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Saturday, February 27, 2010

Fortune Tech Picks - No Sonic Foundry / Mediasite? Don't Discard Margin of Safety

Fortune Magazine's Investors Guide 2010 (from December) included this article: "Tech investing is all about the next big thing. Here are the trends that could really pay off."

The article opens with:
(Fortune Magazine) -- Technology trends can be easy to spot -- iPod earbuds become ubiquitous, people casually use the term "Google" as a verb -- but technology investing is hard. For every Apple and Google, there are plenty of tech companies that fail to turn their innovations into top-performing stocks.

So how to pick the winners?

The key is to find the companies best positioned to execute on massive shifts in the way consumers and businesses use technology.

The article goes on to highlight a handful of seemingly well-positioned, niche technology companies that are, in fact, posting excellent growth. However, there's only one minor problem: the Market is already aware of these growth stories and, thus, all companies appear to fetch fair to rich multiples of earnings, cash flow, and/or sales (if no "E" or "CF" to measure against).

As we've discussed previously, we believe high multiples leave little room for error and can lead to sub-par investment performance (disappointment and losses for long positions) if optimistic Market expectations are not met.

Here's how Fortune describes the valuation of one company, CommVault (CVLT):
Trading at 28 times earnings, the stock is expensive, but analysts expect the company's earnings to grow 17% annually for the next five years, while the S&P 500 is projected to grow just 11% a year during the same period. The company today holds its own against larger rivals, but analysts say CommVault is a prime acquisition target for a big tech outfit.
SO, the company is trading at almost two times its expected growth rate. We don't know this company well, but the numbers suggest there's no bargain here. Again, a high multiple -- in this case, a high P/E and a high "PEG" ratio, or P/E to growth rate -- does not allow for potential hiccups that may result in slower-than-anticipated growth and subsequent multiple compression.

Here's how Fortune describes the valuation of another company, EnerNOC (ENOC), which is trading at 85 times forward earnings (consensus 2010E GAAP):
The company's share price has been soaring of late, tripling in value since last November's lows. Still, the stock trades far below the $50 a share it hit in December 2007, not long after its IPO; analysts believe its earnings are poised to grow 33% for the next five years, suggesting the stock has a lot of room to run.
*note: EnerNOC is trading at a lower multiple (~26 times) of expected non-GAAP earnings, yet the company is very generous with stock compensation.

EnerNOC is delivering impressive growth, yet we're both amazed and disappointed that Fortune takes such a rose colored view ("lot of room to run") of the stock without consideration of current valuation and potential risk factors (i.e. the bullish five year forecast could be wrong).

Not surprisingly, our micro-cap Sonic Foundry (SOFO) receives no mention in the story although we see Mediasite as fulfilling Fortune's "key" to picking winners -
The key is to find the companies best positioned to execute on massive shifts in the way consumers and businesses use technology.
Moreover, we think Sonic Foundry might be trading at only six or seven times forward earnings for the year beginning this summer. We're the first to admit that forecasting is a dangerous game and often wrong, yet we'll explain our analysis in a follow-up post. In this regard, let's add to the "key" the following: uncovering companies driving "massive shifts" before the Market catches on is far more rewarding than otherwise, especially when positions are established at low valuation multiples. Of course, such a feat is not easy.

Below, for reference, we include valuation data from Yahoo! Finance for SOFO (a much smaller company in terms of revenue) versus ENOC, CVLT and select other tech companies:

Following Sonic Foundry's last earnings report, we promised to share our interpretation of the company's fiscal 2010 guidance sometime in February. The month has nearly escaped us -- we'll share our view in the next few days, prior to Sonic Foundry's annual meeting on Thursday.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long SOFO.

© 2010 Jeffrey Walkenhorst
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