so, that means you have to learn a whole new way of ultimately managing your taxes. That's something I've always thought about in the back of my head. But what Bro did that I thought was really great, he presented a nice framework. He gave us a good list, Dylan. Everybody likes a good list. Who doesn't love a good list? Who doesn't love a good list? And so, I thought it

was just really clever. And the list basically was breaking down when you need your income in your retirement, there was a list of general guidelines in order of how to go about raising that money, right? Where should you take that money from first? And it was ultimately, it was a five point list. And I will, before I list this off, I mean, as a reminder, I mean, he said there's a lot of nuance to this, right? So these are general guidelines, but also recognizing the fact that everyone's situation is unique. But again, I love a good framework. And I just thought this was really helpful advice. In order, he said, number one, take your required minimum distributions. Then, number two, spend your interest in dividends from your taxable accounts.

Then, number three, selling assets in taxable accounts. Number four, withdrawing from traditional retirement accounts. Then, number five, withdrawing from Roth retirement accounts. He was quick to make the point, too, and I don't know if everybody knows this, It's something to remember is that Roth accounts actually don't have a required withdrawal, right? There is no minimum withdrawal required. So, you know, I assume that's why he put it last. But again, the whole session was super. That list stood out to me as something I was like, you know, I'm going to file that away somewhere because I'm going to need to refer to it at some point.

And I think our members really got a lot out of it as well. I think the flip from wealth accumulation to drawing on that wealth is the ultimate what got you here isn't what is going to get you there, Jason. That's very, very well put. Very well put. I will say, being on stage and meeting the crowd, I learned the word exogenous over the last couple of days. That was a word that popped up a few times with members asking about the external factors in the market, looking over at the political realm here in the United States, but also globally, and also the macroeconomic picture.

I love the reminders from Emily Flippen, Andy Cross, David Gee, our colleagues, just saying, we are net buyers of stocks, we are looking at the businesses, and we are believers in the systems that those businesses operate within. Things like rates matter for businesses, but don't let those headlines get in the way of investing and really participating in the progress that those businesses are helping push forward. I think that's a great point. There's so much out there that is completely out of our control. There's nothing you can do about it. You can either choose to participate or you can choose to not participate. But yeah, there's so much out there that's just completely

out of our control. And so you have to kind of bypass that stuff and focus on the stuff that really matters. Well, while we were having fun with our sessions and the live tapings that we for Motley Fool Money at FoolFest. There was some market news this week, and we probably should get up to speed on that. One of the big headlines this week, Jason, Google parent Alphabet reportedly in serious talks to buy cybersecurity startup Wiz. If you've never heard of Wiz, I think you're in good company. This was one that was totally new to me prior to prepping for the show. Jason, what does this company do? Well, it's not a publicly traded company, so you can be forgiven for not really

having heard of it. I will admit I had heard of it, but it was not something I'd ever really dug into for obvious reasons. You say startup, and this acquisition at $23 billion. $23 billion startup, man, you got to love it. But they check the boxes when it comes to cloud computing and cybersecurity. I guess that makes sense, the enthusiasm behind the company. If you check out their website. It says that the company, they help you secure everything you build and run in the cloud. And so ultimately they offer a cloud security platform. It's a cybersecurity company in the cloud age, right? And they say that you can use their cloud security platform to build faster in the cloud, enabling security, dev and DevOps to work together in a self-service

model built for the scale and speed of your cloud development." When you put cloud and cybersecurity in the same sentence, you know there's going to be a lot of investor enthusiasm. It certainly seems like it fits very nicely into Google's or Alphabet's aspirations. I definitely understand the interest. This is still in the speculative phase. We haven't seen it confirmed that this deal is happening. But if you're trying to imagine how it pieces together into Alphabet's business, I've always looked at elements like cybersecurity as features or layers that get woven into the end products

that a company like Google winds up offering, rather than something that a company like that would actually offer as a commercial product, standalone. Basically, if you're a user of Gmail, there are things that are being layered into that experience that make that safer. Or, if you are a cloud customer of theirs, this is something that will protect your data and make you a little bit less likely to be at the risk of a cyberattack. Is that the right way to be looking at this potential deal? I think so. Now, again, there's a lot we don't know, but it does seem like something

that ultimately Alphabet would weave into their cloud offering, so that it would become a seamless part of their overall cloud offering. It's important to note, with Wiz, they say startup, They have a lot of big customers. Customers like Priceline, Chipotle, BMW, Fox, Mars, Shell. They are helping a lot of big companies get it done already. If this is something that ultimately can make Alphabet's cloud offering stronger, and if they can weave that cybersecurity component into that cloud offering, make it stronger, make it seamless, it definitely makes a lot of sense. You got to figure a lot of Wiz's customers are probably Google's customers to an extent. But then, you know, I guess the big question really is, will this deal even be able to happen? I honestly, I think it actually probably could, given that it's cybersecurity. If this was an advertising acquisition, an advertising related acquisition, I think it would probably go under the microscope a little bit more. And it certainly will go under the microscope.

But given that it's cybersecurity, it just, Google's still, Google's a distant third kind of right now still in cloud, you know, versus like your Amazons and Microsoft. So, I feel like this deal probably will go through, but yeah, they still have some judgments outstanding there. And then obviously with an election coming up, things could certainly change in regard to the regulatory environment there as well. We're going to wrap the news rundown here with a look at Five Below. Shares over 20% below today. The stock down big on news that the company guided second quarter sales down, and that CEO Joel Anderson is stepping down to pursue other interests. Jason, Anderson had been at the helm of this business for about 10 years,

and it feels a little sudden for him to be stepping away. It seems really sudden. And when you read the release, they say he's leaving just to pursue other interests. there was nothing else really behind it. It's not like five below has, has fundamentally been a, a poor performer, uh, as, as, as far as a business goes. So, I mean, maybe you said it, I mean, he's been there for a while. I mean, I think, I think since February, 2015. So what other interests are, I'm not sure could be anything. I mean, I assume we all just wish him well, but it does seem very sudden. Thankfully, they are at least able to fall onto Kenneth Bull,

the COO, who will at least take on the interim presidency EO roles. Then Tom Velios, who is the co-founder of the business, will be appointed to the interim executive chairman. They have some familiarity there filling in that leadership vacuum, but I guess now begins the search for a permanent CEO? I'm sure the leadership question is part of the big decline we are seeing today. Part of it also, as I mentioned, guiding down those second quarter results, also forecasting a 6% to 7% decline in comps. This is a business that has had a hard time recently. Some of the discount retailers have done OK. Five Below tends to live in a little bit more of this lane of nice-to-have type products,

things that people don't necessarily need. I think they've had a little bit of a hard time getting people into the stores in this consumer environment, Jason. I think you're right. If you go back to the earnings call in early June, the stretched consumer was a big theme even then. Looking at this guidance change, it's relatively benign. It's not like they cut expectations in half. But they are guiding now for revenue of $820 to $826 million, and that's versus $830 to $850 million from a quarter ago. And then earnings per share guided down to $0.53 to $0.56 per share versus $0.57 to $0.69 just a quarter ago as well. So, it's a little bit more significant, feels a little bit more

significant on the bottom line. But this is a business that flourishes when the consumer is feeling good, right? And we're at a point right now where the consumer is clearly stretched. I mean, I think we're seeing signs of that everywhere. And it's not to say that the consumer is not going out and spending, but they're just being very considerate about how they spend. And for a company like Five Below, that is problematic. The good news is, I think it's temporary, right? I mean, things will get better, right? That worm will turn, as they say. And when it does, assuming they're able to bring in a CEO who can keep this business going in the right direction, this could be a time for interested investors to at least

consider taking a closer look. Traditionally, Five Below has been one of those retailers that has traded at a pretty decent market premium. I think you've generally seen shares somewhere between 35X and 40X earnings after the decline that we're seeing today, 15X trailing earnings. That premium I mentioned before, a lot of that was strong comps and a pretty decent opportunity in front of them when it comes to store footprint, the expansion story for them. I have to ask you here, do you feel like there is a turnaround opportunity and that shares maybe look pretty cheap, if we can get someone at the helm that investors will

be confident in? I think so. One of the reasons why I say that is, Five Below stands out to me as unique. It's somewhere in the middle between your dollar stores and your big box retailer like a Walmart or something like that. It is unique. It has an identity. It has some brand equity there. And consumers love it. I have noticed that through the years. I mean, it has sort of that rabid following. I'm not saying it's to the level of something like a Costco, but it seems to generate that type of sentiment from the consumers that like to go there. And I don't think that changes. So again, I do think that when we see conditions improve and assuming they get the right leadership in place, yeah, I mean, I absolutely

we could see this situation getting a lot better. It may take a little time, right? I mean, they're going back to that exogenous word, right? There are a lot of factors out there right now that are out of our control. So I think you have to be able to look past that. And there are some variables still in play here, but definitely want to keep an eye on. Jason Moser, loved seeing you at Fool Fest over the last couple of days. Thanks for joining me on today's show. It was awesome. Thanks, man. You just found out that your sales team is at risk of missing quota. Don't panic. just ask Rippling AI. Since it's built on your real-time people and business data, Rippling AI can pull metrics from Rippling and Salesforce into a meeting-ready dashboard showing

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and one less common ratio that can tell you a lot about profitability. All right, let's start with some profitability ratios, which I have to assume are just a way to measure how profitable a business is. And you've got some options, right? Yeah, well done, Allison, on that one. Believe it or not, the word profit means different things to different investors. And there are quite literally dozens of ways to measure the profitability of a company. But we're going to focus in on a couple of key ratios for investors to know. Let's start first with return on equity. This ratio has the company's net income in the numerator, net income from the income statement, and the company's shareholders' equity from the

balance sheet in the denominator. Now, this measures how efficiently a company is using its equity to generate income on the equity that it has in the business. Now, a decent number to look at here are the average company in the S&P 500 generates a return on equity of 10%. So if you can find a company that has a return on equity of 15% or more, that indicates that it's doing a very good job at using its equity to generate income. Now, a company out there called NVIDIA, which many people know. In fact, it just recently became the biggest company in the world. They generate a return on equity of 41%. So that itself is a stellar number. It is a stellar number. But then if I look at Apple, I see that Apple has a return on equity

of 119%. What am I supposed to make of that? Yeah. So this gets into one of the flaws of any profitability ratio, which shows you why there are so many to look at. There are ways that companies can game their return on equity number. Remember that the denominator of this equation is shareholders' equity. One way that a company can artificially boost its return on equity is simply by taking on more debt, by using debt to generate income, not equity. That keeps its shareholder equity level low, which makes its return on equity look a little bit high. Another thing that companies can do is actually buy back their stock. When they buy back their stock, it actually reduces the amount of shareholders' equity, which can, again, make their return on equity look very

strong. In Apple's case, it's actually doing both, where it does have debt and it has bought back a ton of stock. So this is one reason why knowing the nuance of these equations is so important. Brian, before you go on, can you define shareholders' equity for me? Absolutely, Alison. So shareholders' equity is found on the company's balance sheet. And there are really two major components that define shareholders' equity. So thing one is how much capital investors put into the business. So the company sold those investors' stock at some price. The company took that capital and used it to invest in the business. So that is one major component of shareholders' equity. The other major component is profits that the company

generated and did not distribute to investors. This is called retained earnings. Retained earnings is the cumulative amount of profit that a company has generated over its lifetime and kept for itself. It's the capital that was raised from investors and the profit that was raised from the business. Those two numbers combined together give you shareholder's equity. All right, let's move on and talk about gross margin. This is one you're going to hear a lot as well if you're just listening to finance people talk. Absolutely. It's a very important term and one that I pay very close attention to when I'm analyzing a business. Gross margin is the company's gross profit in the numerator and the

company's revenue in the denominator. I think everyone understands revenue. Let's dial in on gross profit for a second. Gross profit is revenue minus the cost of generating that revenue. So for example, let's take a very simple business like Starbucks. So revenue is all of the cups of coffee that Starbucks has sold, the value that it's sold to customers during a period. Starbucks' cost of goods sold would be all of the money used to pay for the beans and the cups and the water and the thing that literally goes into the customer's hand. So revenue minus cost of goods sold equals gross profit. And gross margin takes gross profit and expresses it as a percentage. So to give everybody some context, the average business in the S&P 500 has a gross margin of 45%. So if a company has a gross margin above that number, that indicates that the profit, that

the product or the service it's selling is very profitable at the product level. So to add some context to this, so the average is 45%. Apple's gross margin isn't very much above average. It's sitting at 46%. I'm kind of surprised by that. Well, don't forget that Apple, they make a lot of money from selling you computers and iPhones and iPads. So think about the cost that Apple takes on to buy the chips, to buy the metal, to actually

manufacture and produce the iPad. So in fact, 46% gross margin for a hardware manufacturer is actually quite stellar. Whereas if that same gross margin was for a software company, it would be quite poor. So the industry that the company is in can have a big impact on what kind of gross margin investors should expect. All right, let's move on to net profit margin. So this would be, in the numerator of this equation, is a company's net income, aka earnings, aka profit.

This is the bottom line on the income statement. Whenever we use the term margin, all that means we're doing is dividing by revenue. Another way of thinking about net margin is for every dollar in sales, how many pennies become after-tax earnings? A really good figure to aim for is 10%. That is actually the average for the S&P 500. If a company has a net margin over 10%, percent, that's likely to be a very profitable business. Speaking of a very profitable business, NVIDIA is sitting at 53 percent net margin. That is simply an incredible number. So for every dollar in sales that NVIDIA has, it creates 53 cents of after-tax profit. So all of the costs of the chips, of sales, of marketing, of research and development, of interest, of taxes, everything

is inside that 47%. And 53% is truly outstanding. All right, now let's shift and talk about market value ratios. What are market value ratios measuring? So these are some ratios that we can look at that can give us a sense for what the valuation of a business is. Or these numbers can help us to figure out what the price of a share of a stock should be. So the first one we're going to tackle is earnings per share. This number is found on the income statement. Companies do report it when they issue press releases or issue SEC filings. This is the company's net income, aka the earnings during a period. We take that and we divide it by the total number of shares that are outstanding. This gives us a figure which tells us how much

of an economic claim each individual share of a company has on the company's total profits. So when we're looking at, let's say, Apple versus Microsoft versus NVIDIA, Microsoft actually has the highest earnings per share with $11.60 compared to NVIDIA's $1.70 and Apple's $6.50. What should I make of this? Yeah. So you would think that, oh my God, Microsoft is so much more profitable than Nvidia and Apple, but earnings per share by itself doesn't really tell you a lot because remember the denominator here is the number of shares outstanding for a business and companies can control the number of shares they have outstanding simply by splitting their stock. For example, Nvidia just a few weeks ago, I believe split their stock 10 for one. So if they did not split their stock, they would have had $17 in earnings per share. You can't look

from one company to another and compare earnings per share because the share count matters so heavily in that equation. All right, next one to tackle is price-to-earnings ratio. Yeah, this is the granddaddy of all valuation ratios. This is the one that you've probably heard of the most. There's actually two ways of calculating the price-to-earnings ratio, but we're going to go with the simplest. So the numerator here is the stock price. So whatever the stock is trading for right now. And the denominator in that equation is the earnings per share. Now this figure will measure the price that you are paying for each dollar of a company's earnings. Now the S&P 500 has historically traded at a price to earnings ratio of between, let's

just say 15 and 25. And with a price-to-earnings ratio, higher means more expensive and lower means cheaper. So, if you see a price-to-earnings ratio over, let's just say 25, broadly speaking, you could call that stock expensive. So, speaking of an expensive stock, we've got NVIDIA with a PE of 79, which is not too surprising. Yeah. The price-to-earnings ratio often reflects a number of things. One of them would be the company's growth rate, and a second would be the optimism that investors have in the future of the business. In NVIDIA's case, while it's trailing, looking backwards, the price-to-earnings ratio of $79 might seem absurd. You have to compare that to the company's growth rate, both on a revenue

basis and on an earnings basis. Both those numbers recently have been essentially in the double or even triple digits. So, a price-to-earnings ratio in absolute terms will tell you one thing, but you really have to apply the context of the company's growth rate to give it meaning. Think about ratios that I'm discovering here. They're supposed to be useful shortcuts, rules of thumb for measuring, but they always come with a but. Right? It's like, you know, Apple's trading at this, but if you actually go one level deeper, you understand And that just feels like a lot more homework than I wanted to do. I was hoping my ratios would just do the work for me.

Yeah, me too. I would love it if it was just that simple. And this gets into why investing by its large is hard and it's supposed to be hard because you have to know a lot as an investor. But there is a ratio that I look at and that does keep things very simple. And if you're a fan of simplicity, one ratio that I suggest you get to know is something called the free cash flow yield. So, the free cash flow yield, to calculate this, you take a company's free cash flow

and you divide that by the company's enterprise value. Now, this gives you a number that is a percentage, and that is effectively the same thing as giving you the yield in free cash that you are getting by making an investment today. Now, this number fluctuates up and down based on both the company's free cash flow generation as well as the enterprise value, which includes the company's stock price. But one thing that I love about the free cash flow yield is it gives you almost like an interest rate in investing in that company. And you can compare that interest rate to, say, bonds or CDs or even the market in general to give you a one simple number that can tell you if a company is cheap or expensive. All right, class, you have been excellent listeners today.

And I realize that it's really hard to follow a bunch of ratios thrown at you quickly. So your optional homework today is coming to you from Brian. Brian, what's your recommendation? Yeah. So that's a wonderful book that I recommend basically every investor read. It's called Warren Buffett and the Interpretation of Financial Statements. So it was written by Mary Buffett, who was Warren Buffett's former daughter-in-law. And it literally goes through the three financial statements in order and goes line by line saying how Warren himself thinks about every single number. So if you're interested in diving deep into a company's

financials, it's an excellent read. All right, class, that's it for today. Thank you, Professor Feroldi. We will be back next week to cover language arts. As always, people on the program may own stocks mentioned, and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. I'm Dylan Lewis. Thanks for listening. We'll be back tomorrow. Thank you.