Thursday, January 31, 2008

MNST: Dismal outook bouys short case

On Thursday, MNST released more data points that I believe continue to support the bear thesis I outlined previously. With HSII and KFY off substantially since I first wrote them up, and staffing fundamentals continuing to falter, I believe MNST continues to represent the most attractive short of the group. The stock should continue to fall gradually over the next year as North American margins contract, as international growth slows (and margins there contract, too), and as analysts continue to revise estimates downward as MNST reports disappointing MEI numbers, revenue growth, and earnings.

US Monster Employment Index (MEI) turns negative
Monster generates the majority of their revenue from job listings. The MEI index allows us to get a very good sense of how job listings are trending; the data is released monthly, and is an excellent indicator of where revenue is headed. For the first time, the MEI index dropped year over year in January, which increases the likelihood of negative revenue growth in North America in Q1. Even small revenue declines should impact margins negatively as costs remain relatively stable and as pricing is pressured. Because this data is released every month, I expect future announcements to continue to pressure the stock. As of December, international MEI numbers remain positive and impressive, though this should change at some point.

To support this belief, I plotted Year over Year changes in the MNST MEI vs. revenues in the North America Careers segment. Here's what that gets you:

As you can see from the chart, YoY revenue growth is highly correlated to YoY changes in the MEI (for math geeks, the rsquared is a convincing .93!). One other point worth pointing out is the intersection it he graph that occurring in Q2 of 07'. For the first time since 2005, revenue growth dipped below the MEI, which suggests either that MNST is discounting, or that their mix has shifted such that they get less money per listing. I believe its the later: small businesses (who purchase one off listings at higher prices) have, according to MNST, been reducing listings at a faster clip than corporate clients (who buy listings in bulk). Continuation of this trend should continue to pressure margins. Assuming January MEI trends mirror those in February and March, MNST could see NA revenue fall 6-8% in Q1, and should likely see further margin contraction, too.

Management pulls FY08 guidance and dodges tough questions on the CC:
Management sounded very uncomfortable speaking about what happens to MNST in an economic downturn, and conveniently decided that now was a good time to stop giving forward looking guidance. No matter what management says, this is highly suspect, especially in light of their reticence to discuss how they would be impacted by an economic downturn. Management guided to 25% operating margins, despite NA margins dropping. International margins showed strong growth.

Management vows to continue to invest in the business:
This is the right decision long-term, but by having this focus MNST is likely to see a sharp margin down tick if revenue declines, as expenses stay relatively flat and revenue falls.

This remains my highest conviction short. If MNST is ascribed a cyclical multiple rather than a growth multiple, the stock should come under further pressure.

Author is short MNST. Not a recommendation to buy and sell shares. Please do your own due dilligence.

Friday, January 25, 2008

This Is Insanity, and It Will not Last

Today, President Bush and congress announced that they have tentatively reached an agreement to borrow $150 billion dollars from foreign countries to prop up the ailing US consumer. This is on top of the nearly $250 billion dollars the US government was expected to borrow from foreign governments in the currently budgeted fiscal year. These estimates also do not include the untold billions that the government will eventually need to bail out Fannie Mae and Freddie Mac due to the new mandate to insure larger, riskier loans. Wall Street and strapped US consumers cheered the news.

This is not the headline that has been reported elsewhere, but it should be. US consumers have spent beyond their means. They took on too much debt, got used to lifestyles they could not afford. Eventually, the credit spigot ran out, and they pleaded to their government for help.

Now here comes our government to save us, suffering from a similar ailment. Like many consumers, our government spends more money that it takes it. Passing tax increases (revenue generating measures for the government) is political suicide. Decreasing spending (decreasing expenditure) is political suicide.

Let’s look at the US government as if it were a stock. What would you pay for a business that was expected to lose $400 billion dollars this year, has shown consistent losses for much of the last 20 years, and has net debt of $5.5 billion dollars? If you were to lend this entity money, how much would you demand in interest? The market rate is current about 4%--if this were a business, and not the government, the rate would be exponentially higher and, in reality, the entity would be unlikely to get any credit at all. The government is, for all intensive purposes, a bankrupt entity that continues to operate only because of the leniency of its creditors.

Entities that spend more money than they take in eventually face a day of reckoning. We have once again chosen a short term solution that will exacerbate the inevitable day when we must balance our budget. When the US government spends beyond its means, it must issue treasury bonds (read: debt). Our government will rely on mostly foreign governments buying nearly $400 billion dollars of this debt in the upcoming year at interest rates of ~4%, amid a declining dollar, which likely will result in negative real returns.

How long will people take that investment for? What happens if the interest rate rises (note: mortgage rates are tied to treasury rates, not fed fund rates)? What happens when people no longer buy the worthless paper our government is issuing?

We have made a choice as a society. Rather than face the consequences of our poor choices, we continue to make more poor choices that raise the stakes on the eventual pain higher and higher. This is insanity, and it will not last.

Monday, January 21, 2008

How to protect your portfolio in a bear market

With recession fears rising, and evidence continuing to emerge that sentiment has truly shifted towards a bear market scenario, it is prudent to review your portfolio and take steps to ensure that you are well protected in this environment. Bull markets make everyone look like a genius, especially those who invest in high beta stocks, which typically tend to exhibit strong growth, lofty expectations, unreasonable valuations, and a variety of other poor fundamental qualities. None of this matters in bull markets, as these stocks ride the sentiment higher and higher. I'm not even talking about stocks like APPL or GOOG, both of which trade at lofty but not absurd valuations by some standards. I'm talking more about stocks like AMZN, CRM, LULU, and other companies that aren't even growing all that fast or, if they are, they trade at valuations that have tremendous room to come down if sentiment were to change. In tough economic times, stocks with a margin of safety, ideally in the form of cash or hard assets, tend to provide a backstop for how much a stock price can fall. A margin of safety can also be in the form of a company trading at a low valuation, which also happens to have earnings that are unlikely to drop much. Cheap stocks can and do get cheaper in bad market conditions, but they are unlikely to fall as much as expensive stocks.

With that in mind, let's take a look at a broad swath of companies that you should avoid to protect your portfolio in a bear market.

1) Avoid story stocks: Story stocks are stocks whose valuation is based soley on lofty future expectations. Examples today include Solar stocks, CRM, emerging market companies, and basically any company with a P/E in excess of 100x, or a P/S ratio great than 5-10. These stocks are already pricing in tremendous growth that may or may not come. Even if the story does work out eventually, these stocks are unlikely to see their multiples contract heavilly in bear markets as people discount the future, and in general grow more pessimistic. These stocks are also havens for retail investors who tend to panic more in bear markets, exacerbating downward moves. Story stocks always carry these risks, but negative market sentiment is always more likely to be the catalyst.

2) Avoid Wall Street Darlings with cyclical exposure: Stocks in this category would include internet stocks like MNST and AMZN, and even a company like APPL. All these companies are sensitive to economic conditions. If their revenue or margins fall, which often happens to economically sensitive companies in tough economic times, these stocks could get slammed even more than they have already.

3) Avoid Value Traps: trailing P/E multiples in an environment like this are highly misleading. Many companies that look cheap on an environment that no longer exists. The staffing stocks (KFY, HSII, and MNST), which I hae been short for several months now, are great examples of stocks that look deceptively cheap looking backwards, but expensive looking forward. Other examples would include retail companies, financial companies, bond insurers, and a variety of other companies whose future results are likely to look far worse than the results they have experienced in the recent past.

4) Avoid over-levered companies:
Bankruptcies are not pretty and, rest assured, they will come. Companies with poor balance sheets are susceptible to going to zero if their businesses hiccup and they cannot pay off their debt. JAH, one of my favorite shorts, is an example of this kind of company: deceptively cheap, but if they run into issues the creditors will own them and the common shareholders will be left with nothing.

Stock corrections are painful for all investors, but especially amateur investors, who tend to be invested in exactly the wrong kind of stocks to be invested in in bear markets. If you have been going it on your own, or aggressively chasing the latest hot thing, strongly consider looking into time-tested mutual funds like HSFGX or FAIRX, which both have an excellent track-record in consistent, positive returns in all market environments.

The road ahead is fraught with perils. Many who did not learn their lesson from the internet boom, or the real estate bubble, are once again in harms way. Cautious investing to all.

Sunday, January 13, 2008

SMSI: Profit from a fallen wall street story

Smith Micro (SMSI) is a former-high flying tech stock that has been beaten down over the last few months on concerns of slowing growth in one of their product divisions, customer concentration issues, and declining GAPP earnings. Trading now at about $6.70, and with a $200M market cap, SMSI should provide a very favorable risk reward in the near and long-term, as the company continues to benefit from its market leading position in a nascent, high growth, and incredibly profitable (70%+ GM) market. Currently trading at a proforma FY07 PE of about 8, I believe an investment in SMSI could offer upside of 100-300% in a reasonable scenario over the next 2-3 years, with relatively limited downside risk.

Company Overview:

Smith Micro markets a variety of software and solutions targeting mobile carriers and OEMs. It prides itself on being the market leader in offering a wide array of solutions to mobile carriers, primarily geared around enabling convergence in mobile devices. Their music software enables users to transfer music between mobile phones and their computer; their connectivity solution is frequently packaged with the mobile broadband cards that have become so popular with companies, allowing road warriors to access the internet from anywhere they can get cell phone reception. The company also has a consumer division, which recently signed up VMware fusion, a leading software solution for running windows and Mac simultaneously on Intel-based Macs, and which sells the popular Mac software titles like Stuff-it, Poser, and the leading manga software. They claim to have the largest presence of any publisher in Apple stores, with 13 titles on average available.

There are too many business lines to discuss without boring you to death: a wealth of information is available on the company website here. Suffice to say, the company operates in a variety of attractive, emerging growth niche's that are in high demand among carriers, device OEMs, and consumers. The cell phone is increasingly winning out as the consumer choice for mobile convergence, and as consumers continue to migrate to all in one devices like the iPhone, demand for SMSI's products will continue to grow. Let's take a brief look at the company on a by segment basis to see how the revenue and profits break out, based on my 2007 estimates:

% of Revenue % of Gross Profit Q3 Gross Margin % YoY Growth rate
Multimedia: 40% 30% 56% 10%
Connectivity: 38% 49% 94% (!) 108% (!)
Consumer: 18% 18% 73% 25%
Other: 4% 3% ~50% ~150%

The connectivity business is the real gem here. Growth has been stellar, and with new carrier customers continuing to be onbarded, and the overall market for the product expanding at a nice clip, this should be a 50%+ growing category for the foreseeable future. Thanks to the high gross margins, this busines will be an even larger percentage of gross profit next year.

In Q3, Verizon accounted for about 68% of SMSI's business. This concentration rightfully had a lot of people spooked. Since Q3, the company has announced a couple acquisitions which should immediately drop that number to about 50%. More importantly, the company has tremendous opportunity to offer the same services it currently offers to Verizon to other carriers and OEMs. It's latest acqusition of PCTell, while expensive, now gives it inroads into just about every major carrier in the world. This is a story that's hard to quantify. It's impossible to accurately predict revenue growth, but the opportunity is there. A market leading company that can rapidly grow its customer base, increase its services per customer, and also see strong growth in their existing products can benefit from a rare combination of factors that leads to the kind of enormous QoQ revenue increases we've seen from SMSI thus far.

Why is it cheap?
Recently, Verizon partned with Real Networks to straighten its mobile music offering. Some peope worry that this will pressure their lucrative multimedia business if Real networks offers Verizon a competing version of the sort of mobile software SMSI currently provides. The risk, while possible, is overblown. Real has great PC based music playing software, but it currently can't offer the same mobile to PC service that SMSI specializes in. Even if Real does build out this capability (which I imagine they eventually will), SMSI has much better relationships with the carriers and OEMs, and should be able to make up other business through additional carrier wins as market competition increases.

There are also concerns over the mix of SMSI's multimedia business. Currently, the majority of revenue comes from selling music kits, which include headphones, a USB chord, and a Smith-Micro CD. The margin is about 45%, but the revenue per unit is high. The product is sold as an add on, and has an attach rate of about 10-20% (according to management's November investor presentation). Recently, carriers have been bundling the software with certain phones. Under this model, SMSI receives less revenue, but has higher gross margins (~95%), and experiences a higher attach rate as the product comes standard on most phones (~90%). Even though the revenue is much less, the increased profit and volume means that gross profit should stay relatively flat. Unfortunately, management has not provided revenue per unit under both models, so analysts haven't been able to do the modeling and are taking a "wait and see" approach. We can't do the precise math, but we have enough information to get comfortable. Let's do some basic math to see the impact to gross profit from the change:

Gross Profit from Music Kits: revenue/unit (x) * attach rate (15%) * gross profit (45%)
Gross Profit from Software: revenue/unit (y) * attach rate (90%) * gross profit (95%)


Gross Profit from Music Kits: .0675x
Gross Profit from Software: .885y

Which means that as long as revenue per software unit is more than 8% (.0675/.885) of the revenue received from music kits, then changes between models should have no impact on earnings. I think this is a reasonable assumption, with the music kits retailing for $30. Additionally, the higher volume benefit means higher adoption of the software, which in the long run is a strong positive for SMSI, as it validates consumer acceptance and allows SMSI to book more revenue from product usage.

Other reasons for the stock price include analyst frustration with not receiving guidance, and generally having difficulty modeling the business and the frequent acquisitions and customer wins. If you get the story here and understand the potential economics, its clear that revenue and earnings 2-3 years from now should be much more than they are currently, even if you can't quite chart the path to there accurately. I don't mind the quarter to quarter uncertainty, and believe the long term story is compelling.

The company has also burned through much of its cash, making two pricey acquisitions relative to sales. The startegic logic is solid, but the pricey valuations lead some to be cautious in the near-term. The company is acquiring customer relationships that improve the value of all their products through cross-selling opportunities. By acquiring companies that offer best-of-breed solutions to the carriers, it has become a dominant player in multiple high growth solutions, and the only company with true scale to offer multiple solutions to the carriers and OEMs. It also has the opportunity to sell its existing products into the newly acquired customers, and visa-versa.

Another issue worth mentioning is the difference between the pro-forma and GAAP numbers. For those of you who are unfamiliar with the terms, proforma notably adjusts earnings for stock based compensation and other one time expenses, while GAAP earnings do not. Recently, Pro-forma and GAAP earnings have diverged, with GAAP earnings down on a YoY basis due to much higher (and frankly, nearing egregious) stock grant and option expenses, as well as tax rate differneces (GAPP is fully taxed, cash taxes used for Pro-forma calculation are lower due to some NOLs). Analysts are using pro-forma numbers, which peg earnings at about $.80 for the year: a P/E of about 8 on current prices. GAAP should come in at more like $.18, which puts the P/E at about 38. So the stock is cheap on a pro-forma basis, pricey on a GAPP basis, and about fairly valued on a P/S of about 3.

For better or worse, analysts usually value companies on Pro-forma numbers, which helps here: the stock was previously trading at about 20x pro-forma PE, or 30x on a fully taxed pro-forma basis. If the growth story catches on again and stock returns to that same valuation, the stock could very well double to triple over the next year. On a GAPP basis, this can still work out well, too. According to my relatively conservative estimates, GAAP earnings should come in at $.40 in FY08, or a forward P/E of about 18x, with 30%+ growth thereafter , which would still make this a relatively strong performer in a weak market. Note that the company, which had been paying cash taxes in the single digit range in 2007, will likely be fully taxed in 08', which means profit growth will likely pause before accelerating again in FY09.

SMSI is a complex situation with a lot of moving pieces, but the value is there. It trades at an attractive multiple of current earnings, and is perhaps one of the more exciting, high growth, and profitable companies available in the market today--and certainly at these prices. Continued earnings growth, the attractive "story nature" of the stock, and the possibility of drastically increased multiples (from 8x today to 20-30x historically) mean the stock could be worth several times its current value if a few things work right. If things go mediocre, with multimedia growth slowing down, you've still got the high growth connectivity business that is chugging along and should keep earnings from falling apart. In the unlikely event that both the multimedia and connectivity division collapses and/or SMSI loses Verizon at as a customer, the stock could drop substantially, but given the potential upside I think that's a risk we are more than compensated for.

Note: Author is long SMSI