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Thursday, July 30, 2009

Sonic Surviving Turmoil, Answers Questions, Raises Guidance (not kidding)

Last week, we provided an update on Sonic Foundry (SOFO, $0.63) and included our top ten questions for management. The company reported results today and, on the Mediasite Webcast, management mostly answered our key questions. Due to limited time, we can't recount all answers here, but recommend watching the Webcast for those interested - link to new Mediasite version 5.1 Webcast here. We find the 5.1 player very impressive.

June quarter revenue of $5.0 million was down 7% Q/Q and 1% Y/Y as seasonal strength didn't materialize. We were afraid this might happen amidst the state budget crisis as well as retrenchment by private institutions (pension/endowment funds down significantly). However, management relayed some good news: with 46 state budgets now approved, customers are moving forward with purchases and the company expects to realize better-than-expected revenue in the September quarter. As a result, management raised fiscal 2009 revenue guidance from +15-20% to >20% Y/Y. Since very few companies are growing in the current environment, and even fewer are raising guidance, we are encouraged by the increased forecast. In addition, federal stimulus money is coming down the pike, which should assist cash-strapped schools (depending upon allocation) and boost spending for online learning platforms/applications (President Obama's 10 year program - per Sonic Foundry, includes $500 million for this purpose).

While there are really no direct comparable companies for microcap Sonic Foundry, for reference, audio/video companies Polycom (PLCM) reported June quarter revenue down 15% Y/Y while Tandberg saw revenue increase 5% Y/Y in the quarter. Major tech titan IBM saw June quarter software revenue down 7% Y/Y (flat in constant currency) and Adobe (ADBE) reported revenue down 10% Y/Y in its most recent quarter (end-May). Arrow Electronics (ARW), a global electronic components distributor and enterprise IT solutions provider, reported a 24% Y/Y decline (excluding acquisitions) for the June quarter in the company's solutions segment (mostly small/medium sized business customers). Commenting on the segment's results, Arrow noted the following in its press release:
  • "sales were at the low end of our expectations, due to lower demand and IT spending, as capital-intensive projects continue to be highly scrutinized."
So, difficult times in the technology sector with negative/slow growth for most players. Sonic Foundry's anticipated >20% revenue growth appears a major coup, although we submit that the company should be growing given its smaller size and favorable secular trends. We would expect better growth in a "normal" economy.

Sonic's trailing twelve month income statement is as follows:
  • Billings of $19.7 million were up 13% Y/Y
  • Revenue of $18.5 was up 14%
  • Gross profit of $14.1 million was up 19% (margin expansion)
  • GAAP operating expenses of $16.8 million were down 15% (expense reduction)
  • Cash operating income of approximately negative $250 thousand (a $4.3 million Y/Y improvement)
Looking at the balance sheet: deferred revenue at 6/30/09 increased 29% Y/Y to $4.7 million, total debt increased to $1.25 million from $726 thousand a year ago, and net cash declined by $1.5 million to approximately $1.25M (total cash was $2.4 million). Sonic continues to use cash for working capital, although the company tends to generate cash during the September and December quarters as receivables are collected. Considering only accounts receivable, inventory, and accounts payable, working capital increased by $900 thousand (+43%) Y/Y to $2.9 million, which explains a majority of Y/Y cash consumption. The company's accounts payable are the primary difference, down nearly one million Y/Y to $1.5 million. As previously noted, we would prefer a larger cash position, but remain comfortable that Sonic Foundry's access to an additional $3 million from Silicon Valley Bank allows breathing room to fund working capital needs. As noted in our post last week, we believe Sonic Foundry can generate free cash flow in fiscal 2010 if growth remains similar to fiscal 2009. We think incremental economic weakness and related budget woes are the key risk factor to achieving excess cash flow.

Below, we include our updated "June quarter" snapshot which shows muted to no seasonality relative to past years.

The key focal point for us remains the Mediasite franchise, which we believe continues to grow in value as customers expand footprints, new customers join the community, and -- importantly -- the global A/V channel increasingly recommends Mediasite for rich media Webcasting. We think the channel promotes Mediasite because the solution works extremely well, is reliable, and has a clear product development road-map. The growing, installed customer base, combined with brand recognition, trust, and global distribution, are all difficult for a competitor to replicate and take years to establish. In our view, these aspects mitigate the risk of rapid technological change and help secure Mediasite's leading position in the marketplace.

On the customer front, Sonic referenced the following additions:

One that we didn't recognize is "UNIDO" (we guessed United Nations based on the logo, but were not sure about the "IDO"). A quick search and voilà: The United Nations Industrial Development Organization (UNIDO) - link here. While we don't know the extent of their Mediasite use, this is exacty the type of organization that can meaningfully benefit from the use of Mediasite and expose others to the solution (everyone wins).

We're optimistic that we'll continue to see more Mediasite use outside of higher education, similar to what S&P is now doing. Mediasite v5.1 with players that can be embedded on Web pages may help. While we're biased, we write this almost as fact without regard to our SOFO interest: we are disappointed whenever we run into a Cisco (CSCO) WebEx presentation for a one-to-many broadcast type event because the Mediasite end-user experience is far superior. We think anyone who has experienced both will agree with us, but please comment if otherwise. In our view, Sonic Foundry should capitalize on the Mediasite advantage, perhaps by partnering with additional, large-scale Webcast providers or other companies that can effectively help spread the word. We believe management is working toward this end.

One more final point that supports our franchise thesis: Sonic Foundry's services business continues to grow, with revenue increasing 17% Y/Y to $2.4 million and approaching a $10 million annual run rate. We expect recurring license revenue (60% of services revenue) to keep building on the balance sheet as deferred revenue and then contributing to services revenue as annual contracts are amortized. As this occurs, additional installation, consulting, hosting, and events service revenue should also compound as Sonic Foundry participates in a growing, global Webcasting market (particularly whenever economies rebound).

Happy investing,

Jeffrey Walkenhorst

Disclosure: long SOFO, short ARW.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

eFax Still Alive – Short JCOM at Your Own Peril

Another long one, for those interested.... regarding an idea mentioned in a Barron's cover story a few weeks back that we happen to own.

The Saturday 7/04/09 Barron’s cover story, “Shorts Story” by Gene Epstein, highlighted five short ideas from Short Alert, a North Carolina-based research firm with respectable track record on the short side. Barron’s even took a victory lap on Monday 7/06/09, “Barron's Short Picks All Fall Down”, as the picks were down in “midday trading” while the overall market moved higher. In the cover story, Mr. Epstein wrote “that the firm … produced annual returns averaging 18.3% from 1999 through 2008.” The article also included commentary from a New York University professor about earnings manipulation and how ‘short sellers can make a positive contribution by trading against these subterfuges.’ We agree that uncovering companies using accounting shenanigans makes for great short candidates, as does finding firms with broken business models, unsustainably high leverage, and/or negative secular trends. However, we think at least one of Short Alert’s five short calls is off the mark: j2 Global Communications (JCOM, $24.20).

As background, j2 Global was founded in 1995 and provides fax, voicemail, email and call handling services to individuals and businesses worldwide. We’re long the stock (full disclosure) and believe the company is the exact opposite of each major short rationale noted above, with the possible exception of negative secular trends (the major knock on the stock). Yet, in this regard, the sky isn’t falling anytime soon.

j2 Global’s core, cash-cow, subscription-based eFax business keeps adding corporate customers while the company’s voice services business continues to scale. In addition, the company’s financial results, metrics, and position are strong:
  • In 2008, the company generated revenue of $242 million in 2008 (+9% Y/Y) with gross and operating margins of 81% and 41% (GAAP), respectively, earnings per share of $1.58 (GAAP), and free cash flow of $91 million (38% of revenue).
  • As of 3/30/09, the company had no debt and cash/investments of $179 million (17% of market capitalization), and consistently generates astoundingly high return metrics, including a return on net operating assets in excess of 60%. Few companies are capable of this feat, period. Year after year, j2’s management team runs the business to maximize margins, free cash flow, and returns on invested capital.
  • Finally, among category killer companies such as Cisco Systems, Digital River, eBay, Qualcomm, and Salesforce.com, j2 Global slightly edges Qualcomm for the highest profit per employee (measured by GAAP EBIT) and has the highest return on equity of the group (please see below table - click to enlarge). At present, the company also offers the highest FCF yield per share. j2 Global’s high profit per employee illustrates the quality of the company’s business model and extremely cost conscious management.

Detailed Analysis

Let’s take a closer look at the short thesis and why some investors might consider shorting j2 Global. For reference, here is the JCOM short thesis as reported in Barron’s:
  • J2 GLOBAL COMMUNICATIONS, the subject of a June 19, 2008, report by Short Alert, was down 14% a year later, but Guild sees far more downside. About 80% of the company's sales come from transmitting electronic faxes, a business that's in decline. Its growth in subscribers has come from acquiring other companies, he says. And 50% of its paid subscriber list turns over every year. Its stock is now hovering above 20 but could easily plunge below 10, asserts Guild, if it were hit with the one-two punch of no significant acquisitions and fewer paid subscribers. J2 President Scott Turicchi counters that "our short position has fallen to 1.7 million shares, less than 4% of outstanding shares of j2 Global and near an all-time low."
Let’s consider each point in the paragraph:

J2 GLOBAL COMMUNICATIONS, the subject of a June 19, 2008, report by Short Alert, was down 14% a year later, but Guild sees far more downside.
  • Given the market’s swoon over the past year, most stocks are lower than year ago levels. However, JCOM’s performance of down 14% compares favorably to the S&P 500 – down 31% – and the Nasdaq – down 26% – over the same period. Like many stocks, shares of j2 Global were thrown out with the bathwater and briefly touched an intraday low of $13.03 in November. Yet, the stock quickly recovered to near $20 per share and has largely been range bound between the mid/high-teens and mid-twenties over the past year. Investors likely jumped into JCOM because of the company’s high quality business model, not to mention better-than-expected earnings results in each of the last three quarters.
(1) About 80% of the company's sales come from transmitting electronic faxes, a business that's in decline.
  • Indeed, “eFax” is j2’s primary brand and fax services provided an estimated 90% of 2008’s $242 million in revenue. Approximately 79% of 2008 revenue was “fixed” (recurring) versus 76% in 2007 and 72% in 2006 as variable usage revenue declined along macroeconomic trends in recent years. The company had 11.6 total customers as of 3/30/09, including 1.3 million “paying” subscribers (+16% Y/Y including some small acquisitions) and 10.1 million “free” subscribers. The company had approximately 1.1 million paid fax customers and 200,000 voice subscribers at 3/30/09. Geographic revenue mix: 85% US / 15% International in 2008, versus 87% US / 13% International in 2007 and 89% US / 11% International in 2006.
  • We agree that fax is in secular decline as more persons/firms use email to transmit documents. And, j2 faces a double whammy in that the weak economy is negatively impacting usage. Still, as the market leader with perhaps one third of the market (hard to measure), j2 is gaining share as more individuals and corporations utilize digital fax services to reduce costs and improve security. j2’s corporate fax business actually accelerated in 2008 as large enterprises focused on reducing hardware footprints and operating expenses. This trend is continuing in 2009. Faxes are still widely used around the world, especially for business transactions in “FIRE” – finance, insurance, and real estate – industries.
  • Still, even if j2 can still grow in a declining market, an important question is the pace of decline for the sector at large – is the decline similar to rapid creative destruction impacting print media or more similar to the gradual demise of the paging industry? The nature of j2’s business suggests the latter, as numerous competitive advantages protect j2’s subscription-based, high margin/ROIC business model: brand, sticky customers, scale/scope, and intellectual property rights.
  • o Leading market share (brand) and loyalty (sticky customer relationships) lead to low cost, efficient customer acquisition and stability – only modest short-term increase in customer churn following 30% price increase effected in 2006-07 for core eFax service (acknowledge: pricing power not possible in current environment and loyalty also less evident). Viral marketing brings approximately 40%-50% of new paid subscribers directly to j2 Global’s various Web sites.
  • o Global telephony/IP network supports service in more than 3,200 cities in 46 countries across six continents (scope/scale).
  • o Intellectual property rights (IPR) with successful licensing efforts and proactive defense of rights – 59 issued patents.
  • o Recurring revenue model enables meaningful operating leverage and consistently high margins (>80% gross margin and 40% operating margin) and ROIC (31% including large cash position, 89% excluding cash/investments).
  • o Software based product offerings require no inventory – negative cash conversion cycle (negative ~100 days) yields positive carry.
  • o Result: strong, sustainable financial position: as noted previously, the company has no debt, cash and investments of $179 million (17% of j2’s market capitalization), and should again generate FCF north of $90 million this year (approximately 37% of 2009E consensus revenue of $246M).
  • The company’s voice service offerings are gaining traction and j2 Global is claiming a market leadership position in this space. Voice services include automated receptionist offerings (“virtual PBX”) for small/medium sized businesses that tie into email/messaging systems. As of 1Q09, run-rate voice services revenue could represent an estimated 15% of 2009E revenue, up from an estimated 10% in 2008, 4% in 2007 and 2% in 2006. j2’s voice business is achieving critical mass that could propel future growth when the core fax business begins to decline (under normal economic conditions).
(2) Its growth in subscribers has come from acquiring other companies, he says. And 50% of its paid subscriber list turns over every year.
  • Most of j2’s historic subscriber growth was organic, although it is true that small acquisitions over the past year boosted growth. Through the years, j2 Global closed 22 acquisitions across nine countries and different service offerings. The deals are usually small and, per management, contributed a low single digit percentage of average revenue growth in the year of acquisition (i.e. if top-line growth was 20%, acquisitions added perhaps 1% to 3% to that figure).
  • The economic downturn is leading to slower gross new customer additions and higher churn. Churn was 3.5% in 1Q09 versus 2.8% in 1Q08, implying that 42% of j2’s current subscriber base will churn away (disconnect) within one year (not the 50% mentioned in “Shorts Story”). The company’s historic target churn level was 2.50% - 2.75%.
  • The combination of slower additions and higher churn is leading to fewer net new customers. Management’s philosophy with respect to customer acquisition and retention in the current environment is very clear: the company is focused on maintaining/ improving margins and free cash flow, and not afraid to let some customers disconnect.
  • Admittedly, the impact of the recession on the customer base is hard to gauge and differentiate from the impact of the technological change (email substitution). The latter has long been the bear thesis on the stock, yet j2 continued to grow and prove skeptics wrong.
(3) Its stock is now hovering above 20 but could easily plunge below 10, asserts Guild, if it were hit with the one-two punch of no significant acquisitions and fewer paid subscribers.
  • Before directly addressing this point, let’s first address another important investor concern: lower reported average revenue per user. In recent years, j2 began to cannibalize higher ARPU offerings through increased corporate sales (1,000s of users per account, but lower ARPU) and a product/brand segmentation strategy driven by the acquisition of smaller, lower priced competitive fax services companies. Reported monthly ARPU was $14.85 in 1Q09 versus $16.30 in 1Q08 (down 9% Y/Y). In addition, ARPU for voice services is typically in the low-teens versus mid-teens for the core eFax business. At some point, the overall ARPU decline will stabilize, and, pricing power could even return.
  • Lower ARPU and slower subscriber growth are leading to flat organic revenue trends (not bad, all things considered) and valuation compression. But, a snapshot of j2 Global’s overall 1Q09 results suggest the company is far from unraveling:
  • Revenue grew 3% Y/Y to $60.4 million (including small acquisition).
  • Gross margin improved to 81.1% from 80.2% in 1Q08.
  • Operating margin was 43.8% versus 38.4% in the year ago period as the company shows continued operating leverage and scale.
  • Operating earnings of $26.5 million increased 18% Y/Y and net income was up 11% Y/Y (OE strength offset by much lower interest income Y/Y).
  • GAAP EPS of $0.42, up 20% Y/Y from $0.35 (helped by lower share count).
  • Quarterly free cash flow of $30.4 (March quarter is usually strong).
  • Management maintained guidance for modest revenue and earnings growth this year including acquisitions (which will likely be a small contributor).
  • j2 Global's return on net operating assets (RONA) remained extremely high.
  • In 2005 – 2007, with organic revenue growth of 20-30%, j2’s shares traded at a median TTM GAAP EPS multiple of 26 times. The stock is currently trading at 14.5 times TTM GAAP EPS and 11.8 times 2008 free cash flow (defined as CFO less capital expenditures) for an earnings yield of 6.9% and a FCF yield of 8.5% (*slightly below our preferred >10% buy threshold). Although shares are not the bargain they were last fall, the stock arguably could trade at 15 times free cash flow (7% yield) or $30 per share based on j2 Global’s established (but mature) eFax franchise and growing voice services business.
  • Given the strength of recent results and the company’s financial position, we are hard pressed to see how shares “could easily plunge below $10” or even return to the low teens in the near-term. At $10 per share, JCOM would trade at six times 2009E GAAP earnings (17% yield) and only five times 2009E free cash flow (20% yield), which would be an amazing entry point for a cash rich, growing, cash flowing company with shareholder friendly management.
J2 President Scott Turicchi counters that "our short position has fallen to 1.7 million shares, less than 4% of outstanding shares of j2 Global and near an all-time low."
  • Mr. Turicchi is correct that the short interest declined to 1.7 million at 6/30/09, down markedly from 5.0 million almost one year prior at 7/15/08. Short interest ticked slightly higher during the first half of July, to 2.3 million shares, perhaps as a result of Barron’s “Shorts Story”. Unlike last year, where some institutional investors correctly foresaw the impending banking crisis and wagered that j2 Global’s business would suffer, far fewer professionals are willing to make that bet today. The probable reason: j2 Global’s results and cash generation over the past year were very resilient, and 2009 should be no different.

Shares of j2 Global could certainly decline if the economy weakens further and/or the broader market again tumbles. Yet, aside from these scenarios, the short thesis appears fickle, particularly in the face of a high quality business model with numerous competitive advantages. Further, although the risk of technological change cannot be ignored, j2 Global should continue to generate significant excess cash that management can use to both further grow the business and return to shareholders through additional share buybacks. As the market leader with a large cash balance, j2 is well-placed to take advantage of incremental industry consolidation during the down economy. Finally, potential near-term positive catalysts include: (1) continued improvement in usage trends for credit-sensitive customers, (2) incremental M&A activity, and (3) renewed share buyback program (early 2010 seems likely as cash accumulates on the balance sheet, barring a major acquisition, which seems unlikely). The company reports June quarter results Wednesday 8/05/09.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long JCOM, EBAY.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Saturday, July 25, 2009

Update on Languishing SOFO, Mediasite v5.1, and Top Ten Questions for Management

Our primary investment focus is on companies that have a history of generating consistent free cash flow. However, Sonic Foundry (SOFO, $0.65) fits within one of our caveats:

Every now and then, we may invest in off-the-run, smaller franchise companies that we believe have sustainable competitive advantages and are trading significantly below the valuation an informed private market buyer would be willing pay for the entire business.

We acknowledge that the stock remains speculative and akin to public venture capital. We call it what it is. We questioned Berkshire Hathaway's BYD purchase the other day, yet -- in fairness -- our SOFO interest could equally be questioned. The short answer is that we continue to believe that the Mediasite franchise is under-appreciated relative to reproduction cost and the valuation that would be assigned by an informed private market buyer. As a reminder, our confidence arises from several competitive advantages that point to a powerful, sustainable franchise: (1) Sonic Foundry/Mediasite is far along the learning curve with (2) intellectual property protection, and (3) very satisfied, captive customers that face high switching and search costs.

Still, we can't hold our breath for a strategic acquirer to purchase the company and, therefore, need to consider Sonic Foundry as a standalone, self-sustaining company. Our thesis needs to be supported by steadily growing revenue and positive cash flow, which is a challenge for most companies in the current environment, let alone a small technology company evangelizing a rich media solution (risky endeavor). Positive earnings and free cash flow are the lifeblood for all companies and the only thing that create tangible value for shareholders.

What do the numbers tell us on a trailing twelve month basis through March? We previously reviewed progress in an earlier post, but again -
  • Billings of $20.2 million were up 13% Y/Y
  • Revenue of $18.6% was up 17%
  • Gross profit of $13.9 million was up 21% (margin expansion)
  • GAAP operating expenses of $17.3 million were down 15% (expense reduction)
  • Cash operating income of approximately negative $100 thousand (a $4.7 million Y/Y improvement)
Looking at the balance sheet: deferred revenue at 3/30/09 increased 36% Y/Y to $4.7 million as recurring license and service revenue increasingly contribute to the top-line. Total debt increased slightly to approximately one million from $800 thousand a year ago and net cash declined by $1.5 million to approximately $1.5M (total cash was $2.5 million). We would prefer a larger cash position on which to hang our hat, yet the lower cash balance and modest leverage forces management to remain disciplined on the expense side. After achieving cash break-even operations in the March quarter, the company's primary use of cash going forward should be for working capital assuming fundamentals remain favorable. Sonic Foundry's access to an additional $3 million from Silicon Valley Bank provides headroom to maneuver through the tough economy and to fund working capital related to growth. Capital expenditure requirements are minimal. The below slide from Sonic's F2Q09 presentation summarizes progress toward the break-even inflection point:

Actual results indicate Sonic Foundry is moving in the right direction, yet at a critical juncture - revenue needs to keep scaling with constant costs for the company to generate positive free cash flow.

The hurdle to watch: the business can be self-funding with annualized billings of $21 million (almost there now) and cash generating above $21 million. If Sonic Foundry achieves billings of $21 million in fiscal 2009 (+18% Y/Y) and grows billings 15% to approximately $24 million in fiscal 2010 with constant costs, the company could generate free cash flow of $2 million (working capital is swing factor). Given where the stock trades today, such an outcome would likely surprise many. With potential excess cash, management would probably love to spend additional marketing dollars to build the brand, yet we believe they understand the importance of building cash on the company's balance sheet.

Despite improved operating results over the past year and potential free cash flow on the horizon, why does the stock remain out of favor? We see a handful of reasons: (1) limited cash on balance sheet, (2) illiquid microcap company with small revenue, (3) still limited institutional support (the few professionals able to purchase microcaps may not want to stick their necks out even with favorable fundamentals), (4) concerns surrounding competition and technological change (is Mediasite still number one? or are Adobe's Flash-based solutions making inroads?), and (5) economic concerns surrounding IT spending in the higher education market.

We mostly addressed point (1) above and point (4) in prior posts. Points (2) and (3) can take care of themselves if fundamentals keep moving in the right direction. Point (5) is a tough one. Normally, the June quarter is Sonic Foundry's strongest quarter because of seasonal and fiscal year-end spending by U.S.-based schools ("budget flush" to use up IT budgets before possibly losing funds in next fiscal year). To illustrate, we include the following analysis that shows various figures for the last four June quarters (click to enlarge):

This year, we've gleaned a mixed read as many schools are wrestling with budget woes. A 6/15/09 article from ProAVOnline entitled University AV: Doubling Down in the Downturn included positive as well as negative/mixed commentary from Sean Brown, Sonic Foundry's Vice President of Education:
  • Positive: 'Hardware and software that allow schools to stream classes over the Web continue to gain acceptance during the recession, says Brown, whose company sells the products. "Our business is increasing right now," he says. "Streaming is a multiplier. It defeats distance, and it's a quality enhancer."'
  • Negative/mixed: '"[Schools] are cutting and doubling down at the same time," says Sean Brown, vice president of education at Sonic Foundry. "They are reshuffling priorities. The entire pro AV industry needs to be more flexible."'
The good news is that Sonic continues to expand Mediasite usage/adoption and, from our conversations, we know that customers love the product. As a result, Mediasite becomes more entrenched in the daily lives of a growing number of institutions around the world. In addition, the company keeps innovating. To see where the Mediasite platform is headed, we recommend watching minutes 26-41 of the June Mediasite User Group meeting, which provides an overview of Mediasite "version 5.1" -- the user interface appears as follows:

To actually see v5.1 in action, we can watch Sonic Foundry's Sample Unleash 2009 Catalog (link here). Separately, some other Mediasite (v5.0) links to peruse, if interested:
The company's June quarter report this Thursday after market close (Webcast link here) will provide an important progress update. From management, we expect a frank update on the following ten questions:
  1. liquidity position, deferred revenue, cash flow expectations, funding needs and/or plans to increase borrowings
  2. repeat customer business and recurring revenue as a percentage of total revenue and mix between licenses and services
  3. total cumulative customer count, with split between license and service customers
  4. domestic and international deal pipeline, and potential for follow-on business with The King Abdullah University of Science and Technology in Saudia Arabia
  5. customer sentiment amidst budget challenges at public and private institutions
  6. prospects for event services business and how to penetrate more high profile customers
  7. positive/negative feedback regarding Mediasite v5.1 (no playback speed control?)
  8. marketing strategies and ideas to further accelerate Mediasite awareness/adoption
  9. resource constraints/needs, and
  10. competitive landscape and what Sonic Foundry is doing that the competition is not YET doing? (*a favorite question of any company for legend Philip Fisher, author of Common Stocks and Uncommon Profits)
Happy investing,

Jeffrey Walkenhorst

Disclosure: long SOFO, BRK-B.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Thursday, July 23, 2009

Berkshire Hathaway's BYD Purchase - Great "Trade" yet Long-Term Economics are Critical Question

The Fortune magazine cover story for the 4/27/09 issue was "Buffett's Electric Car-Buffet Takes Charge", an interesting read about Berkshire Hathaway's (BRK-A, BRK-B) $230 million purchase of a 10% stake in a Chinese company called BYD (HKG:1211). BYD makes cell phone batteries, mobile phones, and electric cars. The purchase was announced 9/29/08 by Berkshire's MidAmerican Energy Holdings subsidiary and, according to Fortune, is still awaiting approval from the Chinese government.

The article is up-front about Mr. Buffett's primary investment rules:
  • "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is usually the reputation of the business that remains intact.
  • You should invest in a business that even a fool can run, because someday a fool will.
  • And perhaps most famously, Never invest in a business you cannot understand."
The article goes on to say:
  • 'In acquiring a stake in BYD, Buffett broke a couple of his own rules. "I don't know a thing about cellphones or batteries," he admits. "And I don't know how cars work." But, he adds, "Charlie Munger and [MidAmerican Chairman] Dave Sokol are smart guys, and they do understand it. And there's no question that what's been accomplished since 1995 at BYD is extraordinary."'
  • "... Buffett and Munger and Sokol think it is a very big deal.... They think BYD has a shot at becoming the world's largest automaker, primarily by selling electric cars, as well as a leader in the fast-growing solar power industry."
Finally, the article highlights that the primary reason for breaking Mr. Buffett's rules was/is BYD's hard charging founder and chairman, Wang Chuan-Fu. Mr. Wang built BYD into a behemoth in the cell phone battery and component market from scratch over the past decade. Berkshire's Vice Chairman, Charlie Munger, relayed to Fortune the following about Mr. Wang:
  • '"This guy ... is a combination of Thomas Edison and Jack Welch - something like Edison in solving technical problems, and something like Welch in getting done what he needs to do. I have never seen anything like it."
To summarize: Berkshire Hathaway decided to take a swing based on the past success of Mr. Wang and the future potential in the "clean tech" market (electric cars, solar).

So far, Berkshire Hathaway and Mid-American look like champions based on their entry point of HK$8 per share (16 times 2008 earnings) for 225 million shares. Shares of BYD now trade around HK$42 (a whopping 84 times 2008 earnings) -- up 425% from HK$8 -- rising on the back the Berkshire news, optimism that China's stimulus is working (with local stocks zooming upward), and clean-tech sector momentum.

BYD's two-year stock chart is included below -- we believe shares plunged in February 2008 after plans to raise additional capital were announced. The raise never happened in 2008 because of ensuing market conditions, but BYD announced last week a potential 100 million share offering is now in the works. The planned offering is expected to bring total shares outstanding to 2.4 billion, slightly diluting Mid-American's stake.

Yet, Berkshire Hathaway did not invest in BYD for a quick gain. Rather, we know that Berkshire is on-board for the long-haul. In this case, what matters most are business economics over the long-term and, more specifically, the equity earnings stream that Berkshire/Mid-American will realize from BYD. For us, this is where things get hazy.

From BYD's 2008 annual report, we learn the following:
  • Gigantic revenue growth - BYD's 2008 revenue of RMB 26.8 billion increased 26% Y/Y and by a factor of four from RMB 6.4 billion in 2004 (organic and acquisitions).
  • But, margin compression - although gross profit increased 23% Y/Y, gross and net margins declined to 19% and 4% in 2008, respectively, from 20% and 8% in 2007 and 27% and 15% in 2004. Total segment operating margin (before interest/finance costs and taxes) was 6.8%, down Y/Y from 9.8%.
  • And, low return metrics - 2008 return on average equity and return on invested capital of approximately 9%, and a return on average assets of 3.3%.
  • With huge capital consumption to fund growth - cash flow from operations less capital expenditures of negative RMB 3.7 billion in 2008 and negative 2.1 billion in 2007. BYD's net debt increased almost 200% to RMB 7.5 billion, with gearing* increasing to 66% from 24% (*net debt divided by net assets, or shareholder equity).
Quick conclusion: the facts tell us that BYD operates in a low margin, low return, competitive business that consumes significant capital.

More on margins - the annual report provides the following explanation for a 100 basis point Y/Y decline in 2008's gross profit margin:
  • "(1) income from the handset components and assembly services which had lower gross profit margin, the proportion of which to the overall income increased significantly during the year; (2) decreased gross profit margin of handset component business as a result of unfavorable factors such as high price of raw materials, volatile exchange rates and Renminbi appreciation, which offset the increase in gross profit from the lithium-ion battery business and the automobile business."
Now, let's look briefly at BYD's three segments:
  • "Mobile handset components" segment revenue increased 30% Y/Y and was 45% of BYD's 2008 revenue and 37% of the company's total segment earnings, with a segment contribution margin of 5.7% compared to 11.7% in 2007. We know from our experience covering the technology sector -- both wireless handset companies and the supply chain -- that competition is consistently fierce. Ever higher volumes are necessary to offset lower average selling prices across virtually all components that feed into finished products and assembly margins are extremely thin (low single digit operating margins). Large handset makers such as Nokia (NOK), which has seen its average selling price decline to the EUR 62 in 2Q09 from EUR 102 just three years ago (2Q06), constantly press suppliers for lower prices in an effort to preserve their own margins. While BYD certainly has scale in this segment, the handset component and assembly is a very competitive business.
  • "Battery and other products" segment revenue decreased 13% Y/Y and represented 23% of 2008 revenue and 35% of total segment earnings, with a segment margin of 10.4% compared to 10.6% in 2007. BYD makes rechargeable nickel-cadmium and lithium-ion and batteries for all kinds of electronic devices. According to a January 2009 article in Green Car Congress, BYD is the world's "leading provider of NiCd batteries (65% global market share) and lithium-ion cell phone batteries (30% global market share)". BYD definitely appears to have a scale advantage in this segment based on the company's leading market position and stable margins last year amidst a weaker economy. According to the Fortune article, BYD achieved scale by using low-cost, manual labor for production rather than expensive, automatic machines used in Japan and Korea.
  • "Automobiles and related products" segment revenue increased 77% Y/Y and represented 32% of 2008 revenue and 28% of total segment earnings, with a segment margin of 5.8% compared to 5.3% in 2007. BYD sold 170,000 automobiles in 2008, double the number in 2007, but still small relative to both the Chinese and global markets. BYD is rolling out new models this year, including a hybrid called F3DM. To put 2008 unit sales in perspective, we highlight several items:
  • Domestic market size, from annual report - "According to the China Association of Automobile Manufactures, in 2008, aggregate production and sales volumes of the automobile market in China were approximately 9.345 million vehicles and approximately 9.38 million vehicles respectively, representing a year-on-year increase of approximately 5.2% and 6.7% respectively, a significant slowdown in growth rate. Of these, sales of sedans exceeded approximately 5.047 million units, representing a year-on-year increase of approximately 6.8%. Domestic brands accounted for approximately 26% of the total sales volume of sedans and continued to occupy a major position in the market."
Let's note a few more items for the auto sector:
  • Technology and competition - the Green Car Congress article referenced above also says that BYD's auto "battery packs retain 80% of initial capacity through 2,000 full charge and discharge cycles, and have a 10-year lifetime." Berkshire Hathaway is enthusiastic about BYD's technology and track record of success with batteries. Still, we know that -- as in the electronic device battery market -- Sanyo Electric, Sony, Samsung SDI, LG Chem, and NEC are aggressively angling for market share in the electric car battery market.
  • "capitalizing on the electric car's low barriers to entry. Few products are as complex to develop and produce as gasoline-powered automobiles, which are assembled with thousands of precisely engineered parts. But electric cars use only basic motors and gearboxes, and have relatively few parts. Aside from perfecting the battery itself, they're far easier and cheaper to build -- and that makes for a level playing field."
  • Margins/metrics for leading, mature players - we know last year was horrendous for automakers, but what about five year average operating margins, ROE, and ROI? Based on Thomson Reuters data, Toyota's five-year average operating margin, ROE, and ROI were 6.9%, 10.4%, and 5.5%, respectively, with an effective tax rate of 40%. Honda's were 6.8%, 12.1%, and 5.8%, with an effective tax rate of 41%. The industry averages were 6.0%, 9.1%, and 4.9% with an effective tax rate of 38%.
Key Observations:
  • BYD is an insurgent player with arguably* strong battery technology and no legacy cost structure tied to a very large, complex supply chain in major developed markets (we put an asterisk next to arguably because we've heard different views from clean-tech investors).
  • The company is trailblazing to establish market share in a large, global market. However, incumbent players are not going to close up shop and go home. BYD will need to work overtime to achieve the quality and reliability for which Toyota and Honda are well known.
  • Despite not having a legacy cost structure, BYD's automobile segment margin of 5.8% is only in-line with average margins for mature, traditional high cost competitors. BYD's ROE of 9% is in-line with the five-year industry average.
  • Although BYD's auto sales are growing rapidly and the company will benefit from significantly lower tax rates (16.5% in 2008), the company has no established brand or distribution outside China unlike mature players . As a result, these areas will no doubt require meaningful investment on top of continued investment in physical plant.

For sure, given increased global environmental concerns, the world will move toward more clean-tech solutions. Why not try to reduce dependency on fossil fuels by promoting electric cars that can be recharged overnight when electric grid usage is low? Assuming concerns surrounding batteries (heat, efficiency, recycling) and car safety (small size, fear of "electric" accidents, increased pedestrian accidents + silent engine perils) can be addressed, seems very plausible that a growing portion of the population will drive hybrid vehicles over time.

We are certain that Berkshire Hathaway and MidAmerican performed extensive due diligence on BYD and understand that they think the world of Mr. Wang. Other smart, long-term oriented investors are also buying into the BYD story, surprisingly even at now elevated P/E multiples. According to a 7/21/09 report from China Knowledge Online sourcing information from the Hong Kong exchange, The Capital Group Companies recently increased its stake to 7.02% from 6.93%.

Still, even with great management and a potential technology advantage, we can't help but scratch our head over the economics of the business. We have no problem believing that BYD will be around in ten years and quite possibly be bigger, better, stronger in each of the company's key markets. After all, the low-cost provider in a given market can be a big winner with a durable competitive advantage. Plus, perhaps MidAmerican will benefit from access to BYD's battery know-how. However, with low margins and large capital requirements, we are less confident in the company's ability to "generate cash and consistently earn above-average returns on capital" (Berkshire Hathaway's #4 Owner-Related Business Principle, "preference for companies that...."). As a Berkshire Hathaway shareholder with great respect for Messrs. Buffet and Munger, we're curious to see how things develop at BYD.

As an aside, Berkshire's confidence in BYD gives us confidence in our position in American Oriental Bioengineering (AOB, $5.28). AOB also has a motivated, hard-charging CEO with a successful track record and long-term vision, yet has the benefit of business model with high margins and excess cash generation.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long BRK-B, AOB.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Tuesday, July 21, 2009

McGraw-Hill / S&P is Mediasite Customer

In a June post, we noted that McGraw-Hill's (MHP, $33.03) Standard & Poor's unit may now be using Mediasite for analyst commentary. Yet, we weren't sure whether the use was a trial or an actual deployment. We recently confirmed with Sonic Foundry (SOFO, $0.61) that McGraw-Hill's S&P unit has been a Mediasite customer since last year. We believe the firm keeps most of their Mediasite presentations behind their firewall, but we did find public access to the following 7/06/09 presentations:
We are delighted to see an equity research group using Mediasite to deliver analyst commentary. During our time in Equity Research at Banc of America Securities, we encouraged the bank -- with disclosure of our SOFO position -- to adopt Mediasite not just for research, but for the many monthly meetings, continuing education sessions, and compliance presentations that are common at many large financial services firms (and, in general, at many corporations).

An internal archive of these types of events for on-demand viewing would have made life much easier as many meetings were simply missed because of scheduling conflicts and/or offered multiple times on the same topic to accommodate different schedules. Plus, an external catalog available to the bank's institutional investor clients would allow live or on-demand access to analyst stock "calls", facilitating timely communication regarding investment recommendations, potentially improving client relationships, and possibly leading to new business models. Mediasite could also be used to Webcast conferences, as Noble Financial is doing (McGraw-Hill's CEO presented at this conference). All makes perfect sense. But, adoption by BofA never happened during our tenure. Glad to see S&P is taking advantage of the technology.

We'll provide an update on languishing SOFO later this week. In brief: we continue to believe that Mediasite franchise value is meaningfully greater than Sonic Foundry's current market valuation, although the illiquid stock is speculative and not without risk.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long SOFO.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Monday, July 20, 2009

PetMed Express: Results Reaffirm Franchise Strength

Last week, we explained why we think PetMed Express (PETS, $16.65) is a fantastic franchise. We even went so far as to suggest that the company might meet Berkshire Hathaway (BRK-A, BRK-B) Vice Chairman Charlie Munger's definition of a great business, the kind where an investor might be able to purchase, sit back, relax, and hold as net asset value per share increases over time.

Not everyone agrees with this view for PETS. We understand that there are real risks with any business as things can change, whether through competition, creative destruction, and/or business model flaws. According to a Seeking Alpha post from May, pundit Jim Cramer said on 5/21/09 during his "Lightning Round" the following:
  • PetMed Express (PETS): "We've not been a fan of that...it is too competitive...with Wal-Mart coming in."
For sure, competition is a real threat to any retailer and there is a graveyard full of retailers that once thrived. And, Walmart (WMT) - IF it does enter the pet medications - would likely reach a different demographic than PetMed, whose customer base is skewed toward mid/high income families and females (acknowledge: cash strapped consumers of all socioeconomic strata could seek cheaper alternatives).

As noted in our earlier post, another risk factor is PetMed's reliance on third party distributors for access to all products since most drug vendors will not sell directly to the company. Yet, given ever larger volumes moving through PetMed, we suspect that current third party suppliers are likewise realizing increasing sales/profits and are happy with the relationship, even while vets loathe the secular shift that is diminishing their profitable medications business.

Also, a reader pointed out (thank you), that some major pet medications may come off patent over the next year or so, potentially leading to increased generic competition and lower prices (and revenue - part of the bearish short call on PETS). In this scenario, we suspect the branded drug maker will no doubt try to hold pricing as much as it can and generics won't gain 100% share overnight (is a consumer going to stick with a trusted brand such as Frontline, Advantage, and Heartgard for beloved Spot, or immediately move to XYZ imitation drug?). Our guess is that the change is more likely to be gradual for each product, during which PetMed can keep growing the company's customer base as well as revenue from other products, all while passing on savings from generic competition to customers.

Lastly, what about perceived low barriers to entry on the Internet? We argue that barriers to entry are larger than persons appreciate once an Internet franchise successfully carves out a specific niche and has scale - think Amazon (AMZN), Blue Nile (NILE), eBay (EBAY), 1-800-Flowers (FLWS), Youbet.com (UBET). There were and are plenty of me-too participants in the backyards of each player, but the spoils usually go the the number one player in a given market (on- and off-line). And -- a quick aside -- while many knock eBay's e-commerce segment, the reality is that the business generates gobs of free cash flow with excellent margins and isn't going away any time soon.

To summarize: we think PetMed's established brand, market share, and repeat customer base create a meaningful hurdle for potential new entrants, large or small. Further, we believe PetMed's June quarter results (F1Q10) reported today again illustrate the strength of the company's franchise:
  • Growing through recession: Revenue up 13% Y/Y to $77.2 million and EPS up 27% Y/Y to $0.36, better than Wall Street expectations of $76.2 million and $0.31, respectively. Average order size declined 3% Y/Y to $84 as management indicated some customers are purchasing smaller quantities, presumably because of the tough economy.
  • Adding more customers: New customers acquired increased 11% Y/Y to 297K (although new order revenue increased only 5% Y/Y). Cumulative customers (active and inactive) reached 4.95 million, up 20% Y/Y.
  • Loyalty keeps paying: Reorder revenue grew 17% Y/Y to $54.0 million as the convenience of purchasing online keeps customers coming back each year. Habit/frequency is hard to break once established in any business and brand (top of mind) reinforces habit.
  • Carefully managing cost of goods sold: Gross margin of 38.0% versus 37.7% in the year ago quarter, as PetMed used opportunistic inventory purchases during the March quarter and pricing discipline to maintain margins. PetMed is holding the line against competitive threats.
  • Lower advertising expense boosts operating margins: Operating margin of 16.3% versus 14.3% in the year ago period as advertising expense came in lower than management anticipated because, surprisingly, less remnant ad space was available on cable networks (also somewhat impacting new customer additions, per management). Despite less advertising access than desired, management indicated that PetMed "paid less per eyeball", enabling lower expense.
  • Net margins nudge higher: Net margin of 10.4% versus 9.7% in the year ago quarter, boosted by growth/leverage, partially offset by lower interest income and higher taxes.
  • Monster cash flow from operations and free cash flow. The company benefited from a favorable working capital swing as PetMed harvested a large inventory investment in the March quarter. Cash flow from operations was $29.3 million with capex of only $320K for free cash fow of $29 million. However, cash flow should be analyzed on an annual basis to adjust for seasonality: trailing twelve month (TTM) cash flow from operations was $37.6 million with capital expenditures of $3.3 million for free cash flow of approximately $34.3 million. One step further, in this case, we prefer owner free cash flow to eliminate working capital variability: TTM net income of $24.4 million plus depreciation and amortization of approximately one million less normalized capex of one million equals owner free cash flow of $24.4 million.
  • Cash and cash equivalents keep piling up. As a result of large cash generation in F1Q, cash and CE increased to $59.5M at 6/30/09 from $30.1M at 3/31/09. Long-term investments remain unchanged at $14.3 million (illiquid, AAA-rated municipal-based auction rate securities) for total cash/investments of $74 million. The company has no debt.
With the advance in PetMed's share price today and over the past week, we find shares less attractive. In addition, management indicated that PetMed still has approximately $10 million remaining on the company's buyback authorization -- which is the same amount remaining at 3/31/09 -- implying that no shares were repurchased in the quarter. Based on past transactions, we think management prudently prefers to repurchase shares below $15 (at lower multiples).

Still, as noted in our post last week, we can envision PETS trading at 18 to 20 times earnings given the company's consistent, profitable operating model, implying a $20 to $23 fair value. On an owner free cash flow basis, discounted cash flow analysis implies a current fair value in the mid- to high-$20s, more than supporting our P/E based valuation.

On a relative basis, here's how PetMed's pre-results TTM operating metrics and valuation compares to several other online retailers:

PetMed has higher growth and better margins than Amazon and Blue Nile, yet a much lower valuation multiple. ROE metrics are fairly similar, although Blue Nile's 44% bests PetMed's 32% (note: Blue Nile completed a major buyback program over the past year, significantly reducing the company's equity base). We commented on Blue Nile longer ago.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long BRK-B, EBAY, FLWS, PETS, UBET.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Saturday, July 18, 2009

Youbet.com: Free Cash Flow Yield and Fundamentals Provide Support

We've received questions on Youbet.com (UBET, $3.37) and whether we're now sellers after the big run from the bottom over the past six months, aided by the recent addition to the Russell 2000 index.

Answer: not yet, although we may begin to reduce our exposure if the free cash flow yield continues to compress toward 5%. The 2008 equity free cash flow yield is now 9.5%, just below our normal buy threshold of 10%. On a forward basis, the estimated 2009 FCF yield is 10.0% assuming $14 million of owner free cash flow.

As noted in a prior post, shares of small-cap Youbet.com have recovered from fire sale valuations of 2008 (20-30% free cash flow yields) created by company- and industry-specific issues that left the stock for dead. The stock is now back to life as institutional investors understand that overhangs are removed and that Youbet is a viable, well-positioned, cash generating business.

Moreover, while Equibase data shows 2009 industry wagering through June down 10.5%, we expect Youbet.com to grow top- and bottom-line this year. The growth is a result of renewed content relationships and increased wagering per customer, as well as the secular shift toward online betting from offline. Although Youbet's net income won't increase lockstep with revenue because of lower contribution margins from new content, growth in the current environment puts Youbet.com in a small group of companies growing through the recession.

We believe solid fundamentals and the company's difficult to replicate online wagering franchise – brand, customers, platform, marketing partners, and track relationships – can justify higher valuation multiples. If the company traded at 20 times 2009E free cash flow (5% yield), the implied price per share would be approximately $7.00 including year-end estimated net cash of $15 million. At 7%, the implied share price would be $5.00. Even if multiples do not expand further -- not a sure thing in this market -- earnings and cash flow growth can drive a higher share price over time. For a relative comparison, below we include our updated comp sheet for Youbet versus select gaming and niche franchise Internet companies (click table to enlarge).

Last week, Youbet management presented at an investor conference. The message was similar to a presentation in March except that CEO Goldberg did not mention anything about "strategic alternatives" for the United Tote segment. We note that lower industry wagering (on-track) presents some risk to our FCF forecast as the tote segment may remain a drag on Youbet's overall business. Below, we include several key slides from the management deck.
  • Asset light business model with comparison to Netflix (NFLX, $44.22), Blockbuster (BBI, $0.65), and Churchill Downs (CHDN, $34.72):
  • Financial progress in March quarter (small font - click to enlarge somewhat):
  • Growth initiatives:
With respect to the last slide, increased marketing efforts are evident in the horse racing section of Sportsline.com and Youbet also launched a beta version of a community Web site called WhoDoYouLike.com "powered by Twitter".

Happy investing,

Jeffrey Walkenhorst

Disclosure: long UBET.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Thursday, July 16, 2009

PetMed Express: Fantastic Franchise with Growing "Annuity" of Repeat Business

Last week, we dipped our toe back into PetMed Express (PETS, $15.84, $360 million market capitalization, $315 million enterprise value). PetMed Express is an online/phone purveyor of pet medications and supplies that does business as 1-800-PetMeds. The company generated revenue of $219 million (+17% Y/Y) in fiscal 2009 (68% OTC products, 31% prescription, and 1% shipping) and operating income of $34 million (+22% Y/Y). Average order was was $82 in fiscal 2009, up from $80 in fiscal 2008 and $79 in fiscal 2007. The company's gross margin declined 50 basis points to 38.9% in fiscal 2009, while its operating margin increased 70 basis points to 15.6%.

We've followed PetMed's progress for at least several years and believe the company is one of the best we've come across: >70% repeat customer business (an effective annuity), no debt, mid-teens operating margins, healthy free cash flow, limited capital requirements, and an incredibly high return on net operating assets (RONA) of 76% (and ROE of 31%). In addition, PetMed is benefiting from favorable secular trends as more pet owners order medications and supplies online instead of making purchases at vets (to dismay of vet owners). Excess cash generation enables share buybacks and, to-date, management used approximately $30 million to repurchase 2.3 million shares at an average price of $13.04 per share during fiscal 2008-09. We see management as shareholder friendly, although insiders own only 3.0% of shares outstanding per the company's fiscal 2009 proxy statement. Corporate governance is also good, with four out of five directors independent (80%), an independent chairman of the board, and each board seat elected annually.

March quarter revenue of $48 million increased 19% Y/Y and fiscal 2009 (end March) revenue of $219 million grew 17% Y/Y, with diluted earnings per share of $0.25 and $0.98 up 20% and 19%, respectively. The Wall Street consensus forecast for fiscal 2010 is for revenue of $244 million (+11%) with earnings of $1.09, both of which appear low versus our model. PetMed reports June quarter results this coming Monday before market open.

We first established a PETS position during 1H08 in the low teens with an intrinsic value estimate of $17 per share, up approximately 40% from our average cost basis. However, on the back of solid results, shares rallied smartly to $18 and touched $19 in November. We never like to realize short-term capital gains, yet PETS moved too far, too fast, and we opted to take advantage of investor enthusiasm to exit our position. Our decision was made easier since we had the opportunity to reallocate capital into lower priced merchandise amidst the market swoon. We hoped for an opportunity to come back into PETS at more reasonable prices.

Last week, in the mid $14s, we decided to re-establish a position with the intent to scale in over time, preferably at even lower prices. PETS three-year graph is shown below:

At $14.50, the stock was trading at 15 times 2008 earnings (7% yield) and 13 times our estimate of 2009 earnings (8% yield). On a P/E basis, we can envision PETS trading at an 18 to 20 times multiple given the company's consistent, profitable operating model, implying a $20 to $23 fair value. We rely on absolute valuation criteria to make our purchase/sale decisions, but can't help noting that certain online retailers, from large to small, trade at much higher multiples. Amazon (AMZN, $84.55) trades at 54-times trailing EPS and 41-times forward EPS, while Drugstore.com (DSCM, $1.93) has no positive earnings or free cash flow, yet fetches a market cap of $193 million. PETS is an incredible bargain relative to these names.

From a free cash flow perspective, we believe earnings quality is high and, aside from variable working capital needs (inventory), expect FCF to generally track earnings over time since low D&A is fairly comparable to low capital expenditures. The company's working capital requirement can consume cash because of growth and corresponding inventory needs (as in fiscal 2009). We expect the difference to narrow over the medium term and note that FCF for fiscal 2008 was very close to net income.

We normally prefer to purchase companies with a FCF yield north of 10%. However, we made an exception for PetMed (6-7%) because of the company's high quality business model. Based on consistent results over the past five years and growing repeat business, we have high confidence in our forecast of future free cash flows, which imply a current fair value in the mid- to high-$20s (assuming 10% WACC, 3% terminal growth), more than supporting our P/E based valuation. The delta in FCF derived values results from different near- to medium-term growth assumptions. Increasing the discount rate to 12% still yields a fair value of approximately $24.

Key risk factors noted in PetMed's 10-K include the following:
  1. Competition - plenty of small me-too players (perhaps a"couple dozen" per management), plus Doctors Foster and Smith with annual sales of $230 million (large catalog business).
  2. Reliance on third party distributors - major suppliers do NOT sell directly to PetMed and the company must purchase products from a number of third party distributors, presenting both supply and pricing/margin risk.
  3. Resistance of veterinarians to authorize prescriptions and even discourage purchases from online or mail-order vendors such as PetMed -- we've heard of the latter case where a vet had signs posted warning against such purchases.
Still, the company's long track record and recent results suggest 1-800-PetMeds brand -- established through savvy TV and online marketing campaigns -- is winning on the competitive front versus other retailers and vets. PetMed has invested more than $150 million through the years into branding 1-800-PetMeds and the brand is now well-recognized. There have been rumblings that Walmart (WMT, $48.55) might launch an online pet supply/medication offering, yet we believe PetMed's established brand/niche and demographics (mid- to high-income, female) provide protection against such a threat. Per the fiscal 2009 10-K, cumulative customers to-date continues to grow, surpassing 4.6 million, and new additions accelerated last year to 802 thousand as the company likely had better access to reasonably priced remnant TV advertising space given the weak economy.

March 31,






New customers acquired






Total accumulated customers (1)






(1) includes both active and inactive customers

In addition, we know that management prudently manages total advertising costs relative to new customer order revenue to protect margins. Lastly, reliance on third party distributors is mitigated by sourcing the same product through multiple suppliers (management explains that this can also be a strength, serving as a barrier to entry) and PetMed is working to obtain direct supply relationships with manufacturers. We suspect that increased volumes may allow this to happen.

According to a 6/08/09 management presentation (link here - at an investor conference captured with Sonic Foundry's Mediasite), PetMed garners 6% of the $3.6 billion pet medications market with other mail order/online vendors at 5%, for total mail order/online share of 11% (please see slide below). Management believes the market will develop in similar fashion as the human pharmaceutical market and the mail order/online market for contact lenses, where channel share is approximately 19%. Implication: assuming constant PetMed market share, the company's revenue could nearly double from current levels. Assuming constant margins and share count, earnings could also nearly double (although share count should decrease with likely future buybacks). To accommodate future growth, PetMed spent an incremental $2 million in fiscal 2009 above normal annual maintenance capital expenditures of $750 thousand to $1 million to approximately double distribution capacity.

Finally, we think PetMeds might meet Charlie Munger's definition of a great company. In this regard, a 9/02/08 SmartMoney article entitled "Warren Buffett's Best Man" includes the following commentary and advice from Mr. Munger:
  • Sit on Your Assets, if You Can - While most investors associate Buffett and Munger with finding good stocks cheap, Munger points out that quality can trump price. "If you buy something because it's undervalued, you have to think about selling it when it approaches your calculation of its intrinsic value," he says. "That's hard. But if you buy a few great companies, then you can sit on your ass. That's a good thing."
Although we always want to stay on top of our companies and maintain target price discipline -- we can't exactly sit on our behind -- we think PetMed has the potential to consistently increase shareholder value over time, allowing investors to sleep well at night.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long PETS, SOFO.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Monday, July 13, 2009

'J&J: Secrets of Success' and Slight Parallel to AOB

We wanted to highlight a 4/22/09 Fortune magazine article by Geoff Colvin and Jessica Shambora entitled "J&J: Secrets of Success". The online article also includes a five minute interview with CEO Bill Weldon, which is worth a listen while perusing the text. Both the article and the interview succinctly outline how Johnson & Johnson (JNJ, $57.72) manages for the long-term and succeeds by putting customers first (i.e. applying Business 101 principles). The consistent, reliable performance of J&J through the years is perhaps best illustrated by the company's share price performance noted in the article:

"If you'd bought a single share when the company went public in 1944 at its IPO price of $37.50 and had reinvested the dividends, you'd now have a bit over $900,000, a stunning annual return of 17.1%. Even if you hadn't reinvested the dividends, that single share would now be 2,500 shares as a result of splits, and you'd be collecting dividends of $4,500 a year from that $37.50 investment."

Of course, aside from steadily higher dividends, the stock hasn't moved over the past five years and is only marginally higher over the past ten (but still much better than the S&P's performance):

With 2008 revenue of $64 billion, the mere size of the company -- the law of large numbers -- is a challenge to future growth and, therefore, future share price appreciation. However, JNJ is charging ahead and, according to Fortune, follows this recipe for success:
  1. Diversify within a single industry.
  2. Focus on the future.
  3. Let the experts run the business.
  4. Stay financially disciplined - always.
  5. Have a purpose beyond profits.
We believe the company's important/necessary products, global expansion, and prodigious free cash flow ($12 billion in 2008) put J&J in an excellent position to create incremental shareholder value (we know, you're probably not surprised to hear this common refrain about JNJ). Also, with a trailing P/E of 13 times and an implied 7.5% FCF yield, shares aren't egregiously priced. The company happens to report 2Q09 results tomorrow morning - brief preview from Forbes here.

Yet, with an ability to invest in all types and sizes of companies, we're generally angling for businesses with somewhat smaller market capitalizations. J&J's market cap is $159 billion and the company is one of thirty Dow Jones components. Numerous research studies support the view that smaller companies purchased with low multiples tend to outperform larger companies purchased at similar multiples (per our first Blog post, please see: Tweedy, Browne's What Has Worked In Investing).

One idea in the health care arena that is arguably somewhat comparable to J&J, is American Oriental Bioengineering (AOB, $4.96), which we discussed at length in an earlier post. While much smaller than J&J and operating in China (emerging market risk), AOB offers current investors a 16% FCF yield. Further, AOB benefits from similar competitive advantages, including recognized brands/products that people need/want (customer habit/frequency), scale (manufacturing, marketing/selling, indirect/direct distribution partners), and intellectual property (patents/technology/know-how). Finally, management has a 100-year operating plan (book) and is planning for the very, very long-term.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long AOB.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Friday, July 10, 2009

Wireless: Turkcell, Hidden Assets, and Socioeconomic Benefits

Although the wireless industry is competitive and subject to both regulatory and technological change/risk, well-positioned wireless telecom companies provide a utility-like service that can generate mountains of excess cash flow and enable healthy dividends. One such company is Turkcell (TKC, $13.56), which is trading near a three-year low despite meaningful revenue, earnings, and cash flow growth over the period.

Turkcell is the leading wireless carrier in Turkey in terms of subscribers (36 million for estimated market share of approximately 56%) as well as brand and network quality (akin to Verizon Wireless in the United States, but with geopolitical risk). In addition, as explained in Turkcell's annual Form 20-F, the company owns more than 15 thousand base stations (cell sites), which serve as a potential hidden asset (*some investors love U.S. wireless tower companies despite high leverage and high trading multiples presumably awarded because of stable, real estate-like business models). Beyond Turkey, the company has interests in wireless operations in Azerbaijan, Belarus, Georgia, Kazakhstan, Moldova, Northern Cyprus and Ukraine, bringing the group’s proportionate number of subscribers to 61 million and total addressable market to 160 million persons (POPs).

While Turkcell is now building a 3G network in Turkey (license granted 11/28/08 for EUR358 million), the company is well-capitalized with a net cash position of $2.1 billion and total debt to annualized EBITDA of only 41% (as of 3/30/09). Trailing twelve months revenue was $6.7 billion with EBITDA of $2.3 billion (34% margin) and the company is valued at ~4.4x trailing EBITDA and ~7x trailing EPS. In 2008, Turkcell generated $1.1 billion of free cash flow (9% FCF yield on current share price). We note that foreign currency movements complicate reported financial figures and Turkcell has been experiencing margin compression, which is a risk factor to monitor.

For 2009, we believe the company is capable of slight top-line growth on modest subscriber gains and increased usage. The company's bottom-line could be flat to slightly higher Y/Y depending upon Turkcell's ability to maintain margins and manage costs related to new investments (3G and fixed network spending). Importantly, management is committed to maintaining strong free cash flow generation and paying out 50% of distributable profits in the form of cash dividends, and the annual dividend was recently paid to shareholders (approximate 6% yield). We expect forward dividends to grow modestly with excess cash flow over time.

What does Turkcell (or any other wireless telco for that matter) have to do with socioeconomic benefits? A 6/02/09 Fortune article entitled "Turning phones into plowshares - How wireless networks are transforming an ancient profession" aptly summarizes one type of benefit:

"Turkish Farmer Mustafa Bacak used to slog through muddy fields, occasionally in pouring rain, to determine the temperature inside his greenhouse. Today he simply checks his cell phone for text messages informing him that the greenhouse's climate needs adjusting. He can tweak the humidity or temperature using his phone or computer, all from the comfort of his home. Bacak is one of more than 100 farmers using wireless operator Turkcell's network and software to remotely tend their crops...."

For those interested in academic data about how wireless networks are improving life and economic productivity, we point you to page five of a research project in which we were intimately involved and published last week by the GSMA (a global wireless organization).

Happy investing,

Jeffrey Walkenhorst

Disclosure: long TKC.

© 2009 Jeffrey Walkenhorst
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