Motley Fool Hidden Gems Investing - Nasdaq Pain Continues

Episode Date: May 5, 2022

The Nasdaq fell 5%, continuing a rough year for investors. (0:20) Andy Cross discusses: - The short-term pain being felt by all investors, including us - Shopify's 1st-quarter results looking similar to Amazon's - Deliverr, the logistics company Shopify just bought for $2.1 billion - EPAM Systems, the IT services provider that surprised investors with a strong 1st quarter (17:00) Jim Gillies talks with Ricky Mulvey about MTY Food Group, a Canadian food franchisor small cap with potential. Stocks discussed: SHOP, AMZN, EPAM, MTY, MTYFF, WEN Host: Chris Hill Guests: Andy Cross, Jim Gillies Producer: Ricky Mulvey Engineers: Dan Boyd, Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

Don't you wish you could just hit skip on the worst parts of your life? You know, the same way you can skip an ad? I get it. I'm Siaya and I live in Ice Cove. I've made some questionable decisions that didn't end up the way I planned. And today I'm still figuring it out. Somehow things usually get worse before they get better. Apparently, that's how I roll.

So bundle up and come along for the bumpy ride. Stream a new episode of North of North Tuesdays on CBC Gem. Chris Hill, joining me today, the Chief Investment Officer, Andy Cross. Thanks for being here. Andy Cross. Hey, Chris. We're going to get to Shopify, we're going to get to ePAM systems, but can we just start with the pain, just for a second? It's a little after 12 noon on the East Coast. The NASDAQ is down basically 5% in less than three hours, and maybe that bounces back some before the end of the day. But for anyone out there feeling the pain, a couple of things. We're feeling

it too. We're feeling this pain, I'm feeling this pain, and this is the cost of doing business. Yeah. With investing, as we've been experiencing really for much of the year and much of this calendar year, but really for the past year or so of foolish investing is the markets sometimes can be unforgiving. In periods like this, when we're going through this reset, We had two years of a COVID period that was unlike any we ever saw before, Chris. And now we're kind of going through two years of this again. And we're going to have to come out of this. And we see the Fed acting in ways they've never acted before.

We see just some of the data that came out today on the economic side with efficiency and productivity way down, unit labor costs way up. I mean, numbers we haven't seen in decades. trades. We're starting to see the impacts of inflation and just the economic consideration that's having an impact on valuations as interest rates are moving into a much more normalized environment and probably higher than many of us have seen in a long time. The markets are digesting this information and we do go through these periods of cycles and this one's very acute. Bill Gurley was saying the other day, I heard him say, it's very much like a saw. You don't experience it. You think markets maybe go more in waves. When they

go down, they go down in saws, like a saw blade. It drops. We're going through that right now. It can be very painful. We're empathetic to that, to listeners and to our members. The only reason we keep going is because we know the longer you're in the market, the more it's going to pay off. 100%. Yeah. There are down periods the markets, certainly, and bear markets tend to last much shorter than bull markets. There aren't many down when you stretch out over any period, Chris, of going back decades and decades of five to 10-year periods of investing. If you're holding businesses, just in the wide case of the U.S. market, most of the times, almost 90% of the times, the stock prices,

is they generate some return if you add in dividends there. Now, there's a lot of churn inside the index, as we're feeling right now, very acutely. When you have so many stocks, the average stock down so much more than the index right now. We're feeling this very acutely. But over time, they do march higher, but they do go through this. The pain of paying for those returns, those 10% annualized returns in the S&P 500, Chris, that goes back 100 years that we've talked about and point to, and the fantastic returns we've had over the last decade, which we probably won't have over the next coming decade, but we should see some kind of return. But in between, you do see these periods of drawdowns, and to get those kinds of returns,

you do have to weather these storms. And for new investors, that's certainly painful, but even for experienced investors, it's like you and I and others, it's even hard for us to go through. You just have to continue to maintain that focus on the long-term and owning the businesses that you want to own for the next five, 10 years. The unforgiving environment that we are in leads us to Shopify, because Shopify's first quarter profits and revenue came in lower than expected. They said that revenue growth in the near-term is going to be lower. They also spent $2 billion on a logistics company called Deliver. The market's not going to forgive that combination of events and shares of Shopify down about 15%. Where do

you want to start? Because whether we start there or somewhere else, I do want to get your thoughts on this acquisition. Well, we definitely want to talk about the Deliver, a little bit more than $2 billion acquisition that really pushes them further further into the logistics network. This has been rumored for a little bit, Chris, so this is not a huge surprise. There was a news report out that they might make this acquisition, and now it's come true. But before we jump into that, we'll just start about the quarter. Like you said, it was coming off the Amazon quarter. There's a lot of similarities when you look at some of the e-commerce business, some of the threads that were coming out of the Amazon,

you start to see with Shopify, their gross merchandise volume, so all the value of products going across their platform was $43.2 billion. That was up only 16% year-over-year. Now, Tobii was very quickly at a point, they got on a compounded annual basis over two years, that's up 57%. I don't think they made many comments like that in the past. It's a little bit of a, don't look at it as just the past quarter, look at it as over the past year. Last year was was the last quarter, the 2021 quarter, first quarter was pretty exceptional, but still up only 16%. That's a number we haven't seen from Shopify in a while. Gross payment volume of $22 billion, which represented more than half of the gross merchandise volume. That's

an all-time record. That was up from 46% in the first quarter of 2021. What that means is more people are using the Shopify payment network that are also using the Shopify platform overall. Merchant solution revenue, Chris, was up 29%. That's Shopify payments, capital, Shopify markets. But the subscription solutions was up only 8% on the revenue side. You start to see the dynamics, and that's a big part of Shopify's business, the subscription part of their business. Monthly recurring revenue up 17%. These are numbers from Shopify that were not used seen. What they talked about is just this environment, Chris, you pointed at the start that we're seeing as companies are normalizing, trying to figure out what

their online-offline commerce looks like. There was some commentary from some of the analysts that the point of sales was pretty good growth from Shopify. The social was pretty good spend on social, but when you start to bake it all out, the general e-commerce business for Shopify was in the single digits. That's like what the numbers like Amazon was talking about too. You see these threads showing up, Chris, for these big platform companies. It's starting to show and what it means for the revenue growth. Then that impacts the profit picture too. The profits were much lower than analysts were expecting on the earnings side and the operating profit side because the merchant solution business is not as profitable

as the subscription business. You add up that environment, Chris, and that's why you're seeing a stock that just is reacting pretty severely in the markets today. We're seeing this across e-commerce today. You look at what's happening with eBay, Etsy, Wayfair. Part of this for all of these businesses is inflation. Because if you look at the volume of spending that's happening, people are still spending money, but things are more expensive. It's not like people are buying a lot more in terms of volume, they just happen to be paying more because of inflation. Companies that have the ability to increase prices are doing that. In terms of the acquisition of Deliver, again, logistics company based in Denver,

$2.1 billion. It sounds like you think, okay, yes, this is happening on a day when all this other news comes out about Shopify, maybe that's by design, because it seems like it fits with the direction of where Shopify wants to go. Well, it's where it has to go, Chris. Certainly, we're seeing, obviously, Amazon and the logistics network, they have built out this competition there. They are focusing and they've been talking about building out all the logistics. They talked about it on the call, again, how they continue to invest. By the way, the cost structure going forward is going to continue to be high as they make these investments into their business, in people, marketing, certainly, and also logistics,

including the Deliver acquisition. Deliver is going to add a few points to the sales line. Obviously, the costs, they're going to bring 400 people into the Shopify family, so there's going to be costs there. All the costs are almost all people. But it's a technology. Toby was talking about, Toby Lukey, the founder and CEO of Shopify, talking about how it's a technology-first logistics company. And it helps match up the various warehousing and the operations and logistics for various warehousing. So it kind of sits right with Shopify's key warehouse management system and pairs together. And so from that perspective, it seems like it would be a very good fit. The question is,

Do they have to make that as an acquisition? Can they do a partnership? So, there's lots of questions of what is the return on that massive investment? It's the biggest they've ever made. They're clearly excited about it because of what Amazon is doing and has been building out. But Deliver focuses on really getting products into consumers' hands within two days. That's their bread and butter, and they do it from a software logistics side. but it's an expensive acquisition for a company that right now is struggling to really grow in the way that we've been used to Shopify. Now, it has been. I will say, Chris, one of the bright spots is Shopify Plus, the solution that serves larger clients, big Fortune 500 clients. That is

part of the business that continues to do well. It's just more of the mom-and-pops they've attracted over the last couple of years, that part of the business is struggling a little bit. It's certainly a more number of clients, but the Shopify Plus, there's that flywheel effect because they can spend so much more into the merchant solutions part of the business as they as they grow. Some bright spots are Shopify Plus, and I think the Deliver acquisition is something they've had to do to be competitive, but the jury is still out on those investments. Let's move on to EPAM Systems. Not a household name, although maybe it should be. It's an IT services provider. First quarter profits were higher than expected on a day when there is

so much red out there in the market. Shares of EPAM systems are up about 7% when we started recording. This is one you own. What did you make of the business and what did you make of the quarter and what do you like about this business? Chris, between Shopify and EPAM this morning, I was not expecting the green from EPAM and this kind of red from Shopify. Quick refresher, E-PAM is an IT consultant business with most of their employee base based in Ukraine and Belarus with some in Russia. They are very focused from a people perspective in Ukraine and Belarus. Their founder is Belarusian, Arkady Dopkin, founded the business in 1993. I've followed him for many, many years. They're based in my home state of Pennsylvania. He's

been very successful in delivering tech solutions and growing the E-PAM business. The stock went from, gosh, 600 down to a low of 200 right during the period of the Russian invasion of Ukraine because they didn't literally know what their people could do, could they get services. They came out, they pulled guidance. There was a lot of just safety for their employee base in Ukraine. There's a lot of uncertainty about what they would be reporting from an earnings perspective and just how their business would evolve, let alone the safety of their employee base,

which this company has been very successful over the years, serving very large clients, providing lots of different consulting services across travel, leisure, consumer, tech, healthcare, retail, lots of different spaces they help out. I was very eager. The stock has rebounded a little bit, not just today, because they came out maybe a couple of months ago and said, listen, we've been able to take care of our people, move them, redistribute them. We're donating to Ukraine, continuing to support Ukraine. They've been as open as they could be, but it was very interesting about what they would report this quarter. I've got to say, Chris, this quarter was actually pretty impressive. When you think about year-over-year revenue growth of

almost 50%, if you adjust for some of the strong dollar, it was more than 50%. Earnings per share on an adjusted basis up almost 38%. Both of those numbers beat estimates guidance. Their cost structures are increasing, of course, because they have to hire people. They grew their staff. They still grew their staff during the quarter, Chris, their technology delivery staff, by more than 41%. Even with all that's going on for this business, they made it able to find people, allocate people, make the people still productive and still be able to serve clients, and importantly, by the way, all of their divisions basically grew. Traveling consumer was up 91% as more travel companies look for tech solutions to be able to serve their population,

but they really saw growth across all of the areas. Financial services was the next biggest growth. Impressively, they saw growth in Europe and Middle East too, Chris. It was their first best performing market and their second largest market. But their guidance for the quarter, Chris, was really attractive with growth up about 29%, a little drop in earnings as to be expected, But that number was about what analysts were expecting. Overall, this company, considering what they've had to go through over the past few months, has performed really admirably. It's very respectful. Real quick, before I let you go, who does E-PAM compete with?

Yeah, lots of different consulting companies. They compete with all the Cognizant Technologies and Accenture and different providers like that. What E-PAM has done very well. They've outsourced their technology services to programmers who are based in Eastern Europe behind the Soviet bloc because Arkady created the company when he came to the United States and he was looking for programming help. In the Eastern European countries behind the Soviet bloc, when you were a developing programmer, you basically were on the clock. You had to develop under time because you had to pay based by the hour of time that you were on the computer.

So they became very, very efficient programmers. So he started tapping into his old network and realized, well, they could be working overnight, different hours, and I could be working with them to develop those skills. So he just carried that into growing E-PAM from 1993. They went public, I think, in 2012. So he's been at this for a very, very long time. And what they've been able to do is serve their customers in a very technology-first way, in a customer service way, by embedding with their teams and providing technology services at a far lower cost than having to hire full-time tech employees. But the risk you get with that is you have a large workforce that's based in parts of the world that sometimes are unstable, certainly like we've seen over the last few months.

Andy Cross, thanks so much for being here. Thanks, Chris. To ease the pain the NASDAQ is causing, can I interest you in a little pizza and ice cream? Our man Jim Gillies is taking a closer look at MTY Food Group, a Canadian food franchisor with brands like Cold Stone Creamery, Papa Murphy's Pizza, and Blimpy Submarines. And if those franchises don't exactly excite your taste buds. Jim talks with Ricky Mulvey about why they should as an investor. Jim, before we started recording, you said this is the great unknown Canadian success story. What leads you to that conclusion? Well, Rick, they own about 80, just over 80 different banners across Canada and increasingly across North America and even internationally.

And they've done that by a combination of starting a lot of their own concepts early on, which tended to be, you know, here, different ethnic cuisine. So, here's your Chinese offering, here's your Indian offering, here's your Japanese offering. And they would quite often, you'd go to a food court in a mall, and you wouldn't realize that half the concepts in the mall were all owned by the same company. Okay? So, they kind of started out with these different concepts. And once they started getting some success with those, they started buying additional concepts. So, they bought banners like Cultures and CountryStyle, kind of tired third- and fourth-tier brands, to

be honest, in Canada. But the important thing was, the management here, very savvy, and we'll get to them in a bit, the management here always paid very cheaply. So, one of concepts that they own is called Baja Fresh. Baja Fresh used to be owned by Wendy's, which you may have heard of. Back when Wendy's owned Tim Hortons, they had that third brand, Baja Fresh, and they paid about $300 million for it. It wasn't as successful as Wendy's, wasn't as successful as Tim Hortons. They ultimately threw it over the side at some point, and MTY picked it up a few years later for $30 million, like a 10th of what Wendy's had paid. And what they've done is, they've progressively added concepts, added, like I said, third

and fourth-tier brands. And then, as they got larger, they started adding first- and second-tier brands. You mentioned that they have 80 different banners under MTY. That might sound good on the surface, but is it possible to have too much diversification and essentially too many brands going at once? I don't think so, because essentially, you're dealing with individual customers. And so, Ricky, you might want a Cold Song Creamery, okay? But our man behind the glass, Rick Engdahl, he might be really a believer in Papa Murphy's, the take-and-bake pizza concept.

So, you know, it's the same business. It's the same business. I'm selling you a franchise. I'm selling you a concept. They are franchise ores. They are not running. So, they have these concepts, and they have staff dealing with each concept at MTY headquarters in Quebec. But they are not spread thinly, because an individual client might only want

one or two brands, might want only one or two banners. So, they've gone from these concepts, they've now gone into, they made an acquisition called Invescor in 2017, I believe, which is a lot of sit-down table dining. They bought a concept called Turtle Jacks, which there is one here in town, which are sit-down. They've moved up from food court to third- and fourth-tier non-food court brands to brands that are first- and second-tier to table dining. Now, they're across the restaurant spectrum. Out of the 6,700 stores they have, or roughly 6,700 stores, Less than 100 are company-operated. Everything else is franchised. And franchising is a fantastic business model in the restaurant space.

Let's talk about that franchise model. You've described MTY as a check-cashing machine. What brought you to that? And then also, what's MTY's relationship with franchisees look like? How do they make money from franchisees? Sure. So, a franchising business is, I have a system. with, I have a menu, I have ingredient lists, I have products you buy, I've got everything branded, yada, yada. And I sell you the system. You want to open up down the street, you're opening

your very first Cold Stone Creamery. So, I give you an entire restaurant system, restaurant concept, and you pay me a franchising fee up front, let's say 50 grand or whatever. But you also pledge as part of being in my system, and we start you out for, say, a 10-year deal. you are sending me 6% of your sales off the top. Off the top, I'm getting 6% of your sales as a royalty. So you are responsible for the operating of the business. You are responsible for paying the rent. You are responsible for buying the food. And by the way, I'm going to specify what food, what ingredients you buy. You are responsible for buying your apartments, your cups, your napkins, yours, etc. Then you're also going to pay me for your advertising. You're going to give me between,

typically, 1.5% to 3%, depending on the concept. You're going to give me X dollars, X% of your sales that I'm going to be using for my pooled advertising. I'm getting 6% of your sales every month, you got to write me a check, regardless of how well you manage your business. Plus, you're also paying your own advertising through me. Many of MTY's restaurants were beaten up by the pandemic a little bit in the 2021 annual filing. MTY said it had about $834 million in total debt, $300 million in net debt. You said previously that you can expect that the company is going to continue to throw cash into acquisitions. The question, are you happy with how the company is handling

capital allocation right now? 100%. I'm going to challenge you on the number of debt. We use Capital IQ, which makes what I consider to be the cardinal financial mistake of equating operating leases with debt. That's one of my particular bugaboos. I understand the finance prof argument for why you should consider it, but I do not consider operating lease payments to be debt equivalent. The actual debt they have outstanding is just over $360 million in the most recent quarter against just over $52 million in cash. They have actually taken down their debt by a couple of hundred million during the pandemic because they haven't been able to buy anyone. They've only recently completed an acquisition of a company,

I'm going to mangle the name, called Coteau Comptoir à Tartare. It's a chain of Tartare restaurants, which next time in Quebec, I'm going there on day one because I love Tartare. But their debt is fine, their debt is low-cost, this company makes a tremendous amount of cash flow. So, for their lenders, their lenders have no concerns about getting repaid here. And what this does is, it gives them significant dry powder for making acquisitions. And so, one of the things that MTY does is, they can borrow or they can sign a lease with an implicit interest rate lower than you or I can as individuals. So, what MTY does a lot of is, once I sell you a franchise and I set you up, we're going

to locate it here, they take the lease, they turn around and basically do a pass-through and lease to their franchisee. And so, that's a win-win, it lowers the borrowing cost, it lowers the residency cost for the franchisee. And for the franchisor, being MTY, it helps set them up to be more successful. And so, that ends up, you know, as I said, it's a win-win. So, I'm not worried about the debt at all here, to be honest with you. They could repay it quite easily. They got through the worst of the pandemic where a lot of their stores, they got a lot of restaurants in Ontario and Quebec, and those were closed for a significant amount of time.

They navigated through that quite nicely. I don't think the stock, now that most of those stores are pretty much open for full business, full sit-down, full takeaway. The stock market hasn't returned the stock price to where I think it should be, given the performance that this company is. Let's talk a little bit about company leadership. I know you love the chairman, Stanley Ma. What should investors know about this company's management? Here's Stanley Ma. Started the precursor company that grew into MTY. Believe started the first restaurant concept and failing miserably. I think it was Tiki Ming. But it helped develop that as a Chinese food for food courts. It had a large stake, has a large stake to this

day. But what was really interesting, I believe in mid-2003 with the company much, much, much smaller than it is today. Stanley Amal went out and bought 25% of the company on the open market using his own money. Here's the thing, MTY today is about $52 Canadian. I think it's probably worth north of $70, but that's another story. Today, it's $52. When he went out and bought it, it was $0.25. It's been as high as, I believe, close to $80 or if not over before the pandemic. The man sat on a multi-bagger for years, never sold a share, took a modest salary. It's almost comical to read the proxy statement, because it's like, oh, here's Stanley Ma, CEO, taking a fairly modest salary for what he's built. And then you look along the

lines, it's like, oh, and also, he pays for his car lease, and you see the amount of money involved. So, you're driving a Ford Crown Victoria. There's no fancy car here. But he's just interested in creating value for shareholders because he's the largest shareholder. The only time that I've ever seen him sell was about a year and a half ago, I believe. I believe he took about 20% of his money finally off the table. He's no longer CEO. He has kicked himself upstairs to executive chairman. He's in his 70s now, so I suppose he's allowed to retire. But Eric Lefebvre is CEO, he's a longtime CFO, COO of MTY, so there's been some really great continuity there. They are still very stingy with their equity. Any considerations for Americans who may be

interested in this company? I know it trades on the Toronto Stock Exchange. We would have to go to an over-the-counter market. It's always funny to me, because Canadians can trade on the NYSE or the NASDAQ as easy as we trade on the TSX. Every broker has that ability. First, I would say, check your broker. Maybe you can trade on the TSX. I believe Interactive Brokers allows you to do that. It's easy. You can just simply buy MTY, the ticker on the TSX. But if you have to go OTC, that's where the ticker is, MTYFF, you want to look up two things before, three things, before you go buy OTC. Because the volume and liquidity the OTC is, of course, much, much, much smaller than on the TSX.

So the first two things you want to look up, you want to look up the Canadian price, next you want to look up MTYFF, the OTC sticker. And the third thing you want to look up is, what is the present spot exchange rate for the Canadian to U.S. dollar? And you want to take the Canadian price and you want to multiply it by the present spot rate. You would put a limit order for roughly what the price of the Canadian stock price multiplied by the current spot raises, and you try to get that filled. It's a little bit more work, but you'd want to do that. Essentially, you're buying basically the same thing from OTC than

you would be buying on the TSX, but the liquidity thing has a bit of an influence. You might have to pay a quarter of a percent higher or lower, depending. But first, check out if you can actually transact in the TSX first before you need to go to this extra step. So, ultimately, as we put a pin in this, why is MTY Food Group an interesting company to you, and what's the best fish for a tartar? I make a pretty mean trout tartar, actually. So, that's, you know, come on up, we'll feed you. I bluntly think this is an undervalued company today. Because it's a check-cashing machine, it's a capital-light light company. Capital light companies tend to justify higher valuation multiples. Traditionally,

I've been willing to pay up to 12 times EBITDA for this business. Today, you're paying under nine. I have said that the cash flow they generate, they are probably going to generate this year, I'm going to ballpark at about $135 million in free cash flow. I strip out lease payments from that. So, they're going to do about $135 million. Again, it's a shy of $1.3 billion Canadian. And they are going to spend that money on dividends. They've raised their dividend about fourfold, I think, over the past decade. They're going to buy back some stock, and they're very selective about buybacks. I'm hoping they're going to find some additional acquisitions. Because 6,700 stores in North America sounds a lot,

like a lot, until you realize it's less than 1% of the restaurants in North America. There's a lot more ground for them to conquer. What more do you want? Good cash-flowing story, undervalued with great management. What do you need? Own it pays you a dividend to wait. Jim Gillies, you know him from The Morning Show. He runs Hidden Gems Canada. Jim, good to see you. Thanks for coming on. Thank you. 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. We'll be right back.