3 Stocks to Avoid in the Event of a Recession - The Motley Fool

Summary

The United States economy isn't firing on all cylinders. With a shrinking gross domestic product, 9% inflation, rising interest rates, and a struggling stock market, it is more vital than ever to look for high-quality businesses and consider how well they would handle a potential downturn.

Three Motley Fool contributors have identified Shopify (SHOP -3.01%), Robinhood Markets (HOOD -0.66%), and Oatly (OTLY -0.80%) as businesses that may face outsize difficulty navigating rough economic waters despite otherwise intriguing operations.

The United States economy isn't firing on all cylinders. With a shrinking gross domestic product, 9% inflation, rising interest rates, and a struggling stock market, it is more vital than ever to look for high-quality businesses and consider how well they would handle a potential downturn.

Three Motley Fool contributors have identified Shopify (SHOP -3.01%), Robinhood Markets (HOOD -0.66%), and Oatly (OTLY -0.80%) as businesses that may face outsize difficulty navigating rough economic waters despite otherwise intriguing operations.

Shopify still looks pricey after a momentous drop

Bradley Guichard (Shopify): Consumer sentiment is now lower than at any point during the Great Recession and the pandemic. That's right, the most trusted predictor of future consumer spending is flashing bright red. Add to this rising costs for supplies and labor and you get a disastrous setup for retail sales. Shopify doesn't directly sell to consumers, but it makes money from people who use its platform to do so, which spells trouble.

Shopify's second-quarter earnings report was extremely concerning. Revenue increased by 16% year over year, going from $1.1 billion to $1.3 billion, but expenses increased much faster. Operating costs rose to $846 million from $481 million, a whopping 76% rise. The gross margin also shrank from 55% to 51%, which may be the most concerning metric. It is one thing to be unprofitable during a high-growth phase, but gross margin contraction suggests that significant profits are getting further away.

Investors have counted on Shopify's growth to justify its premium valuation. However, that narrative is floundering. The company's revenue growth is slowing to a trickle, from 41% to 22% to just 16% over the last three quarters.

Shopify has announced layoffs that may impact up to 10% of its current workforce, further damaging the growth narrative. It's tough to argue that Shopify deserves a premium valuation with pedestrian growth and evaporated profits. Yet its price-to-sales (P/S) ratio is much higher than competitors, as shown below.

The stock is down nearly 80% from its 52-week high, but that doesn't mean it can't fall further. Unless management can turn the tide quickly, the valuation will probably continue dropping and create even steeper losses for long-term investors.

A slowdown in investing is putting pressure on Robinhood

Jeff Santoro (Robinhood): No one knows for sure if the economy is in a recession or if one is coming. It's also impossible to know how long a potential recession might last. Regardless, it's worth thinking about what companies may be good investments in a recessionary environment and which may not.

Online brokerage Robinhood Markets may struggle through a recession. When times are tough and wallets get constrained, sometimes that extra bit of cash you might have invested gets cut out of the budget. For a company like Robinhood, investors making fewer transactions is very bad for business.

Robinhood makes the majority of its revenue on what's called payment for order flow (PFOF). Basically, the company makes money for routing orders made on its platform to market makers. The market makers match up all the buying and selling and execute the trades. This business model allows Robinhood to offer free trading on its platform.

PFOF can be a profitable business model as long as users are transacting. However, a slowdown in trading activity over the past several months has already had an impact on Robinhood's financial results. Any kind of future recession would likely be a further headwind for the company.

In the first quarter of 2022, revenue decreased 43% year over year. To be fair, this was off of the first quarter of 2021 when revenue increased more than 300%, presenting a tough comparison. However, revenue was also down sequentially, and has been decreasing for each of the last four quarters. Monthly average users (MAU) and average revenue per user (ARPU) followed a similar trajectory..

Quarter Revenue MAU ARPU Q2 2021 $565 million 21.3 million $112 Q3 2021 $365 million 18.9 million $165 Q4 2021 $363 million 17.3 million $64 Q1 2022 $299 million 15.9 million $53

Unfortunately, as revenue has decreased, operating expenses have increased. In Q1 2022, Robinhood's operating expenses represented 231% of its income. That number was 89% in the year-ago quarter. The one-two punch of slowing revenue and increasing operating expenses could spell trouble for Robinhood if it continues.

With the possibility of a recession looming, there doesn't appear to be an easy path ahead for Robinhood. Even if we never formally enter a recession, the macroeconomic environment could be a prolonged headwind for the business if trading volume remains suppressed.

Oatly's cash-burning race against time

Josh Kohn-Lindquist (Oatly): Oatly may be a prime example of the saying, "a great business, but a terrible investment." Offering a healthier and potentially more sustainable solution to the milk industry with its oat-milk production, Oatly went public at a $10 billion valuation in 2021 but has lost over 80% of its value since.

Oatly is incredibly popular -- it's the No. 1 oat milk brand in many major European countries and the No. 2 in the U.S. -- and has grown sales by 71% annually since 2018. Despite these sales, its gross profit margin has dropped precipitously due to inflation, supply chain constraints, and an ongoing transition in the company's production model.

Oatly is trying to shift away from co-packing its milk to building end-to-end self-manufacturing facilities to combat this declining gross profit margin, which management believes could bring 40% margin over the long term. However, the capital expenditures (capex) needed to fund this process will amount to $400 million to $500 million in 2022 alone.

With cash and short-term investments of $411 million and no debt, Oatly will burn through most of its cash balance due to its capex alone over the next year.

This cash burn doesn't account for Oatly's $250 million cash loss from operations, which creates a negative $540 million in free cash flow when paired with capex.

Due to this incredible cash burn, Oatly will most likely need to turn to a dilutive capital raise -- at a reduced valuation -- or the debt markets, with interest rates continuing to skyrocket in 2022. Unfortunately, either route is less than favorable for investors and comes at a terrible time due to the current state of the markets.

While Oatly could surprise everyone and stick the landing with its self-manufacturing buildout, it certainly will not be as smooth a process as was expected at its initial public offering. However, with management expecting quarter-over-quarter growth in its gross profit margin in Q2 of 2022, it will be essential to watch for this figure when the company reports earnings on Aug. 2.

Ultimately, because of this cash burn potentially leading to the offering of new shares or issuing of new debt, Oatly is in a race against time to bring its self-production facilities up to scale -- a race investors may be wise to watch from the sidelines for now.

3 Stocks to Avoid in the Event of a Recession - The Motley Fool
Photo Credit: The Motley Fool

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