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Investment Thesis
My previous bullish thesis on Gigacloud Technologies (NASDAQ:GCT) was extremely unjustified. The stock has lost 45% of its value since May 5, 2024. To provide some context, the broader stock market has risen almost 10% over the same period. Frankly, I may have been wrong, as I overestimated the strength and potential of the company's business model. Despite the continued surge in revenue, key profitability metrics have stagnated over the past few quarters. This may indicate that the operating leverage potential of the business model is rather limited and that EPS expansion may begin to stagnate as revenue growth slows. With revised discounted cash flow model assumptions, the valuation is no longer attractive enough to take the risk. Overall, I am downgrading Gigacloud Technologies shares to Hold.
Recent developments
GCT released its latest quarterly financial results on August 6th, beating consensus estimates by a wide margin. Revenue grew an astounding 103% year over year. Adjusted EPS expanded to $0.65 in Q2 2024 from $0.45 in the same period last year.
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While EPS expansion is generally a good sign, it is noteworthy that earnings growth is significantly slower than revenue growth. This could mean that management is unable to efficiently handle rapid revenue growth. If this is the case, the problem is likely temporary. On the other hand, it could mean that the business model is not efficient enough. To understand this, we need to watch how the next few quarters unfold. If profitability continues to move in the opposite direction to revenue growth, this would be a warning trend.
Still, GCT is in good financial shape, with over $200 million in cash and cash equivalents, and total debt significantly lower than its current market cap. That said, the strong balance sheet gives the company plenty of financial flexibility to invest in further growth.
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The next earnings release is scheduled for November 29th. Consensus estimates are for Q3 revenue of $281 million, implying solid year-over-year growth of 58%. Adjusted EPS is expected to expand to $0.67 from $0.59 year-over-year. This represents modest growth of 14%, and management's outlook for further EPS expansion will be a key factor to watch in the next earnings release. If the trend of strong revenue growth lagging behind earnings continues, it will further heighten market doubts about the sustainability of the business model.
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Given the uncertainty regarding the company's ability to leverage its operations, I tend to agree with Seeking Alpha Quant's overall downgrade on GCT. The ability to demonstrate earnings growth along with revenue growth is what separates great growth companies from fleeting successes.
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That being said, it will be hard to remain bullish until the company starts to show a strong correlation between revenue growth and gross and operating margin expansion. Profitability expansion is crucial for investors looking for long-term growth. The chart below highlights this theory, as GCT's share price began to decline almost immediately after its key profitability metrics stopped expanding in line with revenue growth.
Data by YCharts
Rating Update
The company's shares have risen 79% over the past 12 months, significantly outperforming the overall U.S. stock market. Year-to-date performance has also been very strong, with shares expected to rise 14% in 2024. GCT boasts a high “A” rating from Seeking Alpha Quant. GCT's valuation ratio is significantly lower compared to the industry median.
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To determine the upside potential, we need to simulate a discounted cash flow (DCF) model. To be more conservative, we will use GCT's cost of equity capital as the discount rate. The company's cost of equity capital is calculated using the CAPM approach. A summary of the calculations and underlying variables is provided below:
Author's calculations
Consensus earnings forecasts for GCT are available for the next three years. We make more conservative earnings growth assumptions this time around as our previous bullish thesis has become outdated. Hence, we assume a conservative earnings CAGR of 5% from FY2026 onwards. TTM leveraged FCF margin is 1.6%, which incorporates 50 basis points of FCF expansion. The discount rate is 14.15% and the fair value of the business is $1 billion.
Author's calculations
The fair price I calculated above is about 13% above the current market cap, implying significant upside potential. On the other hand, I believe the discount is justified given growing doubts about the efficiency of GCT's business model.
Risk of downgrade
The stock has significantly outperformed the S&P 500 Index over the past 12 months and still leads by a large margin. Therefore, I believe the stock has a solid fan base. Also, we all know that the stock market is a voting machine in the short-term time frame. Therefore, I believe the stock could see a temporary surge in price. However, I do not believe these gains will be sustained until GCT's profitability metrics return to a growth trajectory.
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Additionally, it's important to remember that there is a massive short interest of 14.3%. If a short squeeze were to occur, this could be a powerful short-term catalyst for the stock. If positive news or momentum spurs a rush to cover short sellers, the stock could surge in price in the short term, creating an opportunity for significant profits.
If third-quarter earnings beat consensus estimates by a large margin, that could be a strong catalyst for a stock price upside, even if it is driven by a one-time event rather than strong operating leverage. In this case, my downgrade of GCT would also have a negative outcome. Investors may view the earnings beat as a sign of resilience and a potential recovery, which could restore confidence in the stock despite the one-time earnings boost.
Conclusion
In conclusion, I consider GCT a “Hold.” Stagnant profitability metrics over the past few quarters may indicate that the business model's potential in terms of operating leverage has peaked. Moreover, the upside potential does not seem substantial for a company with questionable business model strength.
