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Saturday, August 28, 2010

James Grant: There is No "New Normal" and Treasury Bonds are "Not Super Safe" - Rather, They are "Return Free Risk"

We said we'd come back with follow-up on our post about the flight to bonds from stocks: Forget it... Stocks are Worthless! Honey, We're Moving Everything to Bonds. We will respond in two parts, here and again in a future post.

Today, we share an excellent video and commentary from James Grant on Consuelo Mack WealthTrack. The video was broadcast on 6/11/10, but originally recorded in October 2009. He covers many topics, from treasuries, government debt, and central bankers, to gold, economic cycles, forecasting, value investing, and the potential China bubble. The discussion remains highly relevant today.

A few key points:
  • mood swings - "people overdue it on upside and especially on downside."
  • the "new normal" - tired of hearing about "the new normal" on TV and in other media? Mr. Grant correctly emphasizes: "there isn't any 'new'! It's always cycle after cycle, you go from extreme to extreme."
  • "zippy recovery"* - 2010E GDP consensus estimate was +2.5% (October 2009), "I think it'll be faster than that, at least for a couple of quarters."
  • advice from Graham and Dodd - "can't know future, therefore seek margin of safety."
  • "in investments in present.... can't know what will happen in 2010 let alone 2017, but can observe two things: opportunities in front of us as now priced; and, how the world is positioning itself for an expected outcome."
*BEFORE WE GET TO BONDS, one note: his "zippy" GDP forecast for 2010 remains subject to debate given recent economic data. Here is some text from Federal Reserve Chairman Ben Bernanke's speech yesterday (we include an embedded link to our prior post on whether jobs typically lead or lag recoveries - they always lag):
  • "Notwithstanding some important steps forward [in the economy], however, as we return once again to Jackson Hole I think we would all agree that, for much of the world, the task of economic recovery and repair remains far from complete. In many countries, including the United States and most other advanced industrial nations, growth during the past year has been too slow and joblessness remains too high. Financial conditions are generally much improved, but bank credit remains tight; moreover, much of the work of implementing financial reform lies ahead of us. Managing fiscal deficits and debt is a daunting challenge for many countries, and imbalances in global trade and current accounts remain a persistent problem."
Interestingly, global shipping/trade keeps improving, even in the United States - from the Journal of Commerce on Thursday:

Intermodal Hits New 2010 High
Major U.S. railroads set a new 2010 peak for intermodal shipments in the week ending Aug. 21, the second straight week of new highs in container and trailer loadings.

Truck Tonnage Climbs 7.4 Percent in July
Truck tonnage rose 7.4 percent in July, the eighth consecutive month of year-to-year increase, the American Trucking Associations reported.

Short Lines See Traffic on Rise
North American short line and regional railroads report freight traffic gains on the rise since mid-summer, in contrast to the wave of weak economic reports on housing and other activity for July.

Of course, mainstream media isn't currently focused on such positive news. Time will tell what truly comes ahead. It's possible that consumption will remain muted as we crawl out from under our debts. At the same time, the net exports component of GDP may remain overwhelmed by America's still insatiable consumption habits (even if somewhat weaker than in boom times) that pull in massive imports even as exports continue to recover (e.g. areas of export strength: technology, agriculture, industrial). For reference, here's how GDP is calculated from Wikipedia and our How's the Economy Doing update from June. Overall, we think we chug along.

But, there are many topics wrapped into bits of economic commentary. Let's return to Mr. Grant.

FINALLY, regarding bonds and the view that "treasuries are risk free assets," he says:
  • "treasuries are risk less or risk full at a price"
  • "As the WSJ used to say, 'every single day except Sunday, the WSJ would talk about supersafe treasuries."
  • "They're not super safe - as a friend of mine said, they are 'return free risk'. Or, more charitably, they are an option on a certain macroeconomic outcome, which is perhaps falling prices and dodgy business environment. that's where they would do well at current levels, and we might have that outcome. but they are a speculation on that outcome as opposed to an investment with a margin of safety. so, ppl fly to risk or to assets that are priced for a certain outcome. and that outcome is plausible or not and the assets are risky or not, but these assets are not inherently safe or inherently unsafe."
Here's the video - enjoy:
  • Why the dollar, gold and the ballooning federal deficit are critical issues for investors. Consuelo sits down for a rare one-on-one interview with contrarian market observer and historian James Grant, publisher of the influential newsletter, Grant’s Interest Rate Observer.

So, there you have it. Things aren't entirely satisfactory on the home front, we know, thanks to years of excess due to easy liquidity and human nature that always tends toward extremes (we agree with Mr. Grant). BUT, we think there are far better options than Treasury bonds and believe Mr. Grant and his friend are spot on about "return free risk." After all, what happens if government debts and deficits are really the problem everyone currently fears and there's no way out of our current predicament? Imagine this scenario: debt loads get even worse, foreign buyers stop buying our bonds, and rating agencies downgrade United States debt, signaling some slight risk of default (rather than "risk free" AAA). What happens in this scenario? Treasury rates move higher and bond prices move lower.

We'd much rather own dividend paying equities with sound balance sheets offered by "the Market" at attractive prices. We'll come back with more.

Happy investing,

Jeffrey Walkenhorst

Disclosure: n/a.
© 2010 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Tuesday, August 24, 2010

Webcasting Redux: Did Your Firm Get the Mediasite Memo? An Objective View

By now, most of us have watched (or listened to) hundreds or even thousands of Webcasts, whether for investment research, training, education, continuing education, or for any number of other reasons (see 102 uses for Mediasite). Few would debate whether Webcasts and other forms of online video are here to stay, or whether all of us will watch more and more events online over the next five years.

As the market grows and matures, the viewing experience will no doubt continue to improve. YET, surprisingly - to this day - the average Webcast offers limited or even disappointing functionality and performance. At the risk of sounding like a broken record: THERE is a better way. This post is meant to serve as an additional check on our implicit subjectivity as an owner of Sonic Foundry (SOFO). We always strive to be objective in our research.

In January, we shared Who on Earth Needs Mediasite?, positing that everyone can benefit from Sonic Foundry's Mediasite solution for Webcasting all kinds of events -- from schools to corporations to government organizations to hospitals and all of their respective end-users. In that post, we included a number of links to various events for readers to peruse and objectively evaluate different platforms relative to Mediasite.

Among the alternatives, we included Thomson Reuters (TRI), PR Newswire's "MultiVu" /VideoNewsWire, ON24, TalkPoint, Veracast, Wall Street Webcasting, Accordent, and even Cisco's (CSCO) WebEx solution. We see a wide disparity in the quality of the end user experience from these various platforms, especially relative to Mediasite.

As an example, while WebEx may be optimal for group collaboration, we see the solution as suboptimal for lectures, town-hall-type CEO presentations, conference events, or any other
one-to-many situation. Further, we surmise that most viewers would prefer to not see the extraneous WebEx pop-up window that says:

"Playback in progress - Do not close this window, refresh this Web page, click Back or Forward, or click a URL in another window. If you do so, playback will end".
In late July, we again mentioned out that countless Webcasting companies and even Nasdaq's (NDAQ) Shareholder.com unit could use Mediasite. Here, we shared Microsoft's (MSFT) Analyst Meeting that was Webcast live by Shareholder.com -- video only, no synchronized slides (slides available via separate download):

The Shareholder.com approach only features the active video box and all other "boxes" are still images.

Likewise, another example comes from the quarterly conference calls of video gear maker Polycom (PLCM), which uses Visual Webcaster from Onstream Media (ONSM). Here's a snapshot from the latest call in July:

In this case, the slides pop up in successive, separate windows and, like Microsoft's Analyst Meeting, the "POLYCOM" window above is static.

Finally, we watched the proposed Intel (INTC) / McAfee (MFE) acquisition Webcast live last week, which provided yet another example of the shortcomings of most Webcasts. The audio-only Webcast launched pop-up windows for each slide, leaving a number of excess windows open on our PC toward the end of the event:

BTW, looking more closely at this slide -- based on data from Cisco Systems -- please note the expected growth in video traffic (not necessarily surprising; acknowledge difficulty in accurately forecasting both market size and potential growth):

Now, for comparison, we will again share the following recent Mediasite catalogs and presentations:
Please feel free to click through each, compare notable differences versus other offerings, and reach your own conclusions. We welcome any informed feedback.

While shares of Sonic Foundry have moved higher following favorable June quarter results, we continue to believe shares are trading well below fair values based on earnings power and implied private market valuations that would be assigned by an informed strategic buyer. In the latter case, recent M&A activity provides ample valuation support. Further, we fully expect Mediasite video content to contribute a large share of the growing video traffic on the Internet referenced in the above slide. BUT, to be sure, although we like this very positive secular trend and large addressable market opportunity for Sonic Foundry, we're not necessarily buying the trend. We're buying value. Investing solely in the latest, most hyped trends without value is a perilous endeavor.

Just how is Mediasite contributing to online video growth? We shared evidence from Twitter in our July post, The Value of the Mediasite Franchise? First, Many Firms Could Clearly Benefit; Second, Ask Massey University and Others Around Globe. Tweets from the University of Florida, North Carolina State University, and Massey University, respectively:
The last Tweet comes from an IT specialist at Massey University. Toward the end of the Massey video shared in that post (video link here), note this customer commentary:
  • "We looked at what other universities were doing.... We tried Mediasite and, to be honest, we've not looked back.... The automation has just started. It's very successful and again that means we can cope with minimum resources. Basically, our roadmap is to get a number of units so that we can do automated recording across our campuses in three different cities and we can cope with the demand we're getting and that we expect to get over the next year or so... What I like about it [Mediasite], is that it's consistently high quality."
While some could say we're biased given our ownership position in the company, we can objectively say that many more organizations can benefit from Mediasite. Not only staff, but end users like all of us. Webcasting life all around the globe could be significantly improved. Do you agree?

Happy investing,

Jeffrey Walkenhorst

Disclosure: long SOFO.
© 2010 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Monday, August 23, 2010

Forget it... Stocks are Worthless! Honey, We're Moving Everything to Bonds

More headlines are discussing the flight out of stocks and into bonds. The NYTs featured this article over the weekend:
As of mid-afternoon Sunday, it was the "most popular - business day" article emailed on the NYTs' Web site:

The article opens with this commentary:
  • Renewed economic uncertainty is testing Americans' generation-long love affair with the stock market.
  • Investors withdrew a staggering $33.12 billion from domestic stock market mutual funds in the first seven months of this year, according to the Investment Company Institute, the mutual fund industry trade group. Now many are choosing investments they deem safer, like bonds.
  • If that pace continues, more money will be pulled out of these mutual funds in 2010 than in any year since the 1980s, with the exception of 2008, when the global financial crisis peaked.
  • The notion that stocks tend to be safe and profitable investments over time seems to have been dented in much the same way that a decline in home values and in job stability the last few years has altered Americans' sense of financial security.
  • It may take many years before it is clear whether this becomes a long-term shift in psychology. After technology and dot-com shares crashed in the early 2000s, for example, investors were quick to re-enter the stock market. Yet bigger economic calamities like the Great Depression affected people's attitudes toward money for decades.
  • ....
  • Until two years ago, 70 percent of the money in 401(k) accounts it tracks was invested in stock funds; that proportion fell to 49 percent by the start of 2009 as people rebalanced their portfolios toward bond investments following the financial crisis in the fall of 2008. It is now back at 57 percent, but almost all of that can be attributed to the rising price of stocks in recent years. People are still staying with bonds.
  • ....
  • On Friday, Fidelity Investments reported that a record number of people took so-called hardship withdrawals from their retirement accounts in the second quarter. These are early withdrawals intended to pay for needs like medical expenses.
  • According to the Investment Company Institute, which surveys 4,000 households annually, the appetite for stock market risk among American investors of all ages has been declining steadily since it peaked around 2001, and the change is most pronounced in the under-35 age group.
The article includes a graphic detailing the shift:
But, is this really a "flight to safety" as labeled above? Could the crowd be right? What would common sense tell us?

We'll come back with more later this week.

Happy investing,

Jeffrey Walkenhorst

Disclosure: n/a.
© 2010 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Saturday, August 21, 2010

Double Dip? Check "Selfish" Discretionary Spending versus "Gifting" Discretionary Activity; Tough for FLWS, Others Prevailing

For the most part, the American consumer remains weak. We knew this in building our 1-800-Flowers.com (FLWS) position during the first half of 2010. However, we found comfort in a margin of safety relative to our estimate of fair value underpinned by several durable competitive advantages: (1) strong brand equity, (2) economies of scale across segments, and (3) capital light business model. Further, more recently, we also pointed to the bright side of retail sales data showing healthy Y/Y increases (on easy Y/Y comparisons) versus mixed M/M performance in recent months.

Here's the latest month over month retail data from Briefing.com:

AND, part of the "Big Picture" conclusion (emphasis added) and two caveats, also from Briefing.com:
  • Retail sales are likely to remain weak for quite a while given the current trends in employment, and the negative wealth impact for depressed prices for homes and stocks.
  • The retail sales report is a measure of the total receipts of retail stores. The changes in retail sales are widely followed as the most timely indicator of broad consumer spending patterns. Retail sales are often viewed ex-autos, as auto sales can move sharply from month-to-month. It is also important to keep an eye on the gas and food components, where changes in sales are often a result of price changes rather than shifting consumer demand.
  • Retail sales can be quite volatile and the advance reports are subject to rather large revisions. Retail sales do not include spending on services, which makes up over half of total consumption. Total personal consumption is not available until the personal income and consumption reports are released, typically two weeks after retail sales.
YET, performance by retailers has been a mixed bag, with some reporting surprisingly strong results and others beset by weak consumer.

We previously mentioned the favorable performance of Pier One Imports (PIR) and Select Comfort (SCSS), which sell "imported decorative home furnishings and gifts" and "adjustable-firmness beds and other sleep-related accessory products," respectively. Here are two companies one might expect to be in a world of hurt given the ailing consumer, right?

Let's briefly look at a broad sampling of retail results/news, including recent results from Select Comfort:

  • Select Comfort Corporation (NASDAQ: SCSS) reported second quarter results for the period ended July 3, 2010. Net sales for the quarter totaled $139 million, an increase of 15 percent on same-store growth of 28 percent, compared to $121 million in the second quarter of 2009. The company reported net income of $6.2 million, or $0.11 per diluted share in the second quarter of 2010, compared to a net loss of $4 million, or $0.09 per diluted share, in the second quarter of 2009.
  • "During the second quarter, our focus on key priorities delivered double-digit growth in same-store and total sales as well as improved profitability," said Bill McLaughlin, president and CEO, Select Comfort Corporation. "The progress we made during the past 18 months in our cost structure and operational execution is generating sustained profitability. In addition, these enhancements are proving particularly valuable as we lap stronger comparisons to a year ago and the macro-economic environment remains uncertain."
  • McLaughlin added, "In the second half of 2010, we will continue to execute against priorities designed to drive sales and profitability. We also will selectively invest in and test programs to advance longer-term growth including evolving our media messages, our digital and web presence, and store locations, as well as further enhancing our customer experience."
Landscaping gear:
  • The Toro Company (TTC) reported net earnings of $33.4 million, or $1.01 per share, on net sales of $458.9 million for its fiscal third quarter ended July 30, 2010. In the comparable fiscal 2009 period, the company reported net earnings of $19.8 million, or $0.54 per share, on net sales of $394.9 million.
  • For the fiscal year to date, Toro reported net earnings of $90 million, or $2.66 per share, on net sales of $1,353.1 million. In the comparable fiscal 2009 period, the company reported net earnings of $63.4 million, or $1.73 per share, on net sales $1,234.9 million.
  • "Even with concerns expressed by many economists of a slower recovery, we experienced strong end-user demand during our summer selling season," said Michael J. Hoffman, Toro's chairman and chief executive officer. "Positive momentum for our innovative new products, particularly within our Professional markets, enabled us to deliver better-than-expected revenue and profit growth. Additionally, our ongoing focus on asset management resulted in a further reduction of average net working capital which, along with improved earnings, contributed to record operating cash flow for the nine month period."
Assorted items (QVC) -- well-known household name in retailing:
  • QVC, part of Liberty Media Corporation and attributed to Liberty Interactive Group (LINTA), observed its largest CHRISTMAS IN JULY® event in the company’s 24-year history, with more than $46.5 million in orders – representing a 14 percent increase over prior year CHRISTMAS IN JULY results.
  • QVC’s holiday weekend event kicked off early, Friday evening, with special CHRISTMAS IN JULY offers both on-air and online and continued all day Monday on QVC.com. The largest CHRISTMAS IN JULY event in the company’s history gave viewers a head start on holiday shopping, offering everything needed for holiday gift-giving and decorating, including a sneak peek at some of the hottest items for the season.
  • “We’re thrilled with the overwhelming response we received from our customers especially during these challenging economic times,” said Mike George, QVC’s president and CEO. “The entire QVC team worked incredibly hard to provide viewers with a fun and entertaining event that offered unique and exclusive gift-giving items as well as holiday décor ideas at great values. All these elements combined represented the fuel that powered the successful event.”
  • [Beyond an artificial Christmas tree and toys] Additional top selling brands included specialty gift bags, boxes and wrap from Isaac Mizrahi; home fragrance from Slatkin & Co; great gifts for the gourmet from Kansas City Steak Co., Mrs. Prindable’s Apples, Harry London Gourmet Chocolate, Harry & David and Godiva.
Weight loss services, insight from our WTW:
  • Weight Watchers International, Inc. (WTW) announced its results for the second quarter of fiscal 2010, which ended July 3, 2010, and narrowed its fiscal 2010 earnings guidance.
  • Revenue of $376.7 million, up 1.1%, and EPS of $0.73 versus $0.76 in the prior year period
  • Newly launched North American marketing campaigns exceeded expectations
  • Success of new program innovation -- ProPoints(R) -- in Continental Europe continued; CE paid weeks up 11.2%
  • Internet revenues grew 20.6%; Weight Watchers Online active subscriber base passed the 1 million milestone
  • "The second quarter 2010 results of the Weight Watchers business improved significantly after a disappointing first quarter," commented David Kirchhoff, President and Chief Executive Officer of the Company. "In the second quarter, we saw acceleration of revenue growth in our WeightWatchers.com business and substantial stabilization of our North American meeting business as a result of strong spring marketing campaigns. This is all particularly gratifying as most of our planned growth initiatives will not provide their positive contribution until we move into fiscal 2011."
Fragrances - for some European perspective, acknowledging that strength is partially a benefit of new product launches:
  • Inter Parfums, Inc. (IPAR) reported record results for the second quarter and six months ended June 30, 2010. Second Quarter 2010 Compared to Second Quarter 2009:
  • Net sales rose 22% to $107.8 million from $88.6 million; at comparable foreign currency exchange rates, net sales increased 28%;
  • European-based operations achieved sales of $91.9 million, a 16% increase from $79.4 million;
  • Sales by U.S.-based operations rose 71% to $15.9 million from $9.2 million;
  • Gross margin was 60% compared to 57%;
  • Operating income rose 68% to $11.5 million from $6.8 million;
  • Operating margins were 10.7% of sales compared to 7.7%;
  • Net income attributable to Inter Parfums, Inc. rose 27% to $5.4 million from $4.2 million;
  • Russell Greenberg, Executive Vice President & CFO commented, “The continuation of comparable quarter top and bottom line growth is indicative of the strength of our existing brand portfolio, the expansion of the portfolio with new high value brands, our skill in developing and rolling out new brand-appropriate products as well as the onset of a recovery in many of our global markets. Details of the current period sales increases have already been reported.”
  • Raises 2010 Guidance - Mr. Greenberg then stated, “Based upon our year-to-date results and expectations for the second half of 2010, we have raised our full year guidance. We expect 2010 net sales to come in at approximately $445 million and net income attributable to Inter Parfums, Inc. to reach $24.8 million or $0.82 per diluted share. As always, our 2010 guidance assumes the dollar remains at current levels.”
AND, finally, "private sale" fashion E-commerce:
  • RueLaLa.com, a subsidiary of GSI Commerce (GSIC), which we mentioned in our Bidz.com (BIDZ) post the other week, "nearly doubled sales" versus last year during the June quarter: "Rue La La site sales nearly doubled from last year, increased sequentially versus the first quarter and also increased against the seasonally important fourth quarter."

ALL OF THE ABOVE RETAIL NEWS should help allay fears that the world is ending and a double dip is most certainly on the horizon and/or that the U.S. is doomed. Somehow, the consumer lives.

YET, of course, we know: ongoing real estate and government debt/deficit challenges are real and anticipated higher taxes will be a drag on both spending and new capital/entrepreneurial investment. Consumers are clearly picking their spots. Surprisingly, even consumer staples companies such as Walmart (WMT) and consumer packaged goods companies such as Kellogg Company (K) are posting disappointing results amidst a competitive retailing environment.

NOW, putting this all together alongside lackluster results from 1-800-Flowers.com -- we reach the following conclusion: what we'll call "selfish" discretionary retail segments are clearly outperforming "gifting" discretionary segments. Put simply, people are more willing to spend on themselves than on others: buy a new mattress, or a new mower, or new Christmas decorations (in July?), or lose weight for a better self image, or new perfume to smell nice, or discounted fashion merchandise. Maybe this should not be a surprise, especially in the current environment?... Further, note that many of these items have a natural replacement cycle that automatically generates demand over time.

This current trend is negative for our 1-800-Flowers.com and makes life more difficult for a company with low historic margins and seasonality (reasons why some investors steer entirely clear of FLWS or other discretionary retailers). Still, the company is prudently managing costs and focused on driving repeat business across the company's diverse portfolio of products. Plus, the balance sheet continues to improve on the back of steady cash generation. Importantly, we think our analysis of competitive advantages still stands. Meanwhile, the stock is again near an all-time low - from Google Finance:

Like other investors long the stock, we were hoping to see a turn in fundamentals this quarter (or at least stabilization), yet -- per the above summary -- "selfish" purchases are currently higher priorities than gifting. Fortunately, 1-800-Flowers.com can somewhat play in the selfish arena by motivating more customers to indulge in chocolates, cookies, popcorn, and other items for self-consumption. Recall that QVC cited Harry London chocolates as a popular seller. Also, 1-800-Flowers.com's plan to further expand the company's Fannie May chocolate presence is sensible. We think these product lines represent higher margin, hidden gems in the company's basket of properties. For now, we will remain patient. We might even order some Dark Pixies chocolates from Fannie May.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long FLWS, WTW, BIDZ.
© 2010 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Thursday, August 19, 2010

1-800-Flowers.com (FLWS): Fundamentals Remain Challenge; Walmart's SSS Results Were Telltale Sign

Alas, 1-800-Flowers.com's (FLWS) can't escape the U.S. economic malaise - from the press release this morning:
  • Jim McCann, CEO of 1-800-FLOWERS.COM, said, "Throughout fiscal 2010, consumer discretionary spending continued to be impacted by the uncertainty in the macro economy. As a result, total revenues and profitability were below our expectations for the fiscal fourth quarter and the full year, particularly in our core Consumer Floral business category."
  • Company Guidance:
  • Reflecting the continued uncertainty in the consumer economy, the Company is modifying how it provides forward guidance compared with past practices. This includes the elimination of specific guidance for revenues, EPS, EBITDA and free cash flow. In terms of its outlook for fiscal 2011, the Company does not anticipate significant improvements in consumer demand for discretionary purchases and therefore expects continued challenges to top line growth. During fiscal 2011, the Company plans to:
  • * Continue its programs to enhance operating efficiencies by leveraging its business platform;
  • * Improve its gross profit margins through a number of initiatives, including reduced promotional activity and enhanced manufacturing operations, and
  • * Continue to invest and innovate for the future, including expanding its fast growing social and mobile commerce initiatives, growing its new 1-800-BASKETS.COM business and rolling out a new franchising program for the Fannie May brand.
  • For fiscal 2011, the Company expects to maintain capital expenditures at approximately $15 million.

In our FLWS post Tuesday, we mentioned that the risk/challenge remains the weak consumer economy. We know the real estate and job markets both remain problems, especially for discretionary retailers such as 1-800-Flowers.com and our Bidz.com (BIDZ). Walmart's (WMT) negative U.S. same store sales results reported the other day were a telltale sign of the poor condition of cash strapped American consumers.

We'll come back with further commentary within the next several days.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long FLWS, BIDZ.
© 2010 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Tuesday, August 17, 2010

What's Going on with 1-800-Flowers.com (FLWS)? Regardless of Tough Environment, Still Offered at Meaningful Discount

In recent weeks, several friends asked: "Curious what your thoughts are on FLWS these days?"

Our general response:

No changes to our 1-800-Flowers.com (FLWS) view: we believe the company is under-priced by a wide margin given the cash generation of the business, established brand, diversified product portfolio, etc. We actually ordered flowers from the company the other week for family members and the product was excellent.

The risk/challenge remains the weak consumer economy. It's possible that shares of the company could languish as long as the American consumer is ailing, which could be one, two, three years, who knows (although we're a tad slightly more optimistic than the consensus view). AND, since we don't get a dividend from FLWS, we get zero compensation during the interim. HOWEVER, more likely than not, since volatility is a friend to the patient investor, the stock could well bounce between $2 and $4, maybe $5, even if the American consumer remains challenged.

We always think of what the late Sir John Templeton said: "very rarely is any share valued for it's true price... it's true value. In a single year's time, they go 50% too high, 50% too low...."

Recall that the company is trading at approximately five times current trailing twelve months (TTM) free cash flow for a 20% FCF yield. This is crazy. Before long, the company will be debt free and cash will begin piling up on the balance sheet. The business arguably should be at least $5-6 today, but investors shove it aside because of ongoing macro concerns. Also, recall that shares were in the mid $3s as recent as April. Our downside seems limited to around $2 (supported by strengthening balance sheet and cash flow), while our upside potential is 2-3x (possibly near-term, depending upon results and manic market), or even 4-5x looking out over time (3-5 years).

The company should be reporting FY end results in the next week or two [this Thursday]. Revenue could/should be stabilizing on Y/Y basis. If we see an uptick, investor sentiment could shift to positive and we'd see a lift in the share price. If otherwise, we may move sideways until fundamentals improve.

ONE IMPORTANT ADDENDUM: management's forecast for more than $30 million of free cash flow this year is an 18% yield on the company's current market capitalization of $163 million. The truth is, we really care about owner free cash flow: net income plus depreciation and amortization less capex and the change in working capital. Fiscal 2010 free cash flow will be boosted by favorable working capital movement. If instead we assume working capital is a wash and ongoing capex equally offsets D&A, free cash flow would be a relatively small figure for the trailing twelve months. However, based on the more diverse business mix -- largely established over the last five years -- we believe the company is reasonably capable of normalized net income of approximately $20 million. Using this estimate, 1-800-Flowers.com is currently trading at a still attractive normalized earnings and free cash flow yield of 12%. We may provide more insight into our calculations in a future post.

In this TV commercial from 1998, Jim McCann talks about how to properly cut stems on flowers and about the 10 Step Freshness Care System, a concept 1-800-Flowers pioneered and still practices to this day.

We learned something new today.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long FLWS.
© 2010 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Friday, August 13, 2010

Cisco Systems: Everyone's an Economist in a World Awash with Lemmings (Many Already in the Water!)

We've backlog of topics to share, but will again briefly relay how everyone is an economist. We wrote about this in May 2009 and have included various related tidbits in other posts, including our "how's the economy doing?" series. Essentially, in our interconnected world -- where information travels the speed of light -- everyone from large organizations and Wall Street, to government leaders and lone individuals on Main Street seemingly tends to fixate on the latest news, whether positive or negative. That is, lemming behavior is amplified on many levels, not just in the "Market."

Here, we use Cisco Systems (CSCO) as an example, which missed earnings expectations and tempered its tone on the technology market versus the prior quarter. The markets pulled back yesterday and the WSJ published the following headline story last night
  • Dow's Losing Streak: 3 Days: Stocks declined for a third straight session as economic warnings from weekly jobs data and Cisco Systems added to investors' concerns about a possible double-dip recession.
Wall Street sell-side analysts didn't react kindly -- from TheStreet.com:
  • Cisco Systems (CSCO:NYSE) downgraded at BMO from Outperform to Market Perform. $23 price target. Estimates also cut, as business momentum has stalled.
  • Cisco Systems (CSCO:NYSE) estimates lowered at Morgan Stanley through 2012. Company is seeing lower gross margins, but spending more and facing a higher tax rate. Equal-weight rating.
  • Cisco Systems (CSCO:NYSE) downgraded at Oppenheimer from Outperform to Perform. Company reported a mixed quarter and has a soft outlook.
Clearly, expectations matter and, in a myopic-please-me-now Market, this is especially true. No matter than Cisco was trading at 12 times forward earnings with approximately one third of the company's market capitalization represented by net cash on the balance sheet. Or, forget the 20% plus operating margins and high teens return on equity (ROE). The Market wants a beat and raise quarter like that delivered by Priceline.com (PCLN) and our microcap holding Sonic Foundry (SOFO) last week. Recent performance for shares of these companies versus the Nasdaq index from Google Finance:

Back to Cisco: we recommend reviewing the company's results, Webcast, and earnings presentation. We don't have time to share all of the details or key slides, but a quick perusal reveals impressive growth:

The other slides around geographic and product performance are worth a look. Even "U.S. and Canada orders were up approximately 20% Y/Y.

BUT, here are the slides/commentary that caused most consternation:


The Market fixated on the "unusual uncertainty" comment and guidance that was just slightly lower than expectations - from management commentary: "For Q1 FY11 we anticipate total revenue to be up approximately 18-20% year-over-year."

We could discuss a few more things, including Cisco's focus secular growth areas such as video (read: related to our Sonic Foundry thesis), but need to wrap this up for now. CNBC featured CEO John Chambers yesterday morning, giving him an opportunity to put on his helmet and body armor, and defend his Thursday commentary. Give a look and you be the judge - how bad are things, really?

Note some of his commentary:
  • "awesome quarter"
  • "in terms of economy, we share what we're hearing from our customers"
  • "seeing very gradual recovery"
  • "customers hesitant about hiring, new jobs, and capital spending [but still expecting growth, maybe somewhat lower than pace anticipated several months ago]"
  • "added 2,000 new employees last quarter, 70% in U.S."
  • "adding several thousand employees over next several quarters"
  • "feel very good about our future"
  • "think stock will take care of itself if we do those [growth numbers]"
  • "optimistic about future of U.S., I think we're on beginning of decade long productivity run"
It should come as NO SURPRISE to anyone that growth is decelerating from robust, EASY, Y/Y comparisons during the first half of 2010 versus a very weak first half in 2009. Of course, the wall of worry is difficult to overcome and a sensational media is quick to latch onto the idea that a "double dip" is just around the corner. We know jobs figures have been disappointing, too, even if new claims for unemployment are declining faster than in 2002 and 1992. The risk remains that real economic behavior is being impacted by pervasive negative psychology, leading to tightening corporate and consumer purse strings around the globe. Again, lemming-like behavior amplified by easy, rapid information flow. Follow the leader, follow the leader, but who's the leader and where is he/she going?

Yet, per our prior posts, growth is better than no growth and most companies are seeing stable to better results. Some, like Priceline.com, Sonic Foundry, and even Macy's are beating expectations. Plus, small industrial companies like WD-40 (WDFC) are also raising guidance and global shipping companies are posting solid results on the recovery in global commerce. We'll come back to this last point in a future post.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long SOFO.
© 2010 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Tuesday, August 10, 2010

Where to Stash Your Cash? Listen to Hersh Cohen: Buy Equities that "Just Make Sense!"

The other week, a WSJ headline caught our attention: BofA Cuts Some CD Rates. The lead points from the article:
  • Bank of America cut some rates on certificates of deposits this week, the latest in a round of cuts that will leave consumers and businesses with fewer options to stash their cash.
  • Bank of America Corp. cut some rates on certificates of deposits this week, the latest in a round of cuts that will leave consumers and businesses with fewer options to stash their cash.
  • The Charlotte, N.C., lender this week cut the average rate on its five-year CD by 0.50 percentage point, to 1.75% from 2.25%. Its four-year CD went from an average of 1.75% to 1.45%, and its three-year CD dropped to an average of 1.1% from 1.5%.
  • The recent moves are another reminder of how U.S. investors have fewer places to go for healthy returns. Two-year Treasury yields hit a record low Friday of 0.539% in intraday trading, and money-market rates have sunk to 0.75% nationally.
  • Other U.S. banks are expected to follow the nation's largest bank by assets and lower their long-term rates, as well.
Meanwhile, money keeps pouring into bond funds - why, when yields are so incredibly low??? From Liz Ann Sonder's presentation we shared last week, we have an illustration of the recent out-performance of bonds (bottom) relative to past "cycles" versus equities (top):

Related to the BofA news and in spite of the funds flow, we keep hearing a common refrain that goes something like this: "Bond yields are so low, there's nowhere to generate any sort of decent return on our savings." Or, another one: "How are America's retirees going to live off of 1-2% interest income?" Or, "My CDs are expiring, where shall I roll them over?"

The answer is surprisingly simple:
invest in high quality companies with solid balance sheets that (1) sell or provide products or services that people need to buy (think cleaning supplies, food, beverages, telco services, etc.) and (2) offer reasonable, growing streams of dividends. We previously shared this strategy and the importance of dividends in November of 2009 and November 2008 (pre-CS$ blog in latter case).

For excellent, recent commentary on "Where to find income" we highly recommend watching Hersh Cohen on Consuelo Mack WealthTrack - video below from 7/23/10:
  • "Great Investor" Hersh Cohen, Chief Investment Officer of ClearBridge Advisors and Forbes Honor Roll fund member eight times discusses the "greatest investment opportunity" he has seen in decades.

    Link to "The One Investment..." First rate companies with great balances sheets and attractive dividend yields

    Stock Symbol Dividend Yield a/o 7/21/10
    Abbot Labs (ABT) 3.5%
    AT&T (T) 6.7% (a/o 7/20)
    ExxonMobil (XOM) 2.9%
    Heinz (HNZ) 3.8%
    Home Depot (HD) 3.4%
    IBM (IBM) 1.8% (a/o 7/20)
    Intel (INTC) 2.8% (a/o 7/20)
    Johnson & Johnson (JNJ) 3.5%
    Kimberly-Clark Corporation (KMB) 4.0%
    McDonald's (MCD) 3.1%
    Microsoft (MSFT) 2.1%
    Procter & Gamble (PG) 3.0%
    The Traveler's Companies (TRV) 2.7%
    United Parcel Service (UPS) 3.1%
    Verizon (VZ) 7.2%
    Walmart (WMT) 2.3%
    3M Company (MMM) 2.5%

We love his comment that "they just make sense!" We agree: genuine common sense.... While we don't have direct exposure to these high quality companies, we have indirect through various large cap value funds in our retirement accounts. In our directly managed accounts, some of the dividend payers that we might similarly categorize include smaller cap companies Compañía Cervecerías Unidas S.A. (CCU), Lance Inc. (LNCE), NTELOS Holdings (NTLS), and PriceSmart (PSMT). One word of caution on these names is that, aside from NTELOS, recent runs leave valuations somewhat less attractive than earlier this year.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long CCU, LNCE, NTLS, PSMT.
© 2010 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Monday, August 9, 2010

Bidz.com: Something for Nothing; Plus, Top Ten Questions for Management

Our recommendation of Bidz.com (BIDZ) last summer has not worked out to-date. As it turns out, we would have been better off purchasing shares of well established brick and mortar player, Signet Jewelers (SIG), which we mentioned in our original post and have loosely followed through the years. OR, we could have used this capital to follow our instinct and purchase shares of Starbucks (SBUX). Fortunately, our exposure to the jewelry (and, in this case, diamond mining) segment via Harry Winston Diamond Corporation (HWD) has more than offset our languishing Bidz.com position. Of course, despite daily, concerted efforts of so many on Wall Street trying to game (trade around) positive and negative catalysts (hence, annual portfolio turnover greater than 100%, 200%, 300%, etc.) stock performance in the short-term is near-impossible to predict.

What's gone wrong with BIDZ? We addressed some of the risks/issues in a March post and highlighted a key question in a subsequent post where we mentioned QVC (LINTA) and HSN (HSNI). In a nutshell: weaker-than-expected revenue performance and margin contraction, primarily resulting from the still depressed consumer discretionary environment. Competition may also be playing a role as all kinds of retailers discount virtually all types of merchandise, online and offline, and consumers are purchasing with a more discriminant eye. The question remains: is Bidz.com a durable franchise with real earnings power over the long haul?

The flip side? Trading near net tangible book value, the company is now essentially offered for free, assuming all inventory could be liquidated for cash at carried value and, along with existing cash, distributed to equity holders. After all, the company has consistently shown an ability to convert inventory to cash. That said, in a true, distressed liquidation, a discount would need to be applied to all balance sheet assets aside from cash in the bank. YET, this is not a distressed situation.

Company-specific fundamentals are marginally better and most overhangs are removed. The company remains a $100 million plus revenue business on an annualized basis and, behind BlueNile.com (NILE), is the second largest online jewelry retailer (aside: BlueNile's valuation is coming back down the earth - see prior post about things that don't make sense). Further, Bidz has no debt and continues to use excess cash to repurchase shares, shrinking the float and increasing equity owners' individual stakes in the company.

Unfortunately, the majority of repurchases were at higher prices ($3.71 average to date), although we were pleased to see the consummation of a "2.2 million share stock buyback for $2.3 million in a privately negotiated transaction" with Marina Zinberg, CEO David Zinberg's sister and employee of the company. While some investors may cringe at the insider dealing, the fact is that Bidz repurchased a large block of shares at $1.05 per share (an approximate 50% discount to then market value). The Bidz's press release noted:
  • "The 2.2 million shares bought by the Company will be retired, thereby reducing the Company's outstanding share count to 19.8 million. Both the Board of Directors and Management believe the buyback will serve to further enhance its future earnings per share and make its stock more attractive to own for both current and prospective investors."

The obvious question is -- in evaluating the repurchases -- what is the intrinsic value of Bidz? We provided estimates in our "detailed long thesis" of August of last year, which we hope to revisit in a future post. If we believe (1) there's more than meets the eye in establishing/ operating a leading e-commerce business, and (2) the company is capable of returning to moderate revenue growth with total revenue in the mid-$100 million range and achieving mid to high single digit operating margins (below the 11-12% achieved in 2007-2008), repurchases will likely look very smart.

Point one may be subject to debate as at least several private sale, invite-only fashion Web sites such as Gilt.com, Net-a-Porter.com, HauteLook.com, and RueLaLa.com entered the market and met fairly rapid success (at least in terms of revenue, margins uncertain). In fact, well regarded Compagnie Financière Richemont S.A. scooped up higher-end Net-a-Porter.com and GSI Commerce (GSIC) acquired RueLaLa.com. Then again, perhaps the deals support the view that first-mover, well-positioned e-commerce platforms are difficult to replicate.

For what it's worth, the purchase prices were many multiples of Bidz's current valuation (e.g. Richemont Net-a-Porter purchase - implied price to sales multiple of 3.4 times, or eleven times Bidz's current 0.30x P/S ratio). Bidz entered this market segment as a fast follower with the launch of Modnique.com in February, planning to leverage the company's e-commerce know-now, infrastructure, customer base. We are somewhat concerned over the visibility into the margin profile from this potential revenue stream. While RueLaLa and others may generate large revenue, we think margins may be slim.

Web traffic as measured by Alexa.com shows Bidz.com's traffic (excluding Modnique.com) as relatively stagnant versus the fast growth of the upstarts:

Gilt.com, not included in the above graph, is almost off the charts.... There is much more we could discuss here -- including reasons to NOT invest in consumer discretionary companies -- but we'll save commentary for future posts. For now, we end with our top ten questions for Bidz:
  1. Where will the overall business be in one year, three years, five years? Margins? Earnings power?
  2. Key risks/threats other than weak consumer environment?
  3. Outlook and ability to reignite growth in the core Bidz jewelry business? Level of confidence? Key levers?
  4. Traffic trends, conversion, repeat business?
  5. Competitive landscape? Worried about me-too players?
  6. International trends? Growth? Expansion plans? Repeat business? Margin profile versus domestic business?
  7. Current investment initiatives to grow or otherwise transform the business? What is Bidz doing that the competition isn't?
  8. Update on Modnique and how Modnique differentiates itself from RueLaLa, et al.? During the June quarter, RueLaLa doubled sales versus last year (uncertain of marketing spend or margin profile).
  9. Barriers to entry for Bidz.com and Modnique.com (related to #1 and #6)?
  10. No more insider selling?
We've gone through many of these with Bidz management in the past and some are addressed in the company's current management presentation. Nonetheless, we welcome an update with today's earnings report.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long BIDZ, HWD.

© 2010 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Friday, August 6, 2010

Jobs Lead or Lag Recovery? CNN vs. Historical Evidence, Courtesy of Schwab's Liz Ann Sonders

The market is pulling back today as the "Market" digests this morning's jobs report. There is no shortage of news on the lackluster figures -- mid-day headlines from Google Finance:

Economic recovery sputters as companies add only 71000 jobs in July
By Michael A. Fletcher and William Branigin The nation's economic recovery continued to sputter as private-sector employers added just 71000 jobs in July, according to a report released Friday by the Labor Department.
Jobs must lead, not lag, the recovery
Unemployment report portrays stagnant job market

We covered the economy and fickle investor psychology the other week, and acknowledge that the jobs and the real estate market remain legitimate challenges. Creative destruction, in a perverse way, also compounds the situation as "the new" sectors push out, or significantly disrupt, "the old" sectors.

Yet, for a telling perspective on the second headline, "Jobs must lead, not lag, the recovery" from CNN, we recommend watching recent monthly commentary video update from Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

We previously shared her work in our December post, Unemployment: Headlines Gloomy, Yet History Tells Different Story. We think she offers balanced insight on the markets and the economy. From her July Market Update, we share several of many helpful slides -
  • NOTE: CNN might consider incorporating this into their article, borrowing Liz Ann's title: Unemployment Rate Lags Big Time [in every instance]:

  • Never forget that sentiment bounces around in lock-step with the market -- per Sir John Templeton and also from our own experience, we know the best time to buy is at the point of maximum pessimism:

  • Here's another under-appreciated point: CEO confidence leads consumer confidence, which takes more time to recover from bruising during a harsh recession:

  • This is a pleasant surprise - new claims for unemployment are declining at a faster pace than during the "jobless" recoveries of 1992 and 2002 (would you believe it?!):
  • Finally, the familiar Market cycle that we also shared in slide four of our Which Way from Here presentation back in January -- always keep this in perspective:

Despite lingering concerns and federal/state budget woes, most corporate fundamentals remain stable to better and balance sheets remain flush with record levels of net cash. Our expectation is that fundamentals will lead the way to improved sentiment and, ultimately, more jobs. We understand the fear is that America is totally spent because of over-leveraging thanks to easy money and subsequent greed on Main Street AND Wall Street (e.g. humans are prone to behavior that creates problematic bubbles). This is, in fact, true on many levels.

Unfortunately, we all must now pay the consequences of foolhardy behavior and, perhaps, forward growth will be muted. Still, history shared by Liz Ann implies that jobs will arrive, possibly sooner than the current consensus view. Watch for demand from emerging markets for U.S. products and services to buoy our economy. The challenge is that all corporations are evermore focused on running lean and driving out costs. With productivity gains, they can do more with less (people).

As always, investors need to pick their spots. We think an emphasis on cash generating, franchise-type companies offered by the Market at low multiples of earnings and cash flow remains a prudent investment strategy in all markets. Out of favor asset plays trading at meaningful discounts to readily ascertainable net asset value are also sensible.

Happy investing,

Jeffrey Walkenhorst

Disclosure: n/a.
© 2010 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Tuesday, August 3, 2010

The Mediasite Franchise Alive and Kicking as Sonic Foundry is in the Black and Maintains Solid Outlook

We wanted to briefly relay several key points about Sonic Foundry's (SOFO) June quarter results (F3Q10) following our post the other day, The Value of the Mediasite Franchise? First, Many Firms Could Clearly Benefit; Second, Ask Massey University and Others Around Globe.

Full results can be found here, including a link to the brief 28 minute Mediasite Webcast (note: we had a few questions that would have extended the discussion, but didn't get our request in soon enough!). A few takeaways:

(1) Top-line results support our Mediasite franchise thesis: revenue of $5.6 million (+12% Y/Y) and record billings of $6.0 million (+19% Y/Y) as adoption continues. One of two slides highlighting recent customer additions from Sonic's presentation:

More organizations continue to realize the benefits of the Mediasite solution over other Webcasting services, which is fantastic and apparently accelerating. Recall the Nasdaq (NDAQ) Shareholder.com example of Microsoft's Analyst Meeting we highlighted the other day. Why not move to Mediasite for a better experience?

(2) Bottom-line profitability is what the doctor ordered: GAAP EPS of $0.06 and cash NON-GAAP EPS of $0.24, with the latter pointing to our expectation that the company could potentially deliver $1.00 of cash earnings over the next year. While the company continues to have a small net cash position -- now $839 thousand versus $1.1 million at 3/30/10 -- we think today's results confirm that Sonic Foundry is moving past the inflection point. Working capital requirements to fund growth should be met by internal cash generation (operating leverage) and/or the currently untapped $3.0 million line of credit from Silicon Valley Bank (SVB) (details in last 10-Q). Here's the management view from Sonic's presentation:

(3) Outlook/commentary calls for revenue growth of 10-40% (wide range on lumpy deal timing) over the next 12 months -- supports our thesis, but points to the low/mid point of our March earnings scenario range (+10% Y/Y = $21 million, +40% Y/Y = $27 million, midpoint = $24 million) - click to enlarge:

Deal timing remains the big swing factor and, for valuation, we'll see what the Market decides. Above, we use a 20-times P/E multiple, but -- right or wrong --higher multiples are often awarded by the Market to well-positioned, growing niche companies. Full disclosure: we will gladly oblige Market demand if multiples move beyond our estimate of fair value. As noted in our prior posts, we believe recent M&A transactions also provide relevant valuation benchmarks from a private market valuation (PMV) standpoint.

(4) Finally, don't forget about the importance of collaborating with the A/V channel to build the business, which management mentioned in discussing Sonic's presence at the recent Infocomm/Educomm show:

AND, recall what we shared in July 2009 regarding the A/V channel relationship as a barrier to entry:
  • The key focal point for us remains the Mediasite franchise, which we believe continues to grow in value as customers expand footprints, new customers join the community, and -- importantly -- the global A/V channel increasingly recommends Mediasite for rich media Webcasting. We think the channel promotes Mediasite because the solution works extremely well, is reliable, and has a clear product development road-map. The growing, installed customer base, combined with brand recognition, trust, and global distribution, are all difficult for a competitor to replicate and take years to establish. In our view, these aspects mitigate the risk of rapid technological change and help secure Mediasite's leading position in the marketplace.
We think this competitive advantage is likely strengthening for the company, which is another positive.

Lastly, as an unrelated aside, we wonder if many customers have explored placing Mediasite content on Google's (GOOG) YouTube? We happened to stumble upon this -

That said, most content no doubt remains behind firewalls and/or directly housed in continually expanding Mediasite catalogs (again, please see our post with Tweets about rapidly expanding usage from university customers). Still, interesting to watch (but a bit small and too blurry if enlarged to full screen).

Happy investing,

Jeffrey Walkenhorst

Disclosure: long SOFO.

© 2010 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Monday, August 2, 2010

PetMed Express (PETS): Why We Moved to the Sidelines and Prefer Other Ideas Until Proven Otherwise

We mentioned our more cautious stance on PetMed Express (PETS) in our post the other week, More Favorable Earnings Reports, including EBAY; One Exception: PetMed Express (PETS) on Company Specific Risks. Here, we provide more detail.

As it turn out, our timing works well because (1) PetMed Express announced a 25% increase to its dividend today:
AND, (2), The Motley Fool featured PETS as "Today's Buy Opportunity" on Friday 7/30/10.

First, the dividend increase nicely signals management's confidence in their ability to grow the business over time, as well as a willingness to return more capital to shareholders through buybacks and dividends. This commitment is fantastic and exactly what we look for in our companies.

Second, the Fool nicely summarizes the positives: large addressable market opportunity, America's love for pets, healthy historical growth, and healthy free cash flow. The Fool also notes the company's sizable reorder business, incorrectly citing reorders at 75% of sales when - in fact - they were better, at 77% in most recent quarter. From PetMed's earnings release:
  • Net sales for the quarter ended June 30, 2010 were $74.4 million, compared to $77.2 million for the quarter ended June 30, 2009, a decrease of 3.6%. Net income was $7.2 million, or $0.32 diluted per share, for the quarter ended June 30, 2010, compared to net income of $8.1 million, or $0.36 diluted per share, for the quarter ended June 30, 2009, an 11% decrease to EPS. Reorder sales increased by 7%, from $54.0 million to $57.6 million for the quarters ended June 30, 2009 and 2010, respectively.
We have $57.6 million out of $74.4 million = 77% ($57.6 divided by last year's $77.2 = 75%). In any case, the positive story is similar to our original thesis last summer.

NONETHELESS, the company reported disappointing results which, combined with management commentary, brought us to rethink our positive stance. Recall our prior disappointment last October.

Some negative surprises.
Although we expected that a tighter advertising market might negatively impact PetMed Express's access to sufficient remnant advertising space at favorable rates, we still expected Y/Y revenue growth in the quarter (versus a reported Y/Y decrease of 4%). Further, PetMed is having to pay higher prices for product, pressuring its gross margin. This risk factor could be exacerbated by reliance on third party suppliers for products. Another negative surprise was CEO Mendo Akdag citing the economy as a reason for weakness:
  • "I think economy is playing a role. Consumers are giving greater consideration to price, stretching the usual, the preventatives and switching to lower-priced brands. So I think the softer economy has been catching up with us."
To this point, we believe prior management commentary acknowledged the weak economy but pointed to the company's business model as being more resilient, supported by actual results (helped by the previously slack advertising market). It's true that a strapped consumer may be purchasing more selectively, yet heightened competition from Amazon.com (AMZN) and me-too imitators may also be the culprit. Hard to know for sure as they're all somewhat inter-related.

WHAT we do know is that retail pricing for some key medications is intense. Let's quickly review pricing for OTC flea and tick offerings, which along with heartworm preventatives (RX required), make up more than 50% of PetMed Express' sales.
  • Pricing on Frontline Plus from Amazon for a dog 23-44 lbs is listed at $65 (in this case, sold by a third party merchant through Amazon):
  • Another item: Amazon's pricing on Advantix Flea Control for dogs 21-55 lbs, 6 applications is $57.50 (this time, sold and shipped by Amazon):

SO, Amazon is undercutting PetMed Express by a wide margin. That said, this has been the case for some time as we've kept tabs on pricing over the past year. If consumers are continuing to buckle down, which is possible* given the weak employment market and languishing real estate sector, volumes and pricing (and margins) -- as well as repeat business -- will remain under pressure as retailers offer more bargains and consumers hunt for better deals. SO LONG as a buyer is confident that the product is authentic, a "rational" consumer will purchase from the lower-priced outlet. In this sense, customers should be increasingly bargain savvy, even for RX medications which made up 35% of PetMed's revenue in FY2010. While Walmart (WMT), Amazon, and PetsMart (PETM) may not participate in the prescription segment without proper licenses, vets may be steadily more aggressive in an effort to retain the product business that PetMed has been so successful in garnering.

*OF COURSE, deep in the grips of the recession and panic, in late 2008 and early 2009, when the consumer went into hibernation, PetMed Express posted healthy Y/Y growth and new customer acquisitions. We can chalk this up to plenty of remnant advertising space, which admittedly, is crucial for most direct marketing companies, but one could also posit that consumer spending is at least better today than it was during the hibernation period. For those interested, we show absolute retail sales in a prior post, Look at the Bright Side of Retail Sales: STILL UP Y/Y and Don't Forget Recent Commentary from Many Areas.

To summarize: while the economy may finally be a negative factor, we think heightened competition is an equally or more likely culprit (aside from less advertising). As a result, we see risk to both new business AND what we originally considered to be an annuity stream of repeat sales. The company may need to spend more (or give more, discounts, coupons, etc.) on both fronts.

One other risk factor has some investors spooked: the patent expiration for Frontline Top Spot. We asked CFO Bruce Rosenbloom about this and he kindly informed us that the leading flea and tick seller, Frontline Plus, is NOT impacted by the expiration and that the company "will carry any new products that hit the market" (i.e. generics). We've not studied in any significant detail what happens in the traditional pharmaceutical market when generics enter the scene, but common sense suggests lower prices and potentially more competition. YET, it's good news that this is a secondary product and Mr. Rosenbloom also said that there are no other patent expirations on the near-term horizon.

To their credit, management has done a great job building the franchise and is balanced in their commentary. We recommend watching CEO Akdag's presentation at the recent Noble Financial Sixth Annual Equity Conference (captured with Sonic Foundry's Mediasite/SOFO; more conferences should be shared in this format)
Mr. Akdag highlights strengths:

AND also discusses challenges:

Unfortunately, for now, we think concerns outweigh positives until proven otherwise. We still like the company's well-recognized brand, asset-light-high-ROIC business model, iron clad balance sheet, reorder business, excellent free cash flow, and now enhanced 3.1% dividend. However, we must acknowledge that negative Y/Y revenue trends (a new development) and margin pressures bring material risk to our and Street forward estimates, which suggests potential for further multiple compression. At 15 times trailing earnings, we think the company's current valuation leaves little room for incremental disappointment, which could happen should remnant space remain tight (likely, as long as the economy remains stable to better) amidst higher competition (likely). Hence, forward growth and margins are the crux, and are especially critical for valuing the business on a long-term basis (e.g. value of future equity free cash flows to shareholders). The ongoing secular shift to online commerce is a favorable tailwind for PetMed Express and, in addition, we can envision a large strategic buyer making a bid for the company at some point.

Moving to sidelines. For the time being, we are recoiling our positive thesis as the above risk factors raise questions as to whether -- in Charlie Munger style (per our initial post one year ago) -- we can sit back, relax and watch net asset value per share grow. While we take a patient, multi-year perspective and our aim is to never be reactive after an earnings report (always preferable to be proactive prior to positive/negative catalysts, before the crowd), we have higher conviction in our other holdings. For now, we book an approximate 12% total return and will watch from the sidelines. Unfortunately, our prior decision a few months back to let our position ride despite achieving our low $20s fair value range did not pan out. Lesson: always best to maintain target price discipline. Insiders were selling, including a $2.8 million block by Mr. Akdag.

OTHER IDEAS? We have higher conviction in our other "asset-light" holdings, eBay (EBAY), Weight Watchers (WTW), and 1-800-Flowers.com (FLWS), as well as our "asset-heavy" shipping companies, Seaspan (SSW) and Global Ship Lease (GSL), and our aircraft leasing company FLY Leasing (FLY). Recall that we discussed 1-800-Flowers.com, Seaspan, and Weight Watchers in our January video, Which Way from Here, where we also talked about the economy, the market, and psychology. We still like these long ideas and believe they're offered by the market by meaningful discounts to fair value.
  • First, 1-800-Flowers.com is offered at an approximate 20% free cash flow yield to current buyers. Yes, consumer spending remains constrained, but from an owner's standpoint, this is an incredible bargain for an increasingly diversified business that is seeing stabilizing fundamentals and should enable excess cash to consistently build on the balance sheet.
  • Second,we've substantially covered Seaspan and the shipping sector in recent posts. Bottom-line: despite persistent economic fears, global trade is recovering swiftly and Seaspan's real estate like business model is performing as expected. Like PetMed Express, Seaspan also raised it's quarterly dividend by 25% just last week and we see potential for further hikes in the next two years.
  • Finally, Weight Watchers continues to be offered at an approximate 10% earnings yield, far better than paltry bond yields and attractive for a market leading company with fantastic brand awareness and juicy margins.
In addition, over the past six months, we've also committed capital to new ideas, including: snack company Lance Inc. (LNCE) and Central/South American discount club company PriceSmart (PSMT). However, both names have since moved higher and valuations are now more full. If we had more time, we would have previously shared. Apologies for being a bit tardy. We may share more color in future posts.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long SOFO, GSL, SSW, EBAY, FLWS, WTW, FLY, LNCE, PSMT.

© 2010 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer