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Monday, November 30, 2009

Sonic Foundry: To Believe or Not to Believe (in the Mediasite Franchise)?

Sonic Foundry (SOFOD, $5.40) reported fiscal 2009 results today after market close -- link here (includes Mediasite Webcast). Here are some brief points:
  • The company made great strides expanding gross margins and reducing expenses, although full year revenue of $18.6 million (+19.2% Y/Y) came in lower than our expectations and just shy of previously raised guidance calling for >20% top-line growth.
  • Other key metrics also exhibited slower growth: billings of $19.2 million increased only 13.6% Y/Y (not adjusted for slight shift at year-end fiscal 2008) and deferred revenue of $5.3 million increased only 13.1% Y/Y.
  • Lower-than-expected revenue led to a slight cash operating loss for the year of approximately $700 thousand, compared to earlier guidance for full-year cash profitability.
  • Fortunately, cash burn is under control: Sonic Foundry ended the year (9/30/09) with a net cash position of $1.43 million, down from $2.93 million one year earlier (= burn of $1.50 million), but up from $1.25 million at 6/30/09.
  • Some good news: management implied that the revenue "tipping point" is finally upon us. From the press release:
  • “Furthermore, we are beginning to see signs of economic recovery, and specifically, certain signals for expanded growth in mid-2010 as they relate to the Mediasite product and service offering. Correspondingly, our recent prospecting has resulted in additions to our sales pipeline that, if consummated, would dwarf most of the previous sales made by the company to date. These opportunities have been harvested both domestically and internationally and in different vertical segments of our customer base, most of it occurring in the last few months. Based on the expected timing of these new opportunities, mid-2010 may mark a significant turning point for the company, which could substantially expand operating performance, especially given the cost reductions and operating leverage now in place."
We are disappointed by the slight revenue shortfall and continuing operating losses, but cognizant that (1) Sonic Foundry operates in an "emerging" market where forecasting is a challenge and (2) we're in a recession that is crimping IT budgets everywhere. With regard to the latter point, we note that Polycom (PLCM) -- a much larger company but decent proxy for video/audio conferencing systems -- reported revenue down 12% Y/Y for the most recent quarter.

Per our post's title, let's borrow from Hamlet's "To be or not to be" question to ask a related, similar question: to believe or not to believe in the rosy outlook? In this regard, the real question is: do we believe in the Mediasite franchise and management's ability to deliver shareholder value?

Let's look at several slides from the management presentation to provide context:

Customer sampling, including new wins during fiscal 2009:

Potential operating leverage:
Quarterly guidance:
Now, let's review some commentary we added to the comments chain below our recent SeekingAlpha post (slightly modified herein):
  • ... Accordent won the Enterprise Video Platform award, which is a positive for that company and indicates favorable traction. However, Sonic also plays in that arena and has solid mind-share. For reference, please see this Streaming Media article, "Navigating the Enterprise Video Workflow", which highlights four major companies: Computer Associates, Lockheed Martin, Merck, and QAD. Of the four, three use Mediasite and only Merck uses Accordent.
  • Mediasite is far more than simply hardware - there is a major software element, along with service/support. Combined, it's far from commoditized as indicated by gross margins in the mid to high 70% range. Personally, [we're] focused on buying franchise type companies that have multiple competitive advantages and are inherently NOT commodity businesses. Technology companies are often poor investments because of rapid change/competition, yet Sonic Foundry's large and growing installed customer base suggests Mediasite isn't going anywhere anytime soon.
  • Importantly, operating margins and ROE are poised to move from "not meaningful" to "meaningful" as the business crosses a cash flow inflection point and generates positive net income. Acknowledging that the business (and sector) is (are) nascent with sometimes "lumpy" revenue, forecasting can be a challenge. Assuming forward net income of only $2 million would yield an ROE of approximately 20%.
  • [In a sense,] the split had nothing to do with shareholders - likely reasons were detailed in [our] prior posts, with customer perception no doubt very high on the list. Note that shorts can still easily get squeezed since volume is so light (short ratio same pre/post split). If Sonic puts up good numbers Monday, the stock could "gap" higher and others should take notice. Expectations are extremely low.
  • Growing top-line ~20% in a recession isn't too bad. Otherwise, we'd probably be seeing 30-40% Y/Y.
  • All investments carry risk and SOFOD is an illiquid microcap, which carries even more risk. The key is to mitigate risk factors and not bet on "luck". If [we're] wrong and positive free cash flow doesn't arrive as expected, [we] will change [our] tune.
To conclude: while SOFO is not our usual cash rich or dividend paying investment fare, our interest in Sonic Foundry is derived from our extensive technology industry experience. Furthermore, our intrinsic value estimate of $20-27 is supported by an estimate of reproduction cost as well as the probable private market value that would be awarded by an informed strategic buyer (*recent M&A comps provide support). Given the company's expanding customer roster and forthcoming campus-wide adoptions, we continue to believe our initial thesis: competitive advantages point to a powerful, sustainable franchise -- Sonic Foundry is (1) far along the learning curve with (2) intellectual property protection, and (3) very satisfied, captive customers that face high switching and search costs. Points (1) – (3) are both related to and strengthened by (4) economies of scale and (5) leading market share.

One more point: since management signaled (1) multiple, highly probable large-scale deals that would apparently be game changing in terms of Sonic Foundry's financial profile and (2) meaningful undervaluation by the Market based on M&A comps (which we discussed previously), we think it's only reasonable that insiders step up to purchase shares (even if they can afford only a few thousand shares because of the difficult times). Such action would add credibility to the bullish outlook and, thereby, provide confidence to the Market. We will be disappointed if we see no insider purchases in coming weeks.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long SOFOD.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Don't Forget About Dividends - Critical for Total Return Over Time

In our "How's the Economy Doing" update the other week, we mentioned our preference for owning franchise type businesses that are currently generating significant excess cash flow and have limited to no debt. In addition, we again noted a preference for paying low multiples of current earnings and growth. We should add a third component: dividends.

In November 2008, we mentioned to friends and family that a dividend strategy was an important part of our overall, two-pronged portfolio strategy:
  • (1) Focus on defensive names/sectors with stable dividends since income is more certain and capital gains are uncertain, at least in the short-term. These types of businesses have not been immune to the current market swoon, but – in our view – are more likely to outperform as investors gravitate toward their relatively steady operating profiles.
  • (2) Focus on secular growth companies that pay no cash dividends yet have healthy net cash positions, limited to no debt, and a history of large free cash flow that should continue even in a down economy. With everyone clamoring for cash, owning franchise type businesses that (1) have net cash and (2) generate significant excess cash arguably appear as attractive as simply holding cash, in our view, particularly given extremely high earnings and free cash flow yields.
An 11/06/09 article in Fortune, "Go the distance - Dividends for the long run", emphasizes the importance of dividends and what to look for in researching dividend paying companies:
  • Some companies maintained or raised them in the past year, indicating that their payouts can survive even the worst markets. And dividend investing remains a sound course amid market turmoil. Ned Davis Research shows that since 1972, companies that increase or begin paying dividends have returned 9.5% a year, soundly beating the 6.8% return of the S&P 500.
  • So how do you find income stocks you can count on? Ideally you want established companies that have a long history of dividend increases.
  • You also want to look at the coverage ratio -- earnings per share divided by the dividend per share. A figure of two or higher tells you the company has plenty of money to pay its dividend. (Companies with lower coverage ratios can also be steady payers if they have stable cash flows.)
The above graph tells the story. While we suspect that what we'll call reverse-survivorship bias may impact the "green" group in the graph (i.e. successful non dividend paying companies are gobbled up by larger companies, leaving underperforming companies in the green group), the outperformance of dividend paying stocks is noteworthy. Of course, the compounding power of dividends may explain the majority of the large delta.

We mentioned a position in REIT preferred equity last week. Next month, we may share certain companies we own that pay healthy dividends.

Happy investing,

Jeffrey Walkenhorst

Disclosure: n/a.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Saturday, November 28, 2009

Giving Thanks - Legacy 401K now Back to "401K" + Lessons Learned + Dubai

We wrote in early June: "While the sustainability of the recent market recovery remains a question, it's worth noting that the "201K" so lamented in mainstream media is now almost back to a "301K" (S&P500 down only 31% from the index's 52 week high of 1367 versus down 51% at the low). Things can change quickly. At some point, we believe the "301K" will once again be a "401K"."

Well, good news: the recovery was faster than we thought. Last week, we were pleasantly surprised to learn that our legacy 401K account (from a former employer) is now back to what we originally put into the account. Boom - just like that.

We again think of a 60 Minutes episode from 4/19/09 (link here) that focused on the "201K" situation and widely held views that retirement savings and plans for retirement were forever destroyed. Although we're not sure how our 401K recovery performance compares to the national average, we're fairly certain most funds are well above their lows. And, assuming persons didn't run for the hills and kept their monthly allocations unchanged during the massive plunge, they benefited from an amazing dollar cost averaging opportunity through the period. We didn't have this advantage as our legacy account was no longer active during the crisis, but we still made out pretty well.

Two lessons from ring especially true from the past year :
  • Dollar cost averaging is smart since Market timing is near impossible on a consistent basis
  • "The time of maximum pessimism is the best time to buy." (Sir John Templeton)
  • Put another way: "Be fearful when others are greedy, and be greedy when others are fearful." (Warren Buffett)
Per our recent posts, we argue that we're now past the most fearful points as psychology is now in a better place and many Americans no doubt feel better about their retirement savings than only six months ago. Of course, no question that many economic indicators remain troubling and high unemployment with reduced consumption may continue over the medium term. Plenty of fun topics to discuss over Thanksgiving dinner (the other day).

We're not saying the road ahead will be smooth and we may see curve balls such as the Dubai debt problems. On the Dubai topic, we never did believe in the "field of dreams" idea, i.e. "build it and they will come". Last we checked, "spec" real estate projects carry a high degree of risk even in good times (acknowledging that most of Dubai's projects were started pre-crisis, not considering seemingly aggressive global investments such as port properties). Clearly, the overhang of easy money excess is far reaching and will take time to resolve. We think we'll muddle through current issues.

For those interested, our 401K fund is invested in two equity funds: the Dodge and Cox Stock Fund and Artisan Small Cap Value Fund. We know that some onlookers might think we're crazy for concentrating in only two funds, yet we're comfortable with the allocation since the funds' investment approach is time proven, essentially: buy good companies cheap and remain patient as they grow and/or until the manic Market comes to award fair value to the businesses.

The same onlookers would say we're doubly crazy because we subscribe to the same approach with our own capital. Why? Very simple: it works.... However, any agita experienced by the onlookers might be reduced somewhat by our REIT allocation and positions in certain closed-end funds that provide both current income and potential for capital appreciation.

Happy Thanksgiving and Happy investing,

Jeffrey Walkenhorst

Disclosure: long ARTVX, DODGX.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Wednesday, November 25, 2009

First Industrial Realty Trust: Cautious Optimism and Income from Preferreds

We own preferred shares in First Industrial Realty Trust (common is FR, preferred "J" series is FR-PrJ). First Industrial is a beleaguered real estate investment trust (REIT) that is working to recover from a debt-fed acquisition binge during real estate boom times. While high leverage and poor operating fundamentals are a risk, the good news is that new management is moving in the right direction by reducing debt and streamlining the company. As a result, we expect the company to keep paying the preferred J equity 's $0.45313 cash dividend each quarter ($1.813 annualized on $15.60 price for current yield of 11.6%). Further, the preferred should move toward face value of $25.00 over time, assuming the world doesn't fall apart and industrial America perks up at some point.

With regard to our recent update on the economy, select commentary from First Industrial's 11/05/09 conference call is worth sharing - sourced from SeekingAlpha.com:
  • Looking at customer demand, with vacancies near all time high, all of our markets remained very competitive as our public peers and regional competitors are generally focused on occupancy. On the first [point], 12 of our 29 markets showed an increase in occupancy compared to only 4 in the previous quarter.
  • Customer activity and interest has definitely picked up over the last few months, as we are again increasing traffic to our vacancies in nearly all of our markets across North America.
  • This has yet to translate into a significant number of signed leases, but this increased activity is definitely a marked departure from where we were earlier in the year. In our conversation with customers and prospects, many businesses are shifting from a wait and see or even a survival mode and becoming more focused instead on growth plans and related supply chain needs.
  • Some of the traffic is no doubt choppy, very choppy, but most is related to businesses with real needs considering their options. Our people in the field are focused, are making sure we win more than our share. We are aggressively pursuing tenants to improve occupancy, using our definitive advantages in the marketplace, which includes the ability to fund TIs and free rent where they make economic sense and our record in reputation for great customer service.
Although we'd like to see increased activity translate into new leases, signs of stability are encouraging. Per our prior posts, the sky isn't falling.... Separately, we'll soon share more on the importance of dividends.

Happy investing,

Jeffrey Walkenhorst

Disclosure: Long FR-PrJ.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Tuesday, November 24, 2009

E-Commerce Traffic Picking Up? Potential Positive for Bidz.com

We continue to like the Internet and e-commerce space given favorable long-term secular trends. In October, for example, we noted that we have a slight bias toward asset light, cash generating Internet companies such as Youbet (UBET, $2.92), PetMed Express (PETS, $16.58), and Bidz (BIDZ, $2.36). We also relayed data and insights included in Emerging E-commerce Trends and Practical Insights by Mark Brohan, VP of Research, Internet Retailer.

This morning, comScore (SCOR, $16.15) reported that "holiday season retail e-commerce spending for the first 22 days of the November – December 2009 holiday season" was up 2% Y/Y. The web traffic measurement firm also announced expectations for a 3% Y/Y increase for the full season. While still slight, we believe the anticipated increase is not only favorable for the space, but for the overall economy(supporting our earlier retail commentary).

Separately, although Bidz's 3Q09 results and 4Q outlook came in light, we still think the online jewelry retailer has an enviable market position to complement a track record of profitability and high historic returns on capital. Based on publicly available traffic data from Alexa.com (which we sometimes use as a reference point), traffic to Bidz.com spiked in recent weeks and remains above that of Blue Nile (NILE, $56.71) and Bluefly.com (BFLY, $2.25) - click to enlarge:

As we've written before, we argue that barriers to entry are larger than persons appreciate once an Internet franchise successfully carves out a specific niche and achieve scale - in addition to others mentioned above, think Amazon (AMZN, $133) and eBay (EBAY, $23.69). There were and are plenty of me-too participants in the backyards of each player, but the spoils usually go the the number one player in a given market (on- and off-line).

In this respect, we don't believe Bidz's investments over the past year will prove fruitless. Through the recession, Bidz invested in a new enterprise resource planning (ERP) system, web site acceleration through Akamai (AKAM, $24.11), new sourcing relationships, and new distribution partnerships. The growing Middle East presence is also impressive and seemingly under-appreciated by the Market. Below, we highlight world "rankings" and traffic source for Bidz.com versus Bluenile.com (also from Alexa - click to enlarge):

Bidz ranks higher than Blue Nile in nearly all countries with overlap (except for India). However, as noted previously, Bidz trades at a meaningful discount to the latter company. We're holding tight and are inclined to purchase more shares.

Happy investing,

Jeffrey Walkenhorst

Disclosure: Long BIDZ, PETS, UBET, EBAY.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Sunday, November 22, 2009

How's the Economy Doing? Under the Hood in November

This is an update of our "How's the Economy Doing" periodic series. 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. As always, divergent views exist on where the Market and economy are headed. For example, we published our recent "Time to Go to Cash".... Or is It? article on SeekingAlpha.com (here) and had a number of bearish comments. Per our prior posts, we're fully aware that unemployment and housing remain problems -- please see this Washington Post article: Problem mortgages hit new high at 14 percent - Data mean foreclosures may not peak until next year. However, we believe both Market psychology and corporate fundamentals are in a different place than one year ago. Let's look at some hard data across sectors:
  • Railroads - from Association of American Railroads: "Freight rail traffic was down for the holiday week ended Nov. 14, 2009. U.S. railroads reported originating 281,218 carloads for the week, down 8.9 percent compared with the same week in 2008 and down 17 percent from the same week in 2007. Rail carloads showed slight improvement, up 2.3 percent from the previous week. Intermodal traffic totaled 208,056 trailers and containers, down 7.7 percent from a year ago and 15 percent from 2007. Compared with the same week in 2008, container volume fell 1.5 percent and trailer volume dropped 30.2 percent. While 13 of the 19 carload freight commodity groups were down compared with the same week last year, some increases were seen.... Total volume on U.S. railroads for the week ending Nov. 14, 2009 was estimated at 31.6 billion ton-miles, down 7.9 percent compared with the same week last year and 11.2 percent from 2007.... Combined North American rail volume for the first 45 weeks of 2009 on 13 reporting U.S., Canadian and Mexican railroads totaled 15,357,248 carloads, down 17.9 percent from last year, and 10,681,718 trailers and containers, down 15.9 percent from last year." Link here.
  • Trucking - from American Trucking Associations (yes, ATA is plural) for the month of September (reporting lag): "The American Trucking Associations’ advance seasonally adjusted (SA) For-Hire Truck Tonnage Index decreased 0.3 percent in September, after increasing 2.1 percent in both July and August.... Compared with September 2008, SA tonnage fell 7.3 percent, which was the best year-over-year showing since November 2008. In August, the index was down 7.5 percent from a year earlier. ATA Chief Economist Bob Costello said that the latest reading fits with the premise that the recovery will be moderate and choppy.” Link here.
  • Air - from IATA: "The International Air Transport Association (IATA) reported international scheduled traffic results for September 2009. Passenger demand was essentially unchanged, increasing 0.3% compared to September 2008. Demand for international cargo was 5.4% below September 2008 levels. Load factors for passenger and cargo have returned to pre-crisis levels of 77.1% and 50.8%, respectively. The apparent year-over-year improvement in demand is misleading. It is largely due to comparisons with an exceptionally weak September 2008 when traffic fell sharply (-2.9% for passenger and -7.7% for cargo). Seasonally adjusted statistics show a 0.3% drop in passenger volumes and a 1.4% fall in cargo volumes for September 2009 compared with August 2009." Link here.
  • Semiconductors - from SIA: "The Semiconductor industry Association (SIA) today released its annual forecast of global semiconductor sales projecting worldwide sales of $219.7 billion for 2009, a decline of 11.6 percent from the $248.6 billion reported in 2008. The forecast projects that sales will grow by 10.2 percent to $242.1 billion in 2010 and by 8.4 percent to $262.3 billion in 2011. Link here.
  • Residential Housing Permits and Starts - from US Department of Housing and Urban Development: "Privately-owned housing units authorized by building permits in October were at a seasonally adjusted annual rate of 552,000. This is 4.0 percent (±1.9%) below the revised September rate of 575,000 and is 24.3 percent (±1.9%) below the October 2008 estimate of 729,000. Single-family authorizations in October were at a rate of 451,000; this is 0.2 percent (±1.0%)* below the revised September figure of 452,000. Authorizations of units in buildings with five units or more were at a rate of 85,000 in October. Privately-owned housing starts in October were at a seasonally adjusted annual rate of 529,000. This is 10.6 percent (±8.7%) below the revised September estimate of 592,000 and is 30.7 percent (±8.3%) below the October 2008 rate of 763,000. Single-family housing starts in October were at a rate of 476,000; this is 6.8 percent (±7.5%)* below the revised September figure of 511,000. The October rate for units in buildings with five units or more was 48,000." Link here.
So, aside from housing starts at down 24-32% Y/Y, the hard data shows that most sectors are now seeing 5-10% Y/Y declines, which is an improvement from 10-20% Y/Y declines earlier in the year. Although we're now coming up against easier Y/Y comparisons, the environment clearly remains challenging. In this regard, Annaly Capital Management's (NLY, $18.11) monthly commentary for October includes a less than uplifting, but balanced, summary of the U.S. economic situation:
  • The point of the government’s economic push is to “prime the pump,” to get the economic fires roaring sustainably by throwing on some lighter fluid. In order to call the stimulus efforts a success, we now need the multiplier effect to kick in. Companies that are benefiting from artificial demand need to respond by increasing hours worked and then hiring more workers, creating new jobs and stimulating natural demand for goods and services.
  • Is that happening? The plunge in hours worked that began in 2008, a soft form of lost jobs, has not corrected itself as of the October reading (33.0 hours, tied for the record lowest reading), and new unemployment claims have remained stubbornly above the 500 thousand mark. The rate of job loss has slowed, but we are still losing jobs at a pace consistent with recessions, not recoveries. Third quarter corporate revenues and earnings are up quarter-to-quarter but down year-over-year, and bottom lines were helped by the trimming of headcounts and capital expenditures." Link here.
The Annaly commentary also includes the below graph, which illustrates the stimulus driven spike in consumption expenditures (e.g. "cash for clunkers") and the obvious disconnect with personal income:
Thus, we've still some things to worry about, although we still believe easy Y/Y comps will lead to pockets of growth in 2010 that can support share prices and, hopefully, create new jobs.

What to do from portfolio perspective? Our strategy hasn't changed: as always, we need to pick our spots with a preference for very low multiples of current earnings and growth.

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, $22.79) and PetMed Express (PETS, $16.25). Even American Oriental Bioengineering (AOB, $4.18), which disappointed us last week, offers a compelling 17% FCF yield to current buyers. Despite risk factors, we still believe what AOB has established in China is difficult to replicate and worth much more than current levels based on free cash generation.

Finally, per our Approach caveat #2, we may sometimes purchase out of favor companies that offer a meaningful margin of safety relative to current liquidation value and/or normalized asset values. Believe it or not, there remain some names that have not participated in the torrid market rally, but offer what we believe to be significant margins of safety. We may share one such idea in the not so distant future.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long EBAY, PETS, AOB.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Thursday, November 19, 2009

Mediasite Franchise Value Remains Unrecognized by Market

Since our initial post regarding Sonic Foundry's Mediasite franchise on 5/1/09, shares have traded slightly lower despite the expanding franchise and positive financial progress. In our view, the Market remains irrational. At some point, value should track fundamentals -- it always does (over time). Consider this quote included at the beginning of Chapter 8 in More than You Know by Michael J. Mauboussin (shared with us by another investor - thank you):

Key point: patience can bring great rewards as the Market comes to recognize value, so long as the initial assessment is correct. Although SOFO resides in a speculative category, we believe nothing has changed since our initial analysis, which pegged fair value per share at $1.95 to $2.72 ($2.34 midpoint) based on reproduction cost.

Recent event: Sonic Foundry completed its 1 for 10 reverse split Monday night and SOFO is now trading as SOFOD ($5.16, or $0.52 pre-split) for the next 20 trading days before reverting back to SOFO. We previously commented on why we think the company effected the reverse split. Aside from removing delisting risk at year-end and enabling more institutional investors to purchase the stock, we think a significant reason for the move was so existing and/or potential customers are not scared by a sub-$1 share price. The very low prior share price gave the impression that Sonic was distressed and may not be around in 2, 3, 4, 5 years (i.e. if I'm a customer, why buy/install Mediasite if the company won't be around?). However, per our prior posts, we believe such a view couldn't be further from the truth. And, we're not drinking Kool-Aid either.

Why? The balance sheet is not distressed: the company has limited debt, retains borrowing capacity, and should generate excess cash over the next year (assuming growth remains consistent with >20% expected for fiscal 2009). Importantly, we don't expect F4Q09 results to change this reality. Further, favorable working capital swings in the seasonally weak December quarter should buffer a potential operating loss for the period.

Recall progress over the past year:

Next, we come back to the Mediasite franchise. While the economy remains weak and many tech companies are shrinking this year, evidence suggests the franchise continues to grow -- see customer commentary in press releases, Sonic's blog, awards, Webinars, etc. For example, Mediasite again won the Streaming Media Readers' Choice Award for best Webcasting platform (announced yesterday):

Webcasting/Presentations Solutions
Sonic Foundry Mediasite 5.1 (36%)

Accordent Technologies Capture Station (18%)
ON24 Webcast Center (11%)

Other evidence: recent commentary in a Streaming Media article, The Government Video Boom, suggests Sonic Foundry is adding an average of 75 government customers each quarter versus perhaps 15 per quarter for competitor Accordent -- that's five times more new government customers for Sonic, revealing clear market leadership (emphasis added):
  • Within the past year, a growing number of government agencies in the U.S. and Canada have made that jump, according to several providers of online streaming technology. Sean Brown, vice president of education at Sonic Foundry, Inc., says that about 50–100 agencies become customers every 90 days, while Jereme Pitts, senior vice president of sales and marketing and co-founder of Accordent Technologies, Inc., says his company has welcomed about 50–75 new government customers in the past year.
Thus, we think Mediasite's economic goodwill continues to increase. How best to measure such goodwill? As noted in our original post, Mediasite customers are diehard about how Mediasite is improving productivity within their organizations. As a result, customers become voluntary evangelists on behalf of Sonic Foundry and, therefore, drive incremental penetration. These intangibles are extremely difficult for new entrants or even large players such as Cisco (CSCO, $24.00) or Adobe (ADBE, $36.59) to replicate by simply spending millions of dollars in marketing and selling, not to mention R&D to establish a competitive solution.

Sonic is building the franchise through an array of products and services around Mediasite - slides sourced from this August 2008 presentation (worth watching for "rewind" purposes; captured with Mediasite):

And, Mediasite economically addresses an important market need:

Here's what management said at the time (again, August 2008) about the outlook:


Where do we stand today? Fiscal 2009 growth is now forecast at >20% Y/Y with more recurring license and services revenue -- below slides sourced from this September 2009 conference presentation (unfortunately, NOT captured with Mediasite so no integrated video -- "WSW" needs to get with the program):

Most recent outlook:

We expect Sonic to report fiscal 2009 results the week of 11/30/09, providing another update on business progress. Our analysis suggests that fundamentals are as sound as can be in a recession: growing with margin expansion. As for valuation, we still believe our reproduction analysis holds (i.e. $20 - $27), supported by the probable valuation that would be awarded by strategic buyer. On a forward basis, the valuation expands, particularly if Sonic closes additional campus-wide deployments and revenue scales further with positive earnings and cash flow generation. We're not hanging our hat on a buyout, yet more M&A deals are happening and, as noted, the Mediasite franchise appears difficult to replicate.

Finally, just for fun, let's compare the valuation of Ener1 (HEV, $5.34) and A123 Systems (AONE, $15.45) to Sonic Foundry. We expressed caution for both HEV and AONE in our October post, Wall St. Speculation Alive and Well in Clean Tech -- Risky Business. Since that time, shares retreated, but valuation remains rich:
  • Ener1 trades at 21 times trailing twelve month (TTM) revenue and 6 times consensus 2010E revenue.
  • A123 trades at 17 times TTM revenue and 11 times consensus 2010E revenue.
The Market is infatuated with rosy growth prospects and the "clean tech" sector. Meanwhile, both companies are bleeding cash. Sonic Foundry isn't growing top-line as fast, but should be profitable over the next year. If we apply the same 6 to 11 times forward revenue multiples to estimated fiscal 2010 revenue of $22 million (+13% Y/Y growth - conservative), the implied market capitalization would be $132 million to $242 million, or $31 to $56 per share (assuming fully diluted shares outstanding of 4.3 million). We're not justifying the multiples, simply pointing out how the Market can value different assets when it is in love with an idea/trend. Note that we prefer price to earnings and price to free cash flow multiples, not price to sales multiples.

Happy investing,

Jeffrey Walkenhorst

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

Monday, November 16, 2009

Risk Factors Weigh on AOB's 3Q09 Results

We regret to relay that American Oriental Bioengineering's (AOB, $4.18) 3Q09 results missed expectations and prior guidance as key risk factors came to bear. The company also announced a relatively small restatement to prior results following the engagement of Ernst & Young as its auditor (some minor housekeeping is okay, in our view). We noted in our post last week that short interest was elevated, but we hoped the shorts would be wrong this time.

Key figures:
  • 3Q09 revenue increased 11.7% Y/Y to $78.8 million, well below a Wall Street consensus expectation of $89 million and full-year revenue guidance for +30% Y/Y implying 2H09 revenue of $228 million (+95% H/H). Last year's 2H revenue was up 70% H/H and 2H is typically stronger with normal seasonality.
  • Gross profit was $44.1 million (56.0% gross margin) compared to $47.2 million (66.8%) in 3Q08, "reflecting continued revenue mix shift to CCXA's generic product sales, increasing raw material prices and lower margin distribution business from Nuo Hua."
  • Operating income was $15.0 million (19.0% operating margin) compared to $21.6 million in 3Q08 (30.6%).
  • Net income attributable to controlling interest for the third quarter of 2009 was $10.0 million, compared to $16.3 million in the prior year period. Adjusted for certain items, EPS was $0.13 per diluted share versus a consensus expectation for $0.17 and $0.21 in 3Q08.
Revenue mix:
  • Revenue from pharmaceutical products increased 6.3% to $66.0 million.
  • Revenue from prescription pharmaceutical products increased 22.7% Y/Y to $29.8 million.
  • OTC pharmaceutical products decreased 4% Y/Y to $36.2 million.
  • Nutraceutical products increased 8.7% Y/Y to $9.2 million.
Management attributed the top-line weakness to the following: "we are witnessing uncertainty around product pricing related to healthcare reform, and this has caused select disruption in purchasing patterns."

However, we wonder whether necessary price reductions (forced or otherwise) are also eroding revenue and margins. Further, we expected management to have a better handle on revenue performance, especially after reiterating guidance at the recent investor conference in mid-September. Or, even better, given market uncertainty, management should have pulled guidance earlier this year as it had a "free pass" to do so with the stock already under pressure. We think the institutional investor base was then churning to "value" from "growth".

There is some good news: at 9/30/09, AOB had $115.9 million in cash and generated $44.3 million of operating cash flow during the first nine months of 2009 (per 10-Q filed today, down 9% Y/Y). Capital expenditures YTD are small (AOB prepaid some funds in 2008 for certain expenditures this year). As a result, the company's net debt position declined $42.3 million during 9M09 to $13.6 million at 9/30/09 from $55.9 million at 12/31/09. So, the business continues to generate meaningful, consistent free cash flow.

We'll need to see what management says on the conference call tomorrow morning, yet the large revenue miss calls into question our (and management's) ability to understand and forecast the business. Needless to say, we don't like this uncertainty and nor does the Market. Granted, 2009 is a year in transition as China is pushing through sweeping regulatory changes.

Post results today, a friend who is also long AOB aptly raised the paramount question: what is the true earnings power of the business? In this regard, perhaps we made a mistake as we prefer to own businesses with high visibility into operating results and primary drivers. We would like to believe that our initial parallel between buying AOB and Berkshire Hathaway's long-standing investment in Sanofi-Aventis (SNY) holds true: Sanofi-Aventis as a leading pharma company (1) with products that people need/want and (2) that throws off huge free cash flow, thereby allowing Berkshire to become comfortable with operating/regulatory risks. Yet, results today indicate that risk factors in a rapidly emerging market such as China are difficult to assess, particularly when regulatory changes are involved.

Fortunately, negative Market sentiment toward AOB in recent weeks appears to have already priced in an earnings miss and the company's cash generation should provide a backstop. Shares are already inexpensive on a price to free cash flow basis (even with reduced FCF):
  • Market Capitalization (MC): $320 million ($4.29 times diluted shares of 74.5 million, excluding out-of-the money convertible notes of $115 million convertible at $8.08 per share, or 14.2 million shares)
  • Plus Net Debt as of 9/30/09: $14 million
  • Equals Enterprise Value (EV): $334 million
  • Reduced, conservative 2009E Free Cash Flow: $50 million (divided by MC = FCF yield of 16%, or only 6 times FCF)
We find some comfort in the low FCF multiple and expect cash to keep piling up on the balance sheet even if growth is lower than anticipated. On a relative basis, other Chinese pharmaceutical companies (e.g. Simcere Pharmaceutical Group - SCR) trade at higher multiples but have lower growth and margins than AOB. We think management credibility remains the key issue. How will it manage the business and use excess cash to enhance shareholder value?

Happy investing,

Jeffrey Walkenhorst

Disclosure: long AOB.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

More on Retail Sales - Sky Is Not Falling and Stability is Positive for Global Psyche

Briefly following up on yesterday's post with respect to retail sales -- the U.S. Census Bureau reported "October 2009 Advance Monthly Sales for Retail Trade and Food Services" this morning (link here). A Bloomberg article summarizes salient points:
  • October retail sales in the U.S. rebounded more than anticipated as demand for autos climbed, easing concern households will curtail spending after government incentives ended.
  • [A] 1.4% increase followed a [downward revised] 2.3% drop in the prior month that was much larger than previously estimated [originally forecast at down 1.5%], making last month’s gain less impressive, Commerce Department figures showed today in Washington. Purchases excluding autos rose less than forecast.
  • Retail sales were projected to rise 0.9% ... according to the median estimate of 66 economists in a Bloomberg News survey. Forecasts ranged from gains of 0.4 percent to 1.8 percent.
  • Excluding automobiles, sales increased 0.2% after a 0.4% gain in September. They were forecast to increase 0.4%, according to the survey median.
Thus, while the downward revision to September results dampens the October M/M upswing, the positive/stable figures support data in our prior post sourced from the WSJ. Another indication that the sky isn't falling. We believe signs of stability are important for investor and consumer psychology.

Happy investing,

Jeffrey Walkenhorst

Disclosure: none.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Sunday, November 15, 2009

"Time to Go to Cash".... Or is it?

In recent months, we've heard a refrain from some professional investors that it's "time to go to cash". The premise is that the Market has gone too far too fast amidst a still struggling economy and is now set for a major decline this week, or next week, or the week after (or maybe next month?).

One such prognosticator is Robert Prechter, who we mentioned back in August. He was back again in the media on 11/5/09 with a headline interview on Yahoo! Finance's TechTicker that "Stocks are 'Dangerous Place to Be'" - video link here. Mr. Prechter has more on his Web site about "How to Prepare Yourself for the 'Serious Event' Ahead". We understand that many traders follow Mr. Prechter's commentary closely, which could potentially lead to a self-fulfilling Market decline if sentiment becomes overwhelmingly bearish once again.

We don't disagree that the Market rally from the bottom has been incredible. Of course, the speed of the fear and liquidation driven decline last fall and into early 2009 was also incredible. We also don't disagree that economic fundamentals remain challenging with many things to worry about (unemployment, real estate, deficits, health care, energy, war - take your pick). Moreover, any sustainable, upward Market movement needs to be driven by improved underlying business fundamentals (i.e. growth). If the U.S. economy languishes and a Japan-style no-growth period ensues, stocks could also languish or decline as creative destruction continues to reshape industries. Finally, Mr. Prechter's "sell call" is likely on the money in one area: anything trading on thin air should be reduced or sold from portfolios, especially low quality businesses. Even more dangerous than an egregious valuations are weak balance sheets coupled with poor fundamentals -- more reasons to sell.

However, as we've noted in our "How's the Economy Doing" series (update coming soon), we're cautious but don't think the sky is falling, particularly since we'll be bouncing up against easy Y/Y comparisons. Easy "comps" should lead to stability and even pockets of growth. Moreover, our buy/sell decisions for our businesses is based on our estimate of intrinsic value and not related to where the Market happens to be trading.

With respect to easy comps, the other week, many retailers released sales data for the month of October and, as reported and illustrated by the WSJ (link here), results were somewhat of a "mixed bag":

For the most part, discount/value oriented stores fared better than more discretionary retailers, although Nordstrom (JWN, $33.99) delivered a 6.5% Y/Y increase in same store sales. Overall, sales were higher relative to October 2008 (when bank crisis shock and awe was gripping the world):
  • Sales at stores open at least a year, or same-store sales—a benchmark of the industry's health—rose 1.8% from October 2008, according to an index of 30 retailers compiled by Thomson Reuters.
  • Retail Metrics Inc., a retail research firm that uses a slightly different methodology, reported an increase of 2.2% for its index of 31 retailers.
  • Neither index includes Wal-Mart (WMT, $53.20), the world's largest retailer, which stopped reporting monthly sales earlier this year.
So, at least some persons are no longer hiding under a rock and returning to the mall and/or other local retailers. This, plus the fact that public and private equity, as well as debt deals are happening on Wall Street -- that is, companies are successfully raising capital -- are good signs. Further, our conversations with various C-level executives and other contacts indicate that many businesses are, in fact, stabilizing (although timing for a return to growth remains cloudy).

Accurately predicting short-term economic or Market performance is near impossible. Yet, our gut tells us that we simply won't return to the level of fear or economic paralysis that previously halted economic activity and led to the 2008-09 Market carnage (compounded by momentum shorting, in our view). Things remain difficult and the indices may well partially retrace upward moves, but indications are that we're in a different place today. From shock and awe, people move into realization, acceptance and new beginnings.

As before, we remain disciplined with respect to the types of businesses we own and their fair values. We're not going to cash.

Happy investing,

Jeffrey Walkenhorst

Disclosure: none.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Thursday, November 12, 2009

Still No Love for AOB - Results Next Week

American Oriental Bioengineering (AOB, $4.18) remains out of favor following reduced guidance last quarter and as certain Market participants continue to question management dealings. We also understand that some investors are concerned that management is more focused on "empire building" at any cost rather than creating shareholder value as measured by returns on equity and invested capital (credibility issue).

As a result, short interest remains high (although not quite "momentum shorting" as discussed in our prior post here) and sets the stage for a short squeeze if the company can deliver in its 3Q09 earnings report Monday afternoon. Here's AOB's current short interest from Nasdaq.com:

Maybe they'll be right and the company will again disappoint -- we don't have a specific edge on the quarter. However, we do know a few things:
  • In August, AOB announced the engagement of Ernst & Young Hua Ming ("EY") as the company's independent registered public accounting firm for the current fiscal year (end December). We noted then that the move adds credibility to both the company and its reported financial results, with the "rubber stamp" of approval from a big four auditor discrediting short seller claims. The company previously responded to earlier negative claims.
  • There's now more visibility related to regulatory reform in China, which may enable AOB to refocus on M&A activity and help the company's distribution segment since prior uncertainty kept things in a holding pattern - please see this BusinessWeek article and this China Daily article.
  • AOB reiterated guidance at a conference in mid-September -- that said, even with normal 2H seasonal strength, we acknowledge that the 2009E revenue forecast appears aggressive given 1H09 results. The forecast implies 2009 revenue of $345 million versus consensus estimate of $317 million with 2H09 revenue of $228 million (+95% H/H). Last year's 2H revenue was up 70% H/H.
  • More new product launches should be coming.
  • At 7 times TTM earnings and 5 times 2010E earnings, the valuation appears extremely attractive given long-term prospects and provides a margin of safety.
  • Even modest improvement in the Market's perception of management credibility should lead to multiple expansion.
We need to monitor risk factors such as competition, margin compression, and capital allocation (i.e. the credibility overhang), yet we come back to our core thesis: although the real estate purchase last year and facility expansions both consumed capital and raised questions, we believe AOB's core business is stable, asset light and should generate meaningful free cash flow. The Market appears to be giving no credit for the company's franchise and numerous competitive advantages, including recognized brands/products that people need/want (customer habit/frequency), scale (manufacturing, marketing/selling, indirect/direct distribution partners), and intellectual property (patents/technology/know-how).

Happy investing,

Jeffrey Walkenhorst

Disclosure: long AOB.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Wednesday, November 11, 2009

Deep in Left Field, Youbet Waves White Flag and Surrenders to Churchill Downs

As we waited for Youbet's (UBET, $2.41) 3Q09 conference call to begin this evening, a surprise press release crossed the wire: Churchill Downs Incorporated to Acquire Youbet.com, Inc.

For all of the reasons detailed in our prior posts, we didn't expect to see a near-term sale to Churchill Downs (CHDN, $31.57). That said, today's results came up short versus our expectations with the economy and other risk factors somewhat derailing our thesis.
  • Instead of Y/Y handle growth on the back of new content relationships, handle of $121.3 million was flat Y/Y. Moreover, margins came in lower than we anticipated on "an increase in player incentives and track fees". The latter is no surprise, but we suspect the former is creeping higher as YB's battles other ADW players to acquire/retain customers (*management cited success: 14% Y/Y increase in new customer acquisitions and a 6% Y/Y "in the average number of active weekly wagerers on the platform").
  • G&A is running higher on "increased legal fees and other costs related to the investigation of various strategic and business development opportunities."
  • Online (ADW) segment EBITDA was $2.4 million, down 40% Y/Y. For the total company, EBITDA from continuing operations was $2.9 million versus $5.5 million in 3Q08.
  • Finally, although the company's net cash position increased to $8.4 million ($0.19 per share, +$5.7 million Y/Y) from $5.6 million at 6/30/09 and $2.7 million one year ago, free cash generation is running below our reduced expectations of $10-12 million this year. The company did not repurchase shares during the quarter as we'd hoped, presumably because of discussions related to today's news.
The results stand in contrast to a more aggressive Churchill Downs, which previously reported 3Q09 Y/Y revenue and EBITDA growth of 33% and 31%, respectively, for the company's online segment. In the report, Churchill cited a 43% Y/Y increase in handle wagered through TwinSpires.com "driven by access to new racing content that was not available in the third quarter of 2008, an increase in customers and higher average daily wagering". Based on the 43% increase, Youbet's 3Q handle, and assuming flat Y/Y ADW handle (versus overall industry decline 10%), we estimate Churchill's share increased to 21% from 14% in the year ago with Youbet holding steady at 31%.

Thus, YB's relatively new management team is seemingly waving the white flag of surrender to join forces with Churchill, which was late to the online game and only built a foothold by purchasing AmericaTab in mid 2007. At that time, Churchill paid $86 million (assuming $6 million earn-out was paid) for properties generating annual handle of $175 million (purchase multiple of 0.49 times) and revenue of $44 million (1.97 times).

The proposed Youbet acquisition carries the following terms:
  • CDI would acquire all of the outstanding shares of Youbet in a transaction valued at approximately $126.8 million based on the Tues. Nov. 10, 2009, closing price of CDI common stock.
  • Under the terms of the transaction, Youbet shareholders would receive a fixed ratio of 0.0598 shares of CDI common stock plus $0.97 in cash for each share of Youbet common stock they own.
At an implied $2.84 per share, the deal represents approximately 2/3 CHDN stock and 1/3 cash as of 11/10/09. Assuming no movement in Churchill's share price, the company is paying 0.26 times Youbet's 2009E handle of $480 million (our estimate) and 1.41 times 2009E revenue of $90 million (ADW only, our estimate). These multiples appear substantially below the levels paid for AmericaTab and include no value for YB's $0.19 of net cash per share, United Tote segment, or optionality for potential legalization of other forms of online gaming (where YB has been spending lobbying money). With regard to the last point, Youbet obviously has a highly desirable domain name that other gaming companies might covet.

Still, the stock component provides an equity kicker assuming we believe Churchill Downs is currently mispriced by the Market. Prior to the company's 3Q09 report, CHDN was trading in the high $30s and, over the past five years, generally traded between $40 and $50. Churchill Downs is a larger, more profitable business today than it was five years ago. Further, we're certain that management will explain on the conference call tomorrow how the acquisition of Youbet will make Churchill even more of a powerhouse by owning and operating even more irreplaceable assets. We don't disagree -- hard to deny the scale benefit of garnering 50% of the online wagering (combined) market. Of course, one natural question is what happens to existing wagering platforms and prior investment therein (goodbye = one problem with Internet companies is that prior investment often falls by wayside through M&A or obsolescence).

Here's the implied value to Youbet shareholders under different CHDN scenarios:
Data source: company reports and JW estimates.

We're still digesting the news. Let's see how things develop.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long UBET.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Tuesday, November 10, 2009

Youbet Update: Growth Potential and Cash, Cash, Cash = Nice Combination

We've been meaning to provide slightly more color on Youbet (UBET, $2.20), which reports 3Q09 results tomorrow afternoon. So, here we go -- following up on our brief post regarding Breeders' Cup and Equibase data last week, and our online gaming update the other week.

We met briefly with Youbet management back on October 1st at the Thomas Weisel Consumer Conference in New York and watched CEO Goldberg's presentation - link to PDF here. The presentation and our conversation emphasized several key points:

  1. Horse racing industry content disputes should be thing of past (we noted previously in initial post) and improved relations now sets stage for increased online penetration
  2. Addressable market opportunity remains large, particularly relative to other online market segments where penetration is significantly higher
  3. Youbet is working toward the launch of "casual" horse betting games in an effort to expand reach

Related slides from management presentation (click to enlarge) -- 2Q09 online (ADW) penetration jumped to 13% from 10% in 2008 (prior to content resolution):

Casual games will have a simple user interface:

Most points are not new information, but represent key parts of our thesis: that online wagering growth would return in 2009 on the back of new content relationships. Moreover, Youbet is well placed to capture more than its fair share of increased wagering while generating significant excess cash flow. We still think this is the case, but note that Y/Y handle (and revenue) comparisons among industry participants are not comparable as some players (e.g. Churchill Downs) benefit from especially easy Y/Y comparisons. In addition, one caveat was/is potential margin pressure related to new content and customer retention/acquisition, which remain risk factors to monitor.

In tomorrow's report, we look for continued growth with somewhat better margins Q/Q (net yield at/north of 7.0% with an operating margin north of 10% for the ADW segment) and break-even results for the economically sensitive United Tote segment. For reference, we discussed 2Q09 results 2Q09 results here.

With regard to points 1 and 2 above, potential to capture increased market penetration represents a key opportunity for Youbet. While acknowledging that horse racing market dynamics are arguably different than other online segments, we see no reason not to expect incremental penetration over time. Importantly, as noted in prior posts, Youbet's established franchise should allow the company to at least maintain market share. We estimate that if ADW penetration increased to 20% from an estimated 13% in 2Q09, the earnings power of Youbet's online segment might increase by 50% holding margins steady (risk factor, although top-line yields could compress slightly while realizing bottom-line operating leverage).

Recall that in both 2Q09 and the seasonally weak 1Q09, Youbet's ADW segment delivered earnings of $0.06 each quarter (untaxed because of large NOLs, which should offset taxes over time despite some vagaries in California tax law). Annualizing this figure, we have current year earnings of $0.24 for the ADW segment and, at 20% penetration, we have $0.36 per share. We can't help but mention that shares of Youbet are trading at only 9 times the former figure, assigning no cash value to the tote segment and no value to potential growth (e.g. higher penetration, new product launches, international opportunities, or changes in U.S. online gaming laws).

Finally, we continue to view Youbet's online segment as a predictable cash generating business. Even the tote business would be fairly predictable under different operating conditions. Although our current estimate of Youbet's 2009 free cash flow is lower than at the outset of the year, we expect the company to generate at least $10 million of excess cash this year, followed by another $10 million next year, and so on. Put another way, the the company's net cash position of $5.6 million at 6/30/09 should be at least $15.6 million at 6/30/10 assuming no share repurchases. Cash should keep piling up on the balance sheet (even with no growth), which we like.

Per our September post, we hope the company was finally active in 3Q09 repurchasing shares on the cheap. Aside from reinvesting cash in the core business to enhance growth (captured in operating and capital expenditures), we believe share repurchase remains a top priority for excess cash and we certainly expect to see buyback activity over the coming year (if able to repurchase at accretive levels). Strategic acquisitions are another potential cash use, yet we don't necessarily expect to see deals as Youbet already has an excellent platform from which to expand organically. Thus, we're left with one other potential use: paying a dividend, similar to PetMed Express (PETS, $16.35). We expect to see more cash rich Internet businesses initiate dividends over time and Youbet could seemingly join this club.

Separately, interesting industry news from Bloodhorse.com:

(1) Exciting Breeders' Cup race - video here on ESPN.com (provided by YB) - and handle up Y/Y - Breeders' Cup Handle $150 Million and Rising:
  • “The combined handle was actually 4% higher for the corresponding 19 races scheduled over the two days in 2008,” said Kenneth Kirchner, of Falkirk, wagering consultants to Breeders’ Cup Ltd. “International separate pool handle is up by more than $3 million over 2008.” Kirchner also noted that $2,172,266 was refunded to patrons that had wagered on Quality Road, who was scratched at the gate in the Breeders’ Cup Classic.
(2) U.K. horse auction shows continued interest in horse racing - Median Up 12.5% as Tattersalls Sale Ends:
  • The Tattersalls autumn horses in training sale finished its four-day run in England Oct. 29 with a median price that was up 12.5% from 2008. The gross revenue declined 11.3% while the average price fell 8.2%. The clearance rate rose from 78.8% last year to 84.9% this year.
  • The 903 horses that sold grossed 17,457,800 guineas and averaged 19,333 guineas. The median was 9,000 guineas. In 2008, 935 horses were sold for a gross of 19,690,300 guineas and an average of 21,059 guineas. The median was 8,000 guineas [we think one guinea = approximately one English pound].
  • “Quality horses have sold particularly well with buyers from all corners of the world, providing stern competition for the domestic buyers from both the flat and National Hunt fraternities”
(3) Kentucky sale somewhat better than expected: F-T Ky. Fall Yearling Sale Rebounds:
  • The Fasig-Tipton Kentucky fall yearling sale bucked the prevailing negative trends in the Thoroughbred marketplace to post increases of 9.1% in median price and 5.7% in gross revenue during its three-day run that ended Oct. 28 in Lexington.
  • In addition, the number of horses sold rose 2.4% while the average price grew 3.2%. The buy-back/no bid rate fell from 35.6% last year to 25.1% this year.
  • The 566 yearlings that sold grossed $7,895,400 and averaged $13,949. The median was $6,000. In 2008, the 553 horses that sold grossed $7,471,900 and averaged $13,512. The median was $5,500.
(4) Lastly, Why European Sales Are Stronger:
  • Another factor, Collins continued, is a European philosophy about racehorse ownership that differs somewhat from the American approach. “The experience of owning a racehorse for most people in Europe is an expensive experience, but it’s also a very positive one that they enjoy,” he explained. “They continue to buy horses not because they think they are going to make money, but because they really love racing."
  • "I’m in no way minimizing the importance of purses because one of the things you do hear in Europe is ‘Oh my Lord, our purses are terrible.’ But people keep doing it (buying horses) because they enjoy the sport. For some reason, the expression ‘sportsman’ seems to have become a negative term here (in America) as if a sportsman is some kind of an idiot. But sportsmen are people who love racing and are in it for the sport. They looking forward to sharing their experience with their families and friends and, to some degree, the general public."
  • "One of the things we have to address in America is the experience that people who own horses get out of racehorse ownership. It isn’t just about the purse money.”
We share the industry information because it highlights that the sport isn't going away anytime soon and still has many supporters around the world. As we noted back in March:
  • Horseracing dates to ancient times and will survive recession. The slow economy is weighing on wagering activity. However, the sport has existed for millennia, employs a large number of persons (horsemen, breeders, owners, etc.), and generates estimated global handle of $110 billion.

Happy investing,

Jeffrey Walkenhorst

Disclosure: Long UBET, PETS.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Monday, November 9, 2009

Bidz Posts Mixed Quarter and Light Guidance; Retain Focus on Franchise Value

Bidz (BIDZ, $2.92) reported 3Q09 results after Market close today that were mixed: top-line of $24.8 million versus guidance of $22-24 million and a gross margin of 28.9% versus guidance of 28-30% (24.0% in year ago period), but pre-tax income of $0.07 million compared to guidance for $0.2-$1.0 million ($5.5 million in prior year period) and fully diluted EPS of $0.01-$0.03. Slightly higher than expected expenses, including litigation expense, led to the slight bottom-line miss. Bidz also filed its 10-Q today -- link here. Key operating metrics were as follows:
                  Three Months Ended
September 30,
Auction Metrics 2009 2008 % Change
--------------- ---- ---- --------
Number of new buyers 34,252 54,072 -36.7%
Average selling price per order (gross) $187 $175 6.9%
Average orders per day 1,465 2,453 -40.3%
Average items sold per day 6,899 8,431 -18.2%
Average items sold per transaction 4.7 3.4 37.0%
Acquisition cost per new buyer $65 $43 51.2%
Gross Margin $ per average order $54 $42 28.7%
The 37% decline in new buyers matched a 37.4% Y/Y decline in net revenue excluding B2B sales and is a modest improvement from declines of ~40% in recent quarters. Still, fewer buyers are leading to higher acqusitions costs per new buyer (e.g. costs spread across fewer new purchasers).

Unfortunately, forecasting remains a challenge in a tough consumer environment where discretionary items are increasingly secondary. In addition, Bidz cited recent challenges related to the company's new enterprise resource planning (ERP) software deployment. As a result, 4Q09 guidance came up light relative to both consensus estimates ($34.5 million) and prior management commentary (from 2Q09 report) calling for a return to Y/Y growth in 4Q (i.e. greater than $35.1 million):
  • Guidance for the fourth quarter of 2009 of $28-$32 million, gross profit margin of approximately 28-30%, pre-tax income of approximately $0.4-$1.5 million and expects fully taxed GAAP EPS of $0.01-$0.04.
  • The Company's results will be affected by its ERP conversion in the fourth quarter of 2009, but the Company expects to resume normalized operations in the first quarter of 2010.
In addition, we need to keep waiting with regard to SEC/FTC/legal overhangs as management merely said it's working diligently on all fronts, but alluded to positive progress with respect shareholder litigation suits. Today's 10-Q discloses that the SEC issued a subpoena on 10/27/09 for documents "relating to the Company's co-op marketing contributions and minimum profit guarantees". We are disappointed to see this additional request as we thought the case could be nearing a close. Such hair on the story may continue to weigh on shares even if management "does not believe that the investigation will adversely affect management, our results of operations, cash flows or our financial position".

Further, we are disappointed by weaker than expected bottom-line figures/guidance. The results provide more evidence that Blue Nile's (NILE, $61.24) business model is less sensitive to discretionary spending (see 3Q09 results here - revenue actually increased 2% Y/Y and operating margin increased 80 bps Y/Y to 5.8%). As with any retailer, we need to watch competition, including established, usual suspects and upstarts such as Gilt.com and Net-A-Porter.com.

Still, as noted in our post earlier today -- we believe Bidz remains attractive for a number of reasons, which includes making the necessary investments to achieve a stronger, larger e-commerce business into the future. 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. In this case, "near" is pushed into 2010.

The good news is that we continue to believe that risk factors are more than discounted in the current valuation and expect the extreme valuation gap between BIDZ and NILE to narrow over time.

Happy investing,

Jeffrey Walkenhorst

Disclosure: Long BIDZ.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Watching BIDZ Today - Can Growth Return in 4Q09?

Bidz (BIDZ, $2.98) reports results today after market close. While shares of many retail, jewelry, and auction companies (e.g. Sotheby's - prior post) have recovered meaningfully since spring -- in the face of mediocre to poor results/fundamentals -- Bidz remains a castaway despite an established online franchise with a high ROIC, variable cost model.

As far as we can tell, nothing has changed and our core thesis remains intact. As a reminder, 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 (*although we wish all insiders would stop selling, even if in small increments relative to holdings)
  • Attractive absolute and relative valuation on current and future earnings potential
In addition, we continue to watch for several potential positive catalysts to remove key overhangs:
  1. SEC investigation resolved
  2. FTC probe resolved
  3. Law suits fall by wayside
Although timing remains uncertain for these catalysts, we think all are possible.

We'll see how results come out today. Without question, the environment for consumer discretionary spending remains weak and the holiday season may be lackluster. However, if Bidz can point to a recovery in Y/Y growth in 4Q09 and 2010 (per 2Q09 commentary), we think the Market may finally take notice. Further, Bidz continues to invest in areas (e.g. new "ERP" system, new product offerings, international reach) that should bear fruit over the medium- to long-term.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long BIDZ.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Thursday, November 5, 2009

Big Weekend for Horse Racing + October Figures

We wanted to quickly relay some industry news related to Youbet.com (UBET, $2.34), which reports results next Wednesday.

First, this is Breeders' Cup weekend, the biggest fall event in racing. Second, Equibase released October stats this week:
  • PLEASE NOTE: The 2008 Breeders’ Cup World Championships took place on Oct. 24-25. This year’s event will take place Nov. 6-7. Commingled wagering in 2008 totaled $150,593,454 and purses totaled $27,322,500 for the two-day event.
October 2009 vs. October 2008

Indicator October 2009 October 2008 % Change
Wagering on U.S. Races* $932,651,648 $1,125,935,224 -17.17%
U.S. Purses $105,200,583 $124,591,684 -15.56%
U.S. Race Days 530 513 3.31%

YTD 2009 vs. YTD 2008

Indicator YTD 2009 YTD 2008 % Change
Wagering on U.S. Races* $10,587,270,436 $11,880,122,731 -10.88%
U.S. Purses $930,847,834 $1,014,997,145 -8.29%
U.S. Race Days 5,191 5,298 -2.02%

  • * Includes worldwide commingled wagering on U.S. races.
  • Please Note: YTD 2009 purse total adjusted to exclude National Steeplechase Association purse monies, which were inadvertently included in last month’s advisory.
We'll come back with a bit more on Youbet.com in the next few days. Please stay tuned.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long UBET.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Tuesday, November 3, 2009

Sonic Foundry Removes Key Overhang - Now, Market Can/Should Focus on Results

After market close Monday, Sonic Foundry (SOFO, $0.64) announced a Board decision to effect a one-for-ten reverse stock split of its common stock on 11/16/09. In our view, we believe the Board made the decisions for a number of reasons, including:
  1. preemptive action to prevent shares from being de-listed from the NASDAQ should the stock remain below the $1.00 minimum bid price by the 12/21/09 deadline. Per our prior posts, Sonic Foundry has shown considerable progress over the past year, yet the Market has not noticed. Thus, even if Sonic Foundry meets FY09 (end September) guidance for >20% revenue growth and cash profitability, the stock may well remain stuck below the $1.00 requirement and face de-listing. We think the Board wants to eliminate this negative risk (although de-listing isn't necessarily the end of the world as we have seen some OTC companies thrive and ultimately re-list over the past decade).
  2. remove overhang associated with #1 that keeps some investors out of the stock.
  3. remove negative stigma associated with trading below $1.00, from both an investor and a business (customer) perspective.
  4. establish new trading price in mid- to high single digits ($6-7 based on current levels) that is above $5 minimum requirement for some investment funds.
  5. potentially reduce the large absolute number of shareholders who hold fewer than ten shares by not allowing fractional shares to be issued to such holders (*per 10-K, at 12/3/08, Sonic Foundry had approximately 9,000 shareholders, an exceptional number for such a small company that increases public company expense).
  6. improve perceived earnings per share power (although market capitalization will be unchanged) -- by taking fully diluted shares from approximately 43 million (including all options) to 4.3 million, Sonic Foundry could report earnings of $1.00 per share IF net income is $4.3 million (looking out). Depending upon Mr. Market's appetite for high growth, niche technology companies, a forward multiple of 20-30 times this figure would imply a share price of $20-30.
The above reasons appear sensible and are not all-inclusive. One potential negative is that an already illiquid stock could become less liquid with a free float that will be 10 times smaller than current levels. As noted previously, we were encouraged in recent months by increased trading volume and renewed institutional buying. Nonetheless, perhaps the new price range will attract additional investor interest and lead to a more active market for the stock.

We are aware of another technology company, KIT digital (KITD, $9.26) that effected a one for 35 reverse split in March and currently averages 43 thousand shares per day on a float of only 2.8 million shares (per Yahoo! Finance here). KIT digital also happens to be in the Web video realm, but is not a direct competitor to Sonic Foundry.

We emphasize that nothing has changed fundamentally. Changing the share count and share price through a split are essentially smoke and mirrors for any company -- all ownership stakes, large and small, remain exactly the same. What matters above all is a company's ability to generate a growing stream of free cash flow that can be used in a shareholder friendly manner.

While we classify Sonic Foundry as a speculative, venture capital-like position in our portfolio, we continue to believe that the company is at the free cash flow inflection point and could generate one million of excess cash flow over the next year if growth remains similar to fiscal 2009 (key risk factor: public/private school budget woes). Moreover, we believe the franchise value to an informed private market buyer remains significantly higher than current levels.

If management fails to deliver on guidance for the September quarter and the fiscal 2010 outlook runs contrary to our current free cash flow forecast, we will be disappointed and forced to reassess our thesis. However, from what we can tell, the Mediasite franchise continues to grow nicely. We'll share more details in coming weeks.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long SOFO.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer