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Delta Resources: A Junior Explorer With Huge Upside Potential
The following analysis is from the September 21st issue of my mining stock newsletter. I want to emphasize that I do not receive compensation from any of the companies that I cover and recommend and I invest my own money in several of the ideas I present. I have a fairly large percentage allocation to Delta Resources. You can learn more about my newsletter here: Mining Stock Journal
New idea – Delta Resources (DTARF, DLTA.V – US$0.11) – My friend and colleague, Trevor Hall (Mining Stock Daily), showed me this idea. DLTA is advancing two early-stage exploration projects, Delta-1 in Ontario, Canada and Delta-2 in Quebec, Canada. I think DLTA has merit as a highly speculative junior play because, after a deep-dive that included a conversation with the CEO (Andre Tessier), I believe the potential upside outweighs the downside risk if DLTA-1 can not be advanced successfully to an operating mine.
DLTA changed its name from Golden Hope Mines to Delta Resources in July 2019. In October 2019 the Company signed an option agreement to acquire 100% interest in the Eureka Gold Discovery property in Ontario, renaming it the Delta-1 project (as the first project acquired under the new name). Shortly thereafter it signed an agreement to acquire 100% interest in the property named Delta-2. The Company also had the Bellechasse-Timmins project in Quebec, which it sold to Yorkton Ventures in 2022 for C$1.7 million, retaining a 1% NSR on the project.
The Delta-1 project is located in Thunder Bay, Ontario in the Shebandowan Greenstone Belt. Greenstone belts are composed of volcanic rock and interspersed with sedimentary rock. They typically contain high mineral content and are likely to contain high quantities of gold, copper, iron, zinc, silver and nickel. The project is located in the same geologic setting as Goldshore Resources’ Moss Lake gold project, which is currently estimated to have 4.17 million ozs of gold at 1.1 gpt (open pit). Historically 42 holes were drilled to test for copper-nickel targets. The property had been dormant since 2003 (the price of gold was $300 – $400 back then).
DLTA began exploration activities on Delta-1 in 2020. Geochem surveying, sampling and mapping confirmed the presence of a gold-mineralized “halo.” The 2021 drill program returned wide intercepts of economic-grade gold, similar to the Moss Lake deposit, located to the west of Delta-1 on the same geologic structure. The highlight assay showed 1.25 gpt Au over 18 meters. The 2022 drill program results drew investor attention. Visible gold was intercepted and all nine holes intersected the gold-bearing zone. Assays from the headline drill hole intercepted 14.8 gpt Au over 11.9 meters within a broader interval of 5.92 gpt Au over 31 meters. Keep in mind that the Delta-1 mineralization is near-surface, open-pit style with drilling to date going down only to 200 meters. This drill program gained the attention of potential strategic partners.
At the beginning of 2023, DLTA announced a 5,000 meter program. The Company continued to hit broad zones of near-surface visible gold and high-grade intercepts. 100 meter step-out holes to the east also encountered wide intervals of gold mineralization along with visible gold. The Company raised C$10 million through flow-through and standard units. Subsequently it acquired additional claims to expand the size of the property, announced a new 20,00 meter drill program and added a second drill.
The first drill results, though they looked good to me, disappointed the market. This where i think the opportunity lies to acquire “cheap” DLTA shares. The stock ran from 4 cents US$ in late 2022 to 41 cents by April 26, 2023. It then started selling off along with the rest of the sector, particularly juniors. It closed at 26 cents the day before the 1st drill results from the 20k drill program were announced but dropped down to 14 cents after the results were announced.
The Delta-2 project is located 35km southeast of the town of Chibougamau. Optioned in 2021 from Cartier Resources and fully-acquired in 2022, Delta-2 is a VMS formation with gold-copper mineralization. Recall that VMS deposits- volcanic massive sulphide ore – host poly-metallic mineralization, typically copper, zinc, gold, silver and lead. They generally host moderate-sized, moderate-to-high grade deposits. Canada hosts several large VMS camps.
The 2021 exploration program produced a gold discovery in which two drill holes encountered two mineralized zones with visible gold identified. Additional drilling in 2022 encountered four areas of interest that included a gold-enriched target area, a copper-enriched target area and two zinc-enriched target areas.
I had an in-depth conversation with Andre Tessier, the CEO, who came to the Company in 2019 along with a change-over in upper management and the Board. Delta-1 was acquired from a prospector, who still has 1.75% NSR which can be acquired by the Company. The Company was attracted to Delta-1 because of the size of the geologic alteration package. The plan is to advance an open pit resource before spending the resources to explore the underground potential.
Drilling to date has focused on defining the overall “footprint” of mineralization and under-standing the control structures and geometry of the mineralization and potential deposit. “Control structures” are the geologic attributes and hydrothermal alteration that control the formation of mineral-bearing veins. Understanding of the specific control structures of a mineralized area affects the understanding of the technical aspects of exploration and mining, including grade control, resource estimation, targeting, etc.
I asked about the big sell-off in the stock after the “game changer” holes described above from the 2022 drill program were released. At the start of the current drill program the Company announced that it was going to do 100 meter step-out holes to the east of the known mineralization to test a 200 meter, on-strike geophysical attribute (magnetic low) like the one that produced the existing assays. It sounds like retail piled into the shares on the assumption that the first step-out results would produce the fat assays from the 2022 drill program. Andre said the anticipation took on a life of its own.
The assays released apparently disappointed the market despite one assay that intercepted 1.79 gpt gold over 128.5 meters starting at 25.5 meters below the surface and 2.16 gpt gold over 97.5 meters starting at 25.5 meters below the surface. For an open pit configuration, these are home run holes. The market did not like holes further to the east that returned grades generally below 0.5 gpt – grades but that would be considered sufficiently economic in a Carlin trend project. We had a chuckle over that. But these are “first pass” holes testing the targets. Andre believes that the Company will hit higher grades in targeted areas with follow-up drilling.
With respect to the Delta-2 project, I asked why Cartier Resources was willing to sell the project. He said that Cartier has decided to sell ancillary projects in order to focus on advancing its 8.8 million gold resource Chimo Mine project into a mine. DLTA management has elevated Delta-1 as the flagship project and will put Delta-2 on the back burner. That said, the Company raised flow-through money in the last financing that needs to be spent on exploration activities by year-end and will use some of it to do some exploration drilling on Delta-2.
Bottom line – I need to stress that both Delta-1 and Delta-2 are very early stage exploration projects. The series of drill results at Delta-1 are very encouraging. The Company is convinced that Delta-1 hosts an economic deposit. The objective now is to define the scale and grade. The Company’s game plan is to de-risk Delta-1 enough to attract a strategic acquirer to take it over the finish line with DLTA management possibly spinning-off Delta-2 and moving on to develop that project.
Andre said that the Company has several non-disclosure agreements with strategics who want access to data the room to monitor the project. I think Wesdome, Alamos and Agnico Eagle are potential acquirers. That said, it will take a strong, extended bull move in the sector before strategics move to acquire projects until they’ve become almost completely de-risked.
In my opinion, DLTA is worth using some high-risk/high-return capital for a potential 5-10 bagger. I believe the recent sell-off, which appears to have come from the retail momentum chasers, provided a good entry level to minimize the downside risk. While Andre said there’s a seller from the last financing that stripped the warrants and is now selling the stock, a couple of DLTA’s largest shareholders who want to own more shares are buying those shares and Coremark (the deal underwriter) makes sure that they get first look when the shares become available.
The biggest shareholders are 1832 Asset Management (owned by Scotiabank) and some big Quebec funds. Management and insiders own 9%, after taking C$1.4 million of the last $10 million capital raise. The Company has not spent much on promotion. When it does I believe the shares will attract a much wider base of shareholders.
There’s 98.5 million primary shares, with 35 million warrants and 7.8 million stock options, for a total of 144 million fully-diluted shares. However 17.4 million of the warrants are struck too high to be considered relevant (40 to 63 cents C$, with the stock at 19 cents C$). Most of the stock options are in the money or near-money. For purposes of my valuation and potential upside analysis, I’m using 123.9 fully-diluted shares. At the current price this gives DLTA a US$17.3 million valuation.
Assuming we get a sustained rally that takes gold over $2,000 and silver into the high $20’s, I think DLTA could double or triple quickly. Especially if more holes from the current drill program hit good grades. Forty-four holes from the current ongoing drill program have been completed with 23 reported so far. This means there will be a lot of potential positive news flow coming. I have started a position in my personal account, leaving room to add shares opportunistically.
Could Market Crash Drive Gold & Silver Lower? (Hint: NO)
I will be updating and analyzing two junior development gold project companies in next week’s Mining Stock Journal with 10x upside potential. Both companies do not promote themselves, preferring to put their capital into project advancement, and thus neither is on the radar screen of investors. Insiders own a big percentage of the shares in each company and participate in all equity financings. One of the companies has a 10% strategic investor. You can lean more about my newsletter here: Mining Stock Journal (FYI I do not get paid any compensation from the companies I research and present and I own shares in both).
The sell-off in the precious metals sector – which I will argue vehemently is primarily an officially sanctioned, bullion bank market intervention with some help from momentum-based hedge fund algo programs – is startlingly similar to the September/October 2008 decline. Incredibly, the financial markets, banking system and economic backdrop is also remarkably similar, except this time adverse variables that could lead to a system meltdown like 2008 are more powerful and likely will lead to more severe stock and credit market melt-down.
Despite the sharp decline in gold and silver over the past several weeks, relative to 2008 both metals are holding up remarkably well:
The chart above shows the price of gold from 2001 to present on a weekly basis. The price declines in 2006, 2008, late 2011 to late 2015 and early 2020 were much bigger on a percentage decline basis than has been experienced in the recent price decline. To be sure, it’s impossible to know if there will be more pain in gold and silver or if a bottom is forming.
While the current condition of the economy, credit markets and banking system – all three of which are transitioning into a state of distress – is remarkably similar to 2008, there are factors helping to support the precious metals sector which are present now but not in 2008. The most significant factor is the enormous demand for physical gold from eastern hemisphere Central Banks and investors. Eastern hemisphere Central Bank gold buying hit a record high in the first half of 2023. Moreover, the largest historical financiers of the U.S. Treasury’s new debt issuance are now selling down their holdings at an accelerating rate in advance of a de-dollarized world. These two factors will drive the dollar-based price of gold and silver to all-time highs (gold is already at all-time highs as priced in several other currencies).
A Big Homebuilder Stock Price Reset Is Coming
The following commentary is from the October 1st issue of my Short Seller’s Journal. In addition to general market and economic commentary, backed with hard data, on a weekly basis I update my analysis of the housing market, Tesla $TSLA and Nvidia $NVDA, three of the most overvalued financial assets in the market. You can learn more about this weekly economic analysis and short sellers newsletter here: SSJ Information
Housing market update – The highest mortgage rates in 20 years, the worst level of affordability since 1984 and increasingly tight household finances are starting to torpedo housing market activity. After rising slightly in three of the previous five weeks, (from 142 to 147) the mortgage purchase applications index fell from 147 to 144 last week. I suspect that it will fall more this week, as the 10-yr yield has risen inexorably from 3.35% in May to 4.60%, and from 4.38% to 4.60% just this past week alone. The base 30-yr fixed rate mortgage has jumped to 7.5% (20% down, 740+ FICO), which means housing purchase affordability continues to get worse.
New home sales in August fell 8.7% from July vs the consensus expectation of a 2.2% decline, while July’s 4.4% increase over June was revised higher to 8%. I suspect the numbers for both July and August as estimated by the Census Bureau are wildly inaccurate. At the 90% level of statistical confidence, the August number could vary from +6.9% to -24.3%. Why even bother putting together the data series? The months’ supply of new homes according to the Census Bureau is now at 8 months. I thought the propagandists’ narrative was that there’s a shortage of new home supply?
Recall that new home “sales” are based on contracts signed. As mentioned last week, 15.7% of all home purchase contracts signed in August were canceled at the highest rate in 20 years. Based on the weekly trend in mortgage purchase contracts in July and August, and given the cancellation rate in August, I’d say it’s more likely that the 8% increase in new home contracts in July was lower than calculated by the Census Bureau, while the 8.7% decline was more severe than the CB calculus shows.
As more housing data from July and August is released, it looks like my view that home sales hit a wall in July and August may be correct. Existing and pending home sales have declined to near-historic annualized lows. New home sales took off in January primarily because of the low inventory of existing home sale listings. In addition, homebuilders began to offer steep discounts to the list price along with other incentives. Then in 2023 the rate buydown became all the rage, which enabled homebuilders to prevent sales from declining. But the incentives discounts have hammered profitability, as I have detailed in the recent earnings reports of DHI, LEN and KBH. It’s going to get worse, especially with the 10yr Treasury rate relentlessly grinding higher.
Pending home sales for August plunged 7.1% from July and 18.7% YoY. The decline hit all four regions (west, northeast, midwest, southeast), with the southeast down 9.1%. The southeast had been the hottest region during the inflation of the bubble. The pending home sales index is down to the lowest reading during the pandemic lockdown, which is the lowest index level on record.
Pending home sales are based on contracts signed on existing homes. To be sure there may some element of inventory selection holding back some potential sales. But the pendings number corroborates the August plunge in both new and used home sales. It’s now confirmed that the housing market hit a wall in July/August and the level of activity is lower than during the depths of the great financial crisis.
All of the homebuilder stocks have declined quite a bit since peaking in August. But all of them are still substantially higher than they were in late 2022, when new home sales started to take off. I firmly believe that these stocks will retrace back to where they were trading in late 2022. The reason I say this is that, despite steady sales volume, the discounting etc has hammered profitability and earnings for all of these builders. As an example, KB Homes reported EPS for its FY Q2 2022 at $2.86 vs $1.80 for the same quarter this year. Yet, the stock is trading 80% higher than where it was trading a year ago. Similarly, LEN reported $5.03 for its FY Q3 2022 vs $3.87 this year. Yet, the stock is 52% higher than it was a year ago. These valuation levels will soon be reset considerably lower.
Right now I am expressing a bearish view on the housing market with ABNB puts. This is more of a bearish bet on the existing home sales market because I expect that there will be a deluge of ABNB properties for sale in the next 6-12 months. However, I’m going to invest in some TOL and PHM puts because, on a percentage basis, these two stocks have not declined as much as the other homebuilders. My understanding is that the market for high-end and luxury homes is transitioning into a bloodbath.
KB Homes (KBH): An Ugly FY Q3 Earnings Report
The following analysis on KB Homes is from the latest issue of my Short Seller’s Journal. You learn more about this newsletter here: Short Seller’s Journal information.
KBH’s FY Q3 ended August 31st, which means the numbers captured the trend in new home sales over the summer (June, July, August) based on contracts signed in the late spring through mid-summer. I have argued that the housing market hit a wall in July/August and KBH’s results support this claim.
Revenues fell 13.6% YoY and 10% from its FY Q2. Operating income was destroyed, down 45% YoY, with net income down 41% YoY. Net income benefited from a jump in equity income from unconsolidated joint ventures and a big drop in the GAAP income tax, both non-cash and both non-factors in the cash profitability of KBH. Interestingly, the culprit that torpedoed KBH’s numbers was price cutting. Deliveries were down 7% YoY and 8% from Q2. But the average selling price was cut 8.3%.
While both factors affect profitability, cutting prices while costs continue rising hammer margins. KBH’s operating margin fell to 11% from 17% YoY. While new orders rose and the value of new orders, the value of the backlog was hammered 35.4% YoY and 20.3% QoQ. With respect to the new orders, I expect that the cancellation rate cited by Redfin that I referenced above will erase a material percentage of those new orders.
The Company has not released a 10-Q yet so I can’t look at the cash economics of the quarter (cash from operations). The Company pegged its full-year guidance at the high end of the guidance given at the end of Q2 ($6.31 billion in revenues for the full year). We’ll see about that.
Despite the revenue and net income “beat” plus management’s attempt to put lipstick on the pig with positive guidance and a reference to the share buyback program, the stock was drilled for 5%. It affected all of the homebuilders as well. The stock is breaking down quickly:
The stock has dropped below all of the key moving averages except the 200 dma, which was at $43 on Friday. Once it falls below the 200 dma, the real fun will begin. It will also mean that investors are finally accepting the fact that the new home sales market is heading south. Think about this: absent the aggressive price cutting in Q3, deliveries and new orders would have been a disaster. As it is, the price cuts likely pulled forward a material amount of new orders into the quarter, a portion of which will cancel.
The stock is technically oversold using the RSI and MACD. If the 10yr yield falls over the next couple of weeks, it might stimulate homebuilder buying by hedge fund algos. But liquidity continues to drain from the banking system while the Fed postures to keep rates higher than expected for longer than expected. One more thing. At some point there will be big inventory write-downs. KBH has already slashed prices for four quarters consecutively In Q3 prices were cut 8% YoY and 4% from Q2. It will have to continue slashing prices, particularly as unsold homes from canceled contracts become spec homes that just sit collecting cobwebs.
Factors That Should Lead To Higher Gold And Silver
This is an excerpt from my latest issue of the Mining Stock Journal, released this afternoon (Thursday, September 21st):
The point here is that, even with demand from India lower than usual for this time of year (as reflected by the discounts observed in India currently), several other countries in Asia and the Middle East have increased their gold importation. I believe this is why the repetitious attempts to push the price of gold and silver lower recently in the paper derivatives markets in London and New York have been unsuccessful. Moreover, despite the common misperception that the Fed’s “hawkish” policy is bearish for gold and silver, the prices of both metals have not only been resilient buy, in my opinion, are consolidating for a big move higher in the near future.
I discuss my rational for why I believe the confluence of several factors will drive gold and silver higher despite the Fed’s allegedly “hawkish” monetary policy. I also do an in-depth review of a junior explorer with what I believe is at least 5x upside potential. My review includes a conversation the Company’s CEO. You can learn more about the Mining Stock Journal here: MSJ information
Meanwhile, I discuss some of the factors I think will trigger a bull move in the precious sector that could rival, if not exceed, the 2008 – 2011 bull cycle in the sector:
The Economy, Credit Markets, Gold And Silver Are Reminiscent Of 2008
It’s my contention that the current economic, credit risk and stock market conditions are similar the 2007-2008. Specifically, it think there’s a chance that a seriously adverse credit event is percolating while the banks engage in an overt price control effort of gold and silver. Both of these attributes are eerily reminiscent of the fall of 2008. In my latest Arcadia Economics podcast, I refute the common mainstream media and Wall Street “expert” view that the economy is robust. I also explain why I think a big move higher in gold and silver could unfold before year-end:
I publish the Mining Stock Journal newsletter. Each issue features original market commentary and updates of the stocks I recommend. With junior project development mining companies I search for ideas that are not well-covered yet by brokerages and other newsletter publishers. With the larger cap, producing miners I recommend, I look for companies that I believe are undervalued relative to their peers and which offer the opportunity to earn “alpha.” You can learn more about my newsletter here: Mining Stock Journal information
Fortuna Silver Is A Strong Buy After The Stock Price Ambush
The following analysis is from the August 10th issue of my Mining Stock Journal. Click MSJ Information to learn more about this mining stock newsletter.
Fortuna Silver (FSM, FVI.TO – US$2.95) – Fortuna released its Q2 numbers after the close on August 9th. The stock was shot in the head, opening down as much as 12%. Unfortunately the current market sentiment and environment with respect to mining stocks is such that any unexpected “miss” in earnings, even when the causation is non-recurring and the numbers will bounce back the next quarter, triggers a big sell-off in the share price. This occurred with SILV (reviewed below) and Hecla.
On a YoY basis, FSM’s sales declined 6%, mine operating income fell 2% and operating income dropped 41%. Net income actually rose from $1.6mm in Q2 2022 to $3.2mm in Q2 this year due a huge reduction in the income tax attributable to a loss at San Jose as well as lower income before taxes. Unless the prices of gold and silver move substantially lower in Q3, I expect that the decline in revenues etc will be a one-quarter issue this is almost entirely attributable to non-recurring issues during Q2.
The reduction in operating income was due mainly because of the lower volume of metal sold at San Jose from the 15-day mine stoppage due to the illegal blockade at the mine and lower volume at Lindero related to the mine sequence (transitioning from a depleted reserves “block” to the next reserves block). While sequencing occurs intermittently, it is a temporary issue but resulted in higher input costs and lower processed gold grades.
Fortuna settled the labor dispute expeditiously and decisively. However, the Company incurred a $6.3 million non-recurring expense connected to the work stoppage and strike settlement ($2.8 million related to the new labor agreement) and $3.5 million related to one-time charges at San Jose and Yaramoko. In addition, a $1 million administrative penalty payable to the Ministry of Mines was incurred at Yaramoko. The Yaramoko non-recurring expenses were connected to the temporary stoppage of underground mining at the mine.
All of the above had the effect of an unexpected spike higher in the all-in sustaining costs (AISC) per ounce for the quarter. The largest component of this was due to the stoppage at San Jose which resulted in lower Au-Eq ounces sold which caused the cost per ounce to soar for the quarter. In addition, the sustaining capex at Lindero jumped due to the additional expense related to Phase 2 of the leach pad expansion and higher capitalized stripping costs related to the sequencing. Stripping costs a Lindero will revert to a normalized level in Q3 and decline from there in Q4. In addition, the additional capex for higher underground development plus the work stoppage to accomplish this at Yaramoko added to the temporary AISC increase. Note that additional capex/sustaining capital expenditures at Lindero and Yaramoko are positive net present value investments.
Also note that although over 4,000 ounces of gold were produced at Seguela, the gold was not sold until early in Q3. This means that the Company did not get the benefit of the revenues from the gold produced but it has to account for the expense of producing that gold and ramping up the processing facility in the period that the gold was produced. Again, FSM will recapture this loss in Q3. Additionally, Seguela will contribute a full quarter of production, operations returned to normal at San Jose at the end of Q2, Yaramoko is now performing above expectations and the stripping phase at Lindero was completed in Q2. This should result with revenues, profitability and free cash should more than bouncing back in 2H 2023.
The Company reiterated that it expects to achieve full-year production guidance of 6.3mm to 6.9mm ozs of silver and 282k to 320k ozs of gold. San Jose is at risk of finishing the year below guidance offset by Caylloma and Yaramoko achieving the upper end of their guidance range. Seguela is expected to meet the lower end of its guidance range and Lindero is on track to achieve guidance. San Jose and Seguela are both sources of potential upside surprise.
I expect FSM’s numbers to more than recover from the non-recurring events that affected the Q2 results. The additional capex at Yaramoko and Lindero should improve the profitability of those two gold mines. Also, Yaramoko is now performing above the expectations that were set when the Company had to revise lower the proven/probable reserves. Stripping costs at Lindero will improve to less than 1:1 in Q4 which will boost profitability per ounce.
Because I have this conviction, I put on large position in the September 15th $3’s in my personal account (one of my largest call positions ever). If the stock does not recover in the next couple of weeks, I’ll move the calls out to December.
Wayfair Still Burns A Lot Of Cash – Time To Short The Stock
The following analysis and commentary is from the most recent Short Seller’s Journal. In the context of the stock market going “full idiot” right now, $W’s share price has levitated to an absurd valuation. You can learn more about this newsletter here: Short Seller’s Journal Information.
Wayfair (W – $76.88) – W reported its Q2 number on August 3rd before the open. Of course it reported a “beat.” The stock shot up from the previous day’s close of $72.89 to as high as $90 before closing at $84.67. It’s a reflection of the degree of insanity that has engulfed the stock market. Despite the “beat,” revenues declined 3.4% YoY from Q2 2022. Revenues have declined for nine consecutive quarters. The Company did manage to cut costs out of its operations. As such the operating loss declined to $142 million from $377 million. Nevertheless, a $142 million operating loss is not immaterial.
Embedded in the cost of sales and operating expenses is $167 million in equity-based compensation, which is non-cash. Although I think a short-squeeze is the primary driver behind the spike up in the stock price, the numbers manipulators like to look at the “as adjusted” operating income which adds back the cost of stock compensation. With W this manufactures operating income of $25 million. But the cost of stock compensation shows up in the form of stock dilution, which spreads the net income over millions of more shares.
The net loss for the quarter was $46 million vs a loss of $378 million a year ago. However, included in the net income is $100 million non-cash gain from the extinguishment of debt. The Company issued $678 million in 3.5% coupon convertible bonds and used part of the proceeds ($514mm) to buy back some of its 2024 and 2025 convertible bonds outstanding at a discount to carrying value, which gets booked as non-cash income. The remaining proceeds will be used for working capital and general corporate purposes.
But here’s the catch: W issued a greater amount of cash-pay converts at 3.5% and used the money to retire a lesser amount of 1.125% and 0.625% converts, thereby increasing its cash interest expense and increasing the amount of debt outstanding. I would suggest that part of the motivation/benefit of this transaction, aside from moving $514 million in debt maturities from 2024 and 2025 out to 2028, was GAAP earnings management because the transaction enabled the Company to add $100 million to its net income before taxes, albeit non-cash. Net-net the transaction weakened the balance sheet and it hurts shareholders.
The Company attributes the decline in cost of goods sold – which is where W managed to reduce the operating loss YoY – to “operational cost savings initiatives.” In pouring over the breakdown in costs in the footnotes, it looks like most of the savings was carved out of SG&A. Furthermore, a portion of the improvement in gross margin is attributable to sales mix but also lower sales volume. With nine straight quarters of declining revenue, Wayfair’s business is shrinking. And this is before price inflation is removed from the revenues.
In its entire nine-year history as a public company, W has had just five quarters of positive GAAP earnings. This is entirely attributable to the huge jump in revenues during the pandemic period:
W’s net income quickly plunged into big losses once the benefit from the pandemic faded. I think Q2 2023 is an anomaly because Q2 tends to be a seasonally strong quarter for the Company. The business is contracting. I suspect management cut as many costs out of the operations as possible. Unless revenues surge like they did in 2020 I believe W’s losses will revert back to the negativity experienced in 2019 and in the 5 quarters previous to Q2 2023.
The stock price is down 11.4% since the closing price the day it reported Q2. I’ve been riding puts since the day W reported. I currently am sitting on August 25th $74 puts. However, three months ago the stock was trading at $30. I’m considering putting on a position in the November $55 puts.
Here’s Why Amazon.com ($AMZN) Will Be A Profitable Short
The following analysis and commentary is from the most recent Short Seller’s Journal. In the context of the stock market going “full idiot” right now, AMZN’s share price has levitated to an absurd valuation. You can learn more about this newsletter here: Short Seller’s Journal Information.
Amazon (AMZN) reported its Q2 numbers on Thursday after the close and smashed the consensus estimates across the board. The operating profit margin was 5.7%, up from 2.7% YoY and 3.7% in Q1 2023. The stock jumped $11 on Friday, closing at $139.57 although it traded as high as $143.63. The source of the jubilation was an unexpectedly large increase in product sales (e-commerce, Whole Foods, etc) and a $3.2 billion operating profit generated by the products division. Interestingly, the Street and media ignored the glaring slowdown in AWS’ sales growth as well as the 6% YoY decline in operating profits for the cloud services business. Here’s what that slowdown in revenue growth looks like graphically (chart source: Bill Maurer, Seeking Alpha):
Another source of glee from the Street was a decline in the percentage cost of fulfillment for the products division. Analysts measure this as a percentage of total revenues. However, the Company discloses that the cost of AWS fulfillment is lumped into technology and content costs. Fulfillment, technology and content costs combined represented 32.2% of total revenues in Q2 vs 31.6% in Q2 2023. The cost of technology services “fulfillment” rose. In reading through the accounting treatment for products fulfillment, I believe it’s also possible that AMZN was able to shift the timing of recognizing some fulfillment costs to Q3. Finally, note that the average cost of fuel declined during Q2. Fuel costs likely will increase in Q3. These are variables that affect fulfillment cost accounting that Wall Street either neglects to recognize or fails to disclose.
Consolidated operating income more than doubled YoY from $3.3 billion to $7.6 billion, though the international products segment is still generating an operating loss. From a net income standpoint, AMZN generated $6.75 billion in net income vs a $2 billion net loss in Q2 2022. The Company likes to highlight free cash flow as the barometer of its operational performance. On a trailing twelve month basis the company swung from negative FCF to FCF of $7.8 billion.
However, for “show and tell” purposes AMZN uses its own version of FCF, defined as cash flow from operations less capex. This is non-GAAP and quite useless, particularly in AMZN’s case. Including the cost of principal payments on finance leases and financing obligations, AMZN’s GAAP FCF was $1.9 billion. Finance leases and financing obligations are a recurring and integral part of AMZN’s operations and thus true FCF is the $1.9 billion number.
While AMZN’s e-commerce business seemed to be hitting on all cylinders in Q2 and the Company guided revenues higher for Q3, for me the glaring red flag is valuation. First, up until this latest quarter, AMZN’s high valuation (market cap/operating income and P/E ratio) was rationalized by the bulls based on high growth/high margin AWS segment. That seems to be no longer. AWS is getting hammered by competition from the MSFT and GOOG cloud services businesses. It’s losing market share and the price competition is quickly eroding margins. In Q2 AWS’ operating margin was 24.2% vs 29% in Q2 2022. At one point in time historically, AWS’ operating margin hit the 30’s%.
AMZN’s price/sales ratio is 2.52. This is nose-bleed territory for a retailer. The average P/S for WMT, TGT and BBY combined is roughly 0.5. For the first half of 2023, AMZN generated $12.4 billion in operating income. I’ll give it the benefit of doubt and assume it manages to grow that by 10% in the 2H of 2023 to arrive at my estimated full-year operating income of $26 billion. The forward price/operating income ratio on this basis is 50.7. Keep in mind that’s the operating income multiple – 50.7 is more than double the price/earnings ratio of the S&P 500.
AMZN’s stock jumped because, based on just one quarterly observation, the market believes AMZN has turned around its e-commerce/products business and that it will sustain the cost improvements and sales growth. I disagree. AMZN likely will run out of room to cut operational costs and will likely face higher fuel costs for the rest of the year. Gasoline futures are 15.3% higher than at the end of June while oil futures (Brent) are up 19.4% from the end of June. The Company also will face strong headwinds from a rapidly slowing global economy and increasing financial stress of the average U.S. consumer. Also, the high-growth and profitability narrative for AWS is no longer. Furthermore, as the economy slides further into recession, companies will be cutting back on cloud services capex.
I am highly confident that AMZN will have a difficult time going forward to generate the operational and financial performance presented in Q2. Of course, the performance of the stock depends on the degree to which the stock market continues to view companies like AMZN with rose-colored glasses. As long as the bubbleheads continue to chase rainbows, AMZN’s stock will stay aloft. That said, I think longer-dated OTM puts are attractive, particularly if the stock market cracks this fall, which I believe will happen.
Carvana’s Equity Is Worth Zero
The following analysis and commentary is from the most recent Short Seller’s Journal. In the context of the stock market going “full idiot” right now, CVNA’s share price has been squeezed up to an absurd valuation. My rationale for shorting CVNA is that the equity is a bagel. You can learn more about this newsletter here: Short Seller’s Journal Information.
CVNA reported its Q2 numbers on Wednesday (July 19th) along with announcing a debt restructuring and sale of equity to raise up to $1.3 billion. I’ll briefly review the financials. Net sales of $2.9 billion (retail, wholesale, other) were down 23.7% YoY and up slightly from Q1 2023. The Company managed to slash costs enough to generate a small operating profit in Q2, though after interest costs net income before taxes was negative $105 million. A big improvement over the 2022 Q2 NIBT of -$438 million. However, I suspect particularly with used car prices heading south quickly that Q3 for CVNA will show lower revenues and a much wider operating/NIBT loss.
The nuts and bolts behind the revenue numbers are ugly. Retail units sold dropped 35% YoY. The wholesale operations acquired in the ADESA transaction are small compared to retail so I’ll leave that out. The operations generated $509mm in cash but that’s because CVNA continues to sell more vehicles than it replaces. Inventory has declined from $1.87 billion at year-end 2022 to $1.3 billion at the end of Q2. This is not a sustainable business model. CVNA slashed operating costs substantially but cut headcount by more than 4,000 and slashing its marketing expenditures.
Fundamentally CVNA’s business is shrinking. This will get worse in Q3 as both the Company and Autonation (see below) warned that used car prices will fall further in Q3. In all likelihood, the average cost per vehicle in CVNA’s inventory is not much lower that the price it can realize in the market now.
CVNA also announced a debt restructuring that will involve exchanging $5.6 billion in debt that matures between October 2025 and May 2030 for $4.3 billion of new notes that mature in December 2028 through June 2031. The new notes have a PIK feature for up to two years (pay-in-kind, meaning the Company can pay the interest expense for up to two years in more bonds rather than cash). However, the PIK feature comes at a steep cost. The existing debt carries an average coupon roughly of 8.9%. One tranche of the new notes has a PIK coupon rate of 12% and 9% cash thereafter while a second note tranche carries a PIK coupon of 13% and 11% cash thereafter and the third new tranche has a 14% PIK and 9% cash thereafter.
The weighted average cost of the PIK debt payments is roughly 13.1%. If CVNA chooses to PIK the notes for the first two years, after two years there will be roughly $5.6 billion in notes outstanding ($4.3 billion compounded 13.18% over two years). Not really a debt restruc-turing, is it? In conjunction with the debt restructuring CVNA will try to sell up to $1 billion in new shares via a series of ATM transactions (at-the-market in which the brokerages representing CVNA will intermittently dump new shares on the open market).
The mainstream media stated that the debt deal will save CVNA $430 million in interest expense over the next two years. But per the math I showed above, CVNA’s total cost of interest rises. To be sure, the deal will save CVNA from making cash coupon payments on the debt for two years. But from an accounting standpoint, it will still have to recognize the PIK payments as a GAAP interest expense.
This deal doesn’t help CVNA financially at all except short term from a liquidity standpoint. In fact, S&P said it views the restructuring as “distressed and tantamount to default.” The debt ratings were put on negative watch. The next downgrade would assign a “D” for “default” rating. Given that new notes will be secured by a 1st priority lien on all of the assets that are not used to secure the Ally Financial inventory financing facility. The notes will have a 2nd lien on those assets (used cars).
CVNA’s balance sheet is thus still a mess, with what ultimately will be $5.6 billion in debt outstanding on a company that continues to generate operating losses and whose business is shrinking. Website visits are down nearly 40% YoY and the number of vehicles listed online is down almost 50%. In the context of the debt “restructuring” and the need to raise a lot more cash, CVNA is on life support. This Company in my view will hit bankruptcy sometime in the next 12-18 months.
The stock is another matter. The stock price has shot up from under $4 at the end of 2022 to as high as the $55 close on Wednesday. Make no mistake, this was 100% the product of a short-squeeze and a call option gamma squeeze. The short interest at the end of June was over 50% of the float. It was 43% of the float on June 15th. This stock is such an obvious short that any entity that can secure a borrow and finance it is short the stock. On Thursday the stock dropped 16.2% and another 2.4% on Friday.
Carvana’s market cap is absurdly disconnected from reality, notwithstanding the fact that the stock is intrinsically worthless, it does not even have “optionality” value. Autonation (reviewed below) is still extremely overvalued even after Friday’s cliff dive. But here’s a comparison of the two companies:
Carvana is probably one of the most obvious shorts on the NYSE, which is why the short interest at times exceeds 50% of the float. The put options have a high amount of implied volatility but if you go out far enough and play OTM puts, it will pay off eventually. Short calls to take advantage of the high option premium is probably the best way to express a short view on CVNA. If you can obtain, finance and hold onto borrowed shares, you will never have to cover because ultimately the shares will be canceled in a bankruptcy restructuring or liquidation scenario.