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.