Owner-Oriented Investment Research and Commentary - Have a private comment or question? Email us at commonstocksense@gmail.com

Thursday, December 31, 2009

See You in 2010! Plenty to Share Next Year; Thanks for Reading

December, and 2009 for that matter, passed quickly. Per our prior posts on dividends and Sonic Foundry (SOFO), we initially hoped to share more before year's end. However, we'll aim to briefly relay ideas and commentary sometime in January.

Thanks for reading and Happy New Year!

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long SOFO.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Tuesday, December 29, 2009

Warren Buffett Explains BNSF Deal; Hazardous/Solid Waste Companies Similar; In Search of See's Candy-Like Companies

Last week, Burlington Northern Santa Fe Corp. (BNI, $98.73) filed a transcript with the SEC of an interview with Berkshire Hathaway's (BRK-A, BRK-B) Warren Buffett regarding the proposed acquisition of BNSF by Berkshire. The transcript is worth a read and can be found here. A Reuters article also summarized the news here.

Like Berkshire Hathaway's investment in MidAmerican Energy Holdings and BYD (post here), BNSF falls outside of Mr. Buffett's "prototype of a dream business" -- the kind that generates significant, growing excess earnings without significant capital investment (e.g. See's Candy - please see Berkshire's 2007 Annual Report for Mr. Buffett's lucid, insightful discussion).

Energy and railroad businesses both require meaningful capital investment for maintenance and expansion. However, both provide necessary services and can establish/achieve durable competitive advantages (e.g. regulatory approvals/licenses and impossible-to-replicate right of ways and/or plant locations) that assure investors that the companies will be around in ten, twenty, thirty years. This seems to be Berkshire Hathaway's primary thesis in purchasing BNSF. From the transcript:
  • Question from BNSF's CEO: You said in the past, you’d rather buy a great business at a fair price than a fair business at a great price. What does BNSF meet the definition of a great business?
  • WB: Well, it’s a great business in that you know it’s going to be here forever, to start with. I mean, the hula-hoop business came and, you know, went, and then, you know, the pet rocks and all that kind of thing. And even television set manufacturers have, you know, moved over to Japan. All of that sort of thing. The rail business is not going to go anyplace. It’s going to be right here in the United States. There’s going to be four big railroads that are moving more and more goods. So it’s, it’s, it’s a good business. It, it can’t be, it can’t be something like Coca Cola or Google, because it’s, you know, it’s a public service type business, too, and it has, it has a fair amount of regulation that is part of the picture. But it’ll be a good business over time. It will make sense for this country to want railroads to continue to invest more and more money, in terms of expanding and becoming more efficient. So you’re on the side of society, and society will largely be on your side. Not every day, but most of the time.
Mr. Buffett goes on to say that, as with other investments, Berkshire Hathaway will sit in the back seat and let existing managers run BNSF, stating "We’ve got 20 people in Omaha, and there isn’t one of them that knows how to run a railroad." He also talks on the importance of owning businesses with passionate managers, among other things.

Although we looked at some railroad companies last spring, we didn't get comfortable with weak fundamentals and ongoing capital requirements. In addition, while we own some REITs and other asset-based companies, we retain a preference for asset-light, cash generating businesses such as eBay (EBAY - prior post here) and PetMed Express (PETS - prior post here) -- that is, we're in search of See's Candy-like companies.

For a brief comparison, look at BNSF's historical 2006-2008 annual operating cash flows and capital expenditures (in this case, consider free cash flow defined as OCF less capex) -- from Yahoo! Finance (YHOO):

And, that of eBay:


BNSF generates free cash flow, but not nearly as much as eBay. While the latter is a "new economy" company and the Internet will continue to evolve, we're fairly certain eBay will not only be around, but that excess cash will keep piling up on eBay's balance sheet over time, enabling share repurchases, additional acquisitions, and potential dividends.

However, we understand the case for owning well-positioned asset-heavy companies at the right price. In this regard, we think hazardous waste companies Clean Harbors (CLH) and American Ecology (ECOL) might fit the bill. Per our prior posts, we continue to watch these companies and did initiate a small position in Casella Waste Systems (CWST - solid waste services, not hazardous) in November.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long BRK-B, CWST, PETS, EBAY, YHOO.
© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Monday, December 28, 2009

Unemployment: Headlines Gloomy, Yet History Tells Different Story

Our focus is primarily on companies -- not the economy -- but let's briefly address a popular American dinner table topic: unemployment. On this subject, a family member brought an AP article to our attention featured on MSNBC: "A decade of high unemployment is looming - ‘New abnormal:’ Some think 10 years won’t be enough to replace losses". The article is similar to others we've seen as well as worrisome conversations in which we've sometimes participated and/or overheard. The article raises various points, including:
  • The unemployed number 15.4 million. The jobless rate is 10 percent. More than 7 million jobs have vanished. People out of work at least six months number a record 5.9 million. And household income, adjusted for inflation, has shrunk in the past decade.
  • Most economists say it could take at least until 2015 for the unemployment rate to drop down to a historically more normal 5.5 percent. And with the job market likely to stay weak, some also foresee another decade of wage stagnation.
  • On the other hand, it's possible some technological innovation not yet envisioned could generate a wave of jobs. Yet at the moment, most economists aren't betting that any such breakthroughs will rescue the labor market.
  • The last time the jobless rate reached double digits, in the early 1980s, it took six years to bring it down to normal levels.
However, Charles Schwab and Co's Chief Investment Strategist, Liz Ann Sonders, shared a very telling graph in her December Market update - link here (unfortunately, not captured with Mediasite). The below slide, with data back to 1948, shows that unemployment tends to quickly reverse course even amidst the most dire circumstances (e.g. 1970s and early 1980s) once a recession is officially over (per National Bureau of Economic Research - NBER):


Good news: risk factors notwithstanding, our suspicion (and hope) is that history will repeat itself and the gloomy mainstream outlook will improve in 2010.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: n/a.
© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Sunday, December 27, 2009

November Durable Goods New Orders Show M/M Improvement; Easy Y/Y Comparisons on Way -- Could Help Global Psyche

The U.S. Census Bureau released durable goods data last week (12/24) - link here. New orders showed slight M/M improvement:

On a Y/Y basis, we're in negative territory, but moving in the right direction as the world begins to lap depressed year ago figures -- from Briefing.com:

As we've discussed in the past, Y/Y comparisons will soon become very easy for virtually all sectors of the U.S. and global economy. Stabilization and/or slight Y/Y growth off of very easy comparisons can provide a psychological boost to the American public and the Market, even with slack industrial production and high unemployment.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: n/a.
© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Friday, December 25, 2009

Opportunity Costs Hard to Predict in Short-Term, Watch Over Full Market Cycle; Mediasite Holiday Wishes

Sonic Foundry's (SOFO, $4.90) share price didn't deliver for us in 2009 and, unfortunately, represented a significant opportunity cost as our other stock purchases (e.g. especially certain REITs), as well as foregone ideas (capital constraints), performed impressively from irrational entry points offered by the Market.

So it is in the short term as price changes are impossible to forecast and, often, are decoupled from expected fair values supported by underlying fundamentals. Some stocks may languish, while others surge for any number of reasons, rational or irrational. j2 Global Communications (JCOM, $19.74) is another idea that went nowhere despite slight top-line growth (through recession) and consistent Q/Q increases in shareholders' equity (book value) through growing retained earnings. Excess cash continues to build on j2's balance sheet and should keep accumulating in 2010. Shareholder friendly management can use the large net cash position (~25% of market capitalization) to reinvest in the business, make acquisitions, repurchase shares, and/or pay a dividend.

But, back to Sonic Foundry. The good news is that we remain confident that the Mediasite franchise continues to grow around the world (e.g. see fiscal 2009 revenue growth, increases in deferred revenue, more customers, etc.) and that true economic value is not reflected in the company's market value. Moreover, customer adoration for Mediasite is tangible everywhere and numerous companies/organizations would benefit from adopting the technology. As such, we're happy to share the Mediasite Holiday Presentation Catalog (2006-2008) for some lighthearted holiday fun. We know Sonic Foundry has a 2009 catalog out there, but for some reason, we couldn't access the link at the time of this writing. Plenty of entertaining skits/takes in the 2006-08 catalog.

Happy Holidays,

Jeffrey Walkenhorst
CommonStock$ense

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

Wednesday, December 23, 2009

Implied Value of Youbet.com Now $3.18 per Share, + 9% from Current Levels

Very brief: per our earlier posts, shares of Churchill Downs (CHDN, $36.98) keep pushing higher, implying more value to shareholders of Youbet.com (UBET, $2,91). Churchill announced a new financing arrangement yesterday that will allow the company to make the proposed $0.97 cash payment to Youbet.com holders. We estimate that this amount, plus newly issued shares of Churchill Downs to satisfy the stock component of the transaction, bring the implied value to $3.18, or up 9.4% from current levels. Shares may yet move higher assuming regulatory approval in early 2010. Market optimism regarding a stabilized economy may also help.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long UBET.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Likely Sources of "Positive Alpha": (1) Be Contrarian and (2) Focus; Former Proved in 2009, Latter More Important for 2010

Last week, we shared our view on the purpose of investment research. When we were originally addressed that question, we were also asked the following:

What are the likely sources of positive alpha relative to the market?

(note: alpha = excess return over the market return)

We responded with two points:

(1) Establishing and acting on investment theses where business fundamentals/ economics suggest different fair values for an asset than implied by current market expectations.

The ability to generate positive alpha is best illustrated by Benjamin Graham’s Mr. Market anecdote: on any given day, a manic Mr. Market may offer a ridiculously low price for an asset. On another day, Mr. Market may offer an egregiously high price for an asset. The challenge and opportunity for investors is to capitalize on regular, whimsical swings in market expectations by maintaining a level head.

Varying market moods often produce asset values that are disconnected from fair values determined by the net present value of the asset’s expected future free cash flows, private market value, and, in some cases, net tangible book value. Sound investment research will allow a fund manager to intelligently purchase highly discounted assets with an informed view of true worth, creating a margin of safety. Later, when market euphoria returns, the manager can happily sell the asset into strength, likely generating alpha from having moved against the herd on the initial purchase and subsequent sale.

AND

(2) Running a focused portfolio of top ideas versus a broadly diversified portfolio that contains hundreds of low conviction ideas is more likely to outperform the market. The former can generate alpha if the underlying research and position sizing process is disciplined. The latter is essentially the market.


Let's expand a bit. We believe both "sources" of excess return were made abundantly clear by investor lessons again learned over the past year: swimming against the tide is paramount, as emphasized by the late Sir John Templeton and Warren Buffett in their well-known axioms (shared in our Thanksgiving post). Money can be made by buying a good business (e.g. our PetMed/PETS idea discussed in July) at a fair price and patiently waiting as earnings compound over time. However, the "big money" is usually made by moving against the crowd in times of distress and by concentrating on the best risk/reward opportunities.

How many companies watched their share prices double, triple, quadruple since fall 2008 and/or spring 2009? Countless. And, not merely in one sector -- our #2 "focus" recommendation wasn't even necessary in 2009 as companies across virtually all sectors, ranging from finance, banking, real estate to mining and industrial to retail. Poor fundamentals and high debt loads didn't matter.

Of course, near the bottom, the Market thought the world was ending and the common refrain was "go to cash or buy bonds", with some professional investors even asking "why spend time researching equities?" We personally heard the equities versus credits question, but disagreed and took the opposite stance. It was time to do more research!

We now concur with the view that the "easy money" has been made, but still see opportunities for those willing to focus, move against the crowd, and remain patient. One idea in this category includes our interest in Bidz.com (BIDZ, $2.08) - why purchase such a business given weak consumer spending and expectations for continued consumer headwinds, not to mention other key risks?.... Exactly. You got it. Did we mention an 18% trailing twelve month operating income to enterprise value (TTM EBIT/EV) yield? Impressive, especially given depressed TTM operating income (note: includes benefit of fairly strong 4Q08 EBIT performance).

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long PETS, BIDZ.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Monday, December 21, 2009

Sizable Insider Selling at Blue Nile (Smart!); Bidz.com Under Pressure (Yet On Sale)

Insiders at Blue Nile (NILE, $59.57) are smartly taking advantage of the company's rich valuation (please see our October post) to unload personal holdings - from Yahoo! Finance:


Meanwhile, Bidz (BIDZ, $2.00) still garners no attention from the Market, likely because of "hair" we highlighted previously and softer-than-expected 4Q09 guidance. Recall that the "hair" includes a modest amount of insider selling -- which we don't like -- but the punting is nowhere near the levels of current Blue Nile selling. We think insider buying at Bidz would provide a positive catalyst for the stock, although we believe insiders still own more than 60% of the company and, therefore, are highly motivated to act on behalf of all shareholders.

We noted back in November that Internet traffic for Bidz.com appeared to be increasing with seasonal trends. The trend continues based on Alexa.com data:


The traffic is a good sign. Of course, tax loss selling may continue to weigh on BIDZ and weak consumer discretionary spending is a real risk. In this sense, we know some investors want nothing to do with companies in the space (possible contrarian signal). That said, shares of some consumer discretionary businesses -- including the powerful Sotheby's (BID, $23.24) franchise -- have moved significantly higher in recent months, presumably on normalized earnings power (we discussed Sotheby's here). Investors seem to have confidence in normalized earnings now that the sky isn't falling and businesses are seeing stabilized results.

We continue to believe Bidz.com's current valuation (9-10x depressed earnings) does not reflect the company's long-term earnings power. Moreover, we feel comfortable that Bidz.com can capture at least its fair share of the growing global E-Commerce pie in coming years. We think the company's Middle Eastern presence is a major positive and should drive international growth even if U.S. sales remain lackluster because of a strapped consumer.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: Long BIDZ.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Saturday, December 19, 2009

Mediasite Catalog for the 6th Nestle International Nutrition Symposium

Briefly: continuing with our themes of rich media Webcasting (Sonic Foundry/SOFO) and weight loss (Weight Watchers/WTW), we share the
Mediasite Presentation Catalog for the 6th Nestle International Nutrition Symposium (October 2009). Some interesting messages and content captured. More information about the event from Nestlé's Web site:

The Nestlé Research Center recently hosted the 6th annual Nestlé International Nutrition Symposium, October 21-23, 2009 in Lausanne, Switzerland.

Selected scientists and key opinion leaders attended the Symposium, Nutrition and Health Economics, to discuss the effects of existing health and nutrition policies and programs implemented by governments. The Symposium also examined how the social and economic transformation of modern society affects the health and nutritional status of various population groups.

In accordance with the Nestlé International Nutrition Symposia mission, outcomes of the meeting will help stimulate new research questions to continue pioneering discoveries in this area. View the 6th NINS scientific sessions and presentations


Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long SOFO, WTW.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Wacky Trading Offers Merger Arbitrage Opportunity in Youbet.com

To put it plainly, stock moves for numerous companies appeared a bit wacky today -- some up, others down. An AP article noted the following:
  • The day began with a frenzy of buying and selling as several types of options contracts expired. Volatility was also high as several stocks were added to and dropped from the Standard & Poor's 500 index, a widely used benchmark and the basis for many indexed mutual funds. Trading on the New York Stock Exchange topped 3 billion shares for the first time. The prior record, just short of 3 billion shares, came in September last year.
One obvious example of funny trading -- Youbet.com (UBET, $2.62) experienced a sudden, late day decline on heavy volume:


We noted the other week that a rising share price for Churchill Downs (CHDN, up $0.08 Friday to $35.60) implies a higher value for Youbet.com. Based on CHDN's closing share price, if the acquisition closed on Monday, Youbet.com shareholders would receive an estimated $3.10 in value ($0.97 cash plus CHDN stock), or +18% from $2.62. While a slight discount from implied value is normal prior to the close of any transaction (given risk of falling apart), we think the acquisition will proceed.

Accordingly, the wide discount created by Friday's late day decline appears irrational. Assuming the discount persists early next week, it provides current UBET buyers with meaningful near-term upside potential.


Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long UBET.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Friday, December 18, 2009

What is the Goal of Investment Research?

Someone recently asked us to discuss the goal of investment research - what is it? Clearly, there is a wide range of answers to this question, but here's our view:

To see the forest through the trees. A sound investment research process should: (1) diligently put the pieces of puzzle* together to consistently find 50 cent dollars which (2) have a high probability of returning to one dollar within a reasonable time horizon. Coupled with portfolio management, disciplined investment research should mitigate risk and preserve capital by (3) recommending a group of holdings that, together, generate favorable absolute and relative performance per unit of risk. Over time, expected asset returns should be realized as temporarily irrational market prices move toward a reasonable range of expected fair values for each of the portfolio holdings.

*Pieces of the puzzle: to learn everything possible about a potential investment.

We believe this approach, along with an emphasis on high quality, cash generating businesses, should lead to attractive returns over a full market cycle. That is, a sound research process leads to a sound investment outcome.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: n/a.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Tuesday, December 15, 2009

Mediasite Adoption Continues = De Facto Global Standard - See "MUG" Presentation

A major part of our Sonic Foundry (SOFO, $5.00) thesis is that Mediasite reliably addresses a clearly defined market need with efficacy. As a result, customers love the solution and Mediasite is becoming the de facto global standard for rich media capture and Webcasting. That is, the Mediasite franchise is growing.

An excellent "window" into Mediasite customer and product happenings are quarterly Mediasite User Group (MUG) meetings (MUG link here). Here's the description and link for last week's meeting:

December 9, 2009 @ 11:00am Central
Don’t have Silverlight? Download it here or watch with classic player.

How cool would it be to have an "Easy Button"? One click and everything happens by itself? Bob Hillhouse, from University of Tennessee-Knoxville, shows us the concepts and how-to's behind the highly automated Mediasite deployment at UT. Colleagues from MediaMission in the Netherlands and Mediasite KK in Japan share how Mediasite is being used internationally. Octavio Heredia from Arizona State University School of Engineering gives us a behind-the-scenes virtual tour of his facilities which have recorded more than 10,000 Mediasite presentations to date. And Sonic Foundry previews what's next for Mediasite. Your host: Helder Conde, Atitude Digital Media – Brazil

We're not going to relay all of the highlights, but the meeting is worth watching for current investors in Sonic Foundry and/or anyone interested in Mediasite. Here are a few noteworthy items:
  • MediaMission, a Mediasite reseller (not a bad business idea for A/V integration companies), is busy spreading Mediasite throughout the Netherlands:
  • First ever User Group Conference in Japan, including presentations from major organizations/companies (link to four minute overview presentation here) -- more than 160 Mediasite customers in Japan per head of Mediasite KK, with 65 customers attending the inaugural conference:
  • On related noted, Mitsubishi used Mediasite at the L.A. Auto Show - link here.
  • Finally, Sonic Foundry announced another new Mediasite release with additional features requested by customers (recall positive feedback loop discussed in our original thesis).
Separately, Sonic Foundry filed a "shelf filing" with the SEC yesterday to issue more equity "from time to time". Although shares are under pressure today, we think the apparent panic in the Market presents a buying opportunity. Companies usually file "shelfs" to have "on file" (sometimes for years) and prepare to "press the button" when share price is at the right level (usually higher). We note that management indicated on the last call that the company may seek additional debt financing for working capital needs related to large deals expected in mid-2010 and has no desire to issue equity at current "depressed prices".

As mentioned in prior posts, we continue to believe shares of Sonic Foundry could fairly fetch at least several multiples of current levels based on private market value supported by recent M&A transactions. We believe Sonic Foundry might consider issuing additional equity at the right price, presumably at or above our estimate of fair value ($20-27) at some future point. We prefer no dilution, but don't mind slight dilution if issued at an appropriate price to finance anticipated, significant growth.

Please stay tuned. We'll come back in the next week or two with how we're making sense of Sonic Foundry's guidance.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long SOFO.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Monday, December 14, 2009

AOB: Management or Cash Generation More Important?

Shares of American Oriental Bioengineering (AOB, $4.04) have held up well since missing our and consensus 3Q09 expectations in mid-November. We were disappointed by the results and stated that we may have made a mistake, yet we still hold shares with a view that intrinsic value is closer to $7 - $8 per share than $4. Here is AOB's one-year stock chart:

We noted at the time that "negative Market sentiment toward AOB [appeared] to have already priced in an earnings miss and the company's cash generation should provide a backstop." Further, at this point, we surmise that the short story for AOB (e.g. potential 3Q miss, regulatory changes, competition, margin compression, management credibility, etc.) has run its course given the large expectation "reset" in November. Based on recent short interest data, "S/I" did tick lower in the most recent period:


Following the same approach applied in our prior post (excluding out-of-the-money convertible shares), we estimate AOB is trading at six times (16% yield) estimated 2009E free cash flow of $50 million (conservative). We continue to find comfort in the low FCF multiple and expect cash to keep accumulating on AOB's balance sheet even if 2010 growth is lower than anticipated. Moreover, we still believe that AOB's products and growing franchise are difficult to replicate -- we sure couldn't do it and also think Western pharma/biotech companies would find the task challenging because of cultural and language barriers.

Thus, even with risk factors (e.g. regulatory, execution, competition), we find the 16% FCF yield very compelling. As with our Weight Watcher's (WTW) post on Friday, we ask ourselves a Warren Buffett-like question, if we could, would we purchase the entire business at the current price offered by the Market? Our answer: YES. Imagine owning the whole company and reinvesting one half of free cash flow to grow the business and paying yourself the other half (8%) as a perpetual dividend -- we'd take that any day.

We also note that other Chinese pharmaceutical companies (e.g. Simcere Pharmaceutical Group - SCR) trade at higher multiples but have lower growth and margins than AOB. Simcere is trading at 21 times consensus 2010 earnings estimate of $0.40 while AOB trades at only 6.5 times a reduced 2010 estimate of $0.62 (only slightly higher than 2009E's $0.58). Our intrinsic value estimates are always based on absolute measures. However, if AOB garnered SCR's 21 times forward multiple, the stock would trade at $13.00 today.

Finally, with regard to management credibility let's share a quote from the Fairholme Fund's Bruce Berkowitz featured in the Winter 2009 issue of Graham & Doddsville:
  • "The management factor is important. But, the ability of a company to intrinsically generate cash is probably more important."
We think Mr. Berkowitz makes a good point, which is somewhat related to a point made by other well-known investors -- something to the effect, "it's best to own a business any fool can run because someday a fool may well be running it" (tongue in cheek as clearly management stewardship of shareholder capital is important).

We'll continue to watch how AOB's management deploys excess cash flow to enhance shareholder value. As noted in our pre-3Q09 results post, only "modest improvement in the Market's perception of management credibility should lead to multiple expansion". We still think this is true.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long AOB, WTW.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Sunday, December 13, 2009

Barron's Calls Out Amazon - Cites Perils of High Valuation

On 10/23/09, we noted that Amazon (AMZN, $134.15) was a powerful franchise with impressive growth, free cash flow, and returns on capital. Yet, we also said that the stock, then at $93.45 with an implied TTM free cash flow yield of 4.7%, was in a fair value range and expensive for our liking. With shares up 44% (versus S&P 500 up only 1%), we find the valuation even less attractive and prone to disappointment (no margin of safety).

Still, the Market includes all kinds of participants, including a large number of momentum traders who keep buying or selling something because "it works". For example, on 12/2/09, Cramer discussed a momentum based valuation approach (i.e. apply a P/E of two times estimated earnings growth of 30%, or 60 times next year's estimated earnings) to derive a $216 target price with a view that current consensus estimates are 20% too low.

We think his analysis probably is inline with that of some momentum based investment funds and some sell-side analysts. News of favorable E-Commerce trends further feeds momentum. Meanwhile, more "shorts" who keep saying the valuation is insane and isn't sustainable, cover positions as patience runs out and short-term unrealized losses increase (dangers of a valuation-based short thesis).

Barron's has a feature story this weekend on Amazon that highlights risks and includes interesting tables. The article draws a parallel to Wal-Mart (WMT, $54.65):
  • Wal-Mart Stores, the archetypal discounter, was the retail growth story of the 1990s. As that decade ended, its shares traded at 69, or for 57 times its 1999 profit of $1.20. Since then, Wal-Mart has slid to 54, even though its earnings have tripled and revenue has more than doubled. The Wal-Mart experience shows that investors can lose money in the shares of a great company if they pay too much.
Also from the story, comparing Amazon to Walmart and Target (TGT, $46.93):


While Amazon benefits from an asset-light business model, we concur that the recent run prices in significant future growth. As valuation multiples further expand, the probability of disappointment increases. We retain a preference for online retailers such as eBay (EBAY, $22.70) and PetMed Express (PETS, $17.85), as well as the completely unloved Bidz (BIDZ, $2.28). We submit that the probability of the share price for any of these companies doubling before that of Amazon is quite high.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

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

Friday, December 11, 2009

Watching the World's Weight with Weight Watchers (WTW)

NutriSystem (NTRI, $29.45) has had an amazing run over past several months on news of expanded distribution with major retailers, which should lead to accelerated growth. Here is the three month stock chart:


We looked at the company in the mid-teens last summer but didn't purchase shares. Although we like the business, we didn't expect shares to move so sharply in the near-term and wanted to keep following the company. It appears the stock responded in similar fashion to the overall market this year, albeit even more quickly -- some good news yields a sentiment shift and concurrent short squeeze that leads to a meaningful upward move. Here's short interest data from Nasdaq.com:


While we missed NTRI (*momentum may yet push shares higher, but we're not in that game), we did recently initiate a small position in Weight Watchers (WTW, $27.81). We see a favorable risk/reward profile given a high quality business model and free cash flow generation. At a 10% TTM FCF yield, we wouldn't mind buying the entire company, and, further debt reduction should enable a higher dividend in two to three years. This, along with slight earnings growth, makes at least slight multiple expansion plausible over the medium term.

Here's a summary thesis with more detail from an analysis we completed in early November (valuation data updated for NTRI and WTW comparison):

Consistently high margins/ROIC and excess cash flow indicate that Weight Watchers operates a high quality business model with durable franchise characteristics. On balance, strengths and opportunities appear to outweigh key weaknesses/threats such as growth concerns, competition, and debt levels. Importantly, a baseline forecast that assumes stable Y/Y revenue in fiscal 2010 (easier Y/Y comparisons and stable economy) followed by slight growth in fiscal 2011 implies that net debt to EBITDA will decline to 2.2x at year-end 2011 from an estimated 3.3x at year-end 2009 (and 3.6x at year-end 2008), providing more than adequate cushion for lenders and the current dividend. At that point, Weight Watchers may finally be able to initiate annual dividend increases, which could lead to higher valuation multiples.
  • The baseline forecast produces a valuation range between $17 (earnings power value) and $40 (private market value)
  • Applying historical 5-year median P/E, P/FCFE, and TMV/EBITDA multiples to forward estimates implies approximately 100% upside at year-end F2009/F2010
  • Even haircuts to historic multiples imply substantial upside
  • On a comparable basis, as of 12/11/09, NutriSystem was trading at 38x TTM earnings and 21x consensus 2010 earnings (5% earnings yield), compared to Weight Watchers at 10x both TTM and consensus 2010 earnings (10% earnings yield)
Conclusion: while growth remains a critical question and multiple expansion is not guaranteed in the current environment, the prospect of a high quality business model once again garnering discounted historic multiples (at minimum) seems a high probability event with a three-year investment horizon. Investors collect 2.6% per year while waiting and potentially more in several years. Assuming normalized earnings growth in the mid-single digits (4-6%), investors should collect a total return of 7-9% over time assuming no multiple expansion.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long WTW.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Tuesday, December 8, 2009

What is the Relationship Between Total Employment and Productivity?

Based on various government and media reports in recent months, we know that economic productivity (output per unit of input) is surging as companies squeeze more effort from smaller workforces. For example, from the Department of Labor's 12/3/09 report:
  • Nonfarm business sector labor productivity increased at an 8.1 percent annual rate during the third quarter of 2009, the U.S. Bureau of Labor Statistics reported today (tables A and 2). This was the largest gain in productivity since the third quarter of 2003, and reflects a 2.9 percent increase in output and a 4.8 percent decline in hours worked. (All quarterly percent changes in this release are seasonally adjusted annual rates.)

  • Manufacturing sector productivity grew 13.4 percent in the third quarter of 2009, as output rose 8.4 percent and hours worked fell 4.4 percent (tables A and 3). The third quarter gain in manufacturing productivity was the largest in the series, which begins in the second quarter of 1987. Over the last four quarters, manufacturing productivity grew 3.0 percent. Manufacturing unit labor costs fell 6.1 percent in the third quarter of
    2009, but rose 3.0 percent over the last four quarters.
While improved productivity is nice, the key question is how lean can companies truly operate, or when will employment growth return? We don't have the answer to this question, but came across an interesting article and graph in an 11/16/09 Forbes Magazine article, "Look Who's Hiring Now: Inquire Within". Here's the graph worth a look:

The graph shows that, historically, "total employment" and productivity tend to track each other fairly closely, with the latter recovering slightly prior to employment. However, this time around: productivity zoomed ahead while employment declined. The good news today: as in the past, based on the recent unemployment report, total employment is possibly now forming a base before again growing.

Of course, many people may say "it's different this time", but time will tell. We think the historic relationship bodes well for improved employment trends in the not-so-distant future.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: n/a.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Sunday, December 6, 2009

CHDN and UBET Keep Nudging Higher - Implied UBET Value Now $3.11; Potential Fair Value $3.70-4.00

Since news of Churchill Downs' (CHDN, $35.79) proposed acquisition of Youbet.com (UBET, $2.99) on 11/11/09, shares of both companies have moved higher. As a reminder, the proposed deal is 2/3 CHDN stock and 1/3 cash. We included a summary table of potential upside/downside values to Youbet shareholders in our post about the merger. Here's the one month relative stock performance from Nasdaq.com:


On Churchill's conference call the morning after the announcement, one of the analysts asked: "I do wonder about the timing of the transaction and the use of stock considering that you guys are basically trading at what seems to be an all-time low valuation?" (transcript here). Management didn't directly answer this question, yet the the ensuing dialogue essentially highlighted where Churchill sees value in Youbet for the combined company.

We subsequently looked at Churchill Downs's historical, ten-year average and median TTM (trailing 12 months) multiples of cash flow (EBITDA), operating income (EBIT), and earnings multiples . Based on our review, CHDN was, in fact, trading at all time low valuation at the time of the transaction, with multiples at only 60-70% of historic median multiples. Thus, if we subscribe to reversion to the mean over time (we do) and also believe that Churchill Downs is solid, durable franchise (we do), then it's reasonable to expect CHDN to once again trade at historical multiples (at some point).

On this basis, we estimate that CHDN is worth $45-50 per share, which puts UBET's value at approximately $3.70-4.00 per share assuming deal terms remain unchanged. We don't think this view is lost on Churchill or Youbet management, which likely explains why the latter company's board (and JB Pritzker's New World Opportunity Partners as well as investor Lloyd Miller III) agreed to the transaction. Also, we note that the less liquid shares of Churchill Downs tend to move quickly and were in the high $30s just a few weeks prior to the announcement. Finally, Churchill Downs currently pays a $0.50 per share annual dividend, which appears sustainable even after expected dilution from issuing new shares to Youbet shareholders (i.e. Churchill will benefit from Youbet's free cash flow generation).

In a way, Churchill Downs reminds us of International Speedway Corp. (ISCA, $28.04), which owns many NASCAR "speedways" and is a favorite of many "value" investors. The margin (and free cash flow) profile is higher for International Speedway, yet both companies own and operate irreplaceable brands/assets.

Although we've slightly reduced our Youbet position to reallocate into other names, we presently retain the lion's share and expect that the implied UBET value may keep nudging higher.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long UBET.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Saturday, December 5, 2009

Nice to Have Cash - China's Railroad Plans vis-à-vis U.S. Plans + RR Car Companies

A WSJ article this week, "House Transport Panel Head Seeks $69 Billion in New Spending", discussed a "looming shortfall in transportation funding". The initial economic stimulus package included "$48 billion for highway, transit and rail projects", which was roughly half the amount the panel was seeking.

An August article in Fortune, "China's Amazing New Bullet Train (It Leaves America in the Dust)", is worth a read and includes a side by side comparison of China's plans versus those of the United States. We include the summary table here for general interest (click to enlarge or go directly to article via above link):


On a somewhat related note (but commercial railroad side), shares of railroad related companies Greenbrier Companies (GBX), American Railcar Industries (ARII), and Trinity Industries Inc. (TRN) recovered smartly from lows despite still negative traffic trends. Signs of economic stabilization and recovery hopes are likely fueling gains.

We've no position in the names and, of the three, we only performed research on Trinity Industries in mid-2008. Our conclusion then was to recommend a sale of the stock (in the $30s) given uncertain fundamentals, high leverage, and no history of free cash flow generation (primarily because of large investments in a railroad car leasing business). In this case, the sell call was timely, although we missed the recent rebound given our focus on other areas and types of companies.

The good news for investors is that the company is now generating free cash flow on inventory liquidation (positive working capital benefit) and reduced capital expenditures. The free cash flow is being used to strengthen the balance sheet.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: no positions.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Wednesday, December 2, 2009

Interesting Stat: How Much Private Sector GDP is from Construction and Real Estate?

Back in June, we discussed commercial real estate at length following attendance at a large real estate conference in NYC. Our tone was cautious and one question we wondered about was the percentage of GDP that real estate represents. We actually came across the answer back in August and meant to share then, but didn't get to it. Since the question/topic remains highly relevant to considering the potential negative economic drag from depressed real estate activity, we're sharing now -- the following table is from an 8/28/09 NYTs article, "Construction That Fueled Growth in the Sun Belt Slows":

Dependent on Real Estate


The data suggest that nearly 21% of metropolitan area private sector GDP is derived from construction and real estate (residential and commercial). If we add in public sector GDP -- which also happened to be approximately 21% of total GDP in 3Q09 based on government data (link here) -- and assume that the private sector GDP referenced in the table includes personal consumption, private investment, and net exports for each metro area, then the contribution from construction and real estate declines to around 16-17% of total GDP.

We did purchase several REITs amidst the Market mayhem last winter/spring and mentioned our First Industrial preferred position last week. While most REITs have recovered smartly from lows and fundamentals remain poor, we are looking to selectively add well-positioned REITs to our portfolio that trade at a discount to our estimate of fair value. Such a move is somewhat akin to Warren Buffett's "bet" on Burlington Northern (BNI, $98.53) in the sense that we're also betting that the U.S. economy will slowly recover.

Real estate isn't exactly the same as an impossible-to-duplicate footprint of national railroad infrastructure, yet well-placed real estate assets can assume monopoly like characteristics on a local basis, which we like. As a result, we're willing to wade through ongoing sector challenges that make valuation difficult (i.e. capitalization rates remain in flux on an uncertain fundamental outlook). Over time, we expect certain implied discounts to net asset value to shrink as equity values increase. Meanwhile, cash dividends provide compensation for patient investors.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: Long FR-PrJ.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer