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Some thoughts on the CNX Midstream guide down

So this isn’t a stock that I own right now.  I have owned it though.  I’ve been following it and some other midstream plays fairly closely since early December.

Up until recently these midstream stocks weren’t performing all that well.  They were getting beaten up with oil even though some of these companies have absolutely nothing to do with crude.

CNX Midstream for example.  100% natural gas and liquids.  They are the child of the old Consol – basically a situation where the E&P assets went into one company (now called CNX Resources) and the midstream assets, so pipelines, compressors, and facilities, went into another.

CNX Resources is a fairly large Marcellus/Utica producer, wet/dry natural gas, 1.4 bcf/d.

CNX Midstream operates all the pipelines for them.  They basically handle gas for CNX Resources and one other customer (HG Energy, which is private) so they are very concentrated.

Most importantly, CNX Resources owns 33% of CNX Midstream.  They are also the general partner, which means they manage and operate CNX Midstream.

On their fourth quarter call CNX Midstream surprised the market.  EBITDA guidance was $200 million to $220 million.  Distributable cash flow guidance was from $150 million to $170 million.

Up until that point analysts had been expecting an EBITDA guide of around $245 million and the floor on DCF was thought to be $170 million.  So this was a significant guide down.  Below is from their analyst day forecast back in March of last year:

So what happened?

Well part of it was that their E&P partner CNX Resources reduced their activity in 2019.  They phrased it as “minimum activity levels” and stressed that they would be “flexible” and add capital depending on prices and returns, but bottom line is that they are budgeting less than was anticipated.

So there’s that.  What can you do – your customer is worried about prices or returns or whatever else and they decide to reduce activity.   That means reduced through-put for CNX Midstream, or at least less growth than the analyst community was expecting.

But that’s only part of the story.  One analyst, I believe his name was Matt Niblack (?) pointed out that there was still something that didn’t quite compute:

…the minimum [DCF] has been adjusted down from $170 million to kind of $150 million to $170 million due to timing and other factors. But there’s still upside to that, and we just have to see how that goes. I guess my only other question here then is, in the minimum guidance range, if that seems — and also, I think implied in CNX’s production growth range, you’re looking at kind of roughly flat economics relative to Q4, right? And I’m just taking your EBITDA in Q4 and multiplying it by 4. I realize there will be some seasonality associated with that, so that will vary quarter to quarter. But for the full year, that’s what you’re looking at. And yet, there’s significant growth CapEx…

So the question is, why are you spending the same amount of growth capital if you aren’t growing as much?

I read the transcripts a couple times and while the company is a bit vague about it I think the hint they give is when they start talking about de-bottlenecking:

“So a significant portion of the capital that we’re spending in 2019 is associated with de-bottlenecking projects”

So CNX Midstream spends money de-bottlenecking.  That’s either compression, looping, twinning… it’s something that is going to lower pressure in an existing line.  Lower pressure of course means more gas.

But it’s more gas on the back of Midstream’s capital.

This brings up the point about the competing interests of the E&P and midstream.  Particularly when the midstream is controlled by the E&P.  Whose best interests is the de-bottlenecking in?

I would argue that the E&P, so CNX Resources, benefits more from de-bottlenecking.   If it was all one company the capital decision would be based on whether we get more bang (ie production/NAV/cash flow per dollar spent) from drilling a new well or from adding compression/looping an existing line and getting uplift from existing wells.

In this case it’s not all one company.  CNX Midstream pays for the de-bottlenecking.  So its a bit of a free-bee for CNX Resources.

Yes, CNX Midstream gets the volumes as well.  But they just get a toll, and they could have gotten those volumes anyway if the E&P had used its own capital and drilled some more wells.  Now I realize that drilling more wells in an area that could use some de-bottlenecking is likely going to back out other production.  Sure. So drill them somewhere else, where there is capacity.  Volumes are volumes for the midstream.  My point here is that the uplift is paid for by the midstream but they aren’t getting the full benefit.

Of course CNX Midstream says that its a good rate of return. From the call: “I mean, we could follow up with those specifics. I mean, those are good rate of return projects. Otherwise, we wouldn’t do those on a standalone basis. It’s sort of like core, like baseload, sort of like easy low-hanging fruit stuff to do.”  And it does give CNX Resources the ability to ramp production more at some point, now that pressures are lower.  So there’s that.

One thing de-bottlenecking definitely does is it helps an asset look better, at least for a while.  Not saying that’s the case here, I really don’t know.  But type curves never talk about pressure.  It’s rate vs. time.  Nevertheless, you lower the pressure and rates go up.  There is a reason engineers do a bunch of crazy math on their wells and introduce concepts like material balance time and pseudo-time.  Its because its pretty easy to get the wrong impression from a rate vs. time graph.

It all just makes you wonder if CNX Midstream might be taking one for the team here?  CNX Midstream spends some money on de-bottlenecking.  It’s not really a big deal in the grand scheme of things, the stock takes a bit of a hit but it bounces because it doesn’t affect the dividend or anything.  CNX Resources gets some free uplift from it.  That helps their guidance.  Everything looks a bit better. No one gets hurt.

Who knows!  Maybe it’s all just efficient capital allocation.  Nevertheless I think the thought exercise is worthy of contemplation: that there is at least the potential of misalignment with these E&P-midstream separations in the United States.

New Position in Digital Turbine

So far I’ve been pretty cautious about buying any stock that is economically sensitive.  I bought some gold stocks, a couple healthcare/biotech names, but nothing that really is at risk of an economic downturn.

Digital Turbine is a departure from that.  They are directly dependent on smart phone sales, particularly in the United States.

So with all the headwinds around smartphones and my own skepticism about the economy, why Digital Turbine?

I think it has potential, even in the return of a bad market, and there is more here than just following the smart phone sales trend.  The stock performed extremely well while the market fell apart in December.

Digital Turbine provides a mobile device app management solution called Ignite.  This isn’t an app-store app.  Digital Turbine partners with carriers (they have 30 carrier customers including AT&T and Verizon) and OEMs (recently signed up Samsung, have another 7 smaller OEMs signed and have hinted at others to come) who install the apps on the phones before sale.

When a customer buys a phone from the carrier Ignite installs sponsored and partnered apps.  These apps have been curated by the carrier and Digital Turbine based on the users preferences and from a list of app developers who have paid for the right to be included on the install list at the time of activation.  A list of other sponsored apps that might interest the customer is also displayed during the set-up process.

In the past virtually all of Digital Turbines revenue came from these installations and recommendations at the time of activation. App developers paid Digital Turbine for those placements and installations.

Recently the company has leveraged their platform by adding a number of products that add value through the device life-cycle: Single Tap, Smart Folders, and Post-Install Notifications.

The Smart Folder app organizes apps into folders.   Embedded in each folder are recommendations of other apps to download, which based on past preferences the user might find interesting.  For example a gaming folder might be created for the users gaming apps.  When accessing this folder they would see “similar” apps, which are sponsored content of other games that can be downloaded.

Another product is Single-Tap.  This allows the user to download an app directly from a notification, advertisement or Smart Folder list without accessing the app store.  Because the app is not installed via an app store, Google or Facebook don’t take their 25-30% cut.  The app developer benefits with more revenue per download.

These downloads and placements also benefit the carrier.   An important aspect of Digital Turbine’s business model is that the carrier is not Digital Turbine’s customer.  In fact, when Digital Turbine receives revenue from app developers they pass on a chunk of it to the carrier.  Rather than being dumb pipes, the carrier participates in revenue from each placement, install or notification that is generated (note: there is an exception to this if the carrier owns media or apps they want placed on the platform in which case they remit revenue to Digital Turbine for the placement).

It seems like an easy win for carriers.  They put in none of the R&D, none of the marketing, but they get maybe 50% of the margins (its not broken out so that’s my ballpark guess) for simply putting the Digital Turbine platform on their phones.  My understanding is that the carriers are also final decision makers on what and how much content is delivered via Ignite, so they remain in control.

You can see the model is working.  Digital Turbine is installed on 230 million phones right now.  These are all Android phone (the Apple ecosystem doesn’t allow for this type of product).  That is up from 155 million phone in March of 2018.  They peg their annualized install rate at 100 million.

They don’t have a recent snapshot of their quarterly device growth but the snip below is from their Inventor Day presentation in June. You can tack on three more quarters (their year end was March) to get them to the 230 devices that are out there now:

Its a strong base (>10% of android phones) to layer on additional products.  Carriers seem happy to comply since they are getting a nice cut.  To wit, Single Tap was introduced about a year ago and its already on 120 million phones as per the conference call last week.  While the post-install products have all been introduced in the last year, they already account for 15% of revenue.

Revenue is generated as app developers pay for adding their app to the pre-install process, adding it to Smart Folder recommendations, and for notifications or advertisements that are displayed.  The agreements vary between app developers and between carriers but they either take the form of a cost-per-install (CPI) fee, a cost-per-placement (CPP) fee, or a recurring revenue fraction after the app is placed.

The recurring revenue is new, within the last year.  They’ve already signed up Amazon, Netflix, the Weather Channel, Yahoo among others.  If a user installs a Netflix, an Amazon or whatever app via the Ignite platform (be it a pre-install from a Smart Folder recommendation or an ad) then Digital Turbine gets a piece of monthly revenue from that app.

A year ago recurring revenue was nada.  Now it amounts to 5% of revenue.  It was 3% the previous quarter.  Annualized that amounts to maybe $5 million but clearly growing quickly.

The latest big win for the company was Samsung.  They made a deal with Samsung in the fall that added Ignite to Samsung’s factory install.  Once it’s fully rolled out this could mean that Ignite is on every Samsung phone.

The OEM partners are important for international carriers where bring-your-own-device (BYOD) is much more common than in the United States.  Until now an international carrier couldn’t do much to customize the experience of a BYOD customer.  With Ignite pre-installed on the phone, they can turn it on and run through their own customized set-up.

While Samsung accounts for some 500 million devices on their own, Digital Turbine has hinted at more OEM relationships in the works (maybe LG, Sony or Huawei, which were all mentioned in passing on the last call?).

Right now revenue primarily comes from the United States carriers (AT&T, Verizon, T-mobile make up 85% of total revenue).  International is growing.  It was up 100% year over year last quarter with revenue from their large Latin American partner (which must be American Movil) tripling.

This is a business where both revenue and margins are a bit deceiving.  Revenue is more recurring then you think.  The company has an annualized install rate of 100 million devices, so the turnover from that base recurs every few years on a replacement cycle.  The ads, notifications and placements are on an on-going basis.

Margins look weak at a glance, coming in at 35% last quarter.  But those margins take into account the carrier revenue share.  While I don’t know what the revenue share is, it wouldn’t surprise me if its around 50%.  That would make true margins for the business closer to 80%.

Revenue would be less of course.  But if you looked at Digital Turbine and saw an 80% gross margin business with what is essentially recurring revenue, relationships with 30 major carriers, most of the major app developers, and that is on over 200 million smart phones growing at 30% per year, what would you pay?

The company might be a play on 5G as well.  They’ve targeted their platform at phones, but there is nothing stopping them from expanding to other connected devices.  TV’s for instance.  In fact the business model here has some similarities to Roku.

I found the stock on a screen after it popped on its earnings beat earlier this week.  It’s moved some since then and has a market capitalization of $200 million.  Revenues last quarter were $30 million.  With analysts expecting 20% growth next year that’s a P/S multiple of under 1.5x.  They generated $4 million of EBITDA and $2 million of free cash last quarter.  It doesn’t seem that expensive for what you get.

Some of the risks would be:

A. Could Google do the same thing? Maybe, but they haven’t.  They would be cannibalizing their own app store and sharing revenue with carriers when they don’t now, so I don’t know if it would make sense for them.  It’s a pretty small business in the overall scheme of things.  Nevertheless its a risk.

B. Could Google block the platform on Android?  It’s hard to believe that this wouldn’t violate competition laws but maybe it’s a risk?

C. Would carriers develop their own product?  Again, maybe, and in fact based on the filings I’ve read I believe this has been the primary competition for Ignite (though there may be others I haven’t found any other than those mentioned in the 10-K: IronSource, Wild Tangent, and Sweet Labs).  But carriers are getting a pretty good deal here.  They basically do nothing, share in ad revenues, install revenues, app developer relationships that Digital Turbine cultivated.  No R&D, marketing spend on their part.

D. Smart phone replacement cycle slows.  This is why international expansion is important and the OEM deals are key.  Digital Turbine can’t rely on growth in the North American phone market.

E. International expansion doesn’t work. Right now 85% of revenue is the the United States.  They have been working on a ramp with American Movil for over a year now and its still fits and starts.

F. Carriers squeeze margins more.  They just signed deals with Verizon and AT&T so this shouldn’t be an issue in the short-term. It will probably be important to show they can drive revenue growth for the carriers, which of course is good for Digital Turbine as well.

G. The fourth quarter (year end March) guidance did not indicate acceleration – 27% year over year growth at the mid-point and a sequential, seasonal decline greater than last year.  With all the levers: ramping Single Tap, Smart Folders growth, Samsung relationship, I might have thought this would be higher. I’m not sure if I should read into it much though.

H. I feel like their R&D spend is low, which makes me wonder about how robust their business is against competition

I. Oath, which is Verizon’s media group (ie. advertising), represents almost 25% of sales so it is a very large piece of the revenue and represents concentration risk. Overall AT&T and Verizon represent around 80% of revenue.

As always, I’m starting my position small, will add if it appears to be working and will sell quickly if I look like I am wrong.


New Position in Evolus

Two biotechs in a row.  I’m out of my comfort zone.

But in a way ,picking biotechs right now is in its own sort of comfort zone.  I remain suspicious about the economy (though the market keeps going up, so what do I know!) and companies with newly commercialized drugs are less economically sensitive then your run-of-the-mill S&P stock.

Of course in this case I picked a plastic surgery toxin, which probably isn’t the best place to be if there is a recession.  So there’s that.


Evolus just received approval for a new neurotoxin called Jeuveau on Friday.  I didn’t hear about it until Monday night.  I took a position Tuesday morning, first at $20 and then at $25.

Its been a big move over the last two days but I am hoping we are just getting stated.

Jeuveau will compete with Botox in the cosmetic neurotoxin market.  Botox has an 70% market share right now.

The cosmetics neurotoxin market is about a $2 billion market worldwide.  Half of that is in the United States.

The market is growing at almost 10% a year.

Apart from Botox, the other competitors to Jeuveau are Dysport (with around 20% market share) and Xeomin (with about 9% market share).

Dysport and Xeomin were the first wave of competition for Botox.  They largely failed in their attempt.  Why?

A few reasons: The drugs didn’t show a real benefit to Botox.  They had different dosing language (called conversion ratios) than botox.  Physicians trained to administer Botox didn’t find it simple to switch over.  In the case of Dysport the conversion ratio changed after the drug was used.  Finally, they didn’t come out of the gate with a marketing push that differentiated them to patients and physicians. They never developed the momentum to unseat the champ.

Evolus is addressing these issues, both with its trials and launch.

Evolus did head-to-head trials with Botox in Canada and Europe.  Patients in those trials preferred Jeuveau to Botox.  No one has done a head-to-head with Botox before.

Evolus plans to use that head-to-head data in their marketing of Jeuveau.

In the marketing push Evolus will focus on brand and on new patients.  They are targeting millennials.  There appears to be more acceptance among millennials for enhancement products like neurotoxins (they say its a consequence of the selfie culture).

Evolus decided to make Jeuveau a cosmetic indication only.  If you look at Botox, more than half the revenue comes from therapeutic indications.  Jeuveau won’t be competing in that market, at least for now.  Limiting the drug to cosmetic means that Evolus has more leeway around pricing and that they don’t have the same constraints on their marketing.

Botox is by far the market share leader but it’s not loved by physicians.  Allergen has jacked up prices on a number of occasions.  The price per unit has increased 50% in the last 15 years.  There is an expectation that physicians will switch if given a better option.

Evolus is owned in part by a group of physicians and plastic surgeons.  The parent company, Alphaeon, which still owns over 75% of the stock, has over 200 dermatologists and plastic surgeons as investors.  I read one place that these investors make up more than 2% of procedures on their own. The top management of Evolus mostly have come from Allergen: CEO, CFO, CMO, Chief Medical Officer.

Evolus said in the conference call Monday that their goal is to be #2 in the cosmetic neurotoxin market.  That implies that they are anticipating at least 20% of the US market.  So $200 million.  That’s only the United States.

Even after this run the stock is trading at $750 million market cap.  My bet is that it can roughly double that if they look like this goal is within reach and get approval for Jeuveau in Europe.

Here’s the risks I see:

  •  Allergan, who owns Botox is “seeking to block U.S. imports of a new rival to the wrinkle-treatment Botox” because they allege that Daewoong Pharmaceuticals stole trade secrets around Botox which led to the development of Jeuveau.  These accusations have been going on for a while but are back in the headlines now that Jeuveau is approved.
  • Botox is a pretty entrenched leader.  Evolus has talked about how their focus are the millennials, which is not in small part because they realize second-generation clients that have had a Botox treatment are less likely to switch over
  • Botox and the other two brands will push back, they will reduce the price of their drugs and step up marketing efforts
  • The stock is basically controlled by the executive team and other owners of Alphaeon.  Hopefully all interests are aligned but you never know for sure.