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Friday, October 30, 2009

M/M Decline in New Home Sales Looks Like Normal Seasonality - Why Does No One Say This?

Positive headlines regarding estimated 3Q09 GDP growth of 3.5% goosed the Market yesterday. However, the day before, the Market was down on a variety of economic concerns, particularly new home sales. The lead headline on Yahoo! Finance was "New Home Sales Drop Unexpectedly- AP" (story here) with a tag line "September new US home sales post surprise drop as benefit of first-time buyer tax credit wanes". Some key details:
  • The Commerce Department said Wednesday that sales fell 3.6 percent to a seasonally adjusted annual rate of 402,000 from a downwardly revised 417,000 in August. Economists surveyed by Thomson Reuters had expected a pace of 440,000.
  • It was the first decline since March. Sales in September were down 7.8 percent from a year ago.
  • The median sales price of $204,800 was off 9.1 percent from $225,200 a year earlier, but up 2.5 percent from August's level of $199,900.
  • There were 251,000 new homes for sale at the end of September, down 3.8 percent from August and the lowest inventory in nearly 17 years. At the current sales pace, that represents 7.5 months of supply.
  • ***The data reflect contracts to buy homes, not completed sales. Many new homes are sold while they are still under construction, and buyers may be worried that they won't be able to complete the deal before the Nov. 30 deadline to take advantage of a tax credit of up to $8,000 for first-time buyers.
Perhaps the tax credit had some negative impact, but why doesn't anyone mention typical seasonality? We're not talking about a "seasonally adjusted annual rate", but M/M seasonality in absolute sales figures - that is, the fact that residential housing market activity is higher in spring and summer each year (for both new and existing home sales) before declining in the fall and winter. Why does the media or even economists not mention this normal, recurring annual trend?

Of course, there are signs of economic improvement as Y/Y comparisons enter the easy phase (comparing against an ugly 4Q08) and some sectors might even start growing again (aside from secular growers like Amazon and PetMed Express - see prior posts here and here). However, we don't think stabilization and gradual improvement translates into immediate improvement on the consumer front, whether shopping for homes or for discretionary items. Therefore, we would expect normal seasonality to dominate M/M residential housing moves.

We understand that seasonally adjusted data are meant to adjust for seasonality, but let's look at the raw, not-seasonally-adjusted (NSA) data for new home sales. Thanks to CalculatedRiskBlog.com we present the following chart:

Looking at the chart, 2009 new home sales are represented by the red bars. We see that the 2009 pattern is shifted to the middle right (with peak sales in August) relative to typical peaks in the spring. Coming off of depressed sales and the economic tundra that was early 2009, this shift -- with gradual M/M improvement prior to September -- arguably makes sense and provided some rationale for economists to expect, yet again, higher M/M sales in September.

Still, looking closely at the graph, we see that -- for every single year, from 2003 to present, -- sales decline M/M from August to September. This looks like normal seasonality to us. Hence, why expect anything different given a still weak consumer environment, not to mention a real estate market where prices are still falling Y/Y and inventories remain extremely high? Or, put another way, why should the Market be so surprised by a modest M/M decline? Finally, we could even go one step further: forecasting M/M movements for anything is no easy task and subject to regular error.

Briefly, for a point of reference, let's also look at the much larger unit figures for existing home sales (again, thanks to CalculatedRiskBlog):

The raw, NSA data show normal seasonality and a slight M/M decline in September. However, we note that the National Association of Realtors reported a M/M increase for the seasonally adjusted annual rate:
  • Existing-home sales – including single-family, townhomes, condominiums and co-ops – jumped 9.4 percent to a seasonally adjusted annual rate1 of 5.57 million units in September from a level of 5.09 million in August, and are 9.2 percent higher than the 5.10 million-unit pace in September 2008. Sales activity is at the highest level in over two years, since it hit 5.73 million in July 2007.
On a related note, we'll update our "How's the Economy Doing?" series in November. As mentioned previously, we expect real estate 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).

Happy investing,

Jeffrey Walkenhorst

Disclosure: n/a.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Wednesday, October 28, 2009

Online Gambling and Youbet.com + Las Vegas Still Reeling (Should be No Surprise)

First, a WSJ/Dow Jones article is reporting that a bill to lift online gambling is making progress in Congress and viewed as a means to help fill empty government coffers:
  • Online gaming could "raise nearly $42 billion for the U.S. Treasury over the next decade, according to an analysis conducted by a non-partisan congressional scorekeeper."
Along with other gaming companies, Youbet.com (UBET, $2.08) supports the measure as a means to expand the company's Internet platform (and clearly valuable, apt domain name) into new areas beyond horse racing. While some investors are concerned about potential cannibalization for Youbet's core horse racing business, we see somewhat distinct market opportunities that should lead to a much larger addressable market for the company. Thus, any news on this front could prove a positive catalyst for the stock, although timing/ execution related to potential new business lines remain unknown and, therefore, not factored into our valuation.

We'll come back to Youbet. We want to touch on an AP article that summarized recent results/ commentary from Wynn (WYNN, $54.00), Boyd (BYD, $7.91), and Harrah's (private), highlighting negative industry trends. The key message was as follows:
  • Gamblers are wagering less than a year ago, visiting casinos less often and holding back on extras when they do, continuing trends that left the industry struggling in the third quarter.
Other points:
  • Industry leader Harrah's Entertainment Inc. lost $1.6 billion, including a $1.33 billion drop in the value of its assets. Harrah's said its revenue fell abroad and in each U.S. market where it operates. Overall revenue dropped 13.7 percent to $2.28 billion from $2.65 billion a year earlier.
  • Boyd Gaming Corp. said its profit fell and will wait at least three years before finishing building its $4.8 billion Echelon casino, which looms empty over the Las Vegas Strip.
  • At Wynn Resorts Ltd., where lower spending by leisure travelers and businesses pushed down profit for the second quarter in a row, billionaire CEO Steve Wynn said his company won't expand in the U.S. until the business environment improves. "The landscape in Las Vegas is troubling and it's rife with uncertainty," said Wynn, whose company is based across the Strip from the Echelon. "It's tough to understand what's going on; my 40 years in Las Vegas is not serving me very well at the moment."
Not surprisingly, the still negative operating fundamentals and commentary are pressuring shares just as the Market digests renewed economic fears and numerous pundits warn investors (or traders) to "go to cash" because the Market has gone too far too fast.

The sudden shift in gaming sector sentiment follows the impressive hope driven rally that was especially kind to cyclical, asset heavy companies over the past nine months (magnified by the bounce off of oversold lows). Giving some credit to the pundits, we agree that selective stock sales might make sense for holdings in this category.

We scratch our head over valuations realized by certain of the gaming companies (no doubt short covering / trading driven), including Wynn. We understand that some well-known value investors place great emphasis on the franchise, management, normalized earnings power, and growth potential in Macau. Still, even giving credit for "normalized" earnings of $2.00 (versus consensus 2010E EPS of $0.89) , shares are trading at 27 times a non-discounted $2.00 estimate. Even if the number is an even more generous $3.00, we're looking at 18 times.

Below, we include a six month stock chart for the companies also including Las Vegas Sands (LVS, $13.17), MGM (MGM, $8.91), and Youbet.

Unfortunately, shares of Youbet (illustrated by gray colored line) are also being thrown out the window despite largely not participating in the recent hope rally and staying profitable. Moreover, Youbet operates an asset-light business model unlike the asset heavy hotel/casino companies that have tremendous negative operating leverage in tough times given huge fixed cost structures.

Nonetheless, gambling on horse racing is also discretionary and the weak consumer is impacting the sector. Churchill Downs (CHDN, $34.60) reported an earnings miss today (Wednesday), with revenue of $101 million versus a consensus expectation of $104 million and a net loss versus an expectation of $0.25 (the loss was related to income tax provisions resulting from an IRS audit). Churchill's President and CEO Robert Evans stated:
  • “Total pari-mutuel handle for the U.S. thoroughbred industry, according to figures published by Equibase, declined 10 percent during the third quarter compared to the same period in 2008. While we outperformed the industry, with our total pari-mutuel handle down only 3 percent during the third quarter, gains in our other business segments didn’t offset the decline in racing."
However, the company's online segment delivered Y/Y revenue and EBITDA growth of 33% and 31%, respectively (slight margin compression). As discussed previously, new industry content arrangements are improving 2009 results for advance deposit wagering (ADW) players such as Churchill and Youbet.

Within the next week, we may share a bit more on Youbet. For now, suffice to say that we believe our core thesis remains intact: 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. With an implied 2009E free cash flow yield of 12% (assuming FCF of $11 million), we believe shares are trading well below the value an informed private market buyer would pay for the entire company.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long UBET.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Saturday, October 24, 2009

Netflix Buying Back Shares with No Room for Error; Probably Better to Hoard Cash

A WSJ article regarding Netflix (NFLX, $55.10), "Netflix's Stock Buybacks: Money to Burn" by Martin Peers, caught our attention. Mr. Peers opens with, "In the corporate world, there are savers and then there are spenders. Apple, for instance, has hoarded $34 billion in cash and investments with no dividends or stock buybacks. At the other extreme is Netflix." He then goes on to correctly summarize the following:
  • Netflix is spending cash more than it generates to repurchase shares at a very high multiple.
  • Management thinks buying even at current levels are a good "value" (*per CEO Reed Hastings on call).
  • Forward free cash flow growth is not a certainty in a competitive marketplace.
  • As excess cash is depleted, Netflix plans to borrow money to fund more share repurchases.
  • And, many companies made ill-timed repurchases in recent years.
Let's dig a bit deeper and look at the details. Some commentary from the conference call transcript (sourced via Seeking Alpha here):
  • Since inception of our first buyback program in Q2 of 2007, we repurchased a total of 17.8 million shares for a net reduction in total outstanding shares including stock option grants of 18%. In total, we have spent approximately $545 million, which is more than we have in total assets at the end of the third quarter [= average price per share of $30.62].
  • In Q3, we repurchased 3 million Netflix shares at a cost of $130 million [= average price per share of $43.33]. In the process, we completed the buyback authorized in December of 2008 and began repurchasing shares under the $300 million buyback authorization we announced in August.
  • Under the $300 million authorization, we have repurchased a total of 2.7 million shares at a cost of $122 million, including 1.2 million shares purchased Q4 to date [= average price per share of $45.19].
  • Last quarter, we announced plans to modestly leverage our balance sheet to fund future share repurchases and that remains our objective. We recently closed $100 million revolving credit agreement with Wells Fargo and BOA to begin the process of leveraging the balance sheet, and we will likely consider additional debt financing.

Here are the non-GAAP free cash flow figures reported by Netflix (essentially cash flow from operations less capex and necessary content purchases):

Based on weighted average fully diluted shares outstanding of 58 million during the September quarter, trailing twelve month free free cash flow as $2.03. Thus, during the quarter, Netflix repurchased shares at 4.7% FCF yield (21 times multiple). On an earnings basis, estimated 2009 EPS (midpoint) is $1.86, implying a repurchase yield of 4.3% and a multiple of 23 times. This is very different from Bidz (BIDZ, $3.00) or Youbet (UBET, $2.36) potentially repurchasing shares with FCF yields north of 10% (please see prior posts here and here, respectively).

As indicated in numerous prior posts (e.g. this Apple post), we view a powerful franchise trading at a FCF yield of 5% as fairly valued and prefer to purchase at yields north of 10%. Assuming Netflix is a powerful, durable franchise -- we know customers love the service and we like subscription business models -- Netflix was buying fairly valued equity in 3Q09 at $43 per share. If repurchases continue in the $50s, the company would arguably be buying overvalued shares.

Why would management do such a thing? Any yield higher than the 1-2% they can earn on cash balances should theoretically be accretive. Borrowing costs are also quite low -- per the new credit facility agreement, Netflix pays either a base rate plus a spread of 1.75% to 2.25% or an adjusted LIBOR rate plus a spread of 2.75% to 3.25%.

Clearly, the business continues to scale and deliver impressive growth. Management appears confident that growth can continue indefinitely. Still, at current levels, increasingly slim FCF yields leave little room for error (no margin of safety), especially in view of price volatility through the years:

Moreover, insiders and institutional holders are aggressively selling into strength:

We can't help but think Netflix might be better served by retaining a large net cash pile (unlevered balance sheet) for a better entry point. If such a point doesn't materialize in due course, then management could initiate a dividend to return capital to shareholders. Despite what corporate finance theory teaches about optimal equity/debt capital structures, we don't think a large, growing cash hoard is necessarily a bad thing.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long BIDZ, UBET.
© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Friday, October 23, 2009

Amazon: "eMall" of World Flexes Muscles

Continuing with our short commentary on the Internet giants, we decided to also share certain highlights from Amazon's report yesterday. As with our eBay (EBAY, $23.97) and Yahoo! (YHOO, $17.67) posts this week, we'll keep this brief as Amazon's results are extensively covered by the media.

We previously mentioned that Amazon (AMZN, $93.45) is becoming the "eMall" of the World in this post, where we shared e-commerce data and insights from Emerging E-commerce Trends and Practical Insights by Mark Brohan, VP of Research, Internet Retailer. However, we also mentioned in prior Bidz (BIDZ, $3.02) and PetMed Express (PETS, $16.41) posts that Amazon was/is richly valued - here and here, respectively.

The stock remains expensive for our liking and is up significantly in pre-market trading today. Yet, we've got to hand it to Amazon: powerful franchise with impressive growth, free cash flow, and returns on capital. Below, we include a few corresponding slides from yesterday's earnings call presentation.

Trailing twelve month revenue growth of 24% Y/Y (FX neutral):

Growing free cash generation that benefits from favorable working capital dynamics (negative cash conversion cycle thanks to Internet business model):

And, an expanding ROIC as the business is asset light (does not consume significant capital to expand):

Despite already trading at 55 times trailing GAAP earnings (as of yesterday's close, adjusted for results), the Market is bidding up shares on strong results. Shorts will be further squeezed and/or forced to cover, further juicing the move. Based on TTM free cash flow of $1.9 billion, Amazon is trading at a 4.7% FCF yield (before today's expected stock move). Not nearly as high as the P/E multiple (because of working capital benefits noted earlier), but currently in a fair range for a powerful franchise. That said, continued strong forward growth should keep pushing implied FCF-based fair values higher Y/Y on favorable secular trends. The P/E will likely remain high on a relative basis.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long EBAY, YHOO, BIDZ, PETS.
© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Thursday, October 22, 2009

102 Uses for Mediasite -- Funeral Webcasting? Not Kidding.

We spend a decent amount of time on Sonic Foundry ($0.72) not simply because of our ownership stake, but because we truly believe in the Mediasite franchise and know that customers love the solution. Mediasite fills an important market need and does so extremely well, making life easier and more productive for customers. As a result, customers are regularly looking to use Mediasite in ways beyond lecture capture.

For example, the University of Maryland (from this August 2008 presentation by the school's CIO):

We expect many universities will follow the lead of the University of Maryland. All applications make sense. In addition, Sonic Foundry is hosting two timely Webinars regarding H1N1 in November (see this link for more information):
  • Fortify Your Institutional H1N1 Plan with Lecture Capture: Mediasite at Washington State University
  • Creating an Online Conference to Reduce H1N1 Exposure: A Tale of Two Virtual Meetings
This presentation next week also should be interesting:
  • Webinar - Judging A Book By Its Cover: What Does Your Webcast Say About Your Event and Your Brand? (by Noble Financial - see this link for Noble's June 2009 conference catalog; side note: more financial firms should use this format as most Wall Street related Webcasts remain poor; Noble is way ahead of the pack!)
BUT, let's shift gears away from education/conferences and look at potential other uses, including a surprising new use for Mediasite.

Perhaps two years ago, Sonic Foundry introduced "101 Uses for Mediasite". The list is comprehensive and includes everything from mainstream applications such as distance learning and conference capture, to potentially less common uses (but still good ideas) such as nutrition guidelines and recycling instructions. Here's the list (to see large version, please download on right side of this page) :

However, we came across a 102nd use today: funeral Webcasting. This wasn't our idea, but comes from a serious article in IEEE Spectrum that a business colleague happened to send our way in relation to a completely different topic. The article, entitled "Funeral Webcasting is Alive and Well", opens the following:
  • If webcasting a funeral seems a little, well, ghoulish to you, you’re not alone. The decade-old service has been a hard sell to most funeral directors until recently. But the advent of cheaper broadband, the financial strain of travel, and deployments to Iraq and Afghanistan have all contributed to increased use of the Web as a tool to connect loved ones during such times of need.
More, with some stats:
  • ”It’s really come up in the last two years, as more webcasting software companies have entered the market, made it more user-friendly, and more aggressively pitched it to funeral directors,” says John Reed, owner of the Dodd & Reed Funeral Home, in Webster Springs, W.Va., and president of the National Funeral Directors Association (NFDA), in Brookfield, Wis.
  • Funeral webcasting is starting to spring up in Hong Kong, India, the Philippines, and elsewhere. Reed estimates that 10 to 20 percent of NFDA’s 20,000 members in 40 countries offer it.
And insight into one service provider:
  • The ubiquity of social media has raised everyone’s comfort level with life taking place online as well as off, says Matthew Fiorillo, who owns the Ballard-Durand Funeral Home in White Plains, N.Y. He’s now webcasting four or five funerals a month; he only began offering it in October 2008. ”Every time I arranged a funeral, I’d ask if there was a family member who wanted to attend but couldn’t. Eighty or 90 percent said yes,” he says. ”Then I’d ask how they would feel about seeing a service live online, and they were open to it.”
We're not sure if any funeral homes are using Mediasite or if Sonic Foundry has ventured down this path. Funeral webcasting is far outside of the company's bread and butter, institutional focus areas and, no doubt, carries different economics. However, the trend clearly illustrates just how ubiquitous Webcasting and rich media is becoming in our lives.

We can now fairly say that Mediasite has 102 potential uses.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long SOFO.
© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

eBay Delivers the Goods - Accelerating Growth with Continued Large Excess Cash Generation

As with our Yahoo! (YHOO, $17.66) post the other day, we'll keep this brief as eBay's (EBAY, $25.03) results will be extensively covered by the media. We previously highlighted eBay's competitive advantages and significant free cash generation. Below, we include some informative slides from yesterday's earnings call presentation.

Organic revenue growth of 5% Y/Y, an improvement from 1% last quarter:

Steady free cash flow generation that keeps building cash on the company's balance sheet:

And, a still high ROIC, although weighed down by acquisitions over the past year -- expect improvement over time:

The Market seems to be disappointed with the company's December quarter outlook, but we are pleased with improved Y/Y organic revenue growth and performance across business segments (detail available in full management presentation) in the September quarter. After all, how many companies are actually growing the top-line organically in the current environment? Not many.

We expect the company's well-positioned assets to continue generating significant excess cash flow and growth, supported by favorable secular trends.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long EBAY, YHOO.
© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Wednesday, October 21, 2009

How About Those New Apple Price Targets?

In our Apple (AAPL, $199) post yesterday, we noted that "Bullish Wall Street analysts will adjust their forecasts and raise target prices (back of envelope, simple approach without considering seasonality and product cycles: annualize the reported $1.82 for $7.28 forward EPS; applying P/E multiple of 30 times yields target price of $218; applying three year average P/E multiple of 37 times yields $269)."

Where did the Street come out? Somehow nearly all within our "back of the envelope" $218-269 range -- for a summary, please see Eric Savitz's Tech Trader Blog in Barrons (busy man - we suspect he has help). We normally won't relay Wall Street targets/estimates as our focus is on our own research, but we find the large sample of very similar target price "results" (per Barrons post) interesting.

Of course, it's not difficult to derive a new price target based on an average historic P/E multiple and an upward revised EPS estimate -- the hard part is estimating the EPS before the big stock move and getting "the call" right. Per the below table sourced from Barrons, more analysts are positive now than three months ago.

As we indicated yesterday, despite the implied upside, we're not buying since we prefer to purchase businesses with much lower multiples when the sun is NOT shining on the company/stock. A lower multiple provides a margin of safety should something go wrong. In addition, based on Apple's trailing twelve month results, free cash flow was $9.0 billion - or, a 5% FCF yield on the current share price. We generally view a FCF multiple of 20 times (5% yield) as fair for a difficult to replicate franchise and prefer to buy businesses with yields of 10% or greater.

Happy investing,

Jeffrey Walkenhorst

Disclosure: no position.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Tuesday, October 20, 2009

Yahoo! Delivers Stable Revenue Q/Q and Steady Free Cash Generation; Market Happy

We'll keep this brief since Yahoo!'s (YHOO, $17.17) results are and will be widely reported by the media. We previously commented that we believe the company's online real estate is quite valuable and difficult to replicate, which is one of our key gauges of franchise quality.

Results were better than Wall Street expected and shares will likely trade higher tomorrow as analysts raise estimates and possibly jump back on the bandwagon with Buy ratings (now that the coast is seemingly clear, e.g. flat revenue Q/Q = stabilization; cost reductions = margin/EPS improvements -- of course, the latter should come as no surprise, in our view, given new management's initiatives).

We'll share two slides from Yahoo!'s management presentation that we like -- steady FCF generation:
And, a growing cash balance on the balance sheet:

We would like to also see increasing deferred revenue and faster page view growth, but we'll settle for the otherwise very strong balance sheet and other positives. For those that watch/listen to the Webcast (no video), you'll notice that the platform is not as user friendly or compelling as Sonic Foundry's (SOFO, $0.70) Mediasite.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long YHOO, SOFO.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Twitter Powerful, but Keeps Going Down - More Infrastructure Necessary!

We were skeptical of Twitter before we hopped aboard perhaps a few months ago to share blog posts and anything else that strikes us as worthwhile.

Now, we've bought into the idea that the instantaneous networking power of Twitter is incredible, especially as the number of "followers" increase. For example, some extremely well followed columnists and politicians have more than one million followers that they can instantly reach with minimal effort -- they can share news, views, or ask questions if they need assistance on a certain topic.

We're not commenting on the durability of the business model or enterprise value. Like all companies, we think valuation should be supported by current/future free cash generation to owners. Yet, we must say that the microblogging platform is arguably powerful and transformational in terms of sharing information.

Unfortunately, the popularity is seemingly leading to network overloads for Twitter as we've seen this message several times in recent days:

Another message also popped up about being overloaded -- we don't recall the exact wording. It appears as though Twitter needs to invest in additional infrastructure to support growth, a potential negative for Twitter, but potential positive for IT hardware/networking companies. However, contrary to the error messages, a recent media report noted the following: "The September numbers from market watcher comScore show Facebook Inc.'s U.S. user number grew 4 percent to 95.5 million as Twitter Inc.'s numbers flattened out at about 20.8 million" (i.e. slower growth should mean less network strain).

Happy investing,

Jeffrey Walkenhorst

Disclosure: no position.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Taking A Bite Out Of APPLE? No, But Impressive Results Show Positive, Fundamental Shifts for Powerful Franchise

Someone asked us the other week what we thought of Apple (AAPL, $198). We essentially came back with the following:

At a high level, we might summarize the consensus view and key positives as following:
  • "cult"-like following and many portfolio managers (PMs) see AAPL as a core holding (similar to GOOG, QCOM, RIMM)
  • numerous positives that PMs hang hat on such as
  • (1) increasing Mac adoption by disgruntled PC users (we bought one a few months ago - great so far, although not as strong for Excel modeling),
  • (2) iPod and iTunes dominance with expanding, entrenched customer base,
  • (3) growing iPhone penetration of smartphone market,
  • (4) App Store growing by leaps and bounds, creating virtuous, sustainable ecosystem (related to points 2 and 3),
  • (5) significant free cash flow generation, large cash pile and no debt
However, at 27x [then] consensus F10E EPS of $7.00 and 33x TTM earnings, much of the good news is seemingly now reflected in the share price. We derived three-, five-, and ten-year average historical multiples across many metrics (e.g. EPS, EBITDA, BV). Over the past three years (during iTunes success and renewed "love" for Apple), AAPL traded at an average of 37x normalized TTM earnings, slightly above current levels. On a EV/EBITDA basis, the three-year average was 20x, in-line with the current level of 19.5x. Finally, price to book - three-year average of 7x, in-line with current levels.

Thus, shares generally appear fairly valued, especially if growth slows in F10 as the law of large numbers take hold in new product categories (i.e. iPhone). Of course, as with many stocks in a myopic, momentum driven Market, the primary question is upside/downside to numbers. If a solid case can be built for either direction, that will influence the stock. We include Apple's five year stock chart below:

Well, yesterday's results tell the story: massive upside to numbers and impressive Mac/iPhone growth: revenue up 25% Y/Y to almost $10 billion (international sales of 46%), gross margins up 190 basis points Y/Y to 36.6% and GAAP profit up 45% to $1.7 billion ($1.82 per share versus consensus estimate of $1.42). Further, deferred revenue related to iPhone, Apple TV, and AppleCare/Other sales increased an incredible 88% Y/Y to nearly $15 billion. The jump is largely because of iPhone sales, where cash is received upfront but the majority of revenue deferred and recognized over the estimated life of the product/contract (costs are also amortized over the estimated useful period). If the impact of "subscription accounting" is eliminated, Apple reported non-GAAP EPS of $3.12 versus $2.29 in the year ago quarter.

Looking briefly at unit sales for the September quarter:
  • 3.05 million Macintosh® computers (+17% Y/Y)
  • 10.2 million iPods (down 8% Y/Y)
  • 7.4 million iPhones (+7% Y/Y)
More information can be in the countless media reports on Apple -- one from Reuters here.

A few conclusions from where we sit:
  • Recession not impacting Apple and at least some consumers are alive/kicking. While the economy remains weak, if things were truly dire, we wouldn't see results such as those reported by Apple.
  • The five positives outlined above are legitimate and have legs. Secular and company specific trends bode well for Apple for 2010 and beyond.
  • Numbers go higher. Bullish Wall Street analysts will adjust their forecasts and raise target prices (back of envelope, simple approach without considering seasonality and product cycles: annualize the reported $1.82 for $7.28 forward EPS; applying P/E multiple of 30 times yields target price of $218; applying three year average P/E multiple of 37 times yields $269).
Yet, given our preference for out of favor, lower priced "merchandise" (stocks), we remain uninvolved in Apple shares. We write this largely for general interest and because we find amazing what Apple has achieved -- and continues to achieve -- as a powerful franchise.

Happy investing,

Jeffrey Walkenhorst

Disclosure: no position.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Monday, October 19, 2009

PetMed Pulls Up Short -- Express Becomes Local Train

In yesterday's post, we pointed to several potential sell signals for PetMed Express (PETS, $19.66): insider selling, still large short interest, and bearish moves in option activity (per another source), as well as a fair valuation indicated by our own model (aside from DCF valuation). We also mentioned that the company's history of beating expectations could prove perilous in the event of a disappointment.

Well, in this case, the warning signs were correct as PetMed's F2Q10 results came up short: revenue of $62.4 million (+5% Y/Y) was below a consensus estimate of $66.0 million (+11% Y/Y) with in-line earnings of $0.28 per share (+12% Y/Y, not good enough given expectations for beat). Further, on the conference call, management explained that the company was unable to purchase as much remnant TV advertising space (left over TV commercial slots in "scatter" market) as prices that make sense for PetMed. Apparently, "general advertisers" that would normally be buying slots "in advance" are buying remnant space this year because of economic uncertainty.

If this is the case, we're surprised we didn't see or hear of this last quarter, although we understand the advertising market can swing around quickly. Perhaps certain advertisers are now being more aggressive given signs of economic stabilization and possible improvement. Management expects the advertising market could be more "orderly" in calendar 2010 with more advance purchasing. Yet, such forecasting is near impossible -- only time will tell. One thing is for sure: access to remnant space is critical for growth in a direct marketing business model such as PetMed's. Investors will now question the company's growth potential into 2010, which may keep shares range bound.

By purchasing less advertising, PetMed added only 233,000 new customers (down 3% Y/Y) which, coupled with a lower average order size of $78 versus $81 in the year ago quarter, led to the revenue miss. However, less spending on advertising (down 11% Y/Y) helped offset a lower gross margin (mix, possible competition) to yield operating income of $9.8 million (+15% Y/Y) with an operating margin of 15.7% versus 14.4% in the year ago quarter. The company ended the quarter with $69 million in cash/investments, compared to $74 million at 6/30/09, and no debt. Notably, PetMed paid the company's first ever quarterly dividend of $0.10 per share during the quarter, resulting in a cash outflow of $2.2 million.

As previously described, we like the company's business model, especially a growing stream of repeat business (73% of F2Q10 revenue, +11% Y/Y). However, the stock will be under pressure today. As with any company, we strive to purchase with a significant margin of safety to our estimate of fair value. Based on most valuation metrics, such a margin did not exist last week. We may soon have another opportunity.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long PETS.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Sunday, October 18, 2009

Watching PetMed Express Tomorrow - Some Pressure, But Different than 2006

PetMed Express (PETS, $19.66) reports F2Q10 (September) results Monday morning before market open. We suspect the results will be just fine and the company has a history of beating Wall Street expectations (which is perilous in event of a disappointment):

However, we know some are questioning further, near-term upside following the recent run (including push through $20 on Friday): insiders (94 thousand shares sold in past six months, see link), short sellers (down from earlier this year, but still 5.0 million shares or 22% of float, see link), and Jon 'DRJ' Najarian's optionMonster.com ("Options Turn Bearish on PetMed Express", see link).

OptionMonster notes that "The $20 mark served as resistance for PetMed Express in [March] 2006, and at least one trader expects that level to keep the stock in check again now." We can't help but submit that PetMed Express is in a different place than in early 2006: the company will earn more than one dollar (consensus F10E = $1.14) this year versus only $0.50 in F06 (end March). We include a five year stock chart below:

Indeed, based on our model, PetMed Express is no longer a bargain. Aside from discounted cash flow (DCF) analysis, the company generally appears fairly valued depending upon approach:
  • DCF assuming 10% cost of capital and 2% terminal growth = $29 fair value
  • FCF multiple of 20x F2011E FCF (discounted 1.5 years to 9/30/09) = $20 (18x = $18)
  • Private Market Value (PMV) with capitalization rate of 10% applied to F2011E EBITDA = $25 ($21 discounted to 9/30/09)
  • Earnings Power Value (EPV) with capitalization rate of 10% applied to F2011E adjusted EBIT = $17 ($15 discounted back)
That said, the company's established niche market position and financial performance in the face of a "couple dozen online competitors" (per management - see this presentation, slide 11) should enable sustainable forward growth and significant excess cash generation, thereby lending support to the DCF valuation.

Our model shows net cash/investments per share increasing to $5.50 per share in F2013 (3.5 years) from $1.90 at year-end F2009 (March) assuming the current dividend of $0.40 growing 10% per year but no incremental share repurchases (*unlikely, but we're allowing cash to simply build on balance sheet). These are the types of businesses we like to own.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long PETS.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Friday, October 16, 2009

Wall St. Speculation Alive and Well in Clean Tech -- Risky Business

A 10/6/09 BBC article entitled Downturn is 'climate opportunity' relayed the message from the International Energy Agency (IEA) that "the global recession provides a window of opportunity to curb climate change and build a low-carbon future". A few key points from the article:
  • [the IEA's] prescription would lead to greenhouse gas concentrations being stabilised at the equivalent of 450 parts per million (ppm) of carbon dioxide - a level that, according to some analyses, offers a good chance that the rise in the global average temperature since pre-industrial times could be kept within 2C.
  • Without these policies, the agency calculates that concentrations will soar to 1,000ppm by mid-century - levels that, in many scientists' views, would lead to catastrophic and irreversible consequences.
  • But political and financial capital needs to be invested soon if the world is to follow the 450ppm path, it says, with emissions needing to peak around 2020.
The article included the following graph showing potential Co2 emissions and reductions, revealing that approximately one half of reductions from the reference scenario result through "End-use efficiency":

This brings us to our primary topic: companies that manufacture electric batteries for cars and other applications (i.e. end-use efficiency). We previously commented on this sector in our post,
Berkshire Hathaway's BYD Purchase - Great "Trade" yet Long-Term Economics are Critical Question in July. In that analysis, we noted the following regarding BYD based on the company's 2008 annual report:
  • Gigantic revenue growth
  • But, margin compression
  • And, low return metrics
  • With huge capital consumption to fund growth
  • Quick conclusion: the facts tell us that BYD operates in a low margin, low return, competitive business that consumes significant capital.
In August, we continued our "clean tech" analysis with Competition for BYD and Divergent Views on "Green" Cars - EVs versus Hybrids. In addition to competition from the auto makers mentioned in that post, we are aware of other companies aggressively seeking market share in the battery segment: Ener1 (HEV, $7.04) and A123 Systems (AONE, $23.06). Both companies are growing top-line rapidly while losing money and consuming massive amounts of capital to fund expansion.
If large operating losses and capital consumption weren't enough to make us cautious with regard to these companies, valuation presents another red flag. On an enterprise value basis, Ener1 is valued at 38 times trailing twelve month revenue and 8 times 2010E revenue. The Market is enthusiastic about recent program wins and DOE grants.

A123, which only went public a few weeks ago at $13.50 and is up 71%, is valued at 24 times TTM revenue. If we apply the same blistering +69% Y/Y revenue growth reported for the company's most recent quarter to TTM revenue of $90 million, the company is valued at 14 times estimated forward revenue of $152 million.

In both cases, we understand that the Market is embracing the growth potential of the businesses, yet the valuations appear very rich. As we recently pointed out for Blue Nile (NILE, $61.26), ENER and AONE appear to be trading on/in thin air.

Briefly, let's take a closer look at A123 Systems. The company has big backers, including GE (GE, $16.79), Qualcomm (QCOM, $42.45), and Motorola (MOT, $8.13), all of which retained a large ownership position post IPO:
The company announced on 9/30/09 that it closed its initial public offering of 32,407,576 shares of common stock at a public offering price of $13.50 per share, with the underwriters purchasing all 4,227,075 shares available through the over-allotment option. The IPO prospectus shows the underwriters involved in the deal: MORGAN STANLEY, GOLDMAN, SACHS & CO., BOFA MERRILL LYNCH, DEUTSCHE BANK SECURITIES, LAZARD CAPITAL MARKETS, and PACIFIC CREST SECURITIES. Based on our prior experience, we believe "sell-side" firms typically initiate equity research coverage 45 days following an IPO. More on this later.

The prospectus also includes a financial summary:

And -- of course -- key risk factors, including:
  • We have had a history of losses, and we may be unable to achieve or sustain profitability. We have never been profitable. We experienced net losses of $15.8 million for 2006, $31.0 million for 2007, $80.5 million for 2008, and $40.7 million for the six months ended June 30, 2009. We expect we will continue to incur net losses in 2009. We expect to incur significant future expenses as we develop and expand our business and our manufacturing capacity. In addition, as a public company, we will incur additional significant legal, accounting and other expenses that we did not incur as a private company. These increased expenditures will make it harder for us to achieve and maintain future profitability. We may incur significant losses in the future for a number of reasons, including the other risks described in this prospectus, and we may encounter unforeseen expenses, difficulties, complications, delays and other unknown events. Accordingly, we may not be able to achieve or maintain profitability.
  • We have yet to achieve positive cash flow, and our ability to generate positive cash flow is uncertain. To rapidly develop and expand our business, we have made significant up-front investments in our manufacturing capacity and incurred research and development, sales and marketing and general and administrative expenses. In addition, our growth has required a significant investment in working capital over the last several years. We have had negative cash flow before financing activities of $29.1 million for 2006, $56.1 million for 2007, $76.0 million for 2008, and $62.2 million for the six months ended June 30, 2009. We anticipate that we will continue to have negative cash flow for the foreseeable future as we continue to make significant future capital expenditures to expand our manufacturing capacity and incur increased research and development, sales and marketing, and general and administrative expenses. Our business will also require significant amounts of working capital to support our growth. Therefore, we may need to raise additional capital from investors to achieve our expected growth, and we may not achieve sufficient revenue growth to generate positive future cash flow. An inability to generate positive cash flow for the foreseeable future or raise additional capital on reasonable terms may decrease our long-term viability.
  • Our limited operating history makes it difficult to evaluate our current business and future prospects. We have been in existence since 2001, but much of our growth has occurred in recent periods. Our limited operating history may make it difficult to evaluate our current business and our future prospects. We have encountered and will continue to encounter risks and difficulties frequently experienced by growing companies in rapidly changing industries, including increasing expenses as we continue to grow our business. If we do not manage these risks successfully, our business will be harmed.
Bottom-line: although we've not completed deep fundamental analysis (e.g. management meetings, channel checks, SWOT analysis, modeling) and could be missing something, we are hard-pressed to build a positive case for purchasing shares at current levels given a perusal of A123's history of losses, risk factors, and valuation. In fact, the evidence points to taking trading profits (a "Sell") and/or betting against further upside (a "Short").

It will be interesting to see where the underwriters come out on the name. We were always objective, unbiased in our "sell-side" days and believe most analysts simply want to make good, fundamental stock calls to keep their stock-picking reputation intact. However, we're not oblivious to potential conflicts at some firms. In this case, we're aware of certain hedge fund traders wagering that at least a few analysts will be bullish on AONE and play into the upward momentum of fast money hands. We're all for innovation and curbing CO2 emissions, but we'll see what happens from the sidelines.

Happy investing,

Jeffrey Walkenhorst

Disclosure: no positions.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Saturday, October 10, 2009

Tech/Online Trends? Interesting Presentations from "E-Biz Consortium"

This year's University of Wisconsin E-Biz Consortium Emerging Technologies Conference included many interesting presentations worth a look/listen for anyone curious about current technology and Internet trends. The UWEBC Conference focuses on "best practices and actionable insights from superior thought leaders" in the sector and archived Mediasite presentations are available. In addition to e-commerce, a wide range of other topics were covered, including Cloud Computing: Types, Levels of Virtualization and Other Challenges by Kevin Leahy of IBM Global Services (IBM, $125.93) , and How Cisco Manages Supply Chain Uncertainty and Risk by C. Kevin Harrington of Cisco Systems (CSCO, $24.03).

Although we look at all types of companies and sectors, we have a slight bias toward asset light, cash generating Internet companies such as Youbet (UBET, $2.26), PetMed Express (PETS, $19.41), and Bidz (BIDZ, $3.32) that should have secular tailwinds for years to come (*so long as the Internet doesn't go away, which only happens in a Mad Max Thunderdome scenario, in which case all companies are in trouble). Accordingly, we appreciated data and insights included in Emerging E-commerce Trends and Practical Insights by Mark Brohan, VP of Research, Internet Retailer. We recommend watching the presentation, but include a few key points/slides here:

  • YTD 2009 (through 2Q09) trends:
  • Still a tough consumer market:
  • Companies looking to spend more for online tech platforms:

To summarize, the strong get stronger as e-commerce becomes increasingly ingrained in our lives and companies across many sectors (including manufacturing) are investing to build out online merchant capabilities.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long UBET, PETS, BIDZ.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Wednesday, October 7, 2009

Can't Help But Mention Mediasite, Again -- Tandberg and More...

Following up on our M&A post yesterday and, specifically, the Cisco (CSCO, $23.61)/Tandberg deal, we couldn't help but mention that Sonic Foundry's (SOFO, $0.67) Mediasite rich media solution easily integrates with video conferencing gear from both Tandberg and Polycom (PLCM, $27.48). Although Mediasite's core application is "one-to-many" presentations (e.g. lecture capture, town hall meetings, conferences) and not point-to-point video communications, we are aware of some customers using Mediasite to capture video conferencing conversations. For more information on this topic, please see this presentation from Sonic's Unleash 2009 Conference: "Integrating Mediasite with Videoconferencing: A Scenario-based Presentation from Basic to Wild" by Helder Conde, Technical Director, Atitude Digital Media. The niche player's ability to readily inter-operate with widespread video hardware/systems is a clear positive.

For those interested, Helder Conde was also the lead presenter at last week's Mediasite User Group meeting - link here. One item he highlighted was a large Mediasite Webcast his firm handled for Sanofi-Aventis (SNY, $37.13). Originally, Sanofi-Aventis was going to have an on-site meeting, but opted for a Webcast because of the H1N1 virus. Thus, Mediasite was used for 15 presentations and 27 hours of content that was Webcasted live "with intense audience participation" to around 800 participants. We expect to see more events like this.

The User Group meeting also included a presentation by Sonic Foundry where the company previewed the Mediasite v5.2 release, which includes several additional upgrades to further improve the solution (e.g. "remote recorder control center" in online "management portal"). Notably, the company expects the release upgrade next week. Sonic Foundry continues to keep the virtuous feedback/upgrade cycle alive with the company's expanding, installed customer base.

The User Group meeting, as well as Sonic's "5.1 in 15 Webinar Series" and a recent Webinar titled "Future Proof Capture: Best Practices for Planning Your Server and Storage Strategy" provide excellent insight into the Mediasite solution and deployment considerations for large-scale installations. Network integration/design become evermore critical as organizations have 20, 30, 40+ recorder units capturing hundreds or thousands of hours each month.

In other news, TU Delft's Leon Huijbers was featured in a brief interview by DIVERSE2009 Weblectures - link here. We believe TU Delft is one of Sonic's largest European customers. After describing the popularity and success of TU Delft's program, one of his key points is that "no institution that should ignore these kinds of developments". We concur.

Finally, Sonic's largest customer to-date, The King Abdullah University of Science and Technology, opened for classes in September - BBC article here (no mention of Mediasite, but press for school).

Although shares of Sonic Foundry are speculative and somewhat akin to venture capital, at approximately 1.3 times trailing revenue, we continue to believe that the private market value for the company is materially higher than current trading levels given the growing Mediasite franchise, annual top-line growth of 20%+ (expected for F09 - end September), and GAAP break-even operations.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long SOFO.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Tuesday, October 6, 2009

More M&A Activity: Cisco/Tandberg, Others; Solid Balance Sheets Provide Kindling

Following up on our corporate M&A activity post on 9/21/09, we're seeing more deals:
  • This morning, Emerson Electric (EMR, $40.00) announced plans to acquire Avocent (AVCT, $24.82) for $1.2 billion ($25 per share), or 2.2 times 2009E sales of $540 million and 17 times 2009E earnings of $1.47. Avocent Corporation "designs, manufactures, licenses, and sells software and hardware products and technologies that provide connectivity and centralized management of information technology (IT) infrastructure in the United States and internationally". Despite operating in an area with favorable secular growth trends, consensus 2009 revenue for Avocent is down 18% Y/Y, with an 8% rebound expected next year.
  • Yesterday, Nuance Communications (NUAN, $14.79) announced plans to acquire privately held eCopy for $54 million in stock. We can't find current financial data for eCopy, but the company had $62 million in sales for its FY06 (end July) and presumably kept growing in the past few years.
  • Last week, Cisco (CSCO, $23.41) announced a deal to acquire Tandberg (listed in Norway) for approximately $3.0 billion, or 3.7 times 2008A sales of $809 million and, according to this Reuters article, the "offer values Tandberg at about 23 times 2010 earnings, analysts say, slightly above U.S. rival Polycom's multiple of 21.7". For 2Q09, Tandberg reported revenue of $204.6 million (+5% Y/Y) with operating profit of $43.0 million (+4% Y/Y, 21% operating margin). In 2Q09, TANDBERG sold 15,663 video conferencing endpoint units (down 5% Y/Y overall, but a 4% increase excluding OEM units) with endpoint revenue of $122 million down 5% Y/Y and 60% of total revenue. Revenue from network products grew 25% and service revenue grew 22% Y/Y.... We probably don't need to say this, but Cisco is increasingly the global arms dealer of networking gear.
Our list is not all inclusive -- there likely have been more transactions in recent weeks. Plus, rumors are circling around a number of other companies, including Brocade Communications (BRCD, $9.24) , DirecTV (DTV, $27.65), and GE's NBC unit.

Bottom-line: as pointed out in the Bloomberg article referenced in our earlier M&A post, many companies are flush with cash, generating more cash, and paying very little for borrowed money (i.e. extremely low rates are reducing interest expense and boosting earnings/cash flow). Despite lingering economic challenges and recurrent media/investor doubts, we see solid balance sheets with mountains of cash as at least one reason for optimism.

Happy investing,

Jeffrey Walkenhorst

Disclosure: none.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Saturday, October 3, 2009

Things That Don't Make Sense: NILE's Valuation

We've previously written on Blue Nile (NILE, $59.57) in our Bidz.com (BIDZ, $3.14) series and in our May post, People are Still Getting Married.

We like Blue Nile's established online franchise, but pointed out the following in our 8/24/09 Bidz post:
  • 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 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.
Updated as of 10/2/09's close:
  • At 9 times TTM earnings and 10 times consensus 2010E earnings, BIDZ is extremely inexpensive compared to Blue Nile (NILE), which trades at 84 times TTM earnings and 59 times consensus 2010E earnings. NILE trades at 46 times TTM EBITDA and 3.1 times sales, compared to 5.8 times and 0.5 times for BIDZ, respectively.
  • TTM operating income and margin figures remain the same as above (through June). On a TTM earnings and free cash yield basis, NILE offers current investors only 1.2% and 2.6%, respectively, compared to BIDZ's 11.1% and 22.4% (for reference: TTM free cash flow generation for Bidz was $15.6 million compared to $22.8 million for Blue Nile). On a TTM operating income to enterprise value yield basis, NILE's yield is 2.0% compared to BIDZ's 20.5%.
Let's make the valuation disconnect even more clear. In one of our favorite investment reads, One Up On Wall Street, Peter Lynch plainly explains the price to earnings multiple as "the number of years it will take the company to earn back the amount of your initial investment--assuming, of course, that the company's earnings stay constant."

SO, with respect to NILE, we're looking at a whopping 59 years on a forward basis to recoup estimated 2010 earnings of $1.02 (consensus). Moreover, the forward estimate gives credit for an earnings recovery from recession-depressed $0.75 in 2008 and an estimated $0.81 in 2009 to the company's prior peak earnings level of $1.04 in 2007. By contrast, for BIDZ, an initial investment today will be earned back in only ten years, which makes Common Stock Sense to us.

What explains Blue Nile's astronomical valuation? At least a few possibilities: (1) economic recovery hopes, (2) short covering amidst small float (9/15/09 short interest of 3.1 million shares versus a 3/31/09 peak of 6.1 million shares), (3) momentum traders bidding higher because the stock "works", and (4) the greater fool theory, where speculative or possibly aloof "investors" purchase on the hope others will keep buying (similar to our #3 momentum traders) with the hope that the valuation will get even crazier. For example -- see irrational, short-lived jump to $100 in 2007:

Although anything can happen in the short-term and shares may move higher on momentum, we see the stock as trading on thin air given the rich valuation, seemingly high expectations, and sizable insider selling in the $40s-$50s. Blue Nile's CEO sold 138 thousand shares in June around $50, or approximately 27% of his position pre-transaction for total proceeds of approximately $6.7 million.

To be sure the valuation lacks fundamental support, let's quickly assess where the stock is trading with respect to future earnings power. We'll award credit for a return to relatively high growth (15% per year) and peak net margins of 5.5% in 2014 (year five). In this scenario, year five revenue is $579 million with net income of $32 million. If net income is discounted back to present (assume 12/31/09) at 10%, net income is only $20 million. Thus, today's market capitalization of $865 million is a rich 27 times the non-discounted result and 44 times the discounted figure. Our summary analysis is below (click to enlarge):

Source: Company reports, JW estimates.

Finally, putting on our former Sell-Side Equity Analyst hat, we would not be surprised to soon see rating downgrades, especially from Argus, Citigroup, or William Blair, all of which upgraded NILE to Buy from Hold in May-July in the mid-$30s to low $40s. Of course, pure "valuation" calls are often frowned upon by Market participants and require fortitude by the analyst (or portfolio manager) making the call. We're aware that many retail investors think the sector can "work" through year-end despite an already prodigious up move in recent months and fair to rich valuations across the sector (as in: keep holding, maybe buy more, then -- quick -- head for exits before everyone else in December or early 2010).

We know some long-time institutional holders of NILE own the company because of its strong, growing franchise (that could well be gobbled up at some point), yet we think valuation discipline is both prudent and necessary. Moreover, many other well-positioned cash generating companies are available for significantly lower multiples of earnings and free cash flow, including Bidz.com, Youbet.com (UBET, $2.08, prior post here), and American Oriental Bioengineering (AOB, $4.71, prior post here). With so much lower priced merchandise offered by the Market, why pay 44 times discounted 2014 earnings? This isn't Common Stock Sense.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long BIDZ, AOB, UBET.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer