Sunday, December 30, 2007

OEH - Shorting Based on Unwarranted Speculation

Orient Express Hotels (OEH) is a geographically diversified luxury hotel operator that has traded up mostly on unwarranted speculation of a buyout. At the same time, the market has conveniently ignored disappointing operating performance in the core hotel business, its risky exposure to the international "2nd-home / investment property" market, and a variety of macro trends that, going forward, are likely to make it difficult for the company to meet analysts' expectations for growth. At these levels, I believe OEH presents an attractive short opportunity, with limited downside of 10-15%, and upwards of 30-40% upside if buyout speculation abates and the company receives a valuation more in line with peers and its near-term growth prospects.

Buyout Speculation
Buyout speculation has surrounded Orient Express for the good part of this year, despite managements fairly clear intent to have no interest in selling the company, and the skewed class share structure that gives management over 80% of voting rights. Buyout speculation began with a UK article in late March, and has been further amped by a failed buyout offer by Dubai holdings ($60), and more recently increased overtures by Taj. Management has rebuked both these suitors, and has stated clearly, on multiple occasions, that they intend to operate as an independent entity. Given the voting structure and the very blunt intentions of management, I view a buyout as highly improbable.

Valuation & Stock Performance
OEH trades at the richest multiple of any publicly traded lodging company with a primarily developed market clientèle, and is valued at over twice comparable companies based on common valuation methods. Based on 2007 estimates, OEH is trading at a P/E of 53, and an EV/EBIDTA of over 20. Comparable companies are trading at P/Es of 20x, and EV/EBIDTA of about 10x.

These valuations aren't warranted by OEH's growth rate, and they aren't warranted on a historical basis, either. Below are OEH historical multiples, which suggest that OEH is overvalued anywhere from 40-60% at current levels:

2003 2004 2005 2006 2007 (close)
EV/Revenue 3.1 3.4 4.1 4.9 5.5
EV/EBIDTA 13.9 16.3 18.8 19.9 20.0
P/E 19.6 23.8 29.6 39.7 53.o
P/B 1.1 1.2 1.9 2.4 3.6

Largely because of this multiple expansion (driven by acquisition speculation), OEH has outperformed the lodging sector this year, and has been largely immune to consumer slowdown fears. OEH is up over 20% YTD, while nearly every other competitor is down on the year at least 10%.

Economic Headwinds
Despite how the stock has held up amidst consumer slowdown fears, I believe OEH is actually more likely to be significantly impacted by current macro trends than many of its competitors. Headwinds include:

1) Focus on the consumer
Unlike many of its larger competitors, the majority of its revenue comes from high-end leisure travelers (2/3rds) vs. business travelers (1/3rd). Many larger companies (that have traded down substantially this year), have an opposite mix, with the larger cap names in particularly relying on business travelers for over 80% of their profits. OEH's mix of customers is about 50% US, 33% Europe, and 17% Rest of World. While this compares favorably to other large cap chains, the company still relies on the US for the bulk of its business. Eventually, these fears should begin to be priced into the stock, and eventually begin to show in the operating results.

2) Real Estate Development
In order to monetize some of its land, OEH has spent a good chunk of its capex building out a variety of condominiums, villas, and other resort ownership properties. This was a big trend amongst many of the large lodging companies, and with the slowdown in housing not only in the US, but also in some developed economies abroad, lodging companies are getting stuck with condo and timeshares they can't sell. OEH has the misfortune of having come late to the party, in particularly overbuilt markets (e.g. St. Martin's). OEH has several existing properties it has not yet been able to sell, and has more coming online throughout the rest of the decade that it could very well have trouble recouping its costs on or holding onto for much longer than expected. Currently, the market is largely ignoring this exposure, though other stocks (notably Starwood) have been hit hard based on their failed real estate ventures. Although real estate sales are only expected to account for about 15% of EBIDTA next year, they are expected to contribute to the majority of growth in year over year EBIDTA. If sales come in below expectations, overall growth at OEH will once again be lackluster. This also gives me confidence in their being relatively low downside to this short, barring increased multiple expansion (which frankly seems nearly impossible).

3) Slowing Acquisition Market
These past two years have been almost unprecedented in their acquisition furry. Acquisition fever has abated some in the US, but has increasingly been replaced with foreign money looking to buy cheap US assets. All of OEH's suitors are from still searing emerging market companies, which should eventually become more rationale when their own red hot growth begins to slow, or as some high profile foreign investors get burned on their US purchases. Regardless, unless management does an about face on their go-it-alone stance, OEH will not be acquired. Once the acquisition hoopla finally abates, OEH should be revalued accordingly.

OEH represents an attractive short with a very favorable risk/reward. Though part of the thesis here relies on continued macro-economic slowdown, I would expect the thesis to play out nearly as well as long as acquisition speculation finally dies down. Since many of my shorts are predicated on a macro thesis which may not come to pass, I believe OEH is an attractive addition to my short book in that it is likely to drop regardless of what happens with the economy. Another way to play this could be to do a pair trade with one of the more undervalued names, though I prefer getting the sector exposure here.

Note: Author is short OEH

Wednesday, December 26, 2007

Jarden Earnings Set to Implode?

Jarden (JAH) is by no means a new, or unique short idea. Jim Chanos has been talking about this stock for years (often through his mouthpiece, Herb Greenberg). More recently, Amit Chokshi has done some good work on Jarden here. I recommend both those articles as a good starting point for those unfamiliar with JAH. I agree with them that, though Jarden has already fallen a good deal, there is room to go and that catalysts are likely to be coming as soon as next quarter. Given the state of the balance sheet, the end of easy credit, the nature of how Jarden's discretionary products would likely fair in a recession, and JAH's extreme leverage, even a small deterioration in the business could result in greatly reduced earnings and, in more extreme circumstances, the possibility of a dilutitive equity raise and, depending on the loan covenants, the possibility of bankruptcy. The bulk of this article will focus on issues that have not been covered in past publicly available write-ups, or go into more detail on issues that have, so I hope it will be useful to those both new and familiar with the story.

The argument for a Jarden short is very simple: Jarden is a highly leveraged consumer products company at the peak of an economic cycle. Furthermore, it's performance has been artificially inflated by a series of acquisitions which gave the illuision of growth and operational improvement. In reality, Jarden owns a collection of cyclical business for which it paid too much. The company has no means to make anymore meaningful acquisitions. As the economic cycle turns, and as the effect of Jarden's most recent acquisitions wears off, it should become clear that Jarden is unlikely to deliver on its promises of higher margins, and that it is likely to experience a double whamy of deceasing revenue and declining margins in the next year. Given its high leverage, even a small degree of deterioration in the underlying business will have a big impact on net income.

The End of Easy Credit
Jarden was built on the prospect of easy credit, which allowed them to leverage themselves as an LBO would to purchase a variety of consumer products companies. The company had been so active in purchasing companies over the last few years that it has been very difficult to separate the growth and performance of the Jarden on businesses vs. the growth attributable to acquisitions. The acquisitions and charges are so frequent that the company reports all its numbers as adjusted earnings and EBIDTA, which strip out a variety of "one time charges." Jarden has not made the analysis very easy either, refusing to disclose pro-forma financial, and (as I will argue below) releasing misleading pro-forma numbers when it does. As Jarden's
acquisition binge has been forced to cease recently, we can for the first time begin to get a good sense of how these businesses are performing. And the picture that emerges is bleak.

The Questionable Timing of Jarden's Latest Acquisitions

As I dug into the story, I was surprised that I have found no mentions of a blatantly simple sign of manipulation and acquisition inflated earnings growth on Jarden's part: namely, that JAH's
last two acquisitions were purchased in the quarters in which those businesses show greatest seasonal strength, allowing JAH to book its acquisition's quarterly earnings as its own earnings. I think it is likely that these acquisitions were made to show misleading profit growth, and to mask the deterioration of Jarden's other businesses.

In Q2, the company acquired Pure Fishing, a leading supplier of fishing supplies. The deal closed early in April, which is the beginning of Q2. Coincidentally Q2 is also the peak quarter for earnings and revenue for marine and fishing supply companies. One comp I found booked nearly 95% of its EBIT (Earnings before interest and taxes) and 34% of its revenue in Q2. Another (K2's marine division, with a comparable product mix to Pure Fishing), booked 32% of its revenue and 43% of its EBIT in Q2. By closing the acquisition of Pure Fishing at the beginning of the 2nd quarter, JAH was able to pad its earnings by including Pure Fishing's most profitable quarter in its financials. Their decision not to release Pro Forma numbers further aided this concealment.

Jarden's Q3 Sleight of Hand
A couple after the Pure Fishing Acqusition, in late April, JAH announced a pricey acquisition of K2. The deal was expected to close in early July (the beginning of JAH's Q3). Coincidentally, Q3 in 06' accounted for 45% of K2's EBIT (though only 26% of its revenue). Once again, JAH
found itself purchasing a business at a time that conveniently allowed JAH to book it's its acquired company's strongest quarter as its own. Unfortunately, the deal took a bit longer than expected to close, and ended up closing August 8th, over a 1/3rd through Q3. Analysts lowered expectations based on the closing date, figuring Jarden would miss out on some of K2's juicy Q3 profits. They were surprised, then, when JAH reported a stellar Q3, reporting adjusted EBIT of $60.7M in its outdoor segment (under which K2 is included).

Jim Chanos accused JAH of "springloading" its Q3 acquisition by essentially having K2 manipulate its earnings before being acquired so it would show stronger profits when integrated into JAH. Though I am not sure exactly what method JAH and K2 used to inflate Q3, I believe the evidence points strongly to something very fishy going on. Let's take a look at the math:

JAH's EBIT in Q3 is composed of its EBIT from the K2 acquisition, Pure Fishing, and JAH's
outdoor segment before both those acquisitions. Based on comps and details released about Pure Fishing at acquisition (I can explain the math in comments if anyone is interested), Pure Fishing likely did about $5.2M in EBIT contribution to Q3. The math is more simple for JAH outdoor pre-acquisition: this segment did $13.7M in Q3 06', and we know that in Q1 (in which there we no acquisitions messing up numbers) EBIT grew 4%. I estimate it actually declined in Q2, but lets be generous and assume 4% EBIT growth YoY, which would give us an EBIT of $14.2 for this segment. So, using some simple algebra (60.7-5.2-14.2, we can assume that K2 must have posted $41.3M in EBIT in the less than 2 months it was a part of JAH.

But, looking at their numbers last year, it's easy to see that this is impossible. K2 generated $38.7 in all of Q3 and, assuming a growth rate in line with Q1, that'd only get us to an EBIT of $42.7M for all Q3 07'. Keep in mind this is an extremely generous assumption, given the extent to which macro-economic conditions have deteriorated since then. Adjusting for the fact that K2 was only part of Jarden for 54 of 92 days in Q3, that give us an expected EBIT of only $25M vs. the $41.3M implied by the performance of JAH's other businesses.

Where did that extra $16M come from? This is not a rounding error (it's over 25% of the reported EBIT in that segment!). Even if you give Pure Fishing a bit more EBIT, and give K2 a bit of a benefit for August and September being stronger than July, you still get nowhere close on this one. The numbers just don't add up, and it calls into question not only the credibility of management and the accuracy of their reporting, but also the company's ability to meet analyst estimates without the benefit of acquisition accounting shenanigans.

Jarden's Misleading Pro-forma accounting
In Q3, the company released consolidated pro-forma results for Jarden and K2 to help show what the results of the combined company would have been on a year over year basis. These results don't include any of management's rosey adjusted numbers, and instead show a company with declining profitability and slow revenue growth. Though these numbers are bleak enough on their own right, it's worth noting that this picture neglects to adjust for the acquisition of Pure Fishing, making the numbers appear even better than they are. Adjusting for the Pure Fishing acquisition, this becomes a no-growth story:

2007 Q3 2006 Q3 Growth
Rev as reported 1442.7 1390 3.8%
Adj for Pure Fishing 1,390.4 1390 0.0%

2007 9 months 2006 9 months Growth
Rev as reported 4001.8 3792.9 5.5%
Adj for Pure Fishing 3,852.7 3792.9 1.6%

The performance of Jarden's Other Business Units
Management has sold the JAH story as a rollup that will generate operational improvement through synergy, scale, and other buzzwords that are easy to say but harder to deliver. Until now, these numbers have not mattered much, as cheap debt and continued acquisitions have allowed JAH to show growth on a consolidated basis. With the acquisition valve off for the foreseeable future, JAH is going to have to grow its earnings through good old fashioned operational improvement, in an increasingly difficult macro environment (declining consumer spending, rising input costs). So, how have these business fared in the hands of the operational experts at JAH, with their scale advantages and synergies? Not very well at all, especially recently.
Note: Numbers based on 2007e mix.

Consumer Solutions (40% of Sales, 45% of Adjusted EBIT)
This segment includes a hodge podge of value household products that are likely to be tied largely to discretionary consumer. If you believe the shopping trends coming out of Target, this segment looks due for a hit in Q4. Prior to the recent consumer slowdown, this segment grew sales a whopping 2% in Q1 and Q2, though EBIT admittedly fared much better, growing 41% and 17% respectively. But as macro headwinds have emerged, trends appear headed the opposite direction. In Q3, sales were flat, and Adjusted EBIT dropped 7% YoY. Analysts, in their unbridled optimism, continue to expect low single digit, positive growth.

Branded Consumables (17% of sales, 17% of Adjusted EBIT)
Branded consumables is a random assortment of items, including
"arts and crafts paint brushes, children’s card games, clothespins, collectible tins, firelogs and firestarters, home safety equipment, home canning jars, jar closures, kitchen matches, other craft items, plastic cutlery, playing cards and accessories, rope, cord and twine, storage and workshop accessories, toothpicks and other accessories. " I must admit my ignorance to the lucrative collectible tins and jar closures markets, but according to the financials this segment has been hard hit in Q2 and Q3 revenue dropped 6% and 4% respectively. EBIT dropped 15% and 20% YoY.

JAH Outdoor, excluding acquisitions (23% of sales, 18% of EBIT in 2006)
Though the year numbers in Q2 and Q3 look stellar, thanks to acquisitions, the underlying business pre-acquisitions has been eroding by my estimates, especially as of late (it's weakness has been concealed, conveniently, by the recent acquisitions). We know in Q1 that Revenue declined 7% while EBIT increased 4% . I estimate that the top-line has continued to decline in outdoor in the high single digits, and its only a matter of time before this shows up in profitability decline (if it hasn't already).

It seems as though many of the issues which shorts have complained about for years with this name are finally coming to light. If the consumer does slow down considerably, I expect all of JAH's business lines to be hit, and unless JAH can invent some new creative accounting (which, I admit, is a real risk to a short thesis here), the company could be facing some serious trouble. As the story unravels over the next year, I expect analysts estimates of low single digit growth, and continued operating margin improvement to reverse itself, providing several nice short term catalysts for continued downward pressure on the stock price.

Note: Author is short JAH

Sunday, December 23, 2007

RC Group: Growth on Sale

At 6x last twelve months earnings, and with top-line growth in the latest reported period of 71%, you'd expect RC Group to have some serious hair on it. The only major issue--which isn't even a company related issue but a stock one, has to be one of the odder (and more unfounded reasons) I've seen a stock drop. Fortunately, at least from what I've been able to uncover, there aren't any operating issues here--except perhaps for the long-term risk that the company experiences increased competitors and margin compression, signs of which have not yet occured. I believe the stock's decline has been unwarranted, and that if this stock gets ascribed anything approaching emerging market valuations, or merely a reasonable valuation, the stock could go up several fold.

RC Group is an exciting high-tech/emerging market growth story in the biometrics and RFID space. It trades on the AIM exchange (UK), though it also likely has a pink sheets equivalent somewhere in the US. RCG has focused primarily on Southeast Asia, but recently has begun seeing substantial revenue growth from the Middle East and China. They also recently signed a distribution agreement in the US, which hopefully will begin to bear fruit sometime next year. It's worth noting that the company's two prior entries into new markets (the Middle East and China) have both been very successful.

In addition to the organic growth (181% in FY06!), the company has also been rolling up complementary businesses. It's been targeting acquisitions in the 8x-12x range, mostly in emerging markets, and has recently been priced out of many attractive opportunities. Rather than continue to acquire at all costs, the company has put the brakes on its acquisition strategy, an uncommonly prudent move for a high growth story. Because of its most recent equity raise at prices about twice current levels, the company has nearly a 1/3rd of its value in cash, making the ex-cash P/E an absurd 4x trailing earnings.

Frankly, anytime I've seen a company with this combination of value, growth, and story, it has almost always turned out to be a scam. But many of the hallmark issues that signal red flags just aren't there:

1) Stock option issuance has been generous, but by no means grossly excessive (about 3% of outstanding shares issued as options per year).
2) Accounts receivables and inventory growth is very reasonable given the revenue growth. The company is actually turning its earnings into cash, maybe not at as fast a rate as analyst would like, but it is happening.
3) There are no reported related party transactions or egregious insider sales. The CEO owns 7.8% of the company, though no other management owns a sizable amount.
4) They're a little bit more dilution happy than I would like, but I've seen much worse. With the cash on hand and the still unfavorable acquisition environment, I doubt we'll see much more in the way of dilution soon.
5) One matter I find somewhat suspect is the background of management. The CEO and Chairman of the Board appears to have almost no tech experience; he worked in property and corporate finance most of his life. In this interview he briefly alludes to his rationalization for his experience, which basically is that he spotted the potential in the market and figured as a non-tech guy he could make dispassionate decisions. The COO, who seems even less qualified (her experience has been working as a research manager at a surveying company, and a marketing manager at a real estate agency). That said, management is very communicative with investors and generally non-promotional, both of which usually are positive signs.
6) The company will likely face margin pressure over time. That said, at these prices and given its growth potential, those risks are more than priced in.

Furthermore, the company actually did, at one point, have a more reasonable valuation. In March, when they did their latest equity raise, the company was valued at a trailing P/E of about 13 (which is still cheap for such a fast grower). The company would be nearly three times its current price if it was awarded that valuation again today.

So, what has changed?

On April 3rd, RCG had just completed an equity offering, and was coming off an incredible year. That same day, a seemingly unrelated event would have a big impact on the share price. Chinachem announced that its owner and "chairlady" Nina Wang had passed away. This wouldn't have mattered to RCG's stock, if not for the fact that Nina owned controlling interest in Veron International, which holds 27.6% of RCG. Over the next three weeks, as investors connected the dots, the stock sold off from 137 to 104 pence, on fears that whoever inherits the fortune will go ahead and sell their shares, providing a huge overhang. On April 24th, the company addressed this issue in a press release. Since then, the stock price has continued to trend down, and my educated guess here is that many of the ra-ra emerging market managers have shunned the name due to fears of short-term selling pressure. In an emerging market environment where everything (until recently) has been going up, and return expectations are absurd, why wait out a name with short term issues?

Also, if Nina Wang's own legal battle to inherit her husband's fortune is any indication, its likely that an award of the assets could drag on for years (it's been nine months thus far, and still no resolution). Wikipedia actually has a fascinating entry on Nina Wang and the issue here. The man who claims to be the beneficiary of the fortune is Tony Chan, who was Nina Wang's fortune teller and fung shui master. Multiple articles have cited him as being most likely to inherit Ms. Wang's fortune, though her family is understandably gearing up for a legal battle to challenge it. Oddly enough, Tony Chan is the brother of Bobby Chan, a passive co-founder of RCG who himself owns a 20%+ stake in the company. Not only do I think that the overhang concerns are overblown, but its very possible that given the family and personal connections, Tony Chan won't even sell the shares (if he is even the one who ends up with them).

The Bottom Line
Though there are some legitimate margin compression concerns and a revenue model that currently lacks a recurring revenue stream, at these prices the risk/reward appears to be incredibly attractive. If RCG's operating performance continues at its torrid pace, or even just continues to grow at a 15% clip, I can't see how the stock can remained at these depressed levels for long. The market also was recently spooked by flat sequential growth, which should reverse itself in Q2, as the company benefits from year-end weighted seasonality of this business.

In terms of catalysts in the near term, outside of continued operating performance, I think the stock could trade up meaningfully at the release of year end earnings (slated for end of February). RCG's latest trading update pointed to another stellar performance. It's also worth noting that RCG has historically traded up noticeably on both trading updates and announcements of interim and year end results. Below you'll find a glimpse of the price appreciation that occurred in all announcements this year, based on the price one week prior to the announcement, and the price 1 day afterwards.

Date Event 1 week prior 1 day after 8 day return (%)
15-Jan Trading Update 93.25 105.50 13.1%
12-Mar FYE Results 109.75 145.00 32.1%
31-May Trading Update 106.00 116.00 9.4%
16-Jul Trading Update 97.00 99.95 3.0%
11-Dec Trading Update 74.75 90.00 20.4%

I normally don't do much short term trading, but with trends like that and the valuation being what it is, I may very well take my chances. I have some more work to do here, but assuming their are no land mines , this has got to be one of the best risk/rewards I have seen in a long time.

Tuesday, December 18, 2007

KFY, MNST, HSII: Recession Risk Not Priced In

The more work I do on staffing stocks tied closely to the economic cycle, the more I continue to believe that the market--despite giving lip-service to cyclical concerns, has not actually taken a look at how badly things really get for these companies when the economy heads downhill. The only analyst report I found that even took a cursory look at KFY and HSII's financials prior to 2003 was CSFB. And is it surprising, then, that they were also the only company I could find that had conveniently not included FY09 or FY10 revenue estimates?

Nearly every analyst cites cyclical concerns in these names, but none of the ones I could find actually models a true recession scenario. Even Goldman, which has probably been the most bearish of all analysts on the permanent staffing companies, does not model anything close to a recession scenario. Let's take a look at implied revenue growth estimates for KFY:

Analysts' compounded annual growth rate estimates (ML, GS, & Davenport), were derived from their latest FY09 or FY10 revenue estimates. Note that these estimates are noticeably higher than the historical CAGR (CAGR from FY01 to FY08 Q2, a full economic cycle), and much higher than the revenue CAGR KFY experienced from the peak of the last economic cycle (a -28.4% (!) CAGR from FY01 to FY03). Though KFY has more favorable industry exposure this time around, they'll still run into some serious trouble if we head into recession. Analyst estimates aren't just off base--they are nowhere in the ballpark.

How about HSII? Analysts have been much more critical of them, and in their latest quarter they've already shown a slowdown in bookings. Also, their industry exposure (34% financial, 19% consumer) is much more exposed to areas that are likely to see significant slowdowns). Surely, estimates are more in line with past recession scenarios, right?

Once again, not even close. Even Goldman, which has a sell rating on the stock and has stated they have serious cyclical concerns for HSII does not price in anything like a recession scenario (they call for revenues to dip in FY08, with growth resuming in FY09).

Lastly, let's take a look at growth story MNST which, many people do not realize, is actually a very cyclical stock.

Once again, analysts (all of them) are way above the mark. Not to pick again on Goldman, but I find it particularly funny the analyst most seemingly concerned with cyclical issues here (Goldman), actually has the highest 2 year revenue CAGR estimate of any analyst I looked it. Even in the last recession, when MNST was a high profile growth story in North America, they saw their core MNST careers revenue drop by 12.1% annualized over 2 years. I estimate that in a similar recession, MNST could see a 2 year revenue cagr of -12.7%, to as high as -19% depending on assumptions. MNST's North America division, even in a more favorable economic backdrop, has struggled to grow, recording mostly single digit YoY revenue growth this year. This time around, with increased competition and a more mature market, I expect that North America will see revenue decreases in line with KFY and MNST (I model a -25% CAGR). I assume flat growth internationally and in their ads business in a recession due to us being earlier in the maturation cycle in many of those markets. That said, if we were to go ahead and assume declines in those markets on par with what MNST experienced in the last recession (which I believe is somewhat probable, especially given the large % of international revenue from developed markets), we'd see a total revenue cagr of -19%. If either recession scenario plays itself out, the stock would be absolutely crushed, as it was in the last recession.

What does it all mean?

Analysts and investors are forgetting how bad things get for these companies when the economy slows down. Comforted by seemingly low P/E multiples (on peak earnings), rosy management guidance, share buybacks, and other sleights of hand that will eventually be shown for what they are, I believe these three stocks will be some of the worst performing investments of the next 2-3 years (before they once again become become on of the best investments at the bottom of the cycle). These companies will eventually post large revenue declines, huge charges, and margin compression; everyone will act surprised, despite the evidence of what happens in poor economic scenarios being right in front of them all along. If the economy does indeed head into a recession, all three stocks will suffer greatly.

Note: Author is short KFY, HSII, and MNST. Author made best efforts to present data accurately, though mistakes may exist. Do your own DD. This should not be construed as advice to buy or sell shares.

Monday, December 17, 2007

Profit from a busted Chinese IPO

Noah Education (NED) is a high growth Chinese company in an attractive market, trading at value prices. With nearly half their stock price in cash ($3.65/share), the company is trading at an ex-cash trailing P/E of 12. Though some short term risks exists, I believe NED offers an incredibly attractive risk/reward here, and a surprisingly affordable relative and absolute value for a Chinese company.

Company Overview
NED IPOed in October, selling 9.8M shares for $14/share. Please note that the proceeds from the IPO (~$130M) are not reflected in the most recent financial statements, which are for the quarter ended September.

NED primarily produces learning devices and content for children aged 5-19. The companies' primary product, their DLD (~80% of revenues), is a handled device preloaded with over 30,000 courses on a variety of subjects. Though there are competitors, NED is the current leader in the space, and their product is generally considered superior to competitor's products. There are about 233M school children in NED's target. With total DLD sales to date estimated at 6mm, there is plenty of potential for increased penetration as prices eventually come down. Current estimates call for DLD unit growth of 20% annually through 2009.

The company also sells an e-dictionary product (~20% of revenue) which has become commoditized and should not be a significant driver of profits going forward.

Though the majority of NED's revenue currently comes from the DLD device itself, it's worth noting that NED is building an extremely valuable library of learning content that, to date, it is mostly monetizing through its DLDs. NED's content was largely compiled by a network of over 250 teachers, and has received strong endorsement from the Chinese government, as well as from users. The company plans to continue to build on and monetize this content in the future through other channels (e.g. the web, cell phones, etc.).

The companies' main growth initiative is its focus on building out after school tutoring centers, targeting school children in the 5-19 year old range. The largest provider of tutoring services, New Oriental (EDU), tends to target a slightly older audience, from senior secondary students to adults. Noah is in a fantastic position to leverage its strong brand and to potentially become a dominant player in the space. This market has attracted lots of attention due to EDU's success, but I think NED's strong brand and existing content should give them a leg up on the emerging competition. This is also an incredibly large market, and there should be plenty of room for multiple large players. NED will also benefit from enormous cross-marketing opportunities. They are in a great position to drive current DLD users to their tutoring centers, and to promote their DLDs to their tutoring customers.

It's also worth emphasizing just how important education is in Chinese households. The Chinese education system is incredibly competitive, and success in school, as well as English language skills, are incredibly important to career success. Due to China's 1 child policy, parents will often invest heavily in their children's education to ensure that their children have the best opportunity to get ahead as possible. NED is a great way to play the rapidly growing income of Chinese families, as its revenue going forward should be highly levered to the prosperity of the Chinese consumer.

So, how did this get so cheap? The company received a lot of negative press after one of its manufacturer's forgot to put a warning label on one of its products. Though this was in actuality not a big deal, the local media overblew the situation, and NED received a lot of bad press. The company has increased its marketing and taken efforts to restore its brand, but it is likely that--at least in the short term--the companies' reputation has been damaged. The news wiped out roughly 60% of NED's enterprise value, which I believe was a strong over-reaction. That said, it is possible that the negative press damages sales going forward, even beyond the next quarter or two.

An additional risk is pricing pressure and eventual commoditization of DLDs. Though the products are currently differentiated significantly, it is possible that NED will lose its edge as its competitors build out their own proprietary content. I think this is a long-term risk, but given strong pricing trends and NED's recent market share gains, this issue seems like it still may be some time away.

Adjusting for cash, NED trades at a P/E of only 12, with incredible growth prospects both in its interactive education content and tutoring business. It's worth noting that the market places a much higher value on tutoring and online education services than it does device manufacturers. EDU has a trailing P/E of 70; though I think that we'll see that come down eventually, I would do think a 25-30 P/E could be reasonable on NED's earnings from its tutoring business when it starts generating significant income. At today's prices, you are getting the interactive education business, which is anticipated to grow 20-30% annually for the foreseeable, at bargain prices, not to mention a free call option on what could be a highly profitable tutoring and education content business, which could allow for multiple expansion as NED transitions from a device company to an education company. With $3.65 in cash providing a nice downward cushion, I believe NED offers an incredibly attractive risk/reward opportunity, especially for a Chinese stock. Though I have no specific price target, I could easilly see this being a multi-bagger of the next few years if the tutoring initiative is successful, and if NED reaches the lofty valuation multiples achieved by education companies in the US or China.

Note: Author is long NED.

Sunday, December 16, 2007

Update on KFY & MPG

Given that both these stocks have moved against me in recent weeks, I thought I would post an update. I previously gave arguments for a short position on both stocks, and each has rallied on short term positive news: KFY had an excellent quarter, and maintained better then expected guidance. MPG announced it looking to put itself up for sale (again), which was one of the main risks I'd mentioned in my short thesis. So, what does this news mean for each company? See my prior write-ups on KFY and MPG.

In KFY's case, I consider short term earnings to be largely irrelevant, except for that they generate a bit more cash for a quarter or two. My thesis remains clear: if hiring in the US slows down, KFY's will business will deteriorate, as it has it in the past. That said, I should note that there are reasons to believe that this downturn may not be quite as bad as in years past. KFY's sector exposure is buoyed by a healthy basic materials and other significant non-cyclical focus, which could potentially help them weather a storm a bit more. In retrospect, I likely should maybe have focused more on HSII, which has over 50% of it's business attributable to Financial services and consumer cyclical industries. I'll be taking a look at them more in the coming weeks. That said, though my KFY thesis has been taking longer to play out then expected, I still believe we will see their earnings erode meaningfully from current levels over the coming quarters as the credit mess spreads to other parts of the economy.

MPG ran up significantly on news that it may be acquired. When they went through a similar process in late 2006, the company had multiple offers in the $35-40 range which they turned down. Fast forward one year, and the market for selling is noticeably worse. MPG has been unable to sell two of their smaller properties that they have hoped to divest due to volatility in the capital markets (read: no buyers offering a price they like). Analysts have continued to use go-go cap rates in the 5-5.5% range, vs. historical rates of 7-8%. With the credit market having fallen apart, recessions beginning in both LA and Orange County, declining occupancy rates, and a distressed seller with some serious balance sheet issues, how favorable can we really expect the sales process to be for MPG? Some analysts, as well as MPG management, claims they are cheap on a square foot basis; though that may be true, they are going to have a mess of a time unlocking value by raising rents or improving occupancy for the foreseeable future given market conditions.

With almost everyone predicting lower prices next year as cap rates rise and occupancy continues to decline, what buyer would be willing to buy now? Why not wait? We're also talking about a significant amount of capital here, depending on how the deal is structured: a buyer would need to put up over a billion in capital and, given how much debt MPG already has (too much), I doubt there is any way you could lever this transaction more than it already is levered. And what kind of REIT is going to want to add anothert $5 billion in debt to their balance sheet? And whose jittery investors will want to learn that their company just purchased a large vat of commercial real estate in two of the worst markets? MPG is essentially a levered play on southern California commercial real estate. Who on earth wants to own the equity portion of that deal?

Given market conditions, I just don't see MPG being taken out and, if they are taken out, I can't imagine anyone paying much north of $30/share, which limits downside at these levels in a short to about 10%. On the upside to a short, if MPG is unable to sell they would likely get hit hard, as this would suggest that the market is valuing their assets significantly below analysts' and the own companies NAV assumptions. You'd also see a lot of hot money that has been holding out for a sale flee once again. As the commercial real estate market continues to decline and cap rates return to more normalized historical levels, it is also entirely possible that MPG's NAV is totally wiped out, as total equity value dips below total debt.

The only way MPG will sell is if they can find a greater fool. And, unfortunately for them, many of the greater fools are going out of business, or quickly wising up. If MPG is left holding the bag on this one, the debt holders may very well own this company.

Note: Author is short KFY and MPG.

Thursday, November 22, 2007

Crisis Looming at Maguire Properties?

Continuing my series on looking for stocks likely to suffer from macro themes, I've recently been doing some work on REITs. I have been short RWR since early in 2007, a play that has finally started to pay off, but was hesitant to choose individual companies due to my lack of ability to distinguish one REIT from another. As I write this now, I still am far from an expert, but believe I have a better understanding of the underlying REIT dynamics due to work I've done educating myself these last couple months, and am confident enough that I plan to begin to make some specific REIT bets. With that disclaimer out of the way, lets dig in.

In my search for potential shorts, I have focused on two main qualities:

1) High leverage (Debt/Equity)
2) Exposure to local economies most likely to be hard hit due to recent macro issues (e.g. Florida, Southern California)

REIT companies with exposure to hard hit aspects of the economy are likely to struggle with lower rents, high vacancy rates, and other issues that should reduce their NOI (Net operating Income). The more a REIT is leveraged, the more macro issues are unlikely to affect their bottom line and the quality of their balance sheet. In some cases, such as Maguire (MPG), it seems as though these issues could very well affect their solvency.

Maguire Properties Overview
Maguire Properties is a highly-levered commercial real estate REIT with properties concentrated in Southern California. The general thesis here is that it is looking increasingly likely that MPG will either be forced to cut their dividend, to continue to liquidate existing properties, issue a dilutitive equity offering (if they can get anyone to buy it), or sell the company. The company needs a friendly debt market to continue operating as it is, paying a dividend and continuing developement of its projects. I believe the most likely outcome is sale of the company, either by choice if they do it soon, or by mandate if they don't. At these prices, I think the downside of a short is limited at NAV, and the upside could be 30-80% depending on how quickly and how much the MPG's assets erode in value.

MPG has some serious balance sheet issues. Let's take an abbreviated look at some key numbers for MPG (numbers in million):
Market Cap: $1,212
Net Debt: $4,817
Enterprise Value: $6,029

Total Equity (including Depreciation): $6,353
Total Debt: $5,492
Debt/Equity: 86%

The big issue here--outside of the enormous interest payments and consistent reliance on borrowings to fund the dividend and operations--is that a relatively small impairment of the equity (in this case, about 14% at book) would entirely wipe out the equity.

The above is a proxy value for the equity based at book (cost). But in reality the value of the equity is always shifting. Here's where things get interesting--analysts are mostly sour on the stock, due to macro issues, poor operating performance, and leverage. Most analysts, however, still see downside protection in the NAV, which most peg at ~$30/share. Management rejected an offer in late 2006 at between $42-44/share, and reportedly tried to engineer a buyout of the company at $60. Though there are several ways to value NAV, the most accepted analysis is the Net Operating Income of the properties divided by the cap rate, which is the discount rate applied to the operating income to get a total value of the cash flows. Then you subtract the debt, and divide by the total outstanding shares to get the NAV/share of the equity. Let's take a look at historical cap rates:

Keep in mind that lower cap rates mean a higher implied NAV value. Cap rates were recently at historical lows, due to higher expectations for underlying asset appreciation, lower cost of borrowing, and the availability of more leverage, all of which made the actual performance of the property as an income producing asset relatively less important. These conditions, which existed as recently as a few weeks ago, are gone, and it does not look like they are coming back. In an increasing cap rate environment, that equity cushion is easily wiped out. What happens if cap rates rise to anything approaching historical levels? Below is an analysis of what happens to NAV when you change the cap rate assumptions (assuming NOI of $324M & value of other assets of $1,602M):
Cap Rate NAV/share
5% $44.54
5.25% $38.89
5.50% $33.75
5.75% $29.06
6.00% $24.76
6.25% $20.81
6.50% $17.15
6.75% $13.77
7.00% $10.63
7.25% $7.71
7.50% $4.98
7.75% $2.43
8.00% $0.04

At a cap rate of about 8% (well within historical norms, especially in tough real estate markets), the equity gets wiped out. Perhaps noticing these trends, several activist investors have recently gotten involved to try to force a sale of the company while cap rates are still somewhat favorable. It remains to be seen to what degree they will be successful, and what cap rate they can negotiate on a transaction. With the uncertainty in the market right now, California's poor economic outlook, and MPG's poor capital position, I would peg the odds of a deal as relatively small.

I value the upside potential in a short by taking a look at four scenarios, which basically involved valuing the company at 4 different cap rates and assuming an eventual sale of the company @ NAV.

Scenario Activist successful Forced Sale Forced Sale Forced Sale
Probability 20% 30% 30% 20%
Cap Rate 5.75% 6.5% 7.0% 8.0%
NAV @ sale $29.06 $17.15 $10.63 $0.04
Dividends 0 $1.60 $2.40 $3.20
Total Return $29.06 $18.75 $13.03 $3.24
Current Price $25.68 $25.68 $25.68 $25.68
Return -13% 27% 49% 87%
Prob Weighted 5.81 5.63 3.91 0.65

Probability Weighted Return: 38%

With minimal downside risk and strong potential upside, I think the risk/reward here looks rather favorable. Catalysts include increasing cap rates, commercial real estate turmoil, increasing credit spreads and risk aversion, dividend suspension, and decreasing occupancy rates and thus NOI.

Note: Author is not currently short MPG, but likely will be soon. Not a recommendation to buy or sell shares. Numbers herein are accurate to the best of my abilities, but should be double checked. Do you own DD.

Saturday, November 17, 2007

Shorting Staffing Stocks Part 2: MNST

In my prior post, I outlined the logic behind a short in Korn Ferry and how it is likely to see its value erode as unemployment rises and demand for its permanent placement services decline.

In looking for shorts that benefit this macro theme, I have tried to focus on pure-play permanent search companies, notably HSII and KFY, with strong US exposure, as I believe these are the stocks most likely to be punished by an oncoming downturn in hiring.

Another interesting way to play this macro theme is via Monster Worldwide (MNST). Monster faces supply/demand economics as the permanent staffing companies. They derive the bulk of their revenues based on the volume of job listing posted to their site, which very neatly follows generally higher patterns. In the prior downturn, MNST suffered a revenue decline despite us being relatively early in the online medium as a primary channel for hiring. Flash forward to today, and a MNST short heading into the next staffing downturn appears even more attractive--with the online hiring market having matured in the US, it is likely we will see a more magnified downturn in this next cycle.

MNST Overview:
MNST has organized itself in 3 business segments: North American MNST, Internation MNST, and Internet & Ad fees. Below is a breakdown of revenue and operating income as a % of total:

Revenue Breakdown:
2007 YTD
Monster NA 54%
Monster Int 35%
Int & Ad Fees 12%

Operating Income Breakdown:
2007 YTD
Monster NA 81%
Monster Int 13%
Int & Ad Fees 6%

Though MNST has generated 54% of its revenue from its US Monster operations, it generated a whopping 81% of its operating income from its US operations before corporate expenses. Without income from its US operations, it would be running at a loss after account for corporate expenses. Though Monster International and the internet content business may be more meaningful contributors to profit in the long term, they are unlikely to generate substantial profits in the near term, as MNST has made it clear that they are investing heavily in these businesses long-term growth potential at the expense of short term profitability. While this is good for shareholders long term, its impact in the years to come, as the US operations profitability declines, will likely not help the stock's short term performance. These divisions are also eventually likely to suffer from a downturn in the US market.

So, what kind of impact might we see in a difficult hiring environment? In the last downturn, Monster was part of TMP, which has since been spun off. I've done my best to compile the income statement for monster only (for WW):

2001 2002 2003 2004 2005 2006
Revenue $533,830 $402,543 $412,796 $516,371 $708,718 $964,331
Operating Inc $152,623 $24,550 $52,891 $101,936 $163,612 $244,625

Ouch. Operating leverage is great when it's working for you (as seen in the great run Monster has had since the bottoming out of the latest employment market), but it can be awfully painful when things turn sour, as all that revenue that was previously flowing to the bottom line suddenly dries up. It's worth noting that Monster took big restructuring charges in 2002 and 2003 which would make their earnings look prettier on a non-gap basis, but doesn't hide the fact that when the employment market swoons, Monster gets creamed.

I could go ahead and run numbers to try and get a downside estimate, but bottom line is that its much lower than what Monster is learning today. Analysts once again allude broadly to macroeconomic fears but still project increasing EPS and EBIDTA numbers off into perpetuity. When the ugliness once again reveals itself, Monster will get creamed.

Like KFY, Monster has generated some impressive free cashflow over the past couple years, which they, like KFY, are wasting on stock buybacks. Monster trades at about 26x FY07 earnings, which I believe should represent peak earnings for this cycle. As those earnings and multiples contract, the stock should see huge declines similar to what it experienced in 2002. I'd peg trough earnings her as sometime in 2009, when I think the stock will really take it on the chin. The $20 Jan 10' puts could be interesting as a small speculative position as well.

Disclaimer: Author is short MNST. Not a recommendation to buy or sell shares. Do your own due diligence.

Shorting Staffing Stocks Part 1: KFY

My apology for the delay in updates. I hope to do a much better job updating more regularly in the future.

With the recent market turmoil in the financials, I have closed out many of my short positions in the space: most notably ABK and MBI, and have been looking to other, more overvalued sectors to hedge my long positions.

The staffing sector has already taken a hit, but if history is any indication, there could be a lot more room to fall. If you believe we are at the onset of a recession that will eventually manifest itself in a considerably weaker jobs market, then several staffing companies look particularly attractive as a way to profit off the upcoming job market turmoil.

Market Overview:
Not all staffing companies are created equal. There are two primary different types of staffing companies:

1) Permanent search: these companies typically hired on a fee basis to find and screen employees for permanent hire on behalf of other companies. They are typically paid a non-recurring fee based on their success in finding a suitable applicant.
2) Temporary Staffing companies: these companies find and screen employees for temporary jobs, which can range anywhere from weeks to months. The temporary business model is different than the permanent placement model, in that staffing companies usually employ the worker themselves, paying them an hourly rate and billing out the employee at a higher rate to another company. These companies make their money on the spread between what they pay the employees and what they bill them out at.

Staffing is a cyclical industry. When economic times are good, companies do more hiring. Not only do they do more hiring, but they usually have a more difficult time finding quality employees, since unemployment rates are low and demand for qualified employees may outstrip supply. Permanent staffing companies are in particular demand when economic times are good--companies like Korn Ferry are often retained to help companies poach talent from other companies because the supply for qualified employees is so low. In bustling economic times, companies are generally also willing to pay more for these kind of services then in poor economic times. Temporary staffing is cyclical but not as much: in good economic times they benefit from increased staffing needs, but they also tend to hold up moderately well in poor economic times as companies shy away from full-time hires and look more to temporary employees to complete a specific task or project.

In bad economic times, the permanent staffing companies in particular face difficulties. Not only do companies hire less, but the supply/demand dynamic shifts strongly in favor of companies hiring. There are more likely to be more qualified workers, making it easier for the company to hire themselves, or to justify lower fees to the permanent staffing company. This can often result in both lower absolute number of permanent hires, plus lower fees/placement.

Why Korn Ferry
Korn Ferry specializes in high level permanent placement. Their earnings have historically been cyclically tied to trends in hiring and unemployment rate, and there is no reason to believe that this will not continue into the future. In addition to the aforementioned negative impact of a poor hiring environment, staffing companies like Korn Ferry further suffer due to their high fixed cost based on recruiters. Productivity/recruiter usually suffers, making relatively small moves in revenue devastating to the bottom line.

Though apparently reasonably valued, Korn Ferry is trading at peak earnings. A quick glance at the companies stock price between 1999-now will give you a good look at the sort of downside potential inherent when the hiring environment turns. Korn Ferry is a slightly different company than they were previously: they have more international exposure, a stronger balance sheet (becoming less so with share buybacks), and a more favorable cost structure than at the last turn in the cycle. SG&A expenses as a percent of total sales are much less than they were in past cycles, making the risk of big losses as the cycle turns less likely. Let's take a look at KFY in 2001 (peak earnings form last cycle) v. KFY's lastest FY ending April 2007.

FY2001 FY2007
Revenue 651.6 689.2
Gross Profit 231.6 196.8
SG&A 149.7 105.3
D&A 26.9 9.3
EBIT 55.0 82.2

Revenue 100% 100%
GM % 35.5% 28.6%
SG&A % 23.0% 15.3%
D&A % 4.1% 1.3%
EBIT % 8.4% 11.9%

I focus on EBIT rather than Net income to remove the affect of Interest Income and one time gains/losses, and focus on the profitability of the underlying business. Though KFY's SG&A expenses are down, their GM % is also down, mostly likely from increasing competitive pressures in the staffing business. If you adjust for differences in D&A, EBIT margins are only 70 basis points (.7%) from their prior peak. Not too impressive of a structural improvement in the business.

Despite talks of cyclical fears in KFY, analysts are still projecting healthy YoY increases in profits and revenue for the foreseeable future, which I think will be unlikely to materialize. Permanent staffing is, and always will be economically cyclical, and although KFY has made strides in reducing its fixed cost structure and global footprint, subsequent downturns are still inevitable. So, assuming we are once again at peak earnings, what is the downside as KFY transitions to trough earnings over the next couple years? Let's compare FY2001 with FY2003:

FY2000 FY2003 Change
Revenue 651.6 338.5 -48%
Gross Profit 231.6 92.2 -60%
SG&A 149.7 73.1 -51%
D&A 26.9 16.2 -40%
EBIT 55.0 2.9 -95%

Revenue 100% 100% 0%
GM % 35.5% 27.2% -23%
SG&A % 23.0% 21.6% -6%
D&A % 4.1% 4.8% 16%
EBIT % 8.4% 0.9% -90%

Not very pretty, is it? So, assuming we are once again at a cyclical peak, what does the future hold? This time, I'm going to use Last twelve month financials and see what trough earnings might come out to, assuming similar declines:

LTM FY2010 (?)
724.3 434.6
209.0 96.1
112.6 78.2
9.3 9.0
87.1 8.9

100.0% 100.0%
28.9% 22.1%
15.5% 18.0%
1.3% 2.1%
12.0% 2.0%

The above assumes a relatively conservative 40% drop in revenues from peak revenues, a 23% gross margin decline (consistent with that experienced in the last downturn), SG&A expenses rising to 18% (keep in mind company become much more lean during last downturn, and they are unlikely to be able to cut expenses again as much this time around). Under this model, EBIT would drop considerably. On a net income basis, it is likely the company would be flat to slightly positive or negative, depending on interest income and write-downs.

In times of trough earnings, it seems most reasonable to value KFY on a EV/Sales basis given the depressed state of earnings. In the past economic cycle, KFY traded at several points in trough periods at .5 EV/sales ratio. Assuming the same valuation on our hypothetical projection of trough earnings, KFY's enterprise value would be approximately $220M. If recent corporate activities are any indication, KFY is likely to buy its stock on the way down, eroding some the value of its cash. If we assume a 25% erosion to current Cash & ST investments of about $245M, that would leave KFY with a a TEV of $220M+ $200M of Cash and equivalents, yielding a market cap of $420M. With a market cap of $832M currently, that gives us an upside of about 50% in two years on our short.

If you think our economy is headed down the drain, this is a relatively low risk trade. KFY's international exposure in emerging economies is still small, and though their international exposure may lessen the blow some, a huge chunk of their business is still US based. In poor economic times with rising unemployment, it's tough to see KFY's stock performing well, even if it holds up better than expected, given all the negative macro fears and dearth of catalyst likely to be present.

Disclosure: Author is short KFY. Not a recommendation to buy or sell shares. Do your own due diligence.

Thursday, August 2, 2007

MCZ: The ups and downs of an evolving story

It's been a while since I've posted on MCZ. I've been receiving some emails on the stock as its drifted lower, so I thought I'd post a brief update. A few events have happened of note since the latest earnings announcement:
1) Several insiders sold shares around the $1.40 level
2) Announcement of a small faceplate deal
3) More details released on the InAir products
4) No GTA or other major faceplate deal announced

Overall, I have been a bit disappointed with the recent developments. I trimmed my position after the insiders sold, as this has been a typically bearish sign for this stock in particular. Take a look at the insider selling in 2005, and you'll see that management has done a pretty good job timing opportunistic points to sell. I don't think this is a long term bearish signal, but I do believe that it, at the very least, signals some short term pessimism.

Though we did get another small faceplate deal, no major deal has struck (in particular, the GTA deal). With Christmas season inching closer, it is beginning to look like MCZ faceplate line-up is set for Christmas. While the line-up itself is strong, I was hoping for more announcements.

The InAir product sounds great--I like the concept, and I think they have their marketing message down. My only concern is on the price-point. Are people really going to shell out that much money on an unproven brand, without a major marketing campaign? I don't know the answer, but its far from assured. Though Inair doesn't need to be a huge hit for it to do well for MCZ, it does need to gain some traction, and I think the price point could be a big hurdle.

Overall, I still believe we'll see a very strong q2 and q3, but that q1 will be weak, due to:
1) No new major product releases
2) Tough revenue comp due to software release in FY07 Q1
3) What is likely to be gross margins below those recorded in q4, which could signal some concerns on sustainability of margins

These are mostly short term issues. I still believe the future is bright for MCZ, particularly as they secure more license deals, launch more software titles, and figure out how to capitalize on the InAir technology. I will be looking to add to my position on continued weakness before the Halo 3 launch in September.

Tuesday, June 12, 2007

Amazon: Why now may be the time to short

This write-up that AMZN is a compelling short at current levels. AMZN has shot up over 70% in the last two months, most recently on its "blowout q1" earnings report, a typically seasonally weak quarter in which AMZN reported EPS higher than their seasonally strong q4. Revenue growth has accelerated, and high hopes for new initiatives (digital distribution, web services, etc.) have fueled a speculative furor not seen in the name since the height of the boom. Analysts are excited by the prospect of amazon as a "media" company, rather than a online retailer of low margin products, trading at a over 100x earnings, with PEG multiples higher than GOOG and EBAY, both of which are more attractive, higher margin businesses.

For a variety of reasons, I believe these growth avenues are overblown, and that AMZN is more likely than not a leading online retailer with a strong online marketplace, low operating margins, and moderate but not spectacular growth going into the foreseeable future. I will argue that even if AMZN overnight became a leader in all areas they hope to grow into, the company would still be overvalued and likely to disappoint given current expectations. AMZN is overpriced on both an absolute basis, as well as relative to peers, and could see a upwards of a 30% drop based solely on a return to its prior lofty valuation levels, or upwards of a 50% drop if valuations were more in line with comps (which, arguably, are overvalued themselves), and potentially see further decreases as new ventures fail and their core retailing business receives continued pressure from offline and other online retailers, as well as the inevitable levy of an internet sales tax, which could wreak havoc on already tiny margins. Given the high PEG, as well as revenue and earnings growth going forward, I believe the risk of multiple expansion or multiples staying the same is relatively low, and that AMZN is an attractive low risk/high reward short.

Q1 "Blowout"
Amazon surprised analysts and everyone following the name. Though there were some legitimate business drivers for the gains (lower than expected margin compression, slightly better sales, etc.) the majority of the earnings surprise can be attributed to lowered R&D investment, a favorable tax situation, and foreign currency gains. These are not the kind of operational improvements that merit such an enormous increase in stock price, but instead served to artificially show earnings growth well above the real growth in the business.

Business Overview:
AMZN is the largest pureplay internet retailer, with $10.7B in sales in 2006, and has grown its revenue at about 25-30% per year for the last few years. Though AMZN is primarily known to US investors for their domestic presence, the company has become an international force, deriving 55% of sales from the US vs. 45% internationally. The company continues to grow outside its core media products into other categories (electronics, etc.), but media--composed of books, dvd, and cds, still account for 66% of revenue.

AMZN is entering other popular spaces, including distribution of online music, dvd rentals, and its much hyped Amazon Web services. These businesses are all in their infancy, but are being relied upon to deliver growth coming forward, which I do not believe will come for several years, if at all.

Amazon's non-retail businesses
Before delving to much into the economics of AMZN's core business, I think it is useful to discuss the prospects of Amazon's non-core operating businesses. I will argue that even if AMZN were to overnight become a leader in each of these new business, the total value of these business would not amount to more than $3B, or 1/10th AMZN's market cap.

Amazon Web Services
This business has received hype for sometime--despite being offered for the last couple years and not gaining much traction. The sales pitch here is that Amazon can sell its best in class technology and logistics solutions to other companies rather than those companies needing to worry about managing their own proprietary solutions. Outside their impressive e-commerce engine, which has been the bulk of the services hype, AMZN has a handful of other tools (a mediocre search product, selling excess storage an computer power, alexa, etc.) that have limited commercial value. Some analysts speculate that this opportunity could become larger than the entire business. I don't think any of these services--particularly the ecommerce service--will ever take off. Reasons include:
1) Amazon is essentially trying to sell its technology to its main competitors (offline companies coming online). This is a lose/lose situation. Either it works and you make your competition stronger, or it doesn't and your business suffers.
2) Unsurprisingly, companies are not too keen on the prospect of outsourcing anything to a large competitor. If you are best buy, for example, how would you feel about licensing technology and trusting your infrastructure to your biggest online threat? It makes no sense to put the core infrastructure of your business into the hands of someone with a clear conflict of interest. Frankly, I can't see this business taking off as long as AMZN also acts as a retailer.
3) AMZN's e-commerce solution, in particular is not friendly with other solutions. If you are a offline retailer building an online presence, you want to be able to integrate your storefront with your webfront with your catalogue. It is very difficult to do this with amazon's solution, and this will never be something they are good at, given that they do not have a retail presence themselves. If you cut offline retailers out of the market, who are you left with, other than a few small niche online retailers who have themselves spent millions developing their own systems?
4) AMZN's other services (search, storage, cloud computing, etc.) are of questionable value, and are not related to their core competency (ecommerce). They might be able to make a few million from selling some extra memory and bandwith to startups (as they do now), but in my mind these don't representative particularly valuable near term or long-term business models.

For many of these reasons, Amazon has been eaten alive by GSIC in the e-commerce services space, which is the only area where I believe AMZN has a potentially valuable product. GSI, originally operator of small website, has taken many of amazon's customers and won many contracts in head to head battles with e-commerce behemoth. GSIC reported $600M of revenue in the last fiscal year with its business here. Though AMZN does not break out this revenue, its other bucket for $263M for FY2006, so at the very least this business is half that of GSIC's and most likely more like a third or a quarter. Anyhow, for arguments sake, I will assume that this division is currently worth GSIC's EV ($1B), despite my belief that these businesses will continue to drain cash, and not be worth much of anything at all.

DVD rental
AMZN's foray into online dvd rentals is a much hyped, but largely irrelevant part of AMZN's future growth prospects. AMZN is a late entrant into the space, and it is unclear what additional value they bring compared with established competitors (NFLX, BBI, WMT, etc.), outside of arguably some benefit from their large customer list and distribution infrastructure. Despite speculation that they would launch in the US, they have only launched in the UK for the time being. I find it ironic that this business is attractive and an asset to a company like amazon, while the business on a stand-alone basis (with BBI and NFLX) is considered to be intensely competitive, unsustainable due to high churn, and at risk altogether from digital downloads. Forgetting all the concerns with the business model and the fact that AMZN is way behind the competition, I will assume that AMZN will become a leader in the space and that this opportunity is worth $1.2B currently, which is NFLX current EV.

Digital Distribution
Amazon is trying to eventually position itself to be a leader in digital content distribution. AMZN is late to the party, and has some formidable competition from the likes of Google, Yahoo, Apple, and a handful of small niche players (MovieLink, CinemaNow, etc.). To date, AMZN has focused on hyping its new digital music service. Lets forget for a moment that nearly all the big players have launched a similar service, or that apple is the undisputed leader in the space. After over a year of discussing ways of differentiating itself, including scrapped plans of releasing its own player, AMZN appears to have settled on a rather unspectacular solution--they will release DRM free music from EMI (for which APPL also has a contract), as well as 12,000 independent music companies. In other words, outside the 12k independent labels (who all likely have deal with APPL as well), there really isn't much differentiation, at least for the time being. Also, unlike other players, AMZN risks cannibalizing its own music sales.

Amazon also went ahead and released Unbox, a video download service that received some pretty awful reviews, particularly in comparison to Apple's storefront. This is another area where there are several established players, though no one has really been able to make the model work the same way it has worked for music. Even with broadband, movies can take a prohibitively long time to download, take up a large amount of server bandwidth, as well as a good deal of physical memory. Not to mention, unless you want to go through the hassle of hooking up your computer to your TV, you'll be confined to your computer screen for video watching. Like Unbox, AMZN's partnership with TiVo has generated little response, for similar reasons. Overall, I think this is another example of an expensive, early, and unattractive business. Despite all my reservatios, I'll assume an EV of $800M for the digital opportunity, or about 8x the EV of Napster.

Reviewing many of AMZN's most touted growth prospects reveals that, beneath the hype, AMZN faces significant competition in most areas, and even if we assume it becomes a market leader in each category, the total value of the opportunity is not particularly attractive currently.

Netting out the $3B in non-core, immaterial businesses leaves us with a $27B market valuation on Amazon's e-commerce business. Using Amazon's upper end EBIT guidance for FY07 ($563M) gives us a forward valuation of 48x/EBIT. I use EBIT to net out the wild fluctuation in tax rate, which came in in the low 20%s vs. 40-50% historically for q1, and contributed to a large portion of the blowout q1. In addition to being an absurd multiple on its own right, this is well above EBAY (20-25x) and GOOG (25x-30x), both of whom I would argue have more sustainable competitive advantages, more attractive margins, and as good if not better growth prospects than AMZN. Even if we assume AMZN is worth the high end of GOOG's EBIT multiple, the stock would be worth about 40% less than it is today. If use consensus forward P/Es rather than EBIT, the numbers look even worse: 70x 2007 for AMZN, 33x for GOOG, and 23x for EBAY. Using GOOG again as the upper end of a market valuation would result in a drop of 0ver 50% from todays levels. Using EBAY (arguably a more fitting comp) would result in 67% drop.

Another way to look at this is that the market was valuing AMZN at about $45/share before their earnings announcement, which it beat largely due to a lower than expected tax rate, a large decrease in R&D investment, and favorable foreign currency gains. I think it's difficult to argue that these factors should result in adding about $25/share increase, and that as a base case it would appear reasonable that AMZN should return to $50, where it was trading before its earning release, or a decrease of about 30% from current levels. Basically, any way you slice the analysis, AMZN is trading at an unjustifiable high valuation compared to comps, where it has traded historically, and on an absolute basis

Though I am usually hesitant to short high growth names, I believe the risk with AMZN is relatively low. Given memories of the internet bubble, and valuations significantly above other internet companies with superior growth profiles, I find it hard to believe that AMZN could achieve additional multiple expansion. Also, given my low expectations from growth initiatives, I don't believe we'll see AMZN as anything more than a 20% grower in a low margin retail business which, if correct, will be rewarded with a much lower valuation than experienced currently. Likely worst case scenario in my mind is that AMZN grows into its valuation over the next couple years and the stock moves nowhere. One option for the risk adverse would be to do a pair trade with GOOG and/or EBAY and profit from the multiple compression while hedging out some risk that the market continues its irrational pricing of some internet stocks.

Potential catalysts:
-Continued failure of new initiatives
-Internet sales tax is enacted or gains momentum
-Increased competition from niche players and offline companies building out an online presence.
-Rotation away from the internet names
-Unexpected tax rate fluctuations in upcoming quarters

Disclosure: I am currently short AMZN.

Friday, June 8, 2007

Track my Performance, and yours too!

Using Coverstor's awesome portfolio performance tracking, I have went ahead and set up a little widget on the right side of my blog, about halfway down, that shows a few of my top holdings in a separate account I manage. This account is different and larger than my personal account, so the weightings of some stocks I writeup (e.g. eylogic and MCZ) may actually be smaller concentrations in this portfolio than I say they are when I refer to my personal holdings.

I just set up the account, so the performance tracker for the time being is largely useless, but it does display the majority of my holdings, as well as brief rationales for several. For those of you looking for a portfolio tracker, I highly recommend Covestor's--it updates automatically, and tracks things like max drawdown, portfolio beta, etc.

Thursday, June 7, 2007

The dawn of "Covesting"

David Jackson from seeking alpha posted a great article on Covestor, a newly launched site that allows investors to track their performance and the performance of other members. The eventual goal will be to charge users to "subscribe" to a members trades, and then split the profits with the investor. Covestor is focusing on a non-professional audience and allowing them to monetize their trading ability. I think this is an interesting approach--it's a bit like a platform that essentially allows anyone to start their own newsletter service, and simply pays a cut to Covestor for their platform.

Outside of the potential financial benefit, Covestor's portfolio tracking itself is pretty impressive--it automatically calculates your portfolio's beta, sharpe ratio, and alpha, and confirms your trades from your brokerage account without you needing to input anything manually. I am in the midst of setting up an account, and will post a link to my portfolio once it is complete.

Tuesday, June 5, 2007

MCZ FY07 Results – Turnaround appears intact

MCZ reported earnings of $.01 in Q4, of $.07 for the year. This is their 2nd straight quarter of strong gross margins, which came in at 29.1%--particularly impressive considering there was no major release of high margin product in the quarter, as far as I am aware. Management has done an excellent job improving gross margins on low margin product, and refocusing the business on more attractive products going forward. Management also kept expenses down, and has continued to paid down a good chunk of debt from cash flows. Looking ahead to next year, the company should benefit from launch of the InAir headphones, halo faceplates, as well as additional licensing deals that should be announced over the next year.

On the downside, management suggested they will not be launching a software title in the next fiscal year, which could make revenue comps difficult. I estimate that software accounted for about 12-13% of revenue in FY07 (including a whopping 28% in Q1), and its possible they could lose upwards of half of that next year as their current titles age. They are going to have to figure out a way to make up for that revenue--InAir and more licensed products could do the trick, aided also by a continuing recovery in the company's core hardware accessory sales, though it may be difficult to grow revenue more than a few percent, barring a knock out hit of some kind. The company will look to launch up to two titles in FY09, once the console transition is well behind us, and the installed base is more favorable to a MCZ release.

At 18x earnings (as of this writing), Madcatz does not appear particularly cheap. But looking ahead to next year and beyond, if the company continues to grow revenues at higher gross margin levels, earnings should ramp up quickly due to the operating leverage in the business. Revenue growth of as little as 3% would translate into earnings of about $.11 at a gross margin of 27.5%, assuming expenses in line with expenses this year. That said, the future is far from guaranteed—the InAir launch in particular is a totally new space for MCZ, and very little has so far been released about it. MCZ is and will likely continue to be a hit driven business, and its success relies on continually churning out new products. I will be looking to further announcements of licensing deals, more details on InAir, a Wii controller announcement, and q2 results (with 6 days of Halo sales) to see how MCZ should fare this fiscal year and beyond.

Disclosure: I am long shares of MCZ, and reserve the right to buy or sell shares without notice. This analysis is for educational purposes only, and should not be construed as investment advice or fact. Do your own due dilligence.

Monday, June 4, 2007

Position Sizing and when to sell

Figuring out the right position size for a stock, and deciding when to sell and when to double down is probably one of the more difficult aspects of stock investing, and an area I find myself struggling with regularly. It is one of those areas of investing that I believe is a bit more of an art than a science.

Position Sizing
A lot of position sizing usually depends on an individual investors risk tolerance and desire for diversification. I know several people who keep a very concentrated portfolio (as few as 2-10 stocks), and others with upwards of 30-50 positions. Each has its benefits, though I personally lean towards the more concentrated portfolio, as it is easier to keep track of, and allows for more $$ in places where you have the most conviction. I personally like to fall within about 15-20 for the long side of my portfolio, as it allows for a bit more diversification while still allowing me to heavily weight my top 5 holdings, which I usually like to have about 40-50% of my total portfolio. I don't like to have a position grow to more than about 15% of my total portfolio, unless there is a very strong margin of safety or unless I am unusually confident in the companies prospects. In general, my largest holdings are ones I have the most confidence in, and those with the largest margin of safety (I will rarely, for example, invest 10% in a speculative stock). Many of my smaller positions (<3% positions) are in companies I would like to own more of but are a bit too expensive for me right now (examples would include MSII and PN). Others are ones that have a high potential payout (200%+), but also a decent chance of being worthless, and often include puts. I have recently considered adding a few puts of high flying growth stocks that I think are likely to face issues at some point (CROX, JDSA, RIMM, and JMBA), but that I would not want to short for fear of being wrong and losing my shirt. I would likely have these as 1% positions, unless I had a very clear catalyst and timing in mind.

Position sizing is a constantly evolving question. As information changes (the stock price, company prospects, etc.), the position should be re-evaluated to ensure exposure is consistent with the risk/reward of the stock. In the case of MCZ, I originally started it off at as a 10% position. When the halo deal was announced and the stock shot up, I continued to hold the position, as my fair value of its upside potential was now more than when I bought. When the stock reached $1.40, it was beginning to near some of my more conservative valuations. I asked myself if I would buy the stock again if I did not own shares, and the answer was yes--but it seemed to me more fitting of a 5% position in light of my other holdings, vs. the 15% holding it had become.

When to sell
I think this is another area that can be a bit more of an art than a science. With certain investments, I usually have a catalyst in mind that I plan to sell around--for example, strong earnings in a particular quarter. With others, I plan to hold the stock indefinitely as it is a company I want to be invested in over the long haul (EYE.A and CASH are good examples).

I try as best I can to stay objective with my holdings, and always ask myself if I would still buy if I did not own it--particularly after big moves in the stock price or news that alters my investment thesis. Madacy is a great example of an investment in which I lost my shirt, but I believe I played well, all considering. The stock got whacked down about 60% after what appeared to be a one-time issue with their largest customer. Management bought back shares, and I decided to double my position, as I believed my thesis was still intact. Over the next couple quarters, however, it became clear that this was more than a one time issue, and that the operating business was significantly impaired. I recently closed the position at a loss.

Most important, I think it is useful to continuing evaluate what strategy works best for you and what doesn't, and to make decisions accordingly. There are rarely hard and fast rules in investing, and I think this is an area in particular where that is true.

Saturday, June 2, 2007

Underperforming CEFs as a hedging strategy?

I have been running my portfolios at about 0-20% net long (long exposure minus short exposure) for the last year, largely in accordance with Hussman's hedging strategy which has, over a full cycle, generally outperformed an unhedged strategy and with less volatility. I make some modifications--most notably shorting individual securities rather than his puts strategy, which I believe affords similar downside protection while allowing for the possibility of returns on the short-side, as well.

Unfortunately, I don't have enough ideas on the short side to fully hedge my portfolio, so I usually end up just shorting the indexes, or a ETF I believe will underperform (e.g. JKK or RWR). When doing this, I look for a sector that I believe is overpriced, and then find the worst ETF I can in that sector. This has had its intended effect, but a lightbulb recently went off in my head, and suggested a strategy that may be more effective. I believe shorting poor CEFs can be a more attractive way to hedge out market risk than shorting indexes, in the same way shorting a historically poor performing mutual fund would have been better than shorting indexes. If you are not familar with CEFs, I suggest reading this article and this. Otherwise, I have summarized:

Closed end funds are similar to mutual funds (open-ended funds) in that they are pooled capital managed by a portfolio manager. The difference is that Open-ended funds IPO to raise capital, and subsequently trade like stocks in a market based on supply and demand, whereas Mutual funds constantly issue and cancel shares as investors buy and redeem their shares. Because CEFs trade in a suply and demand market, the market price can become detached from the net asset value (NAV) of the underlying holdings. This is referred to as the premium or discount a fund trades at, and is usually driven by past returns and the dividend yield. This structure also means you can short CEFs, which you cannot do with mutual funds.

Shorting CEFs, in my opinion, has a few benefits over shorting ETFs:
1) Fees are higher, creating an increased hurdle to achieving returns above the market. It is not uncommon for smaller CEFs to have management fees of abou 1-2%, and expenses of about 2-3%, resulting in a 5% hurdle out the gate.
2) Most CEFs have less incentive to perform well than do mutual funds. When mutual fund shares are redeemed, the mutual fund company loses assets, but because CEFs raise money at the start of a fund they don't have the same concern. If investors are not satisfied, they do not get their money back from the fund, but on the market by selling shares to another investors. The company does not experience an outflow, and thus does not care much about a discount. Good CEFs do care about their reputation and ability to raise future capital, but luckily their are plenty of bad ones out there that don't seem to mind poor performance.
3) CEFs have less incentive to replace underperforming managers, assuming their fees are calculated as a percentage of assets (as most are). Many are happy to collect 2% of $50M indefinitely while exerting zero effort, rather than grow that a couple percent a year extra and have to work for it.
4) High volatility CEFs and/or those that underperform the market typically swing to a discount when the market heads south. In this case, you can profit both off the decrease in the NAV, but also in the increasing gap between the market and NAV price. Many high flying emerging market ETFs, for example, are trading at 5%+ premiums. In the event the NAV dropped 20%, and the 5% premium became a 5% discount, your profit would be 29% (a 20% from the NAV decline, + 9% with the premium contraction).

Next week I will do more work on profiling some of the more shameful CEFs that I plan on adding as short positions in my accounts as a hedge against market fluctuations.