Introduction
A year ago, we published an article recommending investors sell or short Asana, Inc. (NYSE:ASAN). We said then that the stock chart looked like a downward dog, but the downward part still had a long way to go. Since then, the stock has lost a third of its value, while the Nasdaq 100 (QQQ) is up a stunning 30%. The S&P is up 25%, not counting the 2% in dividends along the way. So if you were seeking alpha, the 60% outperformance hasn’t been too shabby!
In this article, we use Asana as an example to provide some lessons for those interested in short-selling. We also provide an update on the company’s latest financial results and resulting valuation.
Short-selling: An under-utilized element in the investor’s quiver
Short positions decrease the overall volatility of a long-biased portfolio, and can also generate positive returns, particularly if the market goes down. The risk is that the potential losses from shorting a stock are infinite, although the mitigating factor is that when a stock spikes up for no reason, the company is likely to do a stock issuance.
One of the most common misconceptions or arguments against implementing a short position is that there is no obvious catalyst for why the stock will go down. In more than twenty years of selling stocks short, we have come to believe that looking for catalysts is a fool’s errand. They are hard to predict in advance, and obvious mostly in retrospect. If pushed to identify catalysts, people tend to make them up. In the case of Asana, we did not point to any catalysts, and there have been none. The company has not missed any earnings estimates in the last year; in fact, it has come in ahead of estimates on every occasion. So why has the stock still gone down? It’s a simple case of fundamentals. In that sense, selling short a stock is no different than going long on valuation. A profitable company will be in a position to return capital to shareholders through dividends and buybacks (unless it is repaying debt or making acquisitions), while an unprofitable company will see its net cash balance deplete or its share count increase. One important lesson here is that stock compensation is a real expense and should not be ignored. The shares that employees receive leak out into the market, putting downward pressure on the stock.
Update on Asana’s annual financial results
For the year ending January 31, 2024, Asana reported $653 million in revenue, up 19% YoY, a big slowdown from the 45% growth in the prior year. Operating income was a loss of $270 million (-41% operating margin, an improvement from the -75% in the prior year). The company did a creditable job cutting operating expenses. The average share count for the year, at 220 million, was up 10% YoY.
The company currently has a market capitalization of $3.4 billion, down from $4.6 billion at this time last year. The balance sheet did not change much, with a cash balance of $0.5 billion and a small amount of debt. The enterprise value is $2.9 billion, amounting to a still hefty 4x forward revenue.
The cash flow statement showed an improvement in cash burn, consistent with the decrease in operating losses. The main funding mechanism for the company was the $200 million in stock-based compensation.
The company guided to $720 million in revenue for the coming year (up 10.5% YoY), with a non-GAAP operating loss of $58 million. This would amount to $270 million in operating losses on a GAAP basis, similar to the current year. So it looks like the company doesn’t plan to cut expenses any further. In our opinion, running an operating margin worse than -30%, while growing 10%, is an untenable situation.
Three ways to win with short positions
When you short a stock, you are in effect borrowing and selling it. The sale proceeds can be invested in the overnight market. Many retail brokerages will keep this interest income for themselves, but with a professional account, you can get this paid out less a spread for the broker’s efforts. This is called a short rebate and is linked to short-term interest rates. At current levels, one can get close to 5% annually. Further, one can sell (covered) puts on the stock to generate some additional income.
In Asana’s case, we have been able to juice our return by regularly selling $15 strike puts when the stock was in the $16-20 range, which we have now rolled over into the $12.50 strike puts. Occasionally, when the stock has spiked above $20, we have also sold the $25 strike calls. We believe the stock price will decay over time, as employees sell their shares and the share count goes up, with occasional bursts of enthusiasm. So we have generated profits in three ways: the (unrealized) capital gain as the stock has declined, the short rebate from the sale proceeds, and the premium from the options sold.
ASAN stock valuation and recommendation
To value Asana, we assume that it can ultimately reach a GAAP operating margin of 5% (from the -37% projected for this year), even though we consider getting to profitability an uphill battle.
A 5% margin on 2024 revenue of $720 million would result in a normalized annual operating profit of $36 million. Given the company’s huge net operating loss carry-forwards (accumulated deficit of $1.5 billion), it is safe to say that it will never pay taxes. Thus, it would have $36 million in after-tax operating income or $0.16 per share. Last year, we applied a generous 50x multiple, but the business has slowed considerably since then, and we think a lower 35x multiple is more appropriate. By comparison, Microsoft Corporation (MSFT) trades at 36x earnings. This would result in a $5.60 per share value for the business (35 x $0.16). We then add back the $2.10 per share of net cash on the balance sheet and round up to arrive at a fair value for the shares of $8, 20% less than the $10 we posited last year. This fair value represents more than 40% downside from the current $15 share price.
In a bull case, we assume that the company gets to a 10% operating margin. This would result in a normalized annual operating profit of $72 million or $0.32 per share. We apply an inflated 50x multiple to get to a value per share of $16 for the business. Adding back $2 per share of net cash results in a fair value for the shares of $18, offering a 20% upside from the current price.
In a bear case, the company will never become profitable. In this case, we continue to value it at its net cash of $2, for an 85% downside from the current share price.
We reiterate our recommendation that investors sell any position in ASAN stock or short it. We see little chance of any fundamental upside, and continued downward pressure as the share count keeps increasing, growth slows and cost-cuts end.
Risks are moderate
The main risk for any small or mid-cap company is acquisition risk. We believe that taking on (or finding a way to substitute for) $200 million a year of stock compensation would be a bridge too far for most potential acquirers.
The CEO has previously stepped in to buy the stock. He owns more than half the company, although he is getting diluted by 5% a year as the company issues shares to its employees (share count up to 224.3 million in the latest quarter vs. 214.2 million in the prior year period). He could try to take the company private, but obtaining financing would be hard.
On a fundamental basis, the company could rapidly increase its revenue, further cut costs, and become profitable.
The company could pivot to an emerging trend like AI and get investors excited about the prospects.
Conclusion
Short-selling is not for the faint of heart, but can deliver substantial alpha with the right picks. Asana is a good example of a stock with a fundamental downside, that gets realized as employees continue to sell the shares they are compensated with.
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