Continuing To Avoid Altair Engineering

In my long career in capital markets, I came to identify what I called "bubble thinking." Generally speaking, it's the mode of thought that extrapolates an investment thesis from some epochal change that is plainly evident. That investment thesis is fueled by optimism and faith that the trend in question is going to generate massive profits for investors. Investors may be short on the details, but they "just know" that this enormous change is going to lead to enormous profits for some people who manage to get in early, and so the drive to invest is strong.

In fairness, it's not like people who engaged in bubble thinking are fully wrong. The internet, for instance, did transform the world. It just didn't do it in a way that was visible from 1999. Similarly, I think it's fairly obvious that next-generation robotics and artificial intelligence will continue to transform the world. So, unlike some, I don't think people are mistaken when they choose to buy into such things.

To get specific, even if it is true that artificial intelligence will transform the world, I'd say that people who consider buying in today have hardly managed to get in early. The shares of AI companies have been trading for years, and many are now very near record valuations. Just because the internet, or railroads, or trade with the South Sea, or whatever invention massively altered the world, it didn't mean the company that you happen to have been looking at "in the space" benefitted. To use a concrete example of what I mean, everyone who was paying attention in 1908 could tell that the automobile was going to transform the world in unforeseeable ways. Who could have foreseen the rise of the roadside motel, for instance? The problem is that it was very difficult to know which of the 485 automobile manufacturers that existed in 1908 was going to win, even if you had the chance to invest in it.

With that sermon out of the way, let's get even more specific and think about Altair Engineering Inc. (NASDAQ:ALTR) again. It's been about four months since I recommended people continue to avoid Altair, and in that time the shares have risen by about 49%, against a gain of 1% for the S&P 500. That's emotionally painful, and a bit of humble pie is probably good for me, as I've been focusing on my winners lately. Today, I want to see if it's worth throwing in the towel and buying in. I'll review the latest financials, and I'll compare those to the valuations. Also, we should remember that this has been a choppy ride. I've frequently recommended "calls in lieu of shares", and this has resulted in results that have been "less bad" than owning Altair shares outright. I'll review the options market again to see if it makes sense to buy these.

Finally, I'm offering up my thesis statement. I know you've already waded through a great deal of verbiage to get here. I can't tell you how distraught I am about that fact. Anyway, I'm of the view that it would be wise to continue to avoid these shares. While the company has a relatively good fourth quarter, the level of losses remains elevated in spite of decent upticks in revenue and gross profit. In my view, the only people who are benefiting economically from this enterprise are the 3,200 employees at the firm. In spite of this, the shares are even more morbidly expensive in my view. This is never a great combination and always ends badly. For those who insist on staying long, I would recommend call options. For a small percentage of the overall cost of the stock, investors catch much of any continued upside from here. If the shares fall in price as I suspect they will, the call owner suffers much less. Thus, "calls in lieu of shares" is fundamentally a capital preservation exercise, which I think is critical at this point.

Financial Snapshot

I'll admit that the company had a decent fourth quarter, but I think the financial results here remain bad. In spite of the fact that revenue and gross profit rose by 7.5%, and 11.6% respectively, net income fell during the year by another $34.6 million, or 393% from the $8.8 million loss last year. The reason for this is obvious enough, given that R&D, sales and marketing, and G&A expenses rose by 23%, 17%, and 6.7% respectively. All of this is one reason why shareholder equity has eroded by an additional $43 million. I think it's troubling that since 2015, revenue has grown at an impressive CAGR of about 8.7%, while net income over the same time period has dropped from a positive $10.9 million in 2015 to a loss of $43.4 million today.

I go through it each time I write about this stock because I think it's telling. One group that has done particularly well here is employees. As of the latest 10-K, the firm employed 3,200 people. Stock-based compensation was $84.787 million. Using the arithmetic skills I picked up many decades ago, I deduce that the per employee stock-based compensation is now at $26,495, which is up about 81% or $11.9 million from the per employee rate last year. For context, per employee stock-based compensation in 2019 was a mere $2,890 per head, so employees have done extraordinarily well here.

Given that, it's interesting to me that none of the employees or insiders have put in a "buy" on the stock that has treated them very well. I guess the cost of hoodies and urban tech wear is rising along with everything else. All that written, I'd be happy to buy this stock at the right price.

The Stock

I sometimes point out that the phrase "at the right price" is a term that I've used to talk myself out of some great investments over the years. I need look no farther than Altair itself as an example of this phenomenon. The stock has soared higher, while I fretted about valuation. I'm cautious because I've been given many painful examples of how a great company can be a terrible investment at the wrong price, and a perpetual money loser can be a very terrible investment at the wrong price. I'm also of the view that we should focus more on capital preservation than on reaching for returns at the moment. This is why I insist on buying cheap.

Additionally, I insist on buying stocks in general "on the cheap" because the performance of a given stock, for example, is a function of the crowd's ever-changing views about the desirability of "stocks" as an asset class. If I'm worried about the overall appetite for stocks starting to deteriorate (I am), then a stock is going to have to pass through the eye of many more intellectual needles before I consider it.

The last thing I want to write about "stocks" in general is that the stock is often a poor proxy for what's going on at the company, and I think it's possible to profitably exploit this disconnect. In my view, the only way to successfully trade stocks is to spot the discrepancies between what the crowd is assuming about a given company and subsequent results. What I want to see in a stock that I take a long position in, is one that the crowd is somewhat pessimistic about that goes on to exceed expectations.

In my previous piece on Altair, I remained cautious about this stock because the shares were trading at a price to free cash of about 156, and speculators were paying $6.90 for $1 of sales. Here we are a few months later, and the shares are between 21% and 43% more expensive, per the following:

As my regulars know, in order to validate (or refute) the idea that the shares aren't objectively cheap, I want to try to understand what the crowd is currently "assuming" about the future of a given company. If the crowd is assuming great things from the company, that's a sign that the shares are generally expensive. If you read my articles regularly, you know that I rely on the work of Professor Stephen Penman and his book "Accounting for Value" for this. In this book, Penman walks investors through how they can apply the magic of high school algebra to a standard finance formula in order to work out what the market is "thinking" about a given company's future growth. This involves isolating the "g" (growth) variable in this formula. In case you find Penman's writing a bit dense, you might want to try "Expectations Investing" by Mauboussin and Rappaport. These two have also introduced the idea of using the stock price itself as a source of information, and then infer what the market is currently "expecting" about the future.

Applying this approach to Altair at the moment suggests the market is assuming that this company will now grow profits at a rate of about 9.5% from here. That is massively optimistic, especially given the history here. Given the above, I recommend continuing to avoid the shares.

Options As Alternative

Do you remember when I recommended people avoid this stock just before it took off like the proverbial "rocket?" I do. So, there may be some people who disagree with me that this is a terrible investment at this price. For such people, I would recommend call options in lieu of actual shares. Call options expose much less capital to risk, which satisfies my need to preserve capital, while offering substantial potential upside. So, if you insist on staying long here, I would recommend you do so with a call option instead of the stock.

In terms of specifics, if I were bullish on this name, I'd buy the October Altair call with a strike of $75. So, it's currently about $5.50 out of the money, but it's priced at only $4.80-$6. So if the shares rise in price from here, the calls will become more valuable and will become much more valuable if and when the calls go in the money. If the shares drop, as I strongly suspect they will, the call owner obviously loses their capital, but they'll likely take a much smaller loss in dollar terms than the stock owner, and minimizing losses is what it's all about, in my view.