High inflation and the U.S. Federal Reserve's interest rate hikes in response to it have slowed economic growth. Spending habits have been altered and investors have reacted.
But when efforts to ease inflation start to pay off and interest rates drop out of the news, a lot of beaten-down stocks could soar. Three Fool.com contributors think Etsy (ETSY +3.84%), Rackspace Technology (RXT +10.53%), and Charter Communications (CHTR +0.28%) could all benefit if inflation ebbs and interest rates settle. Here's why.
E-commerce has lost steam for the first time since the early days of the internet
Nicholas Rossolillo (Etsy): I'd had my eye on Etsy for a while when CEO Josh Silverman took over in 2017. A veteran of the e-commerce world who was running a business when the dot-com bubble burst, Silverman persuaded me to become a shareholder by immediately taking steps to whittle down spending to the company's "vital few" projects that would provide the biggest returns. Silverman has done an incredible job, taking Etsy from a fringe digital shopping site to a household name in e-commerce over the last five-plus years.
NYSE: ETSY
Key Data Points
Fast-forward to today, and e-commerce is undergoing its first major speed bump since the dot-com bubble. With inflation running hot, consumers have pared back spending on big-ticket and more discretionary items (the type that make up the bulk of Etsy's marketplace for handmade and vintage goods). I believe Silverman's experience will pay off for the company during this tough time and the company will be set to fly higher when the economy improves and people loosen the purse strings.
Even with inflationary pressure, Etsy's performance through the first six months of 2022 is notable, with gross merchandise sales and revenue both up compared to the year-ago period. The company is benefiting from the acquisitions of Depop and Elo7 last year and an increase in transaction fees that went into effect in April.
Gross merchandise sales -- the dollar value of items sold in the Etsy marketplaces -- were down slightly year over year in the second quarter and CFO Rachel Glaser noted in the quarterly conference call with analysts that "overall, consumers have many more places to spend their money and less disposable income, which has driven week-to-week volatility in our business. ... we have only seen a modest impact from inflation on the price of goods on Etsy.com as it appears our sellers remain largely hesitant to increase prices and they often offset pricing increases with discounting."
And the Etsy of today is a highly profitable business. Etsy generated free cash flow of $168 million the first half of 2022, a healthy profit margin of over 14%. That's not bad for a growth company. Because it's profitable, Etsy has the luxury of being able to continue spending on projects aimed at growing the business, like more services for merchants and a better shopper experience.
If inflation cools and as Etsy starts to lap a 2022 impacted by economic pressures, there's a lot of room for this top e-commerce stock to take flight once again after falling over 60% from all-time highs in the last year.
Rackspace's counterintuitive debt benefit
Anders Bylund (Rackspace Technology): Cloud computing veteran Rackspace Technology runs a capital-intensive business. The company spent $88.8 million on capital expenses over the last four quarters. Rackspace's balance sheet held just $261 million of cash equivalents at the end of June and also $3.3 billion in long-term debt.
Wall Street noticed the company's heavy debt when inflation started to rear its ugly head. Smelling capital risk around the company, investors have taken Rackspace's share price 67% lower in 2022. Price drops of this magnitude have generally been reserved for high-flying growth stocks recently, and Rackspace's 3.8% year-over-year revenue growth doesn't fit that bill. So a sharp price correction didn't look appropriate when viewed through a sales-growth lens, but it did make sense when considering Rackspace's large debt load in a time of skyrocketing inflation.
But I think investors are making a mistake.
NASDAQ: RXT
Key Data Points
You see, a large debt load can actually be a positive thing during periods of surging inflation. If a $10 bill buys 8% fewer groceries today compared to August 2021, that fixed debt load also looks 8% less burdensome. Companies like Rackspace that hold significant debt figures on their balance sheets shouldn't mind that helpful effect. At the same time, a positive result from rising inflation rates feels wrong and investors can be emotional creatures. So the big debt looks like a risk, even though the actual effect is a round of cost savings.
So Rackspace's stock is being punished for all the wrong reasons. Shares trade at a modest 0.3 times sales and 4.7 times free cash flow today, down from 1 times sales and 15.7 times free cash flow a year ago. Those deeply discounted valuation ratios will likely blow up again when inflation fears have passed. By then, the financial results ought to show clear evidence that the inflation spike actually is helping Rackspace in some ways right now.
This beaten-down broadband stock is too cheap to ignore
Billy Duberstein (Charter Communications): Most people think high-growth, unprofitable stocks are the most reactive to inflation and interest rates, but another sensitive area is the communications and telecom sector. Since most of these companies rely on high levels of debt to build out their infrastructure, they have been particularly impacted as interest rates have climbed quickly as the Fed has tried to tame inflation.
Charter Communications -- which sells broadband, cable TV, and mobile phone services -- has implemented debt and share repurchases aggressively in its business model, and the stock is getting hammered as rates have risen in 2022. It's down 50% on the year and 61% from all-time highs. Yet there are several reasons to like the stock.
NASDAQ: CHTR
Key Data Points
Charter counts cable industry pioneer John Malone as a large shareholder. He is famous for using high levels of debt to grow and shield his companies from taxes and repurchase stock. Given the broadband industry's relatively utility-like characteristics, this model can add a huge amount of value over time.
Charter typically targets a debt-to-EBITDA ratio of 4.5. As the company has grown revenue and EBITDA over the past few years, it has added even more debt, plowing all of its free cash flow and then even more cash from new debt into share repurchases. Since September 2016, Charter has bought back a whopping 44.5% of its shares outstanding.
That allowed Charter to become a value investor favorite. However, its debt load recently hit a whopping $96 billion, with a weighted average interest rate of 4.7%. That is clearly worrying investors.
Additionally, Charter posted a worrying loss of 42,000 broadband net subscribers last quarter after years of nothing but gains. That has fed fears that 5G wireless and newer fiber-based players are outcompeting Charter's coaxial-cable-based technology.
However, that may be making a mountain out of a molehill. There was a discontinuation of federally subsidized programs last quarter, including the Emergency Broadband Benefit program and other requirements of the Affordable Connectivity Program. That negatively impacted broadband customers by 59,000 households; absent that, Charter's broadband segment would have seen 17,000 net additions.
Additionally, longtime CEO Tom Rutledge announced his retirement on Sept. 21, sending Charter's stock down even further amid the uncertainty. But current Chief Operating Officer Chris Winfrey will take over the job, ensuring continuity, and Rutledge will stay on as executive chairman until November 2023.
Given market fears over broadband declines and Rutledge's retirement, Charter looks especially cheap these days. The stock trades at just 8 times last quarter's annualized free cash flow.
Charter may not shoot the lights out in terms of growth, but its customer base seems pretty stable. Moreover, it's successfully growing its mobile offering, with 329,000 net adds last quarter. That shows many customers are finding value in Charter's discounted bundle. While debt is a concern to monitor, there aren't any large maturities until 2025.
If inflation starts waning and interest rates come down, a lot of the concerns over Charter's debt will likely dissipate. I'd expect that to happen before 2025, so this bargain-priced stock looks very attractive for those anticipating a decline in inflation over the next two years.
