Motley Fool Hidden Gems Investing - Eyes on the Cloud

Episode Date: January 25, 2023

Investors are paying up for stability, as big tech growth slows down. (0:15) Dylan Lewis and Motley Fool Chief Investment Officer Andy Cross discuss: - Microsoft's quarter, and lower growth expectations for its cloud business. - What long-term investors can expect from Microsoft. - The Department of Justice's suit against Alphabet, and a shifting regulatory environment. - Kimberly Clark's "less than stellar" quarter. Plus, (16:25) Motley Fool Canada's Jim Gillies joins Ricky Mulvey to give the bull case for one of the most heavily shorted stocks of 2022. Companies discussed: MSFT, GOOG, GOOGL, TTD, KMB, BIG Host: Dylan Lewis Guests: Andy Cross, Jim Gillies Producer: Ricky Mulvey Engineers: Rick Engdahl, Tim Sparks Learn more about your ad choices. Visit megaphone.fm/adchoices

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Motley Fool Money starts now. Sitting in for Chris Hill, I'm Dylan Lewis, and I'm joined by the Motley Fool's Chief Investment Officer, Andy Cross. Andy, how's it going? Dylan, good to see you on the start of earnings here. I know, it's exciting. We got some new updates on some of the companies we follow. And I think maybe few companies are as heavily followed as Microsoft, one of the first big tech companies to come out with earnings, and kind of one of those companies you own whether or not you know that you own it.

Right, Andy? Yeah, I mean, it's so widely owned, you know, near $2 trillion market cap, and so instrumental into so many parts of the world, and certainly has been a big contributor to the massive growth of the S&P 500 and the NASDAQ 100 over the last decade. Yeah, so a lot of bated breath before they reported earnings yesterday. And I think surface level, when you look at the numbers, things look pretty strong to me. It was a strong quarter on the real growth part of their engines, Dylan, or at least I'll say, maybe not as terrible as people were worried about on the cloud side.

I think that's been the big headline. Really continued weakness on the personal computing side. That's where you're really seeing a lot of the weakness. But the cloud business continued to shape up with a pretty decent quarter. Of course, the guidance was a little bit weak and that's what really pressured, I think, the stock today. The tone of the call, Dylan, was really interesting because I think both Amy Hood, the CFO, and Satya Nadella, the well-respected CEO, they've been talking so much about how much inroads they've been making on the cloud and the productivity business and how well it's been received. But this tone of this call was much more muted. Satya Nadella kicked it off by pretty much saying, just as we saw customers accelerate

their digital spend during the pandemic, we are now seeing them optimize that spend. Optimize, a euphemism there. Also, organizations are exercising caution given the macroeconomic uncertainty, and the ABhood went in to further echo that throughout the call. So, if you look at the revenues, we're up about 2%. Earnings per share, we're down a little bit, both kind of like within the matching the expectations game. The productivity and the processing business or the processes business was up 7% at $17 billion. The intelligent cloud was up 18%. And the personal computing, as I mentioned, was the real weak spot, down 19%. Both of those are not on constant currency. The strong dollar continues to have an impact.

The guidance, though, Dylan, was what I think really people were focused on, and that's on cloud side of the business and the expectations that the Azure business, their cloud business that has become such a dominant player in the cloud, I think now the second largest player, that grew 38% on a constant currency basis, but they are expecting that to fall by four to five percentage points over the next quarter and drop down probably closer to the 30% growth level. So, so much of the focus for Microsoft has been on that cloud growth, that weakness has really kind of gotten investors, I think, a little spooked on what it means not just for Microsoft, but also the wider tech and mega tech space.

Yeah, on Microsoft earnings, we're also seeing maybe a little pessimism when it comes to shares of companies like Amazon and Alphabet as well, just Microsoft being a little bit of a bellwether for cloud trends. When you're thinking about those businesses, these segments have really bolstered the financials and helped them offset some flagging segments in other parts of their business. How concerned are you with what we're seeing in the cloud? At a certain point, big things do have to slow down in their growth rate. We're still talking about 30% growth. Is this something that people should be worried about? Obviously, Microsoft is such a large company and it takes so huge investments

to move the needle or trying to push through this Activision Blizzard acquisition sometime this year. The regulatory bodies are still fighting that, so the concerns that that won't go through. They have the other businesses outside of the cloud business tied to their Office 365, the LinkedIn business, the gaming business, the personal computing business, Windows, all those businesses that Microsoft has been known for so long, and have contributed to the long-term growth story. But the intelligent cloud, the cloud business has become their largest business now, and especially as they are making the big push into AI, artificial intelligence, and the investments they've been making into OpenAI, and they talked about that recently.

They've now made three investments into the OpenAI business and the platform, or that entity, I should say. You want to see continued robust growth there because it does drive high-margin uses and engagement. As they think about the ecosystem to Microsoft, such an important part to their business is cloud. You want to see continued growth there. Of course, as you mentioned, not all things can grow to the sky. The Microsoft story, as I see, and I still like the stock for long-term investors, you have a little bit of a dividend yield. stock is probably a little bit on the higher price side. You're paying 25X this year's earnings. They have a fiscal year that ends in June, so this year's earnings. There's healthy growth baked

into that looking out a year or two. They have to deliver on that growth in an environment that is starting to see a little bit of a slowdown or more of a macro slowdown as we're seeing, not just for Microsoft, but for some other companies. I think investors have to own Microsoft, they still think about this as a long-term investment. This is not a business that's going to double in a couple of years, but for high single-digit gains for patient investors over the next three to five years, I think Microsoft can probably deliver that, depending on what macro environment we run into over the next 12 months. We'll get a little bit more of an update on the cloud and what that market looks like when we see results from Alphabet

and from Amazon. Speaking of Alphabet, we have some non-earnings news to hit. Yesterday, the U.S. Department of Justice filed an antitrust suit against the tech giant targeting the company's digital advertising products. Andy, I want to emphasize there, digital advertising products. This is not the first time DOJ has been reaching out to Alphabet in the last couple of years, and this is separate from some of the search concerns that they've had in the past. Oh, my gosh, yeah. The stock's down a few percentage points all with this news. I think the DOJ, Department of Justice coming out and really attacking the underpinnings to Google's technology, especially with their acquisition that they made years ago with DoubleClick for about $3 billion and how they package together.

By the way, approved by regulators, and now some blustering conversation about splitting that apart and really saying that they have been anti-competitive. Their prowess in that technology, in the ad market, in the ad exchange part of the Google world, which is the guts of really their ad business, the practices they have undertaken have been anti-competitive. They're exploring that and investigating that. That's just on that ad part, like you mentioned, separate from the search one. Of course, Alphabet and Google came out and completely denied it. They said it reminds them and is akin to the lawsuit or the investigation that the Attorney General in Texas kicked off in 2020, I think it was. This will go on for many, many years and discussions.

It's always been a risk factor with owning Alphabet and Google, and I do, and I continue to like the investment. I continue to think that it could be a buy-in weakness and can be a buy-in weakness. This is a serious allegation and investigation that they are going to have to defend. There are eight states that have joined this suit and there'll probably be others that hop on. Whether they have acted inappropriately and illegally and been anti-competitive in a very competitive market, the ad space is very competitive and there's a lot of players involved there, but how they have performed, we still don't know the exact details and the Department of Justice and their investigation is using some of the internal documents from

Google and some of the emails and some language that I still think needs to be better defined and understood. But big tech regulation has been a focus of both this administration and the prior administration. This is an extension of that outreach to try to bring investigations and suits against big tech companies, if not forcing them to change practices or at the extreme, perhaps split off businesses and break them up. But we'll have to see how this all plays out. We are in the very, very early innings of just this investigation. As you mentioned, there are some others going against Google. Yeah. If you're looking for a parallel on timeline there. I believe the search investigation and antitrust suit was filed in 2020 and is

going to trial later this year. This is the ultimate, you got to watch it play out kind of thing. Andy, you mentioned that they acquired DoubleClick, and this is really the digital tool that all of the web publishers are using to sell ads on their website back in 2008 for $3 billion. To some extent, I look at this as a consequence of having something that was wildly successful, and maybe a little bit of the regulatory environment changing, where the last 20 years of tech and maybe the next 10 years of tech look a little bit different in terms of how regulators approach big tech acquisitions? That's probably right, Dylan. Google, in so many ways, or at least in some ways,

really created this market and has been instrumental. I like the Trade Desk, and I'm a fan of Jeff Green. Jeff Green had an ad exchange business. I think he ended up selling it to Microsoft. Microsoft, obviously, is a large player now in the ad market. Amazon's come out of nowhere to basically take 10%, 11%, 12% of the market of digital advertising space. It's the mechanism in which Google has packaged together their DoubleClick technology with all the various parts to ad bidding and the kind of bidding that Google likes to do that is different than maybe some competitors want to try to do and Google fighting that off. There's a lot of details to the mechanisms of how consumers see ads when they load up

a webpage in the free internet or in some of the walled gardens, like YouTube, for example, and see the mechanism for ad clients to bid on that. So, a lot of details to go through this, but you're absolutely right. When they made this acquisition, they were a far smaller company, it was not as proven. Obviously, ad tech is still working through its growth spurt a little bit, you know, just become as dominant in such an important part of the market as it is today. And the regulatory environment is shifting, and the way that it seems that regulators and Congress is talking about big tech and mega tech, you know, it starts to remind you

a little bit more of the way they were talking about Microsoft in the late 90s. Before we wrap up today's show, there is news outside the world of big tech, I swear. We also saw earnings from Kimberly-Clark, perhaps most relevant to people who own the stock. Andy, the company announced its Like Clockwork update to its dividend program this year. Yeah, they raised it a little bit. Kimberly-Clark's been raising their dividend for, gosh, I don't know, 50 years or so. It's just one of those stalwart, every year, sorry, just continues to pay that dividend now yields more than 3%, which in this market isn't what it used to be. Dylan, as you and I were talking about before we got on the air, when your bank

accounts or many online savings accounts yield close to 4% now. However, they have raised that dividend. It wasn't a very stellar quarter, they reported. What was interesting is they continued to see pricing prowess, but the volume drop and the guidance for the rest of the year was a little bit disappointing. I think that put some pressure on the stock. I mean, you have Kimberly-Clark as a consumer staple, like many other consumer staples, have seen their stock prices bid up now where they are selling at 23, 22, 25 times earnings for a consumer staple company that really grows less than GDP levels, pays a little dividend, uses a lot of leverage to continue to get some growth and makes acquisitions. So, that's kind of a little bit of an expensive

proposition to pay for a business that isn't going to grow a whole lot, even for a consistent dividend payer. And I'll say my final comment, while they did raise that dividend, I think about 2% this quarter, Dylan, I think historically they've been more between like 4% and 5%. And And the ratio of profits to what they pay that dividend out, called the payout ratio, that continues to creep up higher and higher. And I think investors want to see that a little bit lower because that gives confidence they can raise the dividend over time. So again, Kimberly-Clark, I think the business has been around since the 1870s in some shape

or form. And we all need Kleenex. And if you have kids, you need diapers and those kinds of things and a consumer staple. But, you know, at this level, investors are definitely paying up for some expectations of some kind of stable, single-digit kind of growth in the stock and in returns. And if the market and the economy is souring, that could prove a little bit tough to meet those expectations. Earlier, we talked about Microsoft as a bellwether for tech.

Is there anything you see in the report from Kimberly-Clark that you think people should be paying attention to just in the consumer packaged goods space or in retail? Well, I think the pressure on growth on the volume side from a consumer growth perspective, I think we saw hints of this going into 2023, which is some of the slowdown on the retail side. I think the consumer is going to continue to be much more specific and particular about how they're spending their money, even on things like consumer staples and consumer goods that require with lots of different options out there and ways to spend that. So, that balance for companies, the balance between volumes and pricing, and what that

will look like going forward in an environment that maybe, you know, we don't have as much inflation over the next, say, you know, year or two, at least compared to what we had last year, I think that's safe to say, whether it's going to be, you know, 3%, 2%, 5%, it'll be lower than what it was last year, and how companies manage the balance between pricing and volumes, and what that means to the scale when it comes to profits for the organizations and for investors who are looking for some kind of profit growth over the next year or two. So, Kimberly-Clark, I think what we saw is that they are seeing pressure on the volumes and maybe some questions on what that means for pricing going forward to be able to continue

to drive profits. That's a little bit of a takeaway, and I think we'll hear more and more of that balance from consumer goods companies going forward this year. Andy Cross, excellent, as always. Thank you so much for joining me. Thanks, Dylan. We've got the bull case for one of the most heavily shorted stocks of 2022. Jim Gillies joins Ricky Mulvey to discuss a discount retailer with very low expectations. If investing is about expectations, then the bar is awfully low for Big Lots, discount retailer with 1,400 locations across the United States, type of store that has some

essentials, a little bit of a treasure hunt. You can get a couch and a six-foot-tall nutcracker statue. Joining us now to talk about this retailer is Motley Fool Canada's Jim Gillies. This is a weird company, Jim. It is. As I think we're going to talk, I think we're going to unfold that we're not sure how it's going to unfold, but it could be fun. people want answers. The thing that's odd about this company is it was on the list of the most heavily shorted stocks of 2022. That includes Carvana, Bed Bath & Beyond, Silvergate Capital, which is an alleged bank that does cryptocurrency lending, and Big Lots. It's had inventory issues. It's had management missteps. But does Big Lots deserve to be in that club?

I'm going to say unequivocally, no. Carvana and Bed Bath & Beyond, well, I call Bed Bath & Beyond, I call them either alternatively Bloodbath and Beyond or Bed Bath and Beyond Hope, to your choice. You've got at least two of the three companies you mentioned, at least two of those are bankruptcies waiting to happen. That would be Bed Bath and Beyond Hope and Carvana. Silvergate Capital, we'll see. So, no, I mean, Big Lots, it's not going bankrupt anytime soon, probably no time soon or even further out. So, I'm not sure why it's as heavily shorted as it I don't tend to spend a lot of time worrying about what the shorts are doing. I'm a fan of certain short sellers who do a lot of very good work, but I've not seen one of the names that I

would consider a short seller would make me sit up and take notice. I've not seen anything from any of that group talking about big lots. So no, it's fine. Management has made a few missteps. The one that I have questioned with this company is it is complaining about inventory challenges. And this is a company that is trying to essentially, it's in the name that it's supposed to take advantage of inventory challenges of other companies. So, I mean, why is Big Lots struggling with inventory when that's kind of the promise of the store? It is. Can I maybe take a bit of a disagreement with both you and with management? Is that copacetic and cool? We'll see. No, of course.

Okay. You know, so they are like a retailer. Retailers tend to have end of January fiscal year. So we are still in the middle of their Q4, even though it's fiscal 22, it ends at the end of January 2023. Year to date, their cash use due to inventory is only, I say only, $107.5 million. The reason I say only is because fiscal 21, so the year that ended with the 12 months ending in January of 2022, a year ago, they blew $337 million on inventory. I would suggest that the year where inventory caused problems or created the problems, I suppose, is actually last year and they're digging it out right now. This is a year-to-date number. The big swing in cash, they were free cash flow generative last year in spite of their inventory issues,

actually made about $80 million, I think, in free cash flow for the year. The thing that has crushed them is that they kind of didn't pay their bills, they took on inventory, but they just racked up their payables last year. This year, they've had to fight that, they've had to pay it back down. So, I think the cash flow from what I'm going to call working capital, the cash outflow from working capital is, I think it's a hangover from last year. So, when management starts blaming inventory, I kind of say you're distracting us from maybe a little bit of your management sins, perhaps, which, of course, overbuying inventory is one of them. But it could also include buying back stock at $54 a share, which is not so great when

you're trading at about $17 a share now, and also growing its long-term debt load from $40 million in 2021 to $460 million today. Yeah. Yeah. The last year they basically put the last year or at least year to date on the company credit card. But and that sounds bad and it should sound bad. You know, don't don't put your life on your company or on your credit card, put your life, you know, cash flow your life from your salary or whatever. If you're putting all your bills on a company credit card, eventually that comes due and is generally fairly painful. But I think there's a reason to think that Q4 is quite possibly going to be a cash flow positive quarter, No. 1. When that happens,

they should be taking down. It's about just under $400 million in net debt, because they do have about $60 plus million in cash. Net debt is about $400 million, $398. They halted their buybacks after Q1 of this fiscal year. Smart, they should, they're burning capital other places. But this is a company that has long-term really been actually fairly good with the buybacks. They've meaningfully reduced their shares outstanding from over $60 million about a decade ago to, I think, about $28 million, $29 million today. So, would you like it back at the price they were bought? Yeah, I'd like those back. But that's Monday morning quarterbacking too. What I am looking at is one of the things as well that's not really talked about or not

really understood is they did a big sale and lease back transaction two years ago, I think, two and a half years ago, where they sold some distribution centers and then leased them back. And that freed up a lot of cash. And that's where most of the cash that funded the buybacks, that's where most of that cash came from. They do have a history of being profitable on a gap basis. They do have a history of being cash flow positive. Do we like what's happening now? No, we don't, and you shouldn't. But I think you can push through and say, okay, long-term, This has always been kind of a company that kind of people, like, you know, look at and go, like, what am I supposed to do? It's kind of a Dollarama or a dollar store or whatever your dollar store chain nearby of you is.

Kind of a Dollarama, it's kind of a weird kind of mirror universe. Costco, it's a treasure hunt kind of store. And so, you kind of go, well, what is this supposed to be? And I think you have to look long-term, because if you do look quarter to quarter, yeah, fiscal 22 has been a tire fire, frankly. But I think that if they, A, can turn free cash flow positive, and they sounded confident in the most recent conference call, that confidence in two bucks will buy you coffee down the street, but they at least sounded confident. The second thing is, they've talked about, and there was an activist investor here, and full disclosure,

I own a little bit of Big Lots myself. I've taken a small bet to see what happens. And I've Recommended it in the service I run, Hidden Gems Canada. Recommended it last April 1st. It's down about 50% dividend adjusted since I recommended it. So, I guess recommending on April Fool's Day, I guess, is timely. But I don't abandon stocks nine months in. I generally like to do two plus years and then check in on the thesis. But there was an activist who was there. Now, the activist is out because the activist kind of hedged themselves out of this one. but the activist was calling Mill Capital, I believe their name was. They were calling for another sale and leaseback of some fully owned assets. And management on the most recent conference

call did indicate they were considering that. So, my point in all of this long-windedly is that that debt load could be basically gone with a well-timed sale leaseback transaction. The other thing is, too, is they, in the most recently completed quarter, they refinanced their credit line. And that credit line was a $600 million credit line, I believe, beforehand. I believe it was due to mature in 2026. And they refinanced it with a $900 million credit line that is good through, I believe, 2027 or 2028. So, to go back to your original question about, you know, as a bankruptcy candidate, you know what, when your lenders are A, willing to refinance and B, give you more money, I think that, you know, there's a lot of people around this taking a

longer-term perspective that the market is currently not taking. And certainly, the debt provider is taking that longer-term perspective and willing to give you more money. That should speak well of long-term opportunity here, in my opinion. It's currently, I would say, priced for death at a 0.1 price-to-sales ratio. Big Lots is also paying a pretty heavy dividend based on the stock price, 7% dividend. You're also hearing the CFO in conference calls explain that they're going to cut cash flow by lowering payroll. And I don't know about you, but when I walk in a discount retailer, I don't often think, boy, does this place look overstaffed. I guess the question here is,

is this a case where you'd actually like to see management cut a little bit of the dividend to stay afloat? I wouldn't shock me if they cut it. But again, perhaps you can accuse me of Pollyanna-ishness and rose-colored glasses and all this. The dividend is only about $8.5-9 million a quarter. So, you need to be basically, free cash flow, you need about $36 million annually just to cover that dividend. And like I said, last year, the last fiscal year, where they really heavily spent on inventory, and now I kind of view this year as the year which the inventory gets worked through and you have some issues, but last year they finished year with, like, $80 million in free cash flow, which, of course, fully finances their dividend.

If they do a similar behavior in the almost-completed, but, of course, not yet reported holiday quarter, you know, I'm not sure there's going to be necessity to shut down the dividend. And again, with the refinancing, I would prefer that all cash at this point coming in that's not earmarked for the dividend, which again, $8.5 million, $9 million a quarter, the rest of it just goes to pay down the credit line, which is where they were four quarters ago. So, again, it could hold off on the buybacks, take down the credit line, keep the dividend going, do that sale and leaseback transaction, that's probably not a bad idea at this point, which again, was the activist Mill Road Capital, what was the main thrust of their thing.

And it's funny, you end up with a potential, you know, so, yeah, so, about $16.50 today, I think, gives them an enterprise value just over $880 million. If you look out a couple of years, and I'm looking, like, on a trailing basis, they're about $5.6 billion in sales. Looking out a few years, $5.7 billion, $5.8 billion, if they return to, kind of, a more normalized normalized. They're always trading at a low price-to-sales ratio or low price-to-valuation or valuation ratios. If they take down their debt by about half over the next couple of years, they return to cash generation, maintain the dividend, and if they only get a 0.25 times price-to-sales multiple, which again, most of the time you'd hear that level and you'd go,

well, no, that's ridiculous. But maintaining those 4% or 5% pre-cash flow level, you're talking about an enterprise that will probably have about a $1.4 billion total value. If you're down to $200 million in debt at that point, you're looking at about a $45 stock price, $42, $45 stock price, if you run the math. It's not a straight line, it's not a simple bet. There's real problems here and there's real possibilities that things get darker before the dawn. But here's a rough triple in three years, two-and-a-half years. It's not a bad, in my view, not a bad weighted bet. I don't mean go out and put 10% of your net worth on this thing, because there is substantial downside risk here that isn't present with the TJ Maxx or with the Costco or the Walmart or even

in all these bargain outlets or any dollar store of your choice. But there is, if you put in half a percent, I think my position is less than half a percent. Like I said, I took a small position. It's not a bad risk-reward divergence in my opinion. The hurdle is low. We'll see if this company is a wet cigar butt or if there's a little bit of spark left in it. Big shout-out to David Katanarik. He had a good sub-stack right up on Big Lots as well. Jim Gillies, Always good chatting with you. I always appreciate talking about weird little companies with you. That's my stock and trade, man. 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. Until next time, Fool on! Thank you.