Motley Fool Hidden Gems Investing - E-Cigarette Ruling Hits Wall St.

Episode Date: June 22, 2022

The FDA is preparing to order Juul Labs to take its e-cigarettes off the market in the U.S. (0:25) Bill Mann discusses: - Shares of Altria Group, owner of a 35% stake in Juul, getting hit on the news - Why one of Altria's main competitors is unaffected - How he thinks about "sin stocks" as a category of investing (10:00) Ricky Mulvey talks with Bill about the billions of dollars of Bitcoin on MicroStrategy's balance sheet affects the view of the business, and what a potential margin call means for its shareholders. Stocks discussed: MO, BTI, MSTR, META, NVDA Host: Chris Hill Guests: Bill Mann Producer: Ricky Mulvey Engineers: Dan Boyd, Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

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I'm Chris Hill, and joining me, back by popular demand, Motley Fool senior analyst, Bill Mann. Thanks for being here. Bill Mann Can't get rid of me, can you? Chris Hill Let me just pull back the curtain for the dozens of listeners. Sometimes, doesn't happen often, but sometimes there's a miscommunication in scheduling and the analyst who is scheduled just falls through. Then you go to the emergency route and call up Bill Mann and say, Bill, need you back on the show. Bill Mann Given that I don't know what I'm talking about in the best of times, I'm ready.

I think you're going to have informed opinions and analysis on this story, because this is a pretty big story, which is that the U.S. Food and Drug Administration is preparing to order Juul Labs to take its e-cigarettes off the market here in the U.S. The Wall Street Journal is reporting this. We'll see if the actual ruling comes down by the time this episode gets published. Altria Group has a 35% stake in Juul Labs, and not surprisingly, shares of Altria down 8.5% on this news, which for a stock like Altria, not historically a big mover day-to-day in either direction, pretty significant drop. I find it amazing in this country that Juul e-cigarettes may actually be made

illegal before cigarettes are made illegal. So there are a couple of things that are going on here. Actually, on the one hand, you also have Altria, one of the biggest makers of cigarettes. There's a theory that I think probably holds water, that if they take Juul away, are people just going to go back to cigarettes or start smoking cigarettes? Because one of the issues, Juul has applied for an FDA license to continue operating, and it is a license that has been given to their competitors. So, Reynolds has a product called Vuze Solo, and they're legal. They have been given FDA permission. They were last year. There are plenty of e-cigarettes and Juul-like devices out there on the market.

Juul is the most successful, even though it has been a disastrous investment for Altria. They were applying to the FDA because they are making the claim that Juul e-cigarettes are effective in helping people stop smoking, actually, and the additional carcinogens that are introduced in your body from actual cigarette smoke. And the FDA has said no to them. But it's important to note that vapes aren't leaving the market. Juul is the one that is currently at risk. Do you think there's a world in which Altria just pivots and says, look, we want to be part of the vaping market if it's not going to work with Juul? And by the way, thank you for pointing out that this really hasn't been a great investment for Altria, taking the stake. And at the time, there was speculation that this is just a prelude to Altria just buying Juul outright.

I'm sure there are institutional shareholders and individual shareholders who are thrilled that that did not happen. But do you think Altria pivots now and says, look, we just want to be included in this market somewhere? I don't think they can. I mean, the biggest issue for Altria, and it's kind of a funny regulatory arbitrage. So, there was an original Juul device, like all these other devices, that were in existence before federal regulators, before the FDA came out and said that they had regulatory authority over e-cigarettes. Now, Juul had a device that was somewhat faulty. So in 2017, they redesigned it.

It was called Product Jaguar. And when they redesigned it, the FDA had them. They had them because they had come out with something that was before the FDA had stamped its regulatory authority over the market. Now, any changes that any company wants to make to play in the market, assuming that they would like to go through the full regulatory process, which I would say that a lot of the vape shops on the corners of America don't seem to, but for a company that's got the backing of Altria, they have to. And so, I don't really know how they could pivot without triggering the FDA and another review again, which I think we've learned today, the FDA is not that excited to let Altria and let Juul stay on the market. How much do you think this investment in Juul, and again, bad day for the stock, if you look

over the lifetime of Altria Group, formerly Philip Morris. This has been a stock that has rewarded shareholders handsomely over its lifetime. We'll get to the idea of sin stocks in a moment. But just historically, this has been a great stock. The last five years, shares of Altria are basically cut in half. How much of that is due to Juul and How much of that is due to the overall environment when it comes to cigarettes, particularly here in the U.S.? I would say that it's probably as much to Juul as it is anything else, but not so much. I mean, Altria is still a tremendously profitable company. It bears reminding that they also pay a massive dividend. When you

say the stock is cut in half, their dividend now is nearly 8%. Now, I understand that that is right after the stock has dropped 10%, but they've been averaging 6% or 7%. So, it's not been a great investment over the last five years, but I think that has something to do with the timing of when Juul really became a big part of their portfolio and then has disappointed the market since then or shareholders since then. In terms of the company itself, I mean, they make as much money on their cigarette division now as they did 20 years ago, but they don't sell an eighth as many actual cigarettes as they do. So, to the extent that it's the kind of company that you can be comfortable with owning, it

has done nothing but become more profitable over that period of time outside of Juul. How do you think about sin stocks? Which is a phrase that gets kicked around. The older I get, the more I realize that sin stocks are in the eye of the beholder. There are things that people just don't want to own, whether it's tobacco, alcohol, firearms, casinos. When you hear the phrase sin stocks, what comes to mind? Well, I mean, I think that any industry in which there is a general argument that can be made that the overall influence of that industry is malign. I mean, I think that you could look at pornography, you could look at gun makers, you could look at cigarettes, you could look at alcohol. You can get

yourself wrapped around a tree? Like, for example, hotel companies used to make an enormous amount of their profits from pay-per-view, primarily from adult videos, right? Would you then argue that Marriott is a sin stock? I mean, you could easily get wrapped around the tree. I think it's important for people to have a sense of, David Gardner always talks about having your portfolio reflect the world you would like to see, if you don't care that much about whether people smoke or not, whether they exercise the right to smoke or vape or drink, then it's a fine segment for you to be in. And it is and has been the case that a lot of these companies have been tremendously profitable. So, I don't judge people at all for having a framework in which

they say, these are not areas in which I choose to invest. But at the same time, it is legal. I mean, it's absolutely, I mean, maybe Juul will be tomorrow, but everything else that we've talked about is, in fact, legal in the United States. Bill Mann, always great talking to you. Thanks so much for being here. Thanks, Chris. MicroStrategy is an enterprise software platform with a market cap of $2 billion, but there's an important caveat. MicroStrategy also has billions of dollars of Bitcoin on its balance sheet. Ricky Mulvey caught up with Bill Mann to talk about this software-slash-Bitcoin holding company and what a potential margin call might mean for its investors. The conversation

begins with an interview clip from MicroStrategy CEO, Michael Saylor. I'm not terribly concerned with the volatility. I think there'll be accelerations and pullbacks, but the institutions are collaring it on both sides. The capital is not consumer leverage capital, day traders. The capital right now is insurance companies, big public companies. We're coming in to buy it forever. Ask me when I'm going to sell it. Never. I'm not going to sell it ever. Sometimes an investment thesis changes. Some investors may be feeling that way about MicroStrategy, an enterprise software platform that went headfirst into the world of Bitcoin. Joining me now is Bill Mann. Bill, good to see you. Hey, Ricky. How are you doing, pal?

We just played that quote from Michael Saylor. He's the CEO of MicroStrategy. Our CEO, Tom Gardner, interviewed him in March of 2021. We ran that interview on this podcast in March of 2022. Bill, what's your reaction when you hear that quote today? At the time that he made the quote, MicroStrategy had yet to take on a huge amount of debt in order to buy more Bitcoin. They've essentially swapped their cash for Bitcoin. So while he may feel like that he is never going to sell, it may not be up to him. Because if you are leveraging Bitcoin against the price of Bitcoin, the answer then becomes not so much what do you believe you're to do, but what can the people who are lending you that money, what can they compel you to do?

Let's get into financial engineering in a moment. But backing up, first of all, what is MicroStrategy supposed to do? What is the business? They made $500 million in revenues in 2021, which is basically the same that they made in 2011. This company, what they do, their operating business, is not all that important to the valuation of the firm. It is a no-growth, barely profitable software company at its core. But that is a teeny slice wrapped around a massive Bitcoin position. Yeah, the first sentence of Micro Strategy's business overview in its 2021 annual report reads, quote, MicroStrategy pursues two corporate strategies in the business of its operations. One strategy is to acquire and

hold Bitcoin, and the other strategy is to grow our enterprise analytics software business. What is that? End quote. Yeah, what's that signal to investors? The fig leaf is covering the right bits, I guess, is what that says. At least they did put it the right direction, right? And I think what's interesting to me, oh, gosh, getting into regulatory conversations, it's terrible radio, but I'm going here anyway, Ricky. This is an investment company. It's an investing company. And the only reason that it's not being regulated as an investing company, I think, is because Bitcoin has not been declared to be a security by the SEC. This is what I was saying earlier. What happens with MicroStrategies

enterprise analytics business is almost unimportant, except that it is that fig leaf for the private bids. Yeah. You mentioned earlier that it used Bitcoin as collateral to borrow money to buy more Bitcoin. Can you explain a little bit of how that financial engineering happened? Because it seems odd. Well, basically, they've swapped their balance sheet cash into a Bitcoin, into two convertible debt securities that are backed, basically, they used it to buy Bitcoin. So, essentially, and the price of MicroStrategy at this moment on a per share basis is, call it, $171. So, they have two convertibles that they've put in place that can be put to the company by the investors in December of 2023

and February of 2024, which are convertible at $397 a share, which is about more than twice as high, and $1,432 a share. So, they have an incredibly volatile asset, and we've seen what's happened with Bitcoin. It's down about 70% backing these bonds. Essentially, since you've got a conversion component at the end, they may not be able to satisfy the bonds should Bitcoin drop too low in price, which is not something that MicroStrategy itself has that much control of. Is MicroStrategy unique in putting Bitcoin on its balance sheet as a publicly traded company, or are they unique to the degree in which they're doing it? I love that question. They are not unique at all, but most of the other firms are more frank

financial companies. The company formerly known as Square, which is now Block, has plenty of Bitcoin on its balance sheet, both as an asset that it owns and then also as something that it allows its customers to trade in. So, primarily, financial companies will have some. What's unique about MicroStrategy is that it has about $2.5 billion in Bitcoin and an enterprise value of $4.3 billion, which an enterprise value is basically what's the market cap plus the debt. So, about 60% of its total enterprise value is made up of Bitcoin, and its Bitcoin holding is 125% of its market cap. So, it is not a loan, but it is very, very far to the extreme. And it is, as far as I can tell, the only company that's being regulated as an operating company instead

of a financial company that has any level of exposure like this. At this point, would you say it's closer to being similar to like a grayscale holdings kind of Bitcoin-style ETF than a company? I love the way that you're thinking about that. And I would say yes, except that it's not being regulated that way. I'm not a regulatory expert by any stretch of the imagination, but it would not surprise me at all, given the numbers that I've just told you, that the SEC is at least looking at MicroStrategy in terms of, is this a financial company that needs to be beholden to a whole

different set of regulations, a different regulatory regime, or is this still an operating company? Now, they might get the margin call or forced to sell Bitcoin in order to pay back their lenders. What are the implications of this on the folks who own MicroStrategy stock? A margin call sounds really scary. We all know what a margin call is. That means, basically, the assets that you have do not cover the debt that you have. It's really important to note that MicroStrategy is not at great risk of evaporating tomorrow based on a margin call. If Bitcoin drops low enough that these convertible preferred securities

are not covered by their debt in terms of assets, they may have a call, but it's not going to hit MicroStrategy that hard. I don't think MicroStrategy has a risk of going out of business. Now, a margin call, I don't care who you are, it's not good news. It's not good news at all. It is a forced transaction at a time that is probably inopportune for you. So, when I said at the top that Michael Saylor said, we're never going to sell, this is exactly what I was talking about. They may have to. They may have to add additional collateral to sufficiently back these bonds. So, I feel like we're in a little bit of a negative spot right now. It's reality, right?

It is reality. To close out, we have a balance sheet that is, let's say, surprising and maybe a bit of a negative way. Is there a company or a stock that maybe has a balance sheet that surprised you in a positive way right now? There are a bunch. In fact, there are companies that I think that we really ought to be looking at right now as the ones that probably with their great balance sheets might be in the market of buying other companies. Maybe the top of the list is the company formerly known as Facebook. Meta has a huge, huge cash balance. NVIDIA is another with a big cash balance. Adobe Systems is another one with a tremendous amount of cash. And if you are nervous about

the types of companies that you are in now, one of the best ways that you can find a company that has, I guess, what you would call a safety valve is looking for ones that have those types of cash balances. Bill Mann, thank you for your time. Thanks, Ricky. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.

Thank you.