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Friday, August 28, 2009

Competition for BYD and Divergent Views on "Green" Cars - EVs versus Hybrids

More and more headlines are surfacing about hybrid automobiles and electric vehicles (EVs). For example, Forbes published "Nissan's Plug-In Gamble" on 8/05/09 (link here) and, on 8/20/09, The New York Times published "Toyota, Hybrid Innovator, Holds Back in Race to Go Electric" (link here). we even noticed last week end that the NYTs article was the headline story on Yahoo!'s (YHOO) main page last weekend (at least for a little while - Yahoo! link). Finally, Norwegian upstart automaker Think has a new financial plan and a grand vision of ultimately selling 60,000 EVs per year (see this story).

Before sharing more details, here's our quick conclusion: lots of competition for BYD and investor Berkshire Hathaway (BRK-A, BRK-B). As a reminder, we questioned Berkshire Hathaway's investment in BYD on 7/23/09. One of our observations was as follows: "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 (TM) and Honda (HMC) are well known."

Some highlights from the Nissan article:
  • With the help of government loans in the U.S. and elsewhere, Nissan Motor plans to invest several billion dollars over the next three years to construct factories for advanced batteries and retool assembly plants that could produce 300,000 to 400,000 electric vehicles a year on three continents.
  • .... no manufacturer so far matches Nissan's ambition to create a mass market for all-electric vehicles. GM is looking to sell "tens of thousands" of its plug-in Chevy Volt, due in November 2010. Late this year Toyota Motor will start testing a few hundred plug-in versions of its Prius hybrid. But both have backup gasoline engines. Tesla has a pure-electric sports car, but it costs $101,000. Japan's number four automaker, Mitsubishi, launched its electrici-MiEV in June. At $48,000 it's not likely to sell in huge numbers, either. Subaru and BMW's Mini is testing the market for battery-operated cars but in low volumes. Toyota, Ford Motor and Chrysler say they'll have an electric car in a few years but appear behind Nissan in revving up to high-volume sales.
  • Toyota sold 159,000 Prius hybrids in 2008, compared with Nissan's 8,800 Altima hybrids, which use Toyota's technology.
  • The first of the company's new electric models, the Nissan Leaf, was unveiled in early August in Japan. It's a five-passenger hatchback with a 24-kilowatt-hour battery in the floor that can go 100 miles between charges. Production begins late next year in Japan, with a starting volume of 50,000 units a year. It'll be available in a dozen U.S. cities starting in late 2010. It is expected to sell for around $30,000 [before $7,500 U.S. government tax credit].
  • By 2012 Nissan will have a lithium-ion battery plant and a retooled electric-vehicle assembly line in place in Tennessee, funded in part by a $1.6 billion loan from the U.S. Energy Department. Nissan plans to build 150,000 EVs and 200,000 batteries a year in the U.S. and announced similar plans for battery factories in Great Britain and Portugal.
  • Nissan has been developing lithium-ion batteries in-house for 17 years. Last year Nissan locked up its future supply by purchasing a controlling interest in its battery manufacturing joint venture with Japan's NEC.
Now, some interesting, alternate viewpoints from the Toyota article:
  • ....Toyota does not plan to introduce an all-electric car until 2012. Instead, later this year, it plans to introduce a plug-in electric-gasoline hybrid, and only a few hundred initially.
  • [Why wait?] "The time is not here," Masatami Takimoto, Toyota's executive vice president, said during a factory tour this year. Electric cars "face many challenges," he said, adding that "to commercialize pure E.V.'s, we need a battery that far exceeds the current technology."
  • ....Toyota, which started developing hybrids in the early 1990s, did not make a profit on the cars until 2001, said Takeshi Uchiyamada, the chief engineer of the first-generation Prius.
  • "At first, electric cars will all be small, making profit margins small also," said Maho Inoue, an automobile analyst at the Daiwa Institute of Research, a research group in Tokyo.
  • Toyota executives rattle off reasons to be skeptical of electric cars: They do not travel far enough on a charge; their batteries are expensive and not reliable; the electrical infrastructure is not in place to recharge them.
  • It remains unclear how soon there will be a mass market for expensive cars with limited range, Toyota says.
  • Even when electric cars are sold widely, the company says, they will be suitable only for short trips and serve a decidedly niche market. Toyota is instead building on its hybrid technology, bringing out a plug-in, gasoline-electric hybrid vehicle later this year that runs a short distance on batteries before the hybrid system kicks in.
  • Some experts predict that the auto market will soon be divided among competing technologies. "Small electric cars will be used for short distances within cities, with hydrogen cells powering big buses," the Development Bank of Japan forecast in 2008.
Related to the Nissan article, Forbes Editor, William Baldwin, raises good questions about EV economics while also pointing to the virtues of natural gas (link here):
  • ... let's look at a bad way to reduce atmospheric carbon: subsidizing electric cars. The federal government will chip in $7,500 to the cost of a Nissan Leaf or a General Motors Volt. A Leaf will displace a little sedan burning maybe 5,000 gallons of gas over its 150,000-mile life span. That much gasoline produces not even 50 tons of carbon dioxide. Don't believe that the electric is an "emission-free" vehicle; the juice comes from somewhere, and today the incremental source of electric power is going to be a fossil-fueled plant. You'd be generous to the electric car industry in assuming that the car, the power plant and the charger in your garage are, taken together, four times as efficient as a gasoline car engine. The math is simple. Using a Leaf to reduce carbon dioxide costs taxpayers $200 a ton. Throw in the subsidy for the charger and the price goes to $250.
* "Simple" math: we assume Mr. Baldwin includes some emissions for EV production and power, as well as a potential shorter useful life for the average displaced auto (i.e. not a150,000-mile life span referenced above), leading to net carbon savings of approximately 38 tons, or $7,500 credit divided by $200/ton = 37.5 tons.

Mr. Baldwin's idea for reducing emissions:
  • You want to get carbon out of the atmosphere? There's an easy way to do it. Pay an electric utility to throttle back one of its older coal-fueled plants and fire up an efficient turbine burning clean natural gas. Gas is more expensive than coal (per unit of energy) but spits out not much more than half the carbon. The higher fuel cost translates into something in the neighborhood of $20 per ton of avoided co2, according to calculations from the Electric Power Research Institute.
Thus, much to consider amidst an always dynamic economic, environmental, political, and technological landscape. One thing is for sure: BYD is not alone in its quest to become the world's largest automaker by selling electric cars. We plan to keep an eye on developments and results.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long BRK-B, YHOO.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Thursday, August 27, 2009

WPP: "Little evidence of better heads and stouter hearts"

Global advertising behemoth WPP reported Interim results yesterday, with "like-for-like" revenue down 8% Y/Y versus an initial corporate plan of down 4% Y/Y - link here. Overview:

By region:

Regional advertising trends and expectations for 2010:

Given our recent posts on the economy and old media, we thought we'd share relevant commentary from WPP:
  • "The impact of the recession on the Group’s profitability in the first half was severe. Although action was taken to reduce staff and discretionary costs, such as travel, training and personal costs, as revenues came under pressure, this reduction was insufficient as revenues fell faster than budgeted. Like-for-like revenues were budgeted to fall by almost 4% in the first half of 2009 and fell, in fact, by over 8% with the deterioration against budget even greater in the second quarter, which was a surprise."
Like many other companies, WPP continues to reduce headcount and "the second-half is forecast to show a marked improvement in profitability, both absolutely and in terms of maintaining second half margins at prior years levels."
  • "This relative improvement [cost reductions to improve margins] should be reinforced as we cycle easier like-for-like revenue comparatives. Sequential quarter-to-quarter comparisons are forecast to stabilise, as are year-to-year comparisons, just like recently released country GDP figures. However, although there is little doubt that CEOs and CMOs feel better about the general economic environment, Armageddon or Apocalypse now having been averted, there is little evidence of better heads and stouter hearts translating into stronger order-books or investments – at least, yet. Things look better, as they naturally should, partly because of easier comparatives."
  • "Although it is still very early to budget or forecast what may happen in 2010, top line revenues will probably be “even Steven”, despite the positive impact of the Winter Olympics in Vancouver, the World Expo in Shanghai, the Asian Games in Guangzhou, the FIFA World Cup in South Africa and the mid-term Congressional elections in the United States."

Thus, WPP experienced worse-than-expected trends in the June quarter and pointed to "little evidence" of current improvement. However, the company is optimistic that Y/Y performance in 2010 will be flat on easier comparisons. The good news for investors is that WPP has a long history of excess cash flow generation with increasing dividends and share buybacks, which continued in F1H09:

Conclusion: while guarded economic optimism is emerging in the stock market, trends remain difficult and, in WPP's case, below plan. We believe a cautious investment strategy remains prudent, with a preference for low multiples, excess cash flow, and current-year growth.

Happy investing,

Jeffrey Walkenhorst

Disclosure: none.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Monday, August 24, 2009

Bidding on BIDZ (Part Three/Final) - Detailed Long Thesis

BIDZ continued - this is the third and final part our analysis (written in July, but only published now, including a few current updates)

The Long Thesis - Why We Own BIDZ

Since our initial post on 8/10/09, shares of Bidz (BIDZ, $3.15) are off 35% compared to flat to slightly higher performance for the S&P 500, Blue Nile (NILE), and Amazon (AMZN):

The decline follows lower-than-expected results the same day (after market close on 8/10/09). We previously commented on results and the overall retail sector. While still profitable, revenue was down 51% Y/Y as jewelry remains non-essential and low on the priority list for many consumers. Further, we believe Bidz's business is even more discretionary than the business of Blue Nile and other jewelry retailers that are helped by less discretionary engagement ring sales.

Bidz is not alone in its pain. We are aware of several other discretionary/luxury retailers that suffered large Y/Y revenue declines in the June quarter: Sotheby's (BID) down 48%, Ethan Allen (ETH) down 41% Y/Y, and Nutrisystem (NTRI) down 32% Y/Y. We can even find meaningful Y/Y revenue declines outside of retail: Tyco Electronics (TEL) down 34% Y/Y and Freeport-McMoRan Copper and Gold (FCX) down 32% Y/Y.

We prefer to invest in companies trading a low multiples of earnings with current-year growth, yet sometimes venture outside of this requirement when we find what we believe to be a significant discount to the valuation that would be assigned to a business by an informed private market buyer.

In this case, despite limited short-term forecasting visibility, our BIDZ thesis is focused on the durability and strength of the business model, which we believe warrants a higher valuation and provides a margin of safety at present levels. We believe shares are attractive for following key reasons:

(1) Jewelry retailing is a good business over time.

Many well-known value investors own jewelry businesses with a long-term view:
  • Berkshire Hathaway (BRK-A, BRK-B) owns three jewelry companies: Ben Bridge Jeweler (acquired 2000), Borsheims Fine Jewelry (acquired 1989), Helzberg Diamonds (acquired 1995).
  • Berkshire Hathaway also owns the Richline Group (formed 2007), which is a manufacturer and importer of jewelry. Richline actually purchased some intellectual property and tools from Bidz in April that the latter acquired in a bankruptcy auction - link here.
  • Other value investors, such as Harris Associates, are big fans of Signet Jewelers, which owns Kays Jewelers, Jared, and other chains in the UK. Note: Signet reported June quarter same store sales down 5% Y/Y.
Why own such businesses? They are companies with established brands and scale that keep consumers coming back (frequency/relationships) and that generate excellent margins, earnings, and free cash flow on a normalized basis. Also, jewelry has a large addressable market (slide sourced via Bidz September 2008 management presentation):

(2) Difficult-to-replicate franchise with history of profitability and extremely high returns on invested capital
  • While no company can rest on its laurels, particularly in retail, we argue that barriers to entry are larger than some investors appreciate once an Internet franchise successfully carves out a specific niche and has scale - think Amazon (AMZN), Blue Nile (NILE), eBay (EBAY), Expedia (EXPE), PetMed Express (PETS), and Youbet.com (UBET). As we noted in our second PetMed Express post, there were and are plenty of me-too participants in the backyards of each player, but the spoils usually go to the number one player in a given market (on- and off-line). Moreover, achieving and sustaining profitability is not an easy task for many online players – see Overstock (OSTK) and Bluefly (BFLY), both of which have never been profitable on an annual basis.
  • Based on revenue, excess cash generation, Internet traffic (referenced in Part Two), brand recognition, and repeat business, we think Bidz is an established leader in online jewelry retailing.
  • Over the past five years, Bidz spent $43.2 million in sales & marketing to build the brand and, in 2008, acquired 262 thousand new customers (down 6% Y/Y) with an average acquisition cost of $48. The customer acquisition cost compares very favorably to an average selling price per order of $177 in 2008.
  • Bidz announced on 6/10/09 that the company ranked #2 in Internet Retailer's Online Jewelry Category (behind Blue Nile, based on sales) and #71 in Top 500 Guide of the largest e-retailers, an improvement from #74 in the 2008 guide and the fourth consecutive year that Bidz.com has been on the list.
  • In the last holiday season (4Q08), average orders per day were 2,462 (down 45% Y/Y) and average items sold per day decreased 35% Y/Y to 8,287, yet average items per order increased Y/Y to 3.4 from 2.9. For 2Q09 metrics, please see earlier post. Below, we include data through 2Q08:

  • Prior to the brunt of the economic decline last fall, management reported that an average customer transacts 3.5 times per year and had an average lifetime value of $1,109 (six times average order value).

  • Bidz operating margins in 2006, 2007, and 2008 were 4.2%, 11.2%, and 11.6%, respectively, while GAAP net income was $5.4 million, $18.1 million, and $14.4 million. While now dated, the below graph shows that Bidz operating margins were ahead of online peers through 2Q08 (*Blue Nile's 6.2% edged ahead of Bidz's 4.3% in 2Q09):
  • As with most retailers, the company needs to invest in working capital (inventory) when growing, so free cash flow (CFO less capex) was negative in 2006 and 2007, but a positive $17.6 million in 2008 as inventory declined with slower full-year top-line growth. Capital expenditure requirements are low at $1.0 to $1.5 million per year and the company has no debt.
  • The company is able to reinvest cash flows into the business and, last year, launched Spanish, Arabic, and German language sites. In 2008, approximately 1/4 of sales were international. We potential for international growth to offset US weakness and fuel future expansion so long as marketing/branding works.
  • The company turns net operating assets very quickly: approximately nine times in 2006, six times in 2007 and seven times in 2008. Multiply turns by after-tax operating margins of 3%, 8%, and 8%, respectively, and we have RNOA of 27%, 42%, and 54%. ROIC calculations are similar at 27%, 28%, and 48%.
  • Bidz announced on 7/22/09 that it was ranked number one in the Los Angeles Business Journal's annual list of the most profitable Los Angeles companies as of June 30, 2009, based on a three-year average return on equity of 88.2%. We note that the average is skewed downward (43% in 2008 versus 127% in 2006) because of higher working capital and shareholder equity.
Considering all of the above, we see a niche franchise that is well-placed for future growth and excess cash generation.

(3) Favorable long-term secular trends
  • People like to shop – while the average American consumer is struggling, we submit that Americans will always be consumers, with some arguably addicted to purchasing products from TV channels such as QVC.com and HSN.com, as well as Web sites like Bidz.com. A growing middle class elsewhere in the world also brings more consumers.
  • More commerce will gravitate online over time – although e-commerce growth is lagging amidst the recession, sales are holding up better than offline retail sales. comScore reported 1Q09 online sales flat Y/Y versus overall retail sales down 5% Y/Y.
  • Leading players like Bidz should gain more share for reasons highlighted above in point (2).
  • The below slide (from September 2008) provides perspective on traction for online jewelry sales (note: forecast is now altered, with negative growth at least for 2009):

(4) Shareholder-friendly management team

Despite some areas for improvement noted in the corporate governance section (in Part One), management is highly motivated to generate shareholder value given large insider ownership. Much of management ownership consists of stock options with an average exercise price of $6.20 (based on 6,864,500 options outstanding for entire company per proxy). We think management’s commitment is illustrated by its focus on profitability as well as the large share buyback program (noted previously). In addition, we believe the company’s high RNOA/ROIC demonstrates successful capital allocation.

(5) Attractive absolute and relative valuation on current earnings and on normalized earnings power
  • Shares of Bidz are trading at six times 2008 earnings and fifteen times our downward revised 2009E earnings of $5.0 million ($0.20 per share) from $8.0 million.
  • Although difficult to foresee improved top-line performance and/or multiple expansion in the near-term, we believe BIDZ could fairly trade at 15 to 20 times earnings (5% to 7% yield) given the company’s established, difficult-to-replicate, high-ROIC online franchise. Importantly, we believe an informed private market buyer would award a similar valuation.
  • In our initial post, we established a $5.25 - $7.00 (~$6.00 midpoint) fair value on depressed 2009E earnings, which no longer holds given reduced expectations for 2009. However, giving credit for a return to growth and normalized earnings of $12.0 million ($0.50 per share, still below 2007-08 levels) would imply $7.50 - $10.00 per share (~$9.00 midpoint).
  • On a relative basis, BIDZ is extremely inexpensive compared to Blue Nile (NILE), which trades at 77 times TTM earnings and 53 times consensus 2010E earnings. NILE trades at 42 times TTM EBITDA and 2.8 times sales, compared to 4.7 times and 0.5 times for BIDZ, respectively.
  • Blue Nile’s TTM reported operating income of $16 million and 5.6% margin compare to Bidz’s $14 million and 9.3% margin, respectively. On an earnings and free cash yield basis, NILE trades offers current investors only 1.3% and 2.9%, respectively, compared to BIDZ's 11.3% and 22.0%. On a TTM operating income to enterprise value yield basis, NILE's yield is 2.3% compared to BIDZ's 20.3%. We prefer to buy companies offering at least a 10% EBIT/EV and FCF yield.
  • Even acknowledging lower forward yields and strained American consumers, we find a great level of comfort in BIDZ high TTM earnings/FCF yields (which already include three quarters of intense economic contraction). Although we like Blue Nile's business model and established franchise -- in our view -- NILE's valuation is currently supported by the greater fool theory (with evermore speculative buyers necessary to push shares higher).
  • As mentioned earlier, we see Blue Nile’s business as less discretionary than that of Bidz, warranting at least some premium. However, we see no reason why the wide gap should persist over time, particularly if certain Bidz overhangs are removed. We expect NILE’s valuation multiple to compress while BIDZ’s multiple expands.
  • BIDZ also trades at a significant discount relative to Amazon and a number of other companies. We include two comp sheets below for BIDZ, the first smaller companies and the second larger (click to enlarge - price info as of 8/21/09):
Versus large-cap companies:

  • Finally, we have a recent comparable M&A transaction in the online retail space: Amazon’s purchase of Zappos. Amazon management relayed on the company’s earnings call that Zappos has approximately $635 million in 2008A sales with “a small profit”. Amazon’s cash/stock purchase price of $847 million implies a price to sales purchase multiple of 1.33 times. If we awarded the same multiple to Bidz, the implied share price would be $10.46, or 3.3 times current levels.

Our bet is that Bidz.com won’t forever remain a castaway. Despite all of "the hair" on top of macroeconomic concerns (discussed in Part Two), we see an excellent entry point into a high return on capital business with a growing global franchise. Sooner or later, we expect the market will focus on the sustainability and earnings power of the company’s business model, likely eliminating the margin of safety that exists for buyers today.

Happy investing,

Jeffrey Walkenhorst

Disclosure: Long BIDZ, BRK-B, EBAY, PETS, UBET.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Saturday, August 22, 2009

Snapshot of Sales Tax Y/Y Trends in Southeast

One thing we forgot to mention in our economy post the other day is the state of local, state, and federal budgets (although we noted blowfish-like government expansion on 8/12/09). We found the following graph on the Federal Reserve Bank of Atlanta Web site (link here):

The Federal Reserve Bank stated the following:
  • "On average, District sales tax collections through June continued to decrease on a year-over-year basis. All states except Alabama saw sales tax revenues decline on a month-to-month basis. According to our informal survey of District retailers, June sales continued to be below year-earlier levels. Both traffic and inventories were down, and the outlook remained low."
We don't wish to spend too much time on the economy topic and everyone likely understands the current government predicament presented by lower tax collections (Catch-22 given stimulus activities), yet we found the graph interesting and worth sharing. We suspect trends are similar in regions around the country.

Happy investing,

Jeffrey Walkenhorst

Disclosure: n/a.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Thursday, August 20, 2009

How's the Economy Doing - Under the Hood in August

This is an update of our "How's the Economy Doing" post from June. As a reminder, while our our investment strategy focuses on bottom-up analysis of individual companies, we think awareness of overall macroeconomic conditions is helpful since trends that may impact certain companies or sectors. On 8/12/09, we wrote about the many mixed views regarding what happens next in the Market and the economy. Rather than speculate on which view is correct -- we can't say for sure and the market will do what it does, often detached from fundamentals in the short-run -- let's look at some hard data:
  • Railroads - from Association of American Railroads: "For the week ended Aug. 8, 2009, U.S. railroads reported originating 274,633 cars, down 16 percent compared with the same week in 2008. Regionally, carloadings were down 14.1 percent in the West and 18.8 percent in the East. Intermodal volume of 195,014 trailers or containers on U.S. railroads was down 16.6 percent from the same week last year. Container volume fell 10.8 percent and trailer volume dropped 38.1 percent. Total volume on U.S. railroads for the week ending August 8 was estimated at 29.3 billion ton-miles, off 14.8 percent from the same week last year. All 19 carload freight commodity groups were down from last year, with declines ranging from 6.1 percent for chemicals to 48.3 percent for metals and metal products. For the first 31 weeks of 2009, U.S. railroads reported cumulative volume of 8,159,672 carloads, down 18.9 percent from 2008; 5,764,816 trailers or containers, down 17.1 percent, and total volume of an estimated 868.3 billion ton-miles, down 18 percent. Combined North American rail volume for the first 31 weeks of 2009 on 14 reporting U.S., Canadian and Mexican railroads totaled 10,357,235 carloads, down 19.8 percent from last year, and 7,158,845 trailers and containers, down 17.1 percent from last year." Link here.
  • Trucking - from American Trucking Associations (yes, ATA is plural) for the month of June (reporting lag): "Compared with June 2008, tonnage fell 13.6 percent, which surpassed May’s 11 percent year-over-year drop. June’s contraction was the largest year-over-year decrease of the current cycle, exceeding the 13.2 percent drop in April. ATA Chief Economist Bob Costello said truck tonnage is likely to be choppy in the months ahead. “While I am hopeful that the worst is behind us, I just don’t see anything on the economic horizon that suggests freight tonnage is about to rise significantly or consistently,” Costello said. “The consumer is still facing too many headwinds, including employment losses, tight credit, and falling home values, to name a few, that will make it very difficult for household spending to jump in the near term.” He also noted that inventories, relative to sales, are still too high in much of the supply chain, especially in the manufacturing and wholesale industries. “As a result, this is likely to be the first time in memory that truck tonnage doesn’t lead the macro economy out of a recession. Today, many new product orders can be fulfilled with current inventories, not new production, thus suppressing truck tonnage.” Link here.
  • Air - from IATA: "The International Air Transport Association (IATA) announced international scheduled traffic results for June showing passenger demand declining 7.2% compared to the same month in the previous year while freight demand was down 16.5%. International passenger load factors stood at 75.3%, down from 77.6% recorded in June 2008. The 7.2% drop in international passenger demand was a slight improvement on the 9.3% fall in May. The capacity adjustment of -4.3% did not keep pace with the fall in demand leaving average fares and yields under significant pressure. As a result, June revenue on international markets fell by a shocking 25-30%. Cargo demand remained weak at 16.5% below June 2008 levels. This is a moderate improvement, albeit from extremely weak levels, over May, which was 17.4% below 2008 levels. There has been some improvement in world trade and, after adjusting for seasonal fluctuations, freight volumes rose 6% from the low point recorded in December 2008. However, the utilization of air freight capacity on international routes remained very weak (47.3%) in June due to unbalanced trade flows with Asia and some market share loss to ocean transport." Link here.
  • Semiconductors - from SIA: "Worldwide sales of semiconductors for the second quarter of 2009 were $51.7 billion, a 17 percent increase from the first quarter when sales were $44.2 billion, the Semiconductor Industry Association (SIA) reported today [8/3/09]. Second-quarter sales declined by 20 percent from the $64.7 billion recorded in the like period of 2008. Worldwide sales in June were $17.2 billion, an increase of 3.7 percent from May when sales were $16.6 billion, but 20 percent lower than the $21.6 billion reported for June 2008. Year-to-date sales of $95.9 billion were 25 percent below the first six months of 2008, when sales were $127.5 billion. All monthly sales numbers represent a three-month moving average of global semiconductor sales." Link here.
  • Residential Housing Permits and Starts - from US Department of Housing and Urban Development: "Privately-owned housing units authorized by building permits in June were at a seasonally adjusted annual rate of 563,000. This is 8.7 percent (±3.0%) above the revised May rate of 518,000, but is 52.0 percent (±3.6%) below the June 2008 estimate of 1,174,000. Single-family authorizations in June were at a rate of 430,000; this is 5.9 percent (±1.4%) above the revised May figure of 406,000. Privately-owned housing starts in June were at a seasonally adjusted annual rate of 582,000. This is 3.6 percent (±11.3%)* above the revised May estimate of 562,000, but is 46.0 percent (±4.3%) below the June 2008 rate of 1,078,000. Single-family housing starts in June were at a rate of 470,000; this is 14.4 percent (±11.8%) above the revised May figure of 411,000." Link here.
  • Commercial Real Estate - from Annaly Capital Management monthly commentary: "On Friday July 31, Property and Portfolio Research (“PPR”) issued their Q209 forecast entitled “Keep Your Eyes Shut; It’s Scary Out There.” The picture painted by the report is not pretty. Vacancies have not peaked and occupancies have not hit bottom. This observation was confirmed through the release of the Fed’s beige book on July 29 reflecting data through July 20. All twelve districts reported that leasing of commercial real estate was either “slow” or “weak.” Transactions are at a near standstill reflecting a combination of frozen capital markets and wide “bid/asks” in terms of pricing. Cushman & Wakefield Inc. reported that overall asking rental rates for prime Park Ave, NY office locations have dropped on average 35% to approximately $76 psf. over the past 18 month. Contributing to the eroding rentals is a fourfold increase in sublet space." Link here. As a sidebar, this view is similar to what we wrote in June about commercial real estate -- we think fundamentals remain challenged.
Thus, as relayed above, the hard data is decidedly negative on a Y/Y basis and jibes with anecdotal information we've collected:
  • the job market for white and blue collar workers is extremely difficult around the country
  • like commercial real estate, residential real estate activity is very slow with plenty of for sale signs in most suburban neighborhoods (in particular, we can vouch for the Greater NYC area) -- we think prices will continue to fall well into 2010, especially since real estate typically runs in very long cycles (i.e. seven years up, seven years down, seven years up, etc.) and the last up-cycle lasted approximately ten years (ending in mid-2006)
  • all kinds of services are being impacted by the downturn, including barbers (our NYC barber: "business is slow and we're losing customers because they're moving out of the city")
  • the hatches remain mostly battened up in venture capital community and poor returns over the past decade leave many investors scratching their heads over future capital allocations
Of course, the Market is forward looking, and, what we call "the hope rally" since March is based on the hope that things will surely soon get better on the back of government stimulus packages in the U.S. and elsewhere. We're natural optimists and also hope so, however, we're inclined to remain in the cautious camp. Now and always, we need to pick our spots with a preference for very low multiples of current earnings and growth.

Fortunately, we do see some reasons for hope: inventories are being worked downward to adjust for slack aggregate demand and, as noted in June, once we reach 4Q09 and 2010, Y/Y comparisons for all sectors of the economy will be against very weak 4Q08 and 2009 figures, which could at least bring stability and set the stage for inventory restocking (growth) at some point. We should no longer see negative 10 to 20% Y/Y declines in 2010 and could even see areas of growth (which largely explains the hope rally).

Unfortunately, we've missed a number of incredible stock moves -- four to five times March lows -- by being in the cautious camp and avoiding most cyclical companies with still horrendous fundamentals. Yet, we've done well with select cyclical plays where we saw a margin of safety, such as Harry Winston Diamond Corporation (HWD, $5.60), Brandywine Realty ($10.00), Sun Communities (SUI, $17.50), and Wiengarten Realty Investors (WRI, $18.00). In addition, we continue to sleep well owning franchise type businesses that are currently generating significant excess cash flow and have limited to no debt. As before, examples in this category include eBay (EBAY, $21.37), Yahoo! (YHOO, $14.87), j2 Global Communications (JCOM, $22.91), PetMed Express ($18.00), and Youbet.com (UBET, $2.39). Finally, given our quick post on Y/Y retail sales declines yesterday, people may think we're crazy for owning Bidz (BIDZ, $3.06), yet we see reasons to own the bombed out online retailer. At the more speculative end, we still like Sonic Foundry (SOFO, $0.57) given the company's leading market position and continuing growth.

Happy investing,

Jeffrey Walkenhorst


© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Wednesday, August 19, 2009

Retail Sales - Watching Y/Y Trend, M/M Less Important

We will be posting our "How's the Economy Doing" update post this week, but wanted to quickly share a snapshot of "Retail and Food Services Sales" data as reported by the U.S. Census Bureau on 8/13/09 - lots of great data here. The Census Bureau reported that "U.S. retail and food service sales for July reached $342.3 billion, a decrease of 0.1 percent (±0.5%)* from the previous month."

We think the media focused on the flat M/M figure as another sign that the economy is stabilizing, but neglected to mention the Y/Y trends as highlighted in the chart below (click to enlarge):

Looking at the graph, we see that total sales were down almost 10% Y/Y, sales ex autos were down approximately 7% Y/Y, auto sales were down nearly 20% Y/Y (including some benefit from "Cash for Clunkers" in late July), and "general merchandise" sales were down approximately 2% Y/Y. The ex autos negative 7% figure appears about right given July same store sales reported by a number of retailers and summarized in this Business Wire Retail Report - link here.

So, not to state the obvious, but the Y/Y figures are still concerning. The good news is that we'll be up against easier comparisons in 2010. Stay tuned for more.

Happy investing,

Jeffrey Walkenhorst

Disclosure: none.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Sunday, August 16, 2009

Economy and Creative Destruction Wreaking Havoc On Old Media Biz

On 8/10/09, the E.W. Scripps Company (SSP, $6.55) reported June quarter results. Per the company, Scripps "is a diverse, 130-year-old media enterprise with interests in television stations, newspapers, local news and information Web sites, and licensing and syndication. The company's portfolio of locally focused media properties includes: 10 TV stations (six ABC affiliates, three NBC affiliates and one independent); daily and community newspapers in 14 markets and the Washington, D.C.-based Scripps Media Center, home of the Scripps Howard News Service; and United Media, the licensor and syndicator of Peanuts, Dilbert and approximately 150 other features and comics."

Last summer, on 7/01/08, E.W. Scripps distributed shares of Scripps Networks Interactive (SNI, $33.43) to all shareholders with the idea that the latter would hold cable properties and new media assets. "Scripps Interactive" also reported results last week and "is one of the leading developers of lifestyle-oriented content for television and the Internet, where on-air programming is complemented with online video, social media areas and e-commerce components on companion Web sites and broadband vertical channels. The company’s media portfolio includes: Lifestyle Media, with popular lifestyle television and Internet brands HGTV, Food Network, DIY Network, Fine Living Network (FLN) and country music network Great American Country (GAC); and Interactive Services, with leading online search and comparison shopping services BizRate and Shopzilla."

We could continue with the same tune of our "Tale of Two Auction Franchises" post last May replacing "Auction" with "Media". Both businesses are moving in divergent direction: E.W. Scripps posted 2Q09 revenue down 23% Y/Y to $194 million while the Interactive business posted only a 4% Y/Y decline to $391 million.

Here, we're going to look more closely at the "old" Scripps business -- a quick summary of results:
  • Consolidated revenues were $194 million, down 23% Y/Y
  • Net income from continuing operations, was $2.3 million, or 4 cents per share, compared with a net loss from continuing operations of $608 million, or $11.20 per share, in 2Q08 (reduced by a non-cash, after-tax charges of $583 million).
  • Net debt of $31.2 million, reflecting long-term debt of $73.1 million and cash and short-term investments of $41.9 million.
Revenue from television stations was $61.1 million in 2Q09, down 24% Y/Y percent with category performance as follows:
  • Local, down 26% to $37.3 million
  • National, down 29% to $16.9 million
  • Other, which includes fees for carriage of the stations on cable systems, rose 41% to $6.5 million
  • Political was $333,000, compared to $1.6 million in the 2008 quarter
Revenue from newspapers managed solely by Scripps declined 22% Y/Y to $113 million with advertising revenue down 29% Y/Y to $79.4 million. Advertising revenue by category was:
  • Local, down 28% to $23.6 million
  • Classified, down 39% to $24.1 million
  • National, down 25% to $5.0 million
  • Preprint and other, down 17% to $19.3 million
  • Online, down 25% to $7.3 million
Despite the tremendous Y/Y revenue declines, Scripps management was confident in the company's financial position (balance sheet) and pointed to "slight improvement in the flow of advertising in our markets, particularly at the television stations, which have increased their revenue projections -- albeit very modestly -- during each of the past seven weeks".

Perhaps everyone knows that newspapers are in secular decline as the Internet consumes evermore daily visitors (and hours of media), but we took the above Y/Y decline figures as a sign of just how bad things are in the industry (the negative figures tend to hit readers over the head). In our view, the decline first ignited by technological change is being accelerated by the difficult economy, cementing the newspaper industry as a textbook example of Joseph Schumpeter's creative destruction.

Amidst the challenges, the share price of E.W. Scripps rallied meaningfully over the past month:

Fortunately, the company has a committed, seasoned management team and limited leverage, providing some breathing room to reposition the business. No need, at present, for a quick sale (or giveaway) to XYZ private equity firm (see San Diego Union Tribune and potentially The Boston Globe).

At least two lessons: (1) secular trends typically provide ample notice of where society is headed and usually have long tails (providing many opportunities through time), yet (2) can also accelerate on a dime depending upon surrounding circumstances (in this case, downward). As owner-oriented investors, our goal on the long side is to overweight the uptrends and to preserve capital by avoiding the downtrends. The short side can be used in an effort to capitalize on downtrends, although timing is often very tricky.

Happy investing,

Jeffrey Walkenhorst

Disclosure: none.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Friday, August 14, 2009

Bidding on BIDZ (Part Two) - Backstory: The Hair on the Name and Mitigating Factors

BIDZ continued - this is Part Two of our analysis - first part found here and still more to come. Brief update on recent results found here.

Backstory - the Hair on the Name

Problems for Bidz (BIDZ, $3.64) began in November 2007 following a rapid, three-month stock move from the high single digits to almost $20 per share on Friday 11/23/07. On Monday 11/26/07, Citron Research -- a research/trading firm that was also short the stock -- published an article questioning Bidz's business model and related party transactions - link here.

One of the points was that the company had numerous related party transactions with Mr. Aframian at LA Jewelers and that Mr. Aframian is a "convicted felon and has served time in the Federal System for fencing stolen goods" in the 1980s.

The stock declined 17% that day. Although Bidz CEO quickly defended the company and answered/refuted all points (summarized by Eric Savitz here), the market didn't believe him and the stock continued to slide. For much of the following year, the stock was range bound around $10 despite continued earnings growth and excess cash generation. Then, on 9/1/08, Barron's chimed in with a feature story on Bidz titled "Putting BIDZ.com Shares on Sale".

This time, Barron's raised questions not about the business model, but about the origins of the company and personal relationships of CEO David Zinberg as well as action of co-founder/ director Garry Itkin. The article is well-written, researched, and worth a read to understand issues surrounding Bidz.

The negative Barron's story was compounded by the ensuing economic decline and shares moved to the low/mid single digits. Earlier this year, the SEC initiated a formal investigation into Bidz's inventory accounting practices and, in May, the company announced the FTC probe into its marketing practices. Preying on the situation, a flurry of lawsuits emerged alleging management misconduct and material misrepresentations about business prospects, among other things.

Addressing the Concerns

All of the above items create a negative "first impression" for investors and, therefore, represent major overhangs. To emerge from the tarnish, Bidz needs time, along with continued, favorable operating results. Fortunately, time is marching onward and consistent profitability reveals the advantages of an asset light, variable cost operating model through economic cycles.

We won't spend much time on what appears obvious: we understand that the corporate and consumer de-leveraging will continue for some time to come, with significant consumer headwinds in the face of fewer jobs, lower wages for those who have jobs, and -- probably -- higher taxes everywhere. All in all, a wonderful environment for jewelry retailers over the near- and medium-term.

Regarding the other reasons, our view is that points (1) through (4) will likely go away, while points (5) and (6) are sufficiently mitigated by the strength of Bidz's established online franchise and large insider ownership (as noted above, 67.3% for management and directors).

(1) Questions surrounding management/director relationships

Like any disciplined investor, we prefer to invest in squeaky clean management teams with no blemishes and strong corporate governance. Further, we agree with Bruce Berkowitz of The Fairholme Fund who says, "Usually if you see one roach in the cupboard there are many behind the wall". In this case, we don't have all of the answers around past relationships/dealings and never will. Still, focusing on the facts of the business give us comfort.

Mitigating factors: despite questions regarding relationships, it's not clear if any impropriety occurred at Bidz by management, personnel, or the board of directors. Also, financial results tell a positive story through the years and related party transactions are decreasing: per 2008 10-K, "We purchased approximately 26.4%, 11.9%, and 9.9% of our merchandise in 2006, 2007, and 2008, respectively, from LA Jewelers". We also can understand one of CTO/President Kuperman's statements to Barron's regarding issues raised: 'Tell us how we could run our business differently, knowing this information'.

(2) SEC investigation into inventory practices

Bidz provides the following information regarding inventory accounting in the 10-K:
  • Inventories - Inventories consist mainly of merchandise purchased for resale and are stated at the lower of first-in, first-out (FIFO) cost or market.
  • Inventory Reserve - The unique nature of our business model where customers set the prices they are willing to pay may result in items selling below our cost, and we provide reserves against our inventory based on the difference between the average selling price and the cost of inventory if the average selling price is lower than the cost of inventory. We also provide reserves for obsolescence and slow moving inventory.
We can see how forecasting and applying reserves for items sold below cost could complicate accounting. No doubt, this is what the SEC is reviewing. Management relayed the following on its 4Q08 call (sourced from Seeking Alpha.com):
  • Now turning to another topic I would like to discuss. We were recently notified by the SEC of a formal investigation about certain aspects of our inventory accounting practices. These questions are not new and we have addressed them before and we are confident our inventory accounting is correct and in full accordance with GAAP.
  • We openly welcome the opportunity to finally put this issue behind us. We think it is important to note that when we first received questions on this subject from the SEC both I and our outside counselors proactively and voluntarily met with the SEC staff. We believe the SEC now seeks to confirm by reviewing the documents that our inventory accounting policies and methodologies are indeed conservative and sound.
  • We welcome the investigation so we can in a clear, open and transparent manner discuss our business and accounting methodology and provide further clarity to our investors. We have also repeatedly had our independent public accounting firm, Stonefield Josephson, look into these matters. We have proactively and transparently responded to all inquiries into any specific business practices that have been questioned.
  • In each and every case there were no incidents of wrongdoing. While we are disappointed these accusations continue we also understand that as a small company that did not undergo a traditional IPO we will be subjected to additional scrutiny. We expect this investigation to take time to resolve itself as is usual in these cases. We will keep you apprised of any updates.
Mitigating factors: a long operating history using the auction format should provide fairly reliable benchmarks and internal controls on how to account for Bidz's inventory. In our recent conversation with management, they again emphasized what was relayed above. Not a surprise for management to stick by their story, but we think the company's ongoing share buyback program expresses confidence that Bidz may soon move past this concern (potential positive catalyst number one). See 7/1/09 buyback update from company, with the following highlights:
  • Approximately 714,000 shares repurchased during the second quarter at an average price of $3.50
  • Approximately 2.9 million shares repurchased at a cost of approximately $17.0 million since plan inception at the end of 2007
  • Approximately $16.5 million still remaining under authorized plan
  • Company intends to continue to make additional share repurchases
In addition, we believe it may behoove management to hire a Big Four auditor (in place of Stonefield Josephson) to improve investor perception of Bidz's accounting and controls (another potential positive catalyst) -- similar to the recent move by American Oriental Bioengineering (AOB, $5.65).

3) FTC probe into marketing practices

Like most companies today, Bidz uses email communications and various forms of direct marketing. We have no special insight into the FTC probe, but like the SEC investigation, management expressed confidence that the company is cooperating with the FTC to expeditiously resolve any concerns (potential positive catalyst number two). Below, we include a slide from Bidz's September 2008 management presentation:

Mitigating factors: we believe the share active repurchase program provides comfort.

(4) Flurry of me-too, bandwagon lawsuits related to management, business model questions, and the share price decline

See recent headlines. However, interestingly, if you click on many of the press releases on Yahoo! Finance announcing a suit against Bidz, they no longer open. Instead, we see "Yahoo - Document Has Expired - The requested document, `/iw/090616/0511274.html', is no longer available."

The company's response to the various suits was as follows:
  • The plaintiff's allegations are solely based on a report published by Citron Research on November 26, 2007. After issuing the report, Citron Research, previously known as StockLemon.com, publicly acknowledged that it held a short position in the common stock of Bidz.com, Inc. The Company has publicly refuted all the claims made in the report.
  • The Complaint is another in a series of allegations against Bidz.com in the aftermath of the Citron Report, including complaints made to the Securities and Exchange Commission and the Federal Trade Commission. Bidz.com has previously disclosed the investigation by the Securities and Exchange Commission and has recently received a Civil Investigative Demand for information from the Federal Trade Commission relating to email marketing practices. Bidz.com is cooperating and responding to these investigations.
  • Bidz.com believes the plaintiffs' claims are entirely without merit and intends to defend the action vigorously.
Mitigating factors: we don't know for sure, but think at least some of the suits have fallen by the wayside as lead plaintiffs may not have materialized (potential positive catalyst number three).

(5) Concerns surrounding competition

Bidz March quarter sales were down ~50% Y/Y versus down 10% for BlueNile and down 20% for Zales. Bidz notes in its 10-K:
  • "Our competitors currently include various online auction services and retailers that offer jewelry, including eBay, Blue Nile, Overstock, and uBid. We also encounter competition from national jewelry retail chains, such as Zales, Kay Jewelers, and Finlay Fine Jewelry, and mass retailers and other enterprises that sell jewelry, such as Wal-Mart, Target, J. C. Penney, Costco, QVC, and Home Shopping Network."
In addition, we see a few other competitors: Jewelry.com, LiquidationChannel.com, Signet (Kay, plus Jared, Marks & Morgan, etc.), Tiffany, Ross Simons. Is Bidz losing share?

Mitigating factors: First, Blue Nile mostly targets a different market segment - engagement rings - which isn't as discretionary as Bidz merchandise. Second, we think there will always be consumers who prefer to purchase jewelry in person (see, touch, etc.), possibly explaining a better performance by Zales. Also, Bidz is choosing to preserve margins over chasing sales in the current market and sales/marketing expense was down 38% Y/Y in the March quarter. The reported number of "new buyers" was 51,021 in the quarter, well below 83,179 in 1Q08 but not too far below 58,056 in 1Q07. Finally, as shown below, a sample of Internet traffic trends from Alexa (may be inaccurate, but okay as quick proxy), reveals Bidz.com traffic -- while down from levels one to two years ago -- remains approximately twice that of Blue Nile, Zale's, and Kay.com, with Jewelry.com barely registering. Thus, the brand/site clearly seems to garner significant mind share.

(6) Modest amount of insider selling

We prefer to see NO insider selling for long positions. CEO Zinberg and his sister Marina have been fairly steady sellers under automatic plans over time. CFO Kong also sold 20 thousand shares in mid-July.

Mitigating factors: we are unaware of personal circumstances, especially for Ms. Zinberg, who receives an annual salary of $100,000 and was formerly Bidz's corporate secretary and treasurer. CEO Zinberg's sales have been fewer in number than those of Ms. Zinberg. Since both Zinbergs control ~62% of the company, we are not too alarmed by the small level of selling.

Please stay tuned for our third and final part on BIDZ.

Happy investing,

Jeffrey Walkenhorst

Disclosure: Long BIDZ, AOB.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Wednesday, August 12, 2009

Youbet.com Disappoints - Economy Takes Toll, Yet Still Profitable

We wrote last week that we were surprised by the sudden sell-off in shares of Youbet.com (UBET, $2.75). To our dismay, somehow the market seemingly knew last week that Youbet.com would miss Wall Street expectations for 2Q09. If that sounds a bit fishy, we're with you, although perhaps the downtrend simply gained momentum for those who wanted to take some chips off the table (?) -- please see 10-day graph below relative the S&P 500's flat to slightly higher performance:

The company reported 2Q09 revenue of $30.2 million and EPS of $0.03, below Wall Street estimates of $30.8 million and $0.06, respectively. Since Youbet doesn't provide guidance, forecasting can be a challenge, but we thought EPS of $0.06 was reasonable. We knew online wagering margins would be pressed lower by new content and also thought the company's tote segment might remain a nagging problem given lower industry-wide wagering. On the conference call, management highlighted several things that impacted results:
  • As in 3Q08, California temporarily disallowed use of tax net operating losses, which cost Youbet approximately $100 thousand (NOLs - YB had $59.1 million in federal and $60.6 million in state NOLs at 12/31/08) and Youbet paid another $200 thousand related to a Canadian tax audit of the tote segment for years prior to YB ownership. Combined, these items round up to one cent.
  • Youbet spent approximately $300 thousand related to new ventures, including lobbying related to pro-gaming legislation. Here's another penny (but we view this as recurring and management said as much).
  • And, United Tote delivered an operating loss of $710 thousand compared to break-even in the year ago quarter. This rounds up to two cents (but we view this as recurring). Cost reductions did not match the unit's decline in revenue. YB appears to have no buyers for this segment given tough industry conditions and, as discussed on the conference call, other tote businesses also for sale in the market.
Let's look at the online business, which is our primary interest:
  • Youbet Express gross revenue increased 9% Y/Y to $24.6 million on wagering "handle" that increased 13% Y/Y to $128 million (new content offset 9% decline in "same track" wagers). The handle growth is a notable deceleration from the +30% Y/Y increase in 1Q09 when new content first returned (same track increased 4% Y/Y in 1Q09).
  • Net revenue declined 4% Y/Y to $8.8 million with the net yield down 120 basis points to 6.9% on new content included and "an increase in player incentives".
  • Gross profit declined 5% Y/Y and operating expenses were down only 6% Y/Y, leading to a 2% Y/Y decline in income from continuing operations to $2.6 million.
  • Income from operations represented a 10.7% margin on gross revenue, down 130 bps Y/Y, but was 29.1% margin on net revenue compared to 28.5% in 2Q08 and 27.1% in 1Q09.
  • Finally, just like last quarter, if Youbet operated only the ADW segment, EPS would have been $0.06, illustrating the earnings power of the business (untaxed because of large NOLs, which should still offset taxes over time).
We are disappointed by the segment's slower top-line performance and relatively flat bottom-line since we expected at least some incremental profit with the new content. While pleased that the net margin is holding up, the economy is now clearly impacting the online business (fewer racing days, plus new content to wager on/choose from Y/Y and strained consumers = lower same track wagers). We think some investors may wonder about competition given Churchill Downs' results last week (see earlier post), but we think Churchill benefitted from a very easy Y/Y comparison.

Management was asked about market share on the call and said that YB would need to see Oregon Racing Commission data before commenting on 2Q09 share. They also pointed to the following:
  • Average number of weekly unique wagerers increased 7% Y/Y (versus 10% in 1Q09)
  • Average handle per unique weekly wagerer increased 5% Y/Y (versus 18% in 1Q09)
We note that 2Q09's net yield of 6.9% is actually higher than the 6.3% realized in 2Q06 (when YB last carried the Kentucky Derby and other Churchill content), which we believe reveals prudent yield management.

Although we expected more, the fact that the company's top-line continues to grow in the current environment is a positive and differentiates the company from most other gaming companies today. An 8/11/09 MarketWatch article relayed recent data from the Nevada Gaming Control Board showing June gambling revenue down 14% Y/Y in Nevada with Strip revenue down 15% Y/Y. Amazingly, the share prices of major gaming companies keep moving higher in the face of poor fundamentals on recovery hopes that are squeezing shorts. Below, we include a one-month chart for Youbet, Churchill Downs (CHDN), Las Vegas Sands (LVS), MGM Mirage (MGM), Penn National Gaming (PENN), and Wynn Resorts (WYNN). Youbet is the laggard but should be one of the few profitable companies this year (along with CHDN and PENN):

We acknowledge that hotel/casino companies have established franchises and significant hard asset values. However, they also have huge fixed cost structures that are a major drag in tough times.

Lastly, we know UBET short interest ticked meaningfully higher in July as the stock traded in the $3s:

Settlement DateShort InterestAvg Daily Share VolumeDays To Cover

Source: Nasdaq.com.

So, no doubt "the shorts" will be all over YB's "miss" and we know the tote segment remains a challenge. The good news is that the uncanny sell-off over the past week may have already discounted the lower-than-expected results. Moreover, here's the reality: the company remains profitable with an improving balance sheet (net cash of $5.6 million, up $7.8 million Y/Y) and isn't going anywhere. As noted in prior posts, the company owns an established, asset light business model with a leading online wagering franchise – brand, customers, platform, marketing partners, and track relationships – that is difficult to replicate. Even dialing back forward estimates slightly, assuming 2009 free cash flow of $12 million, the stock trades at a 10% FCF yield.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long UBET.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Doom & Gloom Resurfaces to Check Bulls - Who to Believe?

It's a massive tug-of-war: on one side you have technical market specialist Robert Prechter of Elliott Wave International. Mr. Prechter hit the media this week with his August update, appearing on Yahoo! Finance's "tech ticker" yesterday and sharing his current views:
  • "quite sure the next wave down is going to be larger than what we've already experienced"
  • market averages will go 'well below' March 2009 lows
  • 'the late 2007-early 2009 market debacle was just a warm-up to what Prechter believes will be the bear market's main attraction' (Yahoo! text)
Meanwhile, on the other side, money manager and Forbes columnist Ken Fisher. Mr. Fisher's latest Forbes column (8/5/09), "The Bear Market is Over" points out the following:
  • "In my Sept. 29 column last year I wrote about how we're in a reverse bubble. In this mirror image of a buying mania, people can see only the negatives. But the positives are there and will be reflected in stocks before long."
Mr. Fisher then cites a handful of positives he sees:
  1. "housing affordability is now excellent"
  2. "global leading economic indicators in total (such as real money supply and the yield curve's slope) are the highest they've been in a decade"
  3. "Productivity is up 2% from a year ago, an impressive growth rate within a recession's decline."
  4. "The financial crisis is over. Most rate spreads between risky paper like junk bonds to Treasurys have reverted to precrisis levels."
  5. "U.S. bank cash on hand, at a trillion dollars, is (adjusted for inflation) three times what it was before the crisis. Cash in the form of U.S. money market funds comes to 42% of the stock market's capitalization. That ratio is more than twice what it was in 1982 and 2003, as stocks were about to take off."
  6. "stocks are dirt cheap, as measured by the degree to which prospective earnings yields exceed long-term interest rates globally."
Who to believe? Tough call. Honestly, we can't tell you whether we're headed back to DOW 7,000 or to 10,000 over the next year. We agree that fundamentals and forecasting remain challenged in many -- if not most -- industries. Demand remains slack, unemployment rising, and wages declining. Even energy use is down, which is rare and likely a result of weak industrial activity -- see WSJ's "Electricity Prices Plummet" article today. Finally, the government is in hock to the gills and expanding like a blowfish, likely leading to higher interest rates and taxes everywhere.

Fortunately, the credit and equity markets are now open for business -- bankers are busy again (see REIT sector) -- and plenty of companies have proven resilient amidst the recession. Nonetheless, u
ltimately, we believe that any sustainable, upward move by the broader market needs to be underpinned by growing earnings. The deceleration in the pace of economic/earnings decline this spring/summer does not equal growth. Accordingly, we see risk that Wall Street analyst forecasts for a return to growth in 2010 could prove too optimistic, especially for cyclical companies/industries. Time will tell which way the wind truly blows.

In our view, the best approach remains to focus on high quality franchise type businesses that (1) have net cash and (2) generate significant excess cash. We wrote in our 3/23/09 article on Youbet.com (UBET, $2.94) that such an investment strategy arguably appears as attractive as simply holding cash, particularly given extremely high earnings and free cash flow yields. While earnings and FCF yields are no longer as high as they were in March, we still see a meaningful margin of safety offered by some companies. For those playing the short side, focus on the opposite of (1) and (2) with identifiable negative catalysts.

We can add another owner-oriented approach: focus on defensive names/sectors with stable dividends since income is more certain and capital gains less certain. These types of businesses have not been immune to the market swoon, but relatively steady operating profiles provide both comfort and income.

On a related note, we'll soon update our "How's the Economy Doing" post from June.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long UBET.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Tuesday, August 11, 2009

Perception Matters - AOB Hires Big Four Auditor

American Oriental Bioengineering (AOB, $5.26) announced this morning that it hired Ernst & Young Hua Ming ("EY") as the company's independent registered public accounting firm for the current fiscal year (end December). EY replaces Weinberg & Company, P.A., which says goodbye on good terms with no disagreement or outstanding issues.

We believe the news was a long time in coming and adds credibility to both the company and its reported financial results. In our view, the implied "rubber stamp" of approval from a big four auditor (to take on AOB as a client) further discredits recent short seller claims, which the company also answered last Friday (please see our earlier post).

While many small accounting firms are certainly very capable -- right or wrong -- we suspect that investor perception of accounting accuracy/integrity is improved for companies with books audited by a major accounting firm.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long AOB.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Bidz / Retail Update - Sales Under Pressure, Preserving Profitability

We will continue our "Bidding on BIDZ" (BIDZ, $4.80) posts later this week, but decided to comment briefly on the company's 2Q09 report Monday. As indicated in our post yesterday, we've been buying shares of Bidz with full knowledge that consumer conditions and forecasting remain challenging.

Normally we avoid companies with high revenue variability and negative fundamentals. We prefer to own businesses with positive/improving fundamentals, consistent free cash flow, and growth (e.g., please see prior posts on PETS, UBET). Still, in this case, we're focused on a business model that we believe has enduring franchise value with a margin of safety relative to near- and long-term earnings power.

Unfortunately, Bidz's 2Q09 revenue of $26.9 million (down 51% Y/Y) fell short of already low expectations (Wall Street consensus $30.0 million), indicating the particularly difficult retailing environment for anything non-essential such as jewelry. On the positive side, the company managed to stay profitable, delivering GAAP EPS of $0.03, at the low-end of its $0.03 - 0.05 guidance range but below a consensus estimate of $0.05. Better gross margins helped offset lower revenue -- 30.6% compared to 27.9% in the year ago period.

Forward guidance also came in lower than expectations as summer seasonality may be even more pronounced at the present time. However, management pointed to a 4Q09 return to growth in the press release:
  • "... The combination of our extensive brand name product assortment, recent partnership initiatives, careful expense management and enhanced focus on customer experience gives us confidence that we will be able to successfully execute our strategic plan. As we look ahead, we expect to resume year over year revenue growth in the fourth quarter and throughout 2010."
We agree the Y/Y comparisons will become easier in 4Q09/2010 and it's possible that international efforts will gain traction following local language site launches in 2008. On the conference call, management cited strength in Saudi Arabia, Egypt, and Spain, with Middle East customers often interested in higher priced items. That said, per the 10-Q also filed yesterday, 2Q09 international sales still declined 33% Y/Y to $9.2 million (34.3% of sales versus 25.1% in 2Q08).

Key operating metrics from 10-Q (click to enlarge):
Management believes the company's inventory position -- while admittedly slower moving than desired -- is preparing Bidz for the upcoming holiday season:
  • "Our inventory currently includes a variety of branded merchandise and many at higher prices in preparation for the holiday shopping season in the fourth quarter of 2009. The current abundance of closeouts has allowed us to stock up on merchandise that would offer good value to our customers."
Clearly, execution and discipline remain critical for the company navigating through the current environment.

Elsewhere in retail, an 8/6/09 Financial Times article summarized July same store retail sales. Even some retailers of consumer staples are showing declines and luxury remains notably weak:
  • "Kohl’s, which operates more than 1,000 discount-style department stores, also reported a 0.4 per cent increase in same-store sales, its first gain since April last year. Its rival JC Penney said its comparable sales fell 12.3 per cent, while Target, the discounter, reported a 6.5 per cent drop, and Macy’s was down 10.7 per cent.
  • Costco, the warehouse club, reported a 2 per cent fall in comparable sales at its US stores, excluding petrol, as lower prices for food and large electronics items including televisions offset continued gains in transactions. Costco’s unit sales of TVs were up 30 per cent on July last year.
  • Luxury retailers continued to struggle during the month, with Neiman Marcus and Saks department stores reporting comparable sales down 27 per cent and 16 per cent, respectively."
Happy investing,

Jeffrey Walkenhorst

Disclosure: Long BIDZ, PETS, UBET.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Monday, August 10, 2009

Bidding on BIDZ (Part One) - Core Thesis and Overview

This post is about yet another Internet/tech-related company. We will likely share some non-Internet/tech ideas in the future. If you've been reading along, we previously disclosed certain other holdings (from different sectors) at the bottom of past posts.

Bidz.com (BIDZ, $4.28)
Market Capitalization: $99.5 million (assuming diluted shares of 23.2 million)
Net Cash as of 3/31/09: $3.2 million (no debt)
Enterprise Value: $96.3 million
Net Tangible Assets as of 3/31/09: $35.1 million ($1.51 per share)
2008 Operating Income: $24.1 million (25% of EV or four times)
2008 Net Income: $14.4 million (14% of MC or seven times)
2009E Net Income: $8.1 million (8% of MC or 12 times)

In recent months, we established a position in Bidz.com (BIDZ, $4.28), which is an online retailer of jewelry that utilizes both an auction format (bidz.com) and a fixed-price format (buyz.com). Bidz is another niche franchise Internet company, a description we used in March/April for Youbet.com (UBET, $3.15), Blue Nile (NILE, $49.83), Stamps.com (STMP, $8.61), and The Knot.com (KNOT, $9.92).

Bidz happens to report 2Q09 results today 8/10/09 after market close. On Friday, the company actually moved up the reporting date from Wednesday 8/12/09, which is somewhat unusual and could be perceived as a positive sign coming on the heels of Blue Nile's report last Thursday.

Although revenue is down materially amidst the recession, management is focused intently on profitability and leveraging Bidz's variable cost model to support margins. In 1Q09, Bidz delivered an operating margin of 8.1% with earnings of $0.07 per diluted share and guided to a pretax margin of 5.3% (midpoint) with earnings of $0.03-0.05 per share for 2Q09. Consensus 2009 revenue is $129 million (down 38% Y/Y) with earnings per share of $0.29 (versus $0.57 in 2008).

Our long thesis is NOT a call on the quarter, which could look like this: revenue trends still down 40-50% Y/Y on economic weakness and meaningfully lower marketing dollars, yet margins and earnings could be better than expected, providing support to the stock. We'll see - forecasting is especially difficult at present. Instead, we're focused on the durability and strength of the business model, which we believe warrants a higher valuation.

While shares rallied from recent lows along with the market, the stock remains at the low-end of BIDZ's two-year trading range and currently trade at 12 times 2009E earnings:

We believe shares are out of favor for one obvious reason -- consumer discretionary with a customer demographic skewed toward low- to middle-income households -- plus, a handful of other reasons: (1) questions surrounding management/director relationships, (2) an SEC investigation into inventory practices, (3) an FTC probe into marketing practices, (4) a flurry of me-too, bandwagon lawsuits related to management, business model questions, and the share price decline, (5) concerns surrounding competition, and (6) a modest amount of insider selling.

In our view, all of "the hair" on top of macroeconomic concerns offers an excellent entry point into a high return on capital business with a growing global franchise. We own the company (via the stock) because of the following:
  • Jewelry retailing is a good business over time
  • Difficult-to-replicate franchise with history of profitability and extremely high returns on invested capital
  • Favorable long-term secular trends
  • Shareholder-friendly management team
  • Attractive absolute and relative valuation on current and future earnings potential
In addition, while near-term fundamentals will likely remain challenged, we see several potential positive catalysts to remove key overhangs:
  1. SEC investigation resolved
  2. FTC probe resolved
  3. Law suits fall by wayside
Although hard to gauge probability or timing for these catalysts, we think some could prove near-term events based on the company's aggressive share buyback program. We make the assumption that shareholder-oriented management isn't so foolish to be buying back the stock if there were material risk in any of the above. For what it's worth, the company assured us in June that it is working through the SEC/FTC inquiries and confident that Bidz is in the right (not surprisingly, as also relayed on quarterly conference calls).

We will discuss risk factors and our thesis in future posts, but let's briefly consider valuation now since numbers will shift around after our post today:
  • As noted above, shares of Bidz are trading at seven times 2008 earnings and 12 times our 2009E earnings of $8.0 million ($0.35 versus consensus of $0.29).
  • Although difficult to foresee improved top-line performance and/or multiple expansion in the current market environment, we believe BIDZ could fairly trade at 15 to 20 times earnings (5% to 7% yield) given the company’s established, difficult-to-replicate, high-ROIC online franchise. Importantly, we believe an informed private market buyer would award a similar valuation.
  • Such a valuation would imply a $5.25 - $7.00 ($6.13 midpoint) fair value today on depressed 2009E earnings. Giving credit for a return to growth at some point and normalized earnings of $12.0 million ($0.50 per share, still below 2007-08 levels) would imply $7.50 - $10.00 per share ($8.75 midpoint).
  • On a relative basis, BIDZ is extremely inexpensive compared to Blue Nile (NILE), which trades at 69 times TTM earnings (*pre 2Q09 results for all NILE TTM figures herein) and 50 times consensus 2010E earnings. NILE trades at 39.5 times TTM EBITDA and 2.4 times sales, compared to 4.9 times and 0.55 times for BIDZ, respectively. Further, Blue Nile’s TTM reported operating income of $16 million and 5.5% margin, lower than Bidz’s $19 million and 10.7% margin.
  • BIDZ also trades at a significant discount relative to Amazon (AMZN, $85.32), which trades at 56 times TTM earnings and 40 times consensus 2010E earnings, but has a reported TTM operating margin of only 3.8%.
  • We see Blue Nile’s business as less discretionary (please see our May post) than that of Bidz, warranting at least some premium. However, we see no reason why the wide gap should persist over time, particularly if certain Bidz overhangs are removed. We expect NILE’s valuation multiple to compress while BIDZ’s multiple expands.
  • Finally, we have a recent comparable M&A transaction in the online retail space: Amazon’s purchase of Zappos. Amazon management relayed on the company’s earnings call that Zappos had approximately $635 million in 2008A sales with “a small profit”. Amazon’s cash/stock purchase price of $847 million implies a price to sales purchase multiple of 1.33 times. If we awarded the same multiple to Bidz, the implied share price would be $10.46, or 2.67x current levels.
Company Description and 2008 Financial Results

Bidz.com, Inc. operates as an online retailer of jewelry in the United States and internationally. It operates a Web Site, bidz.com, for the purpose of selling merchandise, utilizing an online sales auction platform; and a fixed price online store at www.buyz.com. The company’s product inventory includes gold, platinum, and silver jewelry sets with diamonds, rubies, emeralds, sapphires, and other precious and semi-precious stones; and a selection of jewelry, including rings, necklaces, earrings, bracelets, jewelry sets, and watches and accessories. It also acts as an agent in the sale of certified merchant merchandise owned by third parties. The company was founded in 1998 and is headquartered in Culver City, California.

Below is an overview from a September 2008 management presentation (note that revenue growth no longer holds given recession and 1Q09 average items sold per day were 6,110 versus 12,186 in 1Q08):

Snapshot of Web site with mouse scrolled over some earrings:

Unlike eBay (EBAY, $22.55), which doesn't source or own the merchandise up for auction, Bidz sources and owns all merchandise, and holds short-term auctions where most bids start at $1. Bidz guarantees that items are "as described" and offers a"100% money-back guarantee if the item is not as described" less a 15% restocking fee.

Bidz generated $207.4 million in 2008 sales (+11% Y/Y, 76% US / 24% International), operating income of $24.1 million (+15% Y/Y, 11.6% margin), and net income of $14.4 million (down 20% Y/Y on higher taxes, 6.9% margin, $0.57 per diluted share).

Management, Corporate Governance, and Insider Ownership

David Zinberg, Chairman and CEO. David Zinberg founded Bidz.com and has served as the Bidz's Chief Executive Officer, President, and Chairman of the Board of Directors since inception in November 1998. Mr. Zinberg also served as the company's Corporate Secretary from its inception until March 31, 2001. From 1988 to 1997 Mr. Zinberg was the Chief Executive Officer of Asset Lenders of America (Bidz's predecessor), a collateral lending company.

Claudia Liu, Chief Operating Officer (wife of CFO). Claudia Liu joined Bidz in 2001 and was promoted to the company's Vice President of Operations. Prior to joining Bidz, Ms. Liu was Director and General Manager of Cybertowers Pte Ltd., a publicly listed company on the Kuala Lumpur Stock Exchange in Malaysia. Ms. Liu has over 15 years of experience in accounting, operations and general management. Ms. Liu received a Bachelor Degree in Social Science from Sheng Cheng University in Taipei in 1985.

Lawrence Kong, Chief Financial Officer (husband of COO) and Director. Lawrence Kong has served as the company's Chief Financial Officer since January 2, 2001 and as a member of its Board of Director since July 2003. Mr. Kong has served as Treasurer and Secretary since March 2006. Mr. Kong has over 20 years of experience in accounting, financial management and consultancy, Mr. Kong earned a Bachelor of Science in Accounting (summa cum laude) from the University of South Alabama in June 1982 and a Masters of Business Administration in Finance from the University of Chicago in June 1984. Mr. Kong is a member of the American Institute of CPA.

Leon Kuperman, President/Chief Technology Officer. Leon Kuperman has served as the Company's Chief Technology Officer since January 22, 2007. Mr. Kuperman has over 14 years experience in engineering, product development, product demonstrations, and business development initiatives for a variety of technical products and services. Most recently Mr. Kuperman was Chief Technology Officer at Truition, a Canadian technology company which he co-founded in 1998. Mr. Kuperman began his career at IBM Canada, where he was instrumental in building the technical structure for Net.Commerce, the flagship product of IBM's Internet division. Mr. Kuperman holds a degree in computer science from York University.

Bidz has three independent directors (60% of board): Peter G. Hanelt, Garry Y. Itkin, and Man Jit Singh, each serving a staggered three-year term. Biographies are available here. We would prefer to see annual elections and a higher percentage of independent directors on the board. In addition, global best practices call for the separation of Chairman and CEO positions.

Per proxy, as of 4/13/09, including shares and options, management and the BOD owned 67.3% of the company. CEO Zinberg owned 31.7%, Marina Zinberg (his sister and a company Vice President) owned 30.7%, and COO Liu and CFO Kong both owned 3.5%. Saied Aframian, a manager at a principal supplier, owned 5.1% of the company (more on Mr. Aframian later).

Please stay tuned - more to come in the coming week(s) on Bidz.

Happy investing,

Jeffrey Walkenhorst

Disclosure: Long BIDZ, EBAY, UBET.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer