MCZ closed today Thursday at $1.17, off about 20% from when I took profits at $1.42. I say this not too boast, as I am not a short term trader and admit ignorance as to all but the most basic technical signals as to what makes a stock go up and down in the short term, absent of news. I do, however, find it fascinating to watch investor psychology play out as stocks rapidly appreciate and depreciate in value absent of any fundamental change in the business.
As a value investor, I try to be agnostic to short term price moves and keep my eye on my fundamental investing thesis, which I outlined in my original post. The general gist of my thesis is that if gross margins continue to improve--driven by increased sales of higher margin products--then MCZ is likely to see stellar FY08 earnings--upwards of $.12--which should result in a revaluation upwards at some point within the next year. As the next year unfolds, we will get clues to the validity of my thesis, through earnings releases, conversations with management, industry trends, and future news releases. So far, the announcement of the Halo deal in particular has increased my confidence that my thesis will play out as I expect it to. Nothing has changed in the past 2 days, yet the market has decided that the company is worth about 20% less than it was two days ago. For those believers in efficient market theory, I would really like someone to explain to me how this is possible.
I have seen this behavior firsthand countless times. It is all around us--a cursory glance of the yahoo message boards of any momentum stock will show this. Just a few days ago, investors reacted somewhat mutely to the first announcement of the Halo deal, before sending MCZ up about 50% in the proceeding days and causing people on yahoo to shout all sorts of silly things. Two days later, with the sharp downward move, the momentum crowd sings a much different tune. Through all of this though--from the day after the run until now--nothing has changed with the business. The company is the same as it was 7 days ago, or two days ago. It is always helpful to keep this in perspective.
My family and friends are also great examples of people who react strongly to price moves (or lack thereof). I have recommended the Hussman Fund to many people--they loved it in 2000-2002, but want to get rid of it because of its recent under-performance. Because I understand and am confident in the effectiveness of Hussman's long-term strategy, I am not worried about his short term under performance, but without this knowledge I too would likely unload it for a high flying fund (at my own peril). I do not expect everyone to be an expert in securities analysis (even many of the experts are pretty bad), but I do believe that it is our responsibility to recognize this ignorance within ourselves, and to make wise financial decisions accordingly--most notably, remove ourselves from the day to day price fluctuations of our investments and protect our portfolios from ourselves.
There are many short term traders that know what they are doing (Charles Kirk of The Kirk Report, one of my favorite blogs, is a good example of one). I do, however, worry for people who trade on no basis at all--who watch the rapid upward and downward
movement in stocks with excitement and anxiety, but without any disciplined approach as to when to buy, when to sell, and what actually causes the stock to move up and down. This is also why I previously wrote people not trained in investing or finance should not invest a significant portion of their own money in individual securities until they get a better feel for what they are doing. Investing in stocks without understanding what causes price movements is not investing or even trading--it is gambling, pure and simple, which has its place, but not at the core of a disciplined long term investing strategy.
Buying and selling stocks can be fun, profitable activity--and cheaper than a trip to Vegas--but its always important for us to be honest with ourselves as to when we are investing and when we are gambling.
Disclosure: I am long shares of MCZ. This post is for educational purposes only, and should not be construed as investment advice. I may buy or sell shares at anytime without notice.
Thursday, May 31, 2007
Tuesday, May 29, 2007
Closed NTWK position
I recently closed my NTWK position. This is a good example of a strong company but poor management and stock. Revenue came in nicely but earnings were weak again, as management seems content to take all the profits for themselves. Even if these business continue their torrid growth, I am doubtful that ordinary shareholders will ever receive a share of the profits.
Trimming MCZ holding
MCZ has had quite a run since I first posted the idea at $.72. Today I took some gains off the table and, though I still believe there may be some upside left here, the risk/reward is not as attractive as it was 2 months ago, justifying a smaller position sizing in my portfolio (from 10% to 4%). On a side note, it is clear that MCZ trading has been taken over by the momentum crowd, which is fickle and generally unpredictable. This crowd could easily take the stock much higher from here, but I do not want to bet on that, at that areas it outside my expertise and investing style. I continue to hold a position based on the valuation prospects, not the short term price movement.
Onto valuation: the halo licensing deal was a big win, and has the potential to add $.04+ of earnings next year alone. At $1.43 per share, the stock is trading for about 20x my estimates of FY07 earnings of $.07 a share. As for FY08, I have outlined four updated scenarios below, updated largely based on my expected impact from the Halo deal.
Worst Case Conservative Likely Aggressive
FY07 rev (est) $102.0 $102.0 $102.0 $102.0
Rev Growth 0% 5% 10% 20%
FY08 Rev $102.0 $107.1 $112.2 $122.4
Gross Margin 25% 27% 28% 29%
Gross Profit $25.5 $28.9 $31.4 $35.5
Operating Exp $20.0 $20.0 $20.0 $20.0
EBIT $5.5 $8.9 $11.4 $15.5
Interest exp net income ($0.5) ($0.5) ($0.5) ($0.5)
Income pre-tax $5.0 $8.4 $10.9 $15.0
Net Income $3.4 $5.7 $7.4 $10.2
EPS $0.07 $0.11 $0.15 $0.20
Probabilities 15% 35% 35% 15%
Price at 15 P/E $1.02 $1.72 $2.23 $3.06
Upside @ 1.43 -29% 20% 56% 114%
Probability Weighted -4% 7% 20% 17%
Probability Weighted upside 39%
The aggressive scenario would include events like the inair product being a solid hit, or mcz getting a GTA license, while the worst case scenario would have the opposite occur (as well a other unexpected issues). You could make an argument that the stock should be valued at more like 20 earnings, in which case the weighted upside would be about 85%. That said, I think MCZ is set up for a stellar FY08, but that the comps will be difficult to match in 2009 and thus deserves a lower valuation.
I am excited about the company's prospects for FY08, and will be looking to add to the position if the stock dips back down to around $1.10, which I think may be a possibility in q1 or q2, given what appears to be a somewhat weak pipeline for mcz in those quarters. I will likely post another update when q4 is announced, though I believe the big catalyst here over the next few months will be the halo release, and any announcement of GTA or other big license deals.
Onto valuation: the halo licensing deal was a big win, and has the potential to add $.04+ of earnings next year alone. At $1.43 per share, the stock is trading for about 20x my estimates of FY07 earnings of $.07 a share. As for FY08, I have outlined four updated scenarios below, updated largely based on my expected impact from the Halo deal.
Worst Case Conservative Likely Aggressive
FY07 rev (est) $102.0 $102.0 $102.0 $102.0
Rev Growth 0% 5% 10% 20%
FY08 Rev $102.0 $107.1 $112.2 $122.4
Gross Margin 25% 27% 28% 29%
Gross Profit $25.5 $28.9 $31.4 $35.5
Operating Exp $20.0 $20.0 $20.0 $20.0
EBIT $5.5 $8.9 $11.4 $15.5
Interest exp net income ($0.5) ($0.5) ($0.5) ($0.5)
Income pre-tax $5.0 $8.4 $10.9 $15.0
Net Income $3.4 $5.7 $7.4 $10.2
EPS $0.07 $0.11 $0.15 $0.20
Probabilities 15% 35% 35% 15%
Price at 15 P/E $1.02 $1.72 $2.23 $3.06
Upside @ 1.43 -29% 20% 56% 114%
Probability Weighted -4% 7% 20% 17%
Probability Weighted upside 39%
The aggressive scenario would include events like the inair product being a solid hit, or mcz getting a GTA license, while the worst case scenario would have the opposite occur (as well a other unexpected issues). You could make an argument that the stock should be valued at more like 20 earnings, in which case the weighted upside would be about 85%. That said, I think MCZ is set up for a stellar FY08, but that the comps will be difficult to match in 2009 and thus deserves a lower valuation.
I am excited about the company's prospects for FY08, and will be looking to add to the position if the stock dips back down to around $1.10, which I think may be a possibility in q1 or q2, given what appears to be a somewhat weak pipeline for mcz in those quarters. I will likely post another update when q4 is announced, though I believe the big catalyst here over the next few months will be the halo release, and any announcement of GTA or other big license deals.
Friday, May 11, 2007
MCZ announces Halo license deal
The company today announced a new multi-year license deal with Halo 3, the next
installation in one of the most popular console games of all time, and arguably the
most lucrative license the company has acquired to date. The previous 2 versions of
halo have sold 14.7 million copies. Halo 3 is expected to launch near the end of the
year (should be madcatz q3). I currently have calls out to try and assess the terms
and breadth of the deal in more detail, but overall view this as a strong catalyst
to the gross margins story in the write up. I've also done a conservative back of
the envelope on the value of the deal, which I have outlined below:
Total Unit estimate:
Avg copies sold per halo iteration: 7.3M
% of customers buying faceplates: 5%
avg faceplates per customer: 1.1
Estimated unit sales: 400,000
Gross margin per unit
average MSRP: $22 (based on gears of war pricing)
average MCZ wholesale (guestimate): $15
average MCZ gross margin (guestimate): 50%
Profit per unit: $7.50
Estimated impact (revenue, profit):
at 5% adoption: ($6M, $3M)
Because all other operating expenses are largely fixed, the additional GM would largely fall to the bottom line, after taxes, resulting in about $2M in net income. This would translate into an additional EPS of about $.04, which I expect would largely come in q3 and q4 of this fiscal year. I
also believe this may help the company secure future deals, including the lucrative GTA license.
I am still optimistic on the gross margins story here, and believe soon to be reported q4 numbers (and, in particular, the gross margin number), will help give further indication of the profit potential going into next fiscal year.
installation in one of the most popular console games of all time, and arguably the
most lucrative license the company has acquired to date. The previous 2 versions of
halo have sold 14.7 million copies. Halo 3 is expected to launch near the end of the
year (should be madcatz q3). I currently have calls out to try and assess the terms
and breadth of the deal in more detail, but overall view this as a strong catalyst
to the gross margins story in the write up. I've also done a conservative back of
the envelope on the value of the deal, which I have outlined below:
Total Unit estimate:
Avg copies sold per halo iteration: 7.3M
% of customers buying faceplates: 5%
avg faceplates per customer: 1.1
Estimated unit sales: 400,000
Gross margin per unit
average MSRP: $22 (based on gears of war pricing)
average MCZ wholesale (guestimate): $15
average MCZ gross margin (guestimate): 50%
Profit per unit: $7.50
Estimated impact (revenue, profit):
at 5% adoption: ($6M, $3M)
Because all other operating expenses are largely fixed, the additional GM would largely fall to the bottom line, after taxes, resulting in about $2M in net income. This would translate into an additional EPS of about $.04, which I expect would largely come in q3 and q4 of this fiscal year. I
also believe this may help the company secure future deals, including the lucrative GTA license.
I am still optimistic on the gross margins story here, and believe soon to be reported q4 numbers (and, in particular, the gross margin number), will help give further indication of the profit potential going into next fiscal year.
Wednesday, May 9, 2007
Eyelogic -- my most exciting long term holding
When I first began my blog, I wrote a detailed overview of eyelogic, which trades on the toronto venture exchange (symbol EYE.A). With their annual and q1 just reported, I thought now would be a good time to finish the write up I had started on them some time ago. Please refer to the prior write up for background info.
Business Overview
The majority of Eyelogic's business is in Canada but, over the last couple years, the company has expanded its sales operation internationally. In Septemember 2006, the company was dealt a brief setback when it was barred from selling its product until it received a class 2 license from the health board of Canada. The company did so in February, but was unable to sell its product in Canada for the intervening five months. This forced the company to focus sales efforts elsewhere, resulting in an increased focus on marketing in the US, and the largest sale in the companies history to a chain in France.
Eyelogics systems sell for 10k-30k, depending on the type of system ordered. A significant portion of revenue comes is recurring (coming from leased systems), and the remainder are sold on a one off basis, which can make earnings a bit lumpy. Gross margins are very high (about 66%), though I would expect this to decline over time as the market matures. We are far away from this point, though, in my opinion.
Financials
Eyelogic reported year end results last week, with EPS down 19% to about $.13 per share, due largely to the health canada issue. Without this issue, the company would have earned about $.20 per share, which would give them a P/E of about 11 on todays stock price. Instead, sales for Q4 were delayed until Q1, when the company made up the majority of the sales. The company recently reported earnings of $.13 for Q1, due to the large sale to the french company, as well as the backlog of orders they had that they could not fulfill in q4. The Health canada issue in q4 06 will inflate FY07 earnings due to the backlog filled in q1, though I expect healthy growth, even adjusting for the Health Canada issue.
Insider ownership is high (about 35%), with another 10% in option grants. Management is highly incented to grow the business, and is themselves excited about the appreciation potential of the stock.
Valuation, Growth Potential, and Catalysts
It is difficult to value Eyelogic, as I view most of the value to be in the form large, lumpy sales that I expect to occur over the next year or two. The majority of Eyelogic's sales, to date, have been small one to three system orders. As the company expands its sales efforts internationally (the sales force has grown considerably over the last year or two, and sales cycles are very long, delaying the impact of the added resources), I expect earnings growth to grow at a steady pace, about 25% per year. The real value, however, is in the possibility of Eyelogic winning large orders from chains (e.g. like the French order). For various reasons, I believe this is more a possibility now then ever.
The French order for 80 systems was the largest order in the history of this industry. Eyelogic was up against several competitors, but ended up winning the order due to the quality of their system. The french chain has about 600 stores, and purchased 80 as a pilot. So far, they are very happy. If they were to go ahead and order more for just half their store base, I would anticipate the revenue from this order to be roughly equivilent to all of Eyelogic's revenue in 2006. According to the COO, the french chain is currently very happy with the systems (he is currently meeting them in France). It is not a jump to assume that, if things go well, more orders from the company is inevitable.
The COO has been meeting with the large retail chains pitching the system for years. They are all intrigued by the technology, but no one as of yet has willing to make a dive. As with most new technologies, many companies are followers more than they are innovators. Once they see it work for someone else, they'll want it to. I believe the large French sale will help to be a strong catalyst to generate interest in the technology, as well as be a huge selling point for eyelogic in sales negotiations. Remember, eyelogic beat out all the other companies to win this big order, and they'll be able to leverage that win in deals, both small and large, against competitors. If another chain wants to purchase systems, Eyelogic will be the logical frontrunner to win the business.
The 2nd potential catalyst comes in the form of what should be a new product launch by the end of the year. Though still a bit murky on details, the COO has confirmed that they are in the works on a new model of their system that they expect to help the technology gain much more market acceptance. Other companies have released new models, too, but the upgrades have been largely cosmetic. The COO is very excited about this potential product release, though I assume we will have to wait for details on this in the upcoming months.
Trading
Important: For those of you looking to purchase Eyelogic shares, please note that it is very illiquid and difficult to accumulate in blocks. I highly reccommend using limit orders, and being patient. Occasionally sellers come into the market and sell big blocks. There was one such seller for the last couple months, off whom I purchased most my shares, but I believe he was taken out after the last earnings announcment. Anyhow, given the run the stock has had over the last couple years, and the frustrating liquidity, patience should be rewarded. Also, its not particularly easy to exit your position, so you have to be content parking the money here for an indefinite ammount of time.
Conclusion
Though Eyelogic is very small, and extremely illiquid, I consider it a core long term holding due to a combination of low valuation, exciting growth prospects, multiple near term catalysts, and a nice 6% dividend while we wait for it all to come together. If eyelogic wins just one or two deals with chains, we can expect revenue and profit numbers from those deals alone to be potentially multiples of current revenue and profits, which I would expect to give the stock simmilar upside (multiples from its current price).
Note: This write up is based on my research and opinion, and should not be taken as investment advice. It is not a recommendation to buy or sell shares.
Business Overview
The majority of Eyelogic's business is in Canada but, over the last couple years, the company has expanded its sales operation internationally. In Septemember 2006, the company was dealt a brief setback when it was barred from selling its product until it received a class 2 license from the health board of Canada. The company did so in February, but was unable to sell its product in Canada for the intervening five months. This forced the company to focus sales efforts elsewhere, resulting in an increased focus on marketing in the US, and the largest sale in the companies history to a chain in France.
Eyelogics systems sell for 10k-30k, depending on the type of system ordered. A significant portion of revenue comes is recurring (coming from leased systems), and the remainder are sold on a one off basis, which can make earnings a bit lumpy. Gross margins are very high (about 66%), though I would expect this to decline over time as the market matures. We are far away from this point, though, in my opinion.
Financials
Eyelogic reported year end results last week, with EPS down 19% to about $.13 per share, due largely to the health canada issue. Without this issue, the company would have earned about $.20 per share, which would give them a P/E of about 11 on todays stock price. Instead, sales for Q4 were delayed until Q1, when the company made up the majority of the sales. The company recently reported earnings of $.13 for Q1, due to the large sale to the french company, as well as the backlog of orders they had that they could not fulfill in q4. The Health canada issue in q4 06 will inflate FY07 earnings due to the backlog filled in q1, though I expect healthy growth, even adjusting for the Health Canada issue.
Insider ownership is high (about 35%), with another 10% in option grants. Management is highly incented to grow the business, and is themselves excited about the appreciation potential of the stock.
Valuation, Growth Potential, and Catalysts
It is difficult to value Eyelogic, as I view most of the value to be in the form large, lumpy sales that I expect to occur over the next year or two. The majority of Eyelogic's sales, to date, have been small one to three system orders. As the company expands its sales efforts internationally (the sales force has grown considerably over the last year or two, and sales cycles are very long, delaying the impact of the added resources), I expect earnings growth to grow at a steady pace, about 25% per year. The real value, however, is in the possibility of Eyelogic winning large orders from chains (e.g. like the French order). For various reasons, I believe this is more a possibility now then ever.
The French order for 80 systems was the largest order in the history of this industry. Eyelogic was up against several competitors, but ended up winning the order due to the quality of their system. The french chain has about 600 stores, and purchased 80 as a pilot. So far, they are very happy. If they were to go ahead and order more for just half their store base, I would anticipate the revenue from this order to be roughly equivilent to all of Eyelogic's revenue in 2006. According to the COO, the french chain is currently very happy with the systems (he is currently meeting them in France). It is not a jump to assume that, if things go well, more orders from the company is inevitable.
The COO has been meeting with the large retail chains pitching the system for years. They are all intrigued by the technology, but no one as of yet has willing to make a dive. As with most new technologies, many companies are followers more than they are innovators. Once they see it work for someone else, they'll want it to. I believe the large French sale will help to be a strong catalyst to generate interest in the technology, as well as be a huge selling point for eyelogic in sales negotiations. Remember, eyelogic beat out all the other companies to win this big order, and they'll be able to leverage that win in deals, both small and large, against competitors. If another chain wants to purchase systems, Eyelogic will be the logical frontrunner to win the business.
The 2nd potential catalyst comes in the form of what should be a new product launch by the end of the year. Though still a bit murky on details, the COO has confirmed that they are in the works on a new model of their system that they expect to help the technology gain much more market acceptance. Other companies have released new models, too, but the upgrades have been largely cosmetic. The COO is very excited about this potential product release, though I assume we will have to wait for details on this in the upcoming months.
Trading
Important: For those of you looking to purchase Eyelogic shares, please note that it is very illiquid and difficult to accumulate in blocks. I highly reccommend using limit orders, and being patient. Occasionally sellers come into the market and sell big blocks. There was one such seller for the last couple months, off whom I purchased most my shares, but I believe he was taken out after the last earnings announcment. Anyhow, given the run the stock has had over the last couple years, and the frustrating liquidity, patience should be rewarded. Also, its not particularly easy to exit your position, so you have to be content parking the money here for an indefinite ammount of time.
Conclusion
Though Eyelogic is very small, and extremely illiquid, I consider it a core long term holding due to a combination of low valuation, exciting growth prospects, multiple near term catalysts, and a nice 6% dividend while we wait for it all to come together. If eyelogic wins just one or two deals with chains, we can expect revenue and profit numbers from those deals alone to be potentially multiples of current revenue and profits, which I would expect to give the stock simmilar upside (multiples from its current price).
Note: This write up is based on my research and opinion, and should not be taken as investment advice. It is not a recommendation to buy or sell shares.
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