Research Intensive Investing

This Guidance is not Guidance

2008-03-18T18:52:00.000-07:00

MNST, which suddenly saw the light at the end of last year and decided it would no longer issue guidance, "corrected" analysts today on what number they should plug into their models for Q1 operating expenses. This "correction" should have the result of reducing the non-GAAP EPS by about half of what analysts currently projected for the quarter. Below are a rough snapshot of consensus estimates before the announcement.

Revenue: $369

Non-GAAP OPEX: $300

EBITDA: $85

EBIT: $52

Interest Inc: $6

EBT: $58

Net Income: $38

EPS: $.30

And now my own estimates, using this announcement as guidance:

Revenue: $368

EBITDA: $54

EBIT: $37

EPS: $.19

These are pro-forma estimates, which means they don't include one-time charges. Given the decline in business and the ongoing restructuring, I would not be surprised if actual GAAP earnings were to turn negative.

The important takeaway from this announcement is that we are finally starting to see the consequences of heavy investment in a business with declining growth. EBIT margins should decline by over half YoY. If this trend continues, as I expect it will, the affect on MNST's operating results, and share price, should be severe.

I also think this announcement speaks a lot to management credibility. If there was any doubt that management was withholding guidance on principle, those doubts should be put to rest. Their operating margin guidance (another form of guidance that apparently doesn't count) is now basically unattainable unless trends reverse themselves drastically in the back half of the year. Expect this to be the first of many "corrections" to come.

Author is short MNST. Above writing should not be construed as "guidance" of any kind. Do you own DD.

Trouble brewing at GLG Partners?

2008-03-15T12:59:00.000-07:00

Alternative investments have, over the past 3 years, attracted record attention from investors, the public markets, and eager business students eager to cash in on the boom. Over the past several months, as the financial markets have been rocked by credit issues and declining valuations, the fairy tale, in many cases, has begun to turn dark. GLG Partners is one of the leading hedge funds in Europe, with a strong investment track record, diversified assets across strategies, and a solid investor base. At the same time, the company's unsustainable FY07 results (driven largely by gains in emerging markets), and it's uncertain use of leverage, provide substantial catalysts for a sharp decline in revenue and earnings in FY08. If past performance is any indication, it is possible that a large chunk of GLG's performance revenue will dry up in 2008, resulting in a strong drop in revenue, margins, and profit.

GLG Incentive fees at risk
GLG is structured like a typical hedge fund, in that it earns revenue primarily based on a combination of incentive and incentive fees. Annual management fees equate to an average of about 1.9% of AUM. Incentive fees vary across funds, but typically average between 20-30% of all performance gains across most single manager products. Incentive fees accounted for 50% of revenue last year, but also tend to be higher margin, and so have a disproportionate impact on earnings.

As of the year end 2007, GLG managed approximately $24B in assets spread across over 40 funds. Though funds are widely spread, there are some concentration issues, particularly in regards to revenue:

Fund % of Gross AUM FY07E Rev % of rev Annualized net return*
GLG Emerging Markets Fund 17% 265 32% 70.6%
GLG European Long-Short Fund 13% 141 17% 13.6%
GLG Market Neutral Fund 10% 124 15% 20.0%

*Based on morningstar estimates

GLG's top three funds account for only 37% of AUM, but accounted last year for 64% of revenue. Most importantly, I think it's fair to say that the emerging markets performance is nowhere close to sustainable. This implies gross returns (returns before fees) of annualized 90% since inception in November of 2005, compared to ~35% for the emerging markets ETF. Given the tougher emerging market conditions (down about 13% YTD as of this write-up), and the high growth in AUM (which makes high performance more difficult), incentive fees are poised to come down substantially in 08'. Also, note that this one fund may have accounted for over 50% of GLG's performance fees in the 2nd half of the year. Many of GLG's funds were actually down in the 2nd half, so this fund in particular helped artificially keep the firm's profits afloat.

The Leverage Risk
The other two funds noted above (European L/S and market neutral) have components of hedging, making them less prone to market fluctuations. At the same time, these sorts of hedged funds are the most likely to use leverage. Leverage allows funds to amp of their performance, and was a particularly common practice over the last couple years, as low risk premiums and eager prime brokers would often loan funds capital at low interest rates. Over the last few months, and in particular over the last few weeks, prime brokers have begun reigning in this excess. The result varies from crippling to disastrous (see the Caryle Capital collapse). GLG is very hush hush on the extent of leverage it uses: I doubt it took on the sort of ratios that Caryle took, but analysts reports indicate that it has, in some documented cases, used leverage in excess of 4x. Also, anecdotally, there are two points worth mentioning:

1) GLG is part owned by LEH, which itself was an aggressive prime broker. You've got to think that at the height of the boom, there was a chance that LEH encouraged GLG to gorge itself with leverage to boost its prime brokerage business.
2) Freedom Acquisition, the SPAC that took GLG public, is run by the infamous CEO's of Jarden, who I have written about previously. If their own appetite for leverage and risk is any indication, the leverage in GLG's funds could be scary.

If the leverage at GLG is extreme, the downside is clear: funds could blow up, leading to mass redemptions, lawsuits, loss of key talent, and potential collapse. While possible, I have no reason to believe this outcome is likely.

Painful de-leveraging
The alternative and more likely scenario, while not as bleak, is still damaging to GLG's earnings prospects. Let's assume that GLG's market neutral fund conservatively used 4x leverage in 2007 and earned 13.7% net fees (according to morningstar), and charges typical hedge fund fees. Using those assumptions, you'd get an un-levered performance gross performance of only 8.2%, vs. the estimated 18.5% levered gross performance that was implied to get to a net performance of 13.7%. By borrowing 4x its money at 5% and earning 8.2%, GLG was able to return more than double on a net basis what it would have been able to do if no leverage was available. If it does continue to use leverage, and rates go up and/or gross returns go down, leverage could magnify the losses. Also, due to the nature of leverage (typically short term lending), these agreements must be negotiated often. Depending on GLG's terms, it's possible that de-leveraging could force a liquidity crisis and force GLG to liquidate positions and rapidly reduce its leverage, resulting in a sharp decline in the value of the stocks it holds. This is somewhat unlikely, but always a risk.

The High watermark and hurdle risk:
Relationships between performance and incentive fees are not linear. It's impossible to know without reviewing the incentive structure of each fund, but we do know that certain of GLG's funds are subject to high watermarks, which means a fund that declines in one period must reach its prior highs before incentive fees can be charged again. Some funds are also subject to hurdle rates, meaning a certain performance benchmark must be exceeded before incentive fees can be charged. These measures should hurt GLG in tougher stock market times.

2008 Update:
The bulk of GLG's funds had an abysmal January. The flagship European L/S fund was down over 4% in January and the Market Nuetral fund was down 3%. The emerging markets fund was flat, which is impressive on a relative basis, but will not be particularly helpful in repeating GLG's outstanding emerging markets performance last year. If GLG's performance in a tough January is any indication of its ability to weather a tough 2008, flat YoY performance (and, consequentially, little/no performance fees) is not out of the question.

What does this all mean financially?
Barring stellar out-performance by GLG in these tough economic markets, GLG should experience somewhere between a rough and devastating 2008, cases that are not currently reflected in the stock price. If GLG does not keep up it's rabid performance, and, worse, if performance turns flat or even negative, much of GLG's revenue and profitability will dry up. Performance turning flat or negative is not out of the question, and has occurred before. Let's take a look at GLG's historic performance:

The image quality isn't great (blogger is giving me trouble), but you can see that performance in 2000-mid 2002 remained relatively flat. Also, before the incredible launch of GLG's emerging market fund in late 2005, GLG's overall performance was not very impressive. GLG returned 10.4% and 8.2% net fees in 2005 and 2004, well below its most recent performance, driven primarily by its emerging market returns.

Best Case Scenario:
In my best case scenario, GLG sees half of its AUM rise an average of 20% gross, and the other half of its fund experience losses. This could be possible if Emerging markets and a few other big funds do exceptionally well, despite losses in most other funds. In this scenario, GLG earns about $1/share, at the high end of estimates.

Base Case Scenario:
A more likely outcome given the market turmoil is a scenario under which 65% of assets perform negatively or otherwise do not hit the rate required to charge performance fees. The other 35% of assets return 15% gross of fees. In this case, GLG earns $.65, well below estimates.

Bear Case Scenario:
In another likely outcome, if January is indicative of how the year will turn out, it's entirely possible that about 75% of assets end up negative or below the rate at which performance fees can be charged. The other 25% return 12% gross returns, meaning earnings around $.40.

Conclusion:
I believe the best case scenario for GLG is that they meet or slightly exceed expectations, while the likely scenario leaves them under performing by a wide margin. Slap a 10-15x P/E on the base and bear case scenario and we can see downside between 25-55% to the stock price, or 50-80% to the warrants.

Note: Author is short GLG common and warrants.

Divergence in Staffing Stocks?

2008-03-07T04:28:00.000-08:00

I have written at legnth on MNST, KFY, and HSII in the past few months, arguing that the upcoming turmoil in the economy and, eventually, the job markets will reveal the underlying cyclicality of these businesses, resulting in massive decreases in earnings, earnings estimates, and share price. So far, my thesis has begun to play out nicely with MNST, which has seen pressure in both US and international MEI (a good proxy for business going forward). In the US, MNST has not only seen the MEI fall, but has also seen it's pricing fall as well due primarily to fewer sales to small and medium size businesses, which on average pay more per listing. This trend accelerating in the recently announced February numbers, which saw MEI fall 7% YoY. The same deterioration, however, has not been seen in the executive search companies, KFY and HSII in particular.

MNST serves as a broad proxy for the larger employment market. It is not surprising, then, that current weakness in the employment market in the US (and, increasingly, abroad) has and will continue to erode its business. KFY and HSII, however, focus on a very small niche of the job market: that of executives, and higher level management. The market for executives and high level management is driven primarily by the creation of new management jobs and increased turnover in management. Factors that influence these two drivers are tighter markets for talent, increases in poaching from other companies, reductions in promotion from within, business creation, and general economic conditions.

My original thesis was that all the aforementioned factors would be negatively influenced in deteriorating economic conditions. I believe I misjudged a couple key elements which have delayed but not prevented an eventual drop. These develops include:

1) Continued robust growth abroad, which should begin to slow noticeably as the US drags down international economies with it. Also, keep in mind that most of HSII & KFY's business is from multi-nationals, not country domiciled businesses, which means that many of these businesses country growth plans could be harmed by issues in the US.
2) Increased mandatory turnover as companies (especially financial companies) clear house, firing scapegoats and bringing in fresh blood. This has the effect of increasing demand for HSII & KFY's services. I believe this affect is temporary. Once house is cleared, the impact of decreased turnover should be revealed. In tough economic times, employment opportunities tighten, leading to less voluntary turnover as people are presented with less opportunities to move elsewhere.
3) HSII alluded to strong demand in financial services for risk managers that offset much of its weakness elsewhere. The financial markets turmoil has, it appears, at least temporarily created demand for new management positions. I believe this shock is one time in nature and that, eventually, we should see new job growth at the management level slow noticeably, both domestically and abroad.

MNST should continue to experience pressure to its earnings and stock price nicely mirroring declines in US and abroad job growth. Whether or not these same pressures will eventually hit KFY and HSII remains to be seen, but I for one believe they will.

Author is short MNST, KFY, and HSII.

Tough times ahead for Evercore Partners (EVR)?

2008-02-05T15:17:00.001-08:00

In keeping with my recent theme of finding cyclical companies trading at peak earnings, enter Evercore Partners (EVR): a near pure-play investment bank specializing in advising US M&As on behalf of corporate clients. Currently trading at 13x what I believe are peak earnings, and with a pipeline that is in the process of drying up, I believe the company's cyclicality will reveal its full force in the financials as soon as next quarter. Despite clearly slowing M&A trends in Evercore's main market, analyst estimates are still nowhere near reflecting likely trough earnings in this business. Current estimates are counting on a H2 rebound above and beyond the peak M&A activity experienced this year, which I believe will not materialize. For regular readers of this blog, the argument below will share a striking resemblance to the argument I laid out for shorting staff stocks several months ago. As earnings are revised downward to become inline with likely future results, EVR should fall even more than it has already as the true trough earnings emerge.

The M&A Cycle
Mergers and Acquisitions activity fluctuates in tandem with the equity markets and general economic activity. M&A activity tends to peak in economic boom times, as optimism, easy credit, and fluffy growth prospects rule the day. As economic times head south, companies tend to slam the brakes on M&A furies: credit dries up, attractive growth stories become harder to find, and CEOs have enough to fix in their own companies that they can't bother to be distracted by integrating acquisitions. There are other factors at play at well, but for simplicities sake, lets leave it at that. Lets take a look at total global M&A volumes from 1997-2006 (estimates from dealogic):

Total RoW US
1997 $1,512.82 $632.2 $880.6
1998 $2,307.69 $307.7 $2,000.0
1999 $3,073.77 $1,637.0 $1,436.8
2000 $3,459.02 $916.8 $2,542.2
2001 $1,764.71 $953.9 $810.8
2002 $1,400.00 $933.3 $466.7
2003 $1,411.76 $878.4 $533.3
2004 $2,037.67 $1,190.1 $847.6
2005 $2,875.86 $1,582.8 $1,293.0
2006 $3,891.72 $2,096.4 $1,795.3

In the tough economic years of 2001-2003, M&A fell off a cliff. The results look particularly awful when we take a look at the US only (look at the US drop from 2000-2002!), despite falling interest rates. Several bulls have come out on M&A because of the falling interest rates, but they are not taking into account rising corporate yields (the real cost to buyers), nor stricter credit standards, which were basically non-existent in 2006 and early 2007. Similar trends repeat themselves to varying degrees in nearly every recession of the last 30 years. This time truly may be a little different. Most notably, M&A activity abroad has picked up substantially in recent years, and the trends are even more pronounced in 2007. Though not pictured here, M&A activity has slowed down substantially since the credit crunch, as easy credit has dried up and economic prospects outlooks have turned downward. Things will likely get even worse as private equity firms, currently flush with cash, run out of money and have trouble raising new funds.

How the M&A cycle affects Evercore
Evercore was one of the prime beneficiaries of the latest M&A boom, and is also likely to be one of the greatest victims when this current cycle turns. EVR derives ~90% of their revenue from M&A advisory (helping companies sell themselves or buy other companies), with over 80% of that revenue coming from the US. EVR also tends to focus on mega deals ($5b+ acquisitions), that have been all the rage the last two years due to the LBO craze, which has officially come to an end. Going forward, we are likely to see declining overall M&A volumes, increasing volumes in the rest of the world compared to the US, and sharp declines in both the number and size of megadeals. These trends, which I will discuss in detail, do not bode well for EVR.

EVR provides a financial advisory services, including M&A advisory, recapitalizations, and restructuring, but the biggest chunk of that is M&A. Unfortunately, the company--probably for good reasons--does not break-out advisory revenue into its different segments. They are often hired by the acquiror or the seller to advise on a prospective deal. They are typically paid a % of the total deal size upon the deal's closing, ranging to an average of about .06% of the deal size for sub $1B deals, .224% for $1B-5B deals, and .545% for <$1B deals. These numbers are estimates, but they should be relatively accurate. If the deal does not close (if EVR cannot find a buyer to match with a seller, or find a deal for a buyer), then the company makes no money.

The Mega-deal decline:
Even if the only thing to decline is the number of mega-deals, EVR will be in serious trouble. Megadeals have accounted for the majority of their revenue the past few years, and are likely to decrease in both number and size. Below is the estimated dollar value megadeals ($5B+ deals) that EVR has closed since 1997:

1997 $0.0
1998 $0.0
1999 $0.0
2000 $52.5
2001 $10.4
2002 $0.0
2003 $0.0
2004 $46.8
2005 $24.0
2006 $194.7

Note megadeals have generally peaked as the market has peaked, and can even dissapear entirely from EVRs pipeline in more mild economic times. This trend has continued in 2007, though we've already seen the completed mega-deal number for EVR come down substantially as megadeals are increasingly being done in non-US markets, or by foreign companies in US markets (neither of which EVR is particularly strong in). Megadeals have accounted for an estimated 78%, 55%, 94%, and 84% of EVR's deals in 2004, 2005, 2006, and 2007 respectively. The numbers are a bit lower as a % of revenue (since the % fee per deal dollar is lower), but it is stil substaintial: likely 50%+ in each of the last 4 years). EVR has only one mega-deal in its pipeline (the ADS deal, which has blown up and likely won't happen), and odds are seemingly increasingly likely that even if they do nab one or two of these deals in 08', the average value of these deals is likely to be smaller than the average mega-deal size in 07' and 06'. This development alone could cut revenue in half (or more) in 2008, even if small to medium size deals increase slightly.

The vanishing pipeline:
US M&A activity has grind to a halt since August, but because deals take time to close after they are announced, EVR's revenues have held up deceptively well. In the most recent quarter (Q3) they closed on two megadeals they'd announced moths early (KKR and CVS acquisitions), as well as a variety of smaller deals done before the credit crunch. They are estimated to have closed only $15B in Q4, and go into 2008 with a relatively tiny backlog of $18B. The company only announced $5B in new deals in Q4 according to dealogic. If production continues at these levels, EVR will come nowhere close to equaling the amount of deals they completed in 2005-2007. Yet, analysts somehow are projecting continued revenue growth, mostly due to newly hired MDs. Even if the new MD hires allow them to grab some market share, I expect this will be more than offset by declining macro trends.

EVR set up to disappoint in 2008
I estimate that EVR may earn between $.42-$.62 in 2008, well below the $1.70 consensus. EVR has almost no tangible book value (~2.50 v. $19 share price), so there is little in the way of a margin of safety if earnings drop as I expect they will.

To get to my revenue estimates, I assume that completed M&A deals below $5B/deal will revert to 2005 levels, which seems like a reasonable assumption given that much of the M&A growth of the last 3 years was unsustainable. I assume Mega deals ($5B+) will revert to 2004 levels for simmilar reasons. I also add in the fees from the current estimated backlog going into 2008 (~$18B), as well as some amount for non-M&A advisory revenue (~$20M). I assume a 25% pre-tax margin, vs. the 30-35% experienced the last couple years, due to lower revenues on a partially fixed cost base.

The earnings range comes by assuming different market share numbers for EVR. Even under the most optimistic of share scenarios, I estimate revenue should fall between 40-70% if the M&A market (particularly the US market) contracts as much as history would suggest.

Note: Author is short EVR.

MNST: Dismal outook bouys short case

2008-01-31T17:27:00.000-08:00

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.

This Is Insanity, and It Will not Last

2008-01-25T06:52:00.000-08:00

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.

How to protect your portfolio in a bear market

2008-01-21T15:51:00.000-08:00

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.

SMSI: Profit from a fallen wall street story

2008-01-13T17:55:00.000-08:00

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%)

So...

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.

Conclusion:
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

OEH - Shorting Based on Unwarranted Speculation

2007-12-30T16:00:00.000-08:00

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.

Conclusion
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

Jarden Earnings Set to Implode?

2007-12-26T13:18:00.000-08:00

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).

Conclusion
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

RC Group: Growth on Sale

2007-12-23T17:50:00.000-08:00

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.

Prices
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.

KFY, MNST, HSII: Recession Risk Not Priced In

2007-12-18T10:31:00.001-08:00

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.

Profit from a busted Chinese IPO

2007-12-17T08:33:00.000-08:00

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.

Risks:
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.

Valuation:
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.

Update on KFY & MPG

2007-12-16T09:05:00.000-08:00

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.

Crisis Looming at Maguire Properties?

2007-11-22T13:59:00.000-08:00

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.

Shorting Staffing Stocks Part 2: MNST

2007-11-17T16:09:00.000-08:00

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

2007-11-17T14:07:00.000-08:00

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.

MCZ: The ups and downs of an evolving story

2007-08-02T13:37:00.000-07:00

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.

Amazon: Why now may be the time to short

2007-06-12T01:19:00.000-07:00

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 Fogdog.com, 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.

Conclusion
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.

Valuation
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.

Track my Performance, and yours too!

2007-06-08T15:30:00.000-07:00

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.

The dawn of "Covesting"

2007-06-07T13:49:00.000-07:00

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.

MCZ FY07 Results – Turnaround appears intact

2007-06-05T22:04:00.000-07:00

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.

Position Sizing and when to sell

2007-06-04T21:48:00.000-07:00

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.

Underperforming CEFs as a hedging strategy?

2007-06-02T10:33:00.000-07:00

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.

MCZ: The difference between investing and gambling

2007-05-31T16:32:00.000-07:00

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.

Closed NTWK position

2007-05-29T12:27:00.000-07:00

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

2007-05-29T08:49:00.000-07:00

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.

MCZ announces Halo license deal

2007-05-11T16:55:00.000-07:00

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.

Eyelogic -- my most exciting long term holding

2007-05-09T01:36:00.000-07:00

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.

Overbought and Over Bullish

2007-04-26T02:13:00.000-07:00

With new headlines peppering the media about how the stock market (or, more accurately, the dow) is reaching all time highs, its worth taking a step back and evaluating your holdings and market exposure. As a general rule, when we see headlines like this, I get nervous. A rule of thumb I have is that when your taxi driver and everyone you know if bragging how much they are making with a certain kind of investment, you know you have reached a top. Though that may not be the condition of the market now, conditions seem unlikely to produce good long term value from here, and run the risk of a deep, prolonged downturn.

Though I have the majority of my investments in stock holdings, I have hedged out most of my market exposure through shorting individual stocks, as well as indexes. In conditions such as these, the performance of my portfolio is the difference between the performance of my long holdings, against those of my short holdings. In conditions such as now, where I believe short term returns to be negative to flat, this investment stance has the benefit of lower volatility and higher returns than a simple long only strategy woudl afford me.

For those of you interested in a great catious view of the stock market, I strongly urge you to take a look at Hussmans new article, posted here. As always, his weekly articles are gold.

Catious investing to all

MCZ update, New licenses deals

2007-04-24T09:07:00.000-07:00

A brief update on MCZ. In the last month, they have signed a couple significant licensing deals, one for Biowares mass effect, and another which was a renewal with the NBA. The NBA deal is of particular significance, as MCZ should get more out of the deal than last time around, by manufactuering additional accessories (mainly controller and console skins) than they had previously. I hope to see more deals like this announced on a continuing basis, as it is these deals that allow MCZ to create higher margin products.

To reiterate, the main thesis here is that margins will settle at or above their historical levels (25% plus) over the next few quarters, with resumed revenue growth. Deals such as these are good steps, but ultimately Q4 earnings will be crucial to get a sense of where margins will fall going forward. Until then, its wait and see for me.

An Alternative Mutual Fund Primer

2007-04-13T03:28:00.000-07:00

For people without the time or experience, to invest in individual securities (and even for others), I am a big proponent of a significant allocation to mutual funds. Unfortunately, the majority of mutual funds are awful, particularly those that are advertised most heavilly and that are most popular with investors. With proper research, however, you can find some truly great investment funds and managers that should deliver strong returns over a long time horizon. Though there are many excellent resources online for selecting the proper mutual funds, there are several points of convential wisdom that I believe are innacurate and worth correcting. Please note that many of these pieces of advice assume you know the generally accepted basics (examine long term returns and drawdowns, watch for manager changes, etc.).

Debunking the underperformance myth

Before diving into specific recommendations, it is worth briefly discussing the active v. passive debate. In recent years, with the rise of ETFs, many people have put forth arguments that active investing does not make sense. They have pointed to statistics of overall underperformance of mutual funds v. the indexes, tax inefficiency, the efficient market myth, transaction costs, and a host of other arguments.

While this may be fair, on the average, a selection of the upper crust of mutual fund managers avoids many of the issues that passive proponents point to. Though the average mutual fund is junk, there is a significant subsection of funds and managers that have consistently outperformed the market over long periods of time, net fees and taxes. Though, statistically, it is possible (and expected) for this outcome to be observed, it is worth noting that many of these managers operate a simmilar strategy: value investing. In a past writing, by either Hussman or Buffett (I forget which one), they illustrated this logic through a brief anecdote, which went something like this:

If you went ahead and gave 1,000 monkeys money to invest, set them lose, and tracked performance over the next 20 years, you would expect there, by randomness, to be variance in their performance. Some, by sheer luck, will naturally have outperformed others, and the market as a whole. Lets say, of those 1,000 monkeys, by chance, 100 will have outperformed the market by 5% or more. By chance, this would be what we expect. But suppose that 80 of those 100 monkeys happened to come from a small town in Omaha, where a monkey named Warren Buffett had, for quite some time, been teaching the other monkeys a particular way of selecting stocks. Well, you may begin to wonder what was so special about Omaha and the monkey there, and whether or not they were onto something.

Unconventional mutual fund recommendations

There are several important factors when trying to find those monkeys that will outperform the market. Morningstar.com is a great resource for information, and although they have some excellent write ups, there are several areas in which my philosphy differs signficantly from theirs, as well as traditional mutual fund wisdom. First, some against the grain recommendations:

1) Fees do not matter if performance net fees is high:
Morningstar and other mutual fund commentators will often knock strong funds with high fees. Though there are many poor funds that have high fees, I believe high fees alone are no reason to avoid a particular fund. Better funds can charge higher fees, and still deliver better results, and it in general makes sense that you will often get what you pay for with fees. Observe the fees of the following two funds:
Fund A: 2% with a 1% deferred load
Fund B: .2%

Fund B appears to be a better value, but you get what you pay for. Fund B is IWM (the Russell 2000 index), with 5 year returns of 11% and high volatility. Fund B is Hotchkis and Wiley small cap value, with returns net fees of 15.8% over 5 years, despite significantly higher fees. For .2%, you get what you expect: a strategy that basically consists of buying whatever stocks are in the index, regardless of value. For the higher fees of Hotchkis and Wiley, you get a team of analysts and portfolio managers who have consistently outperformed the market.

2) Concentrated portfolios are often better than unconcetrated ones
In general, when selecting mutual funds, I prefer a concentrated portfolio. Fairholme fund (FAIRX) is one of my core holdings, with only 21 stocks and over 60% in their top 10 ideas. I prefer concentrated porfolios as I generally like to see managers put conviction (read: more money) in their best ideas. Lets say a manager holds 20 stocks, 5 of which they expect to appreciate 30%, and the other 15 they expect to appreciate 10%. One manager puts 50% 0f their fund in those top 5 ideas, while the other equal weights each idea. What is the peformance difference?

Concentrated: (.5*.3)+(.5*.1)=20%
Unconcentrated: 1*.10=10%

Though a concentrated fund may experience higher volatility, the overall volatility of a properly balanced portfolio using mutual funds will be minimal. If, for example, you invest in 4 equity funds, each of which have a concentrated portfolio of 20 holdings, your overall equity porfolio will be 80 holdings. Keep in mind that many of these holdings are likely also conglomerates, which are made up of multiple business divisions and thus can often represent 5 to 10 different companies. In this way, investing in 4 concentrated funds would give you a stake in potentiall hundreds of businesses, which arguably is too diversified.

3) Volatility can be your friend, if it has the right correlation
Volatlity is mostly a bad thing when the correlation between your different investments is all related. If you have all your money in large cap US financial stocks (generally low volatility), you will likely experience volatility in the same direction all the time, resulting in sizeable swings in your portfolio value. When diversified across multiple asset classes, industries, currencies, and strategies, you can build a portfolio such that something of yours is likely to be always going up. Though the individual components of the diversified portfolio may each have higher volatility on their own, the overall volatility of your porfolio will be less than when invested in a single mid to low volatility asset class. If you chose the right investments and asset claseses, you should be able to construct a portfolio with significantly less volatility than the stock market, which is also capable of outperforming the stock market over a long period of time. In other words, if your stock advisor telling you you must accept lower returns and put more money in bonds if you want to experience less risk, it is probably time to find a new stock advisor with more progressive views of asset allocation.

A good example of this point are foreign funds with unhedged currency exposure. Currency exposure is a great way to get uncorrelated volatility, with the potential for amplified returns if you believe in the immeninent decline of the dollar. In fact, without foreign currency exposure, investing in foreign stocks provides little diversification as the majority of equities head in the same direction on the way down.

4) Look for a competitive advantage and added value
Most funds operate somewhat similarly: they have the same value screens, peform the same analyses, and generally invest in the same stocks (many mutual funds invest in so many stocks, for example, that they are essentially ETFs. With each of my largest mutual fund holdings, I can usually point to something that fund does that is different or better than other funds. Hussman has a unique hedging strategy that signficantly reduces volatility, while creating long term returns that outperform the market. Bridgeway aggressive investors (BRAIX) has propriety quantitative models that have consistently outperformed the stock market over the last 10 years. Fairholme, Dodge & Cox foreign (DODFX), and Hotchkis and Wiley small cap all come from fund families that have consistently outperformed the market, and have some of the best investment talent around.

5) Operating history is nice, but not nessecary
Though I alway prefer funds with a long operating history, many of the best funds close long before they get to prove themselves in this way (particularly funds focusing on small caps). If you want to get into many of these top performing funds befor they close to new investors, you need to invest before the fund has shown a long operating history. As a rule of thumb, I will often eagerly invest in a new fund by a reputable company regardless of early returns, as long as the new fund is in a strategy that that fund has done well with in the past. Examples of fund families whose funds close rapidly and are generally respected include Dodge & Cox, Hotchkis and Wiley, Wasatch, Bridgeway, and Royce.

6) Exotic does not mean risky or bad
With the popularity of hedge funds and their strategies (e.g. long short, arbitrage, etc.), new mutual funds are emerging with new strategies that offer lower volatility or inverse correlations to typical investments. Hussman, for example, often gets knocked because people do not understand his strategy, and see his recent underperformance as a failure (when, for the most part, it is not). Though I believe people should not invest in strategies they do not understand, that does not mean these are bad strategies (or not worth reading about to learn how they work). Funds such as hussman are the only way to benefit off some of the more sophisticated strategies that the uber-rich have enjoyed, for years, with hedge funds, that are finally being made available to individual investors.

In the coming weeks, I will follow up with more articles on mutual funds and overall porfolio construction, as I believe some of the more popular conventional wisdom in this area to be more popular than it is wisdom.

My trip around the world

2007-03-24T01:30:00.000-07:00

In the interest of actually have some semblance of an adventurous life before committing myself to a hedge fund office later this summer, I'll be heading off on a trip to Asia and Europe for a couple months starting tomorrow. I will likely still update the blog once a week (I've stored up a couple articles I'll be releasing), but just wanted to let everyone know in case I fall behind on updates or answering e-mails.

The response thus far to the blog has been more positive than I ever expected--in particular, I never thought this blog would be such an effective means for exchanging ideas. Thanks again for reading, and please do continue to post comments/e-mail me to exchange ideas.

Thrive,
Eric

MCZ--Conversation with the CFO

2007-03-22T23:23:00.000-07:00

Note: See full write-up and thesis for MCZ here

Below are the highlights from the call with the CFO. I am preparing for a trip abroad for a couple months (more on this shortly), so I unfortunately do not have time to write this up as cleanly as I would like. These are based on my notes and interpretation in several cases, and should not be seen as direct word or guidance from the company:

1) We should likely only expect about 1 game/year to be released by MCZ for the time being. They are trying to take a measured approach to ramping up software releases
2) They are very excited about the Inair technology. They see it as a low risk/high reward situation
3) They do not yet have a license with Nintendo to produce Wii's controller. Also, from what I could tell from his careful choice of words, they do not appear to have reverse engineered it yet, though it sounds like they are working on it (he did not confirm this, but that was my impression of what he was saying between the lines).
4) On gross margins, they have made some tangible changes the last 2-3 quarters to try and improve these. Though they don't want to guide for 29% every quarter, it was clear to me that, in the historical range of 22-29%, they are hoping to hit the higher end of that range, primarily through the sale of more licensed products ( e.g. NFL controllers) and keeping costs under control.
5) They clearly have ambitions to grow revenue up from $100M going forward, and it sounds as though they expect they are able to do so.

A few other points I learned:
1) On licensed product, the main issue in getting these deals done is that some publishers want to protect their brand, and are concerned with diluting it by providing accessories. Also, some publishers that decide to make accessories want to control the quality of those accessories, and thus decide to produce in house. That said, publishers like these deals because its free money, and some don't like doing it themselves because its not their core competency, and not enough money on its own right to be worth the bother of doing it in house. I found this explanation helpful to better understanding the dynamic in how publishers decide whether or not to do a deal.
2) Management appears to take a very measured, risk-adverse approach to developing and launching products. They do not take big risks--they go for singles and doubles, not homeruns. This is good, in the sense that one big mistake likely won't sink a year's earnings, but at the same time this to a degree limits the possibility of a fast ramp in revenue (e.g. by investing heavilly in releasing more hardware/software bundles, which are higher risk/reward).
3) They expect strong operational leverage, meaning they can grow revenue from here with limited increases in expenses pertaining to operations. This was a good confirmation, as it supports my FY07 earnings expectations of ~$.11, if we can grow revenue 10% and have gross margins of 26%.

Overall, though I have some concerns about the Wii controllers not being ready (particularly given the potential here if they could get something out the door), things still seem on target. Q4 in terms of both revenue and gross margins should be helpful going forward in assessing what to expect for next year.

Eric

Disclosure: I am long MCZ shares

WZEN: Another undervalued Asian Name?

2007-03-22T16:59:00.000-07:00

For whatever reason, the majority of the value I've been finding recently is amidst several Asian companies with businesses in transition, that are trading near cash value. Though I am hesitant on the prospects of China to keep up its tepid growth, value is value, and cash is cash.

Thesis
WZEN is a South Korean based game developer that is in the process of building a series of high profile releases from proceeds received in IPO about 2.5 years ago. They are currently trading near book value, with limited value being assigned to their attractive game porfolio going forward. Though I am excited about the prospects of the company, I can see this trading down even further, more near something approaching cash value, and would be looking to add the name on weakness before several of their big releases later this year.

Business Overview
WZEN is one of the leading game development company's in south Korea. About three years ago, they released "MU online", which was one of the more popular games in major Asian markets for a couple years. This game propelled the stock, and gave WZEN the clout to become a national game developer. After IPOing, WZEN ramped up development on several big budget titles, including SUN, Huxley, Kingdom of Warriors, and APB. WZEN began developing many of these games 2+ years ago, when they received their big cash infusion, and are getting ready to release many of these games within the next year or two. As WZEN has ramped up developement, they have accrued significant costs without any revenue benefit (they do not receive revenue until the games launch). At the same time, they have experienced a decline in MU revenue, due to the natural aging of the franchise. This combination of investing in the future, and eventual winding down of MU revenue has led to an apparently grim operating picture, though things aren't nearly as bad as them seem. Typically, developers expense upcoming games while they are receiving current income from the games they have developed in the past. Becasuse WZEN has been ramping up its developement so rapidly, and because they have not released a game for quite some time, the financial picture is currently distorted. As new games are released over the next year or two, we will begin to see the investments of the past two years ($50M+) reap dividends.

The Games
WZEN has several games in varying stages of development. I will outline a few of the big launches below, including timing, and thoughts on potential

Huxley -- End of 2007
Huxley is a Massively multi-player online game being developed for the PC and Xbox 360. Of all releases to be released in the near future. Though I do not have specific expectations for the release, nor the knowledge at this point to predict sales, I can give some anecdotal evidence I believe to be compelling:

WZEN announced in February that it had sold the rights for China publishing to NCTY, one of the leading Chinese publishers, for an estimated $35M over 3 years (actual can be more or less, depending on milestones) plus a 22% royalty. From what I can tell of operating expenditures over the last 3 years, it would appear as though this one up front payment in China has paid for most, if not all of Huxley's development costs.

In the US, Huxley has received very favorable coverage from Gamespot, the largest online videogaming news/review site. The Xbox 360 version is ranked #5 out of 415 games in popularity, very impressive for a game not launching for at least 6 months. It has also won awards and received very favorable coverage at E3, the largest yearly videogame conference. Though I have not conducted scientific studies on this, gamer anticipation is usually an excellent sign of things to come. Assuming the quality is there (which, by early indications, it is), this seems to be lining up to be a hit.

SUN -- 2007 in various geographies
NCTY also agreed to purchase Chinese rights here, this time for $13M in payments + 22%. NCTY profiled this acquisition as a milestone on its Q4 2005 conference call, and said they had high expectations. Also, accoring to 17173.com, a popular chinese gaming site, SUN was in the top 2 most aniticpated online games in the several months between August and November. Sun was released in Korea in November, though I have had trouble assessing its success. One thing to note is that, at least in Korea, the game will be free, and be supported through "micropayments", or the in-game purchase of game items (e.g. special swords, charaters, etc.). Because of this payment model, I would expect that revenue will ramp up more slowly, but have more longevity. By providing free access to the game, WZEN creates a hook that gets people to play, and will hopefully eventually induce them to spending as much (or more) as they would have paid under a subscription model.

Though the game appears to have presence in China, prospects in the US seem more dull (it has gotten very little coverage and does not seem to have much anticipation, again using gamespot rating as a proxy.

APB: 2008 Release
Still a year off, but this game is one to watch. It is by the creator of Grand theft auto, which may very well be the most successful gaming franchise of all time. More details to come on this as it is still early in development, but this appears promising

TBD Red 5 game:
Last year, WZEN brought further clout by teaming up with Red 5 to publish their first game. Red 5 was founded by a team of World of War craft developers who have been involved some of the more popular games of the last several years, including Diablo 2, Warcraft 3, and starcraft. They have some very ambitious goals, and though their project has not been announced, WZEN will be set to launch it worldwide when it is ready. WZEN is clearly intent on becoming a force in the development of multiplayer online games.

Other games:
WZEN has 2-3 other games in developement. Though these are not on the same scope as the prior games, they do provide revenue potential as they move from development to launch.

Financials
WZEN's ADS shares are equivalent to 3/10 of one share on the KOSDAQ. WZEN's market cap is a bit difficult to track down, but from what I can tell the ~13M shares outstanding translates into about a $180M market cap @4.15. If you back out the ~$100M in cash, the company is trading for an EV (market cap - cash + debt) of ~$90M. WZEN is also burning through about $20M in cash/year, and I won't expect this to change until we see the release of Huxley later this year, so I'll assume they burn through another $20M before breaking evening, giving them an EV of ~$110M. On a Price:book value basis, this is trading at about 1.25x book.

My big concern with the business is that costs have really ballooned here, well beyond what seems to be required for the business. Gross margins on MU revenue fell from about 90% three years ago to under 30% in 2005. I'd assume that this is partially related to the aging of the game, and that a number closer to 80% is what is expected on multiple games (though I need to confirm this). Additionally, SG&A has gone up about $10M. Add onto this $20M is R&D costs (which I expect the company will continue to need going forward, to produce continued hits), and the business is operating on a fixed cost basis of about $45M, much more than the $20M it operated on when it released MU and achieved $36M in profit several years ago. That same revenue, on today's cost basis, would generate $6M in operating profit. At an 80%, instead of 90% margin, the company would have lost a couple million.

In other words, WZEN will need hits about twice the size of MU (~$100M in annual revenue @ 80% gross margin) to return to net income of $35M. This is where the analysis gets tricky, because the video game business has a relatively unpredictable hit cycle. Nevertheless, I'll take a very rough look at how this may play out.

Between SUN and Huxley, I think there's a good chance we can expect MU style revenue, given the existing contracts in place with NCTY, and the degree to which these have been tracking high on the hype meter.

The real wildcard then, in my mind, is the success of Huxley in the US. If present coverage is any indication, this is lining up to be a hit. Even if it is a hit however, it will need o generate $50M+ in revenue to really create the kind of net income impact that would allow WZEN to move substantially from here, given the increased cost base.

Conclusion:
For the time being, I will sit on the sidelines here, though I'll be watching to see if this drops nearer to its book value (about $3/share). As the company will continue bleeding money for the next couple quarters, and with the slow revenue ramp of SUN and coninued cooling in Asian names, I think there is a decent possibility. At that price, however, I think the risk/reward becomes favorable enough to make a go at this one. Since I don't forsee any upward catalysts for ~6 months (as we near the release of huxley, and as SUN revenue ramps up), I think this will become a more attractive play

MCZ—Conversation with IR

2007-03-20T01:57:00.000-07:00

MCZ—Conversation with IR

Spoke to MCZ Investor relations today, and am hoping to set up a meeting with management later this week. Overall, call was very positive. I am getting comfortable with the thesis, and am increasingly confident that the gross margin and revenue recovery will play out as I expect it to.

Gross Margins

A big focus of the call was getting a better sense of the reasons for the fluctuations in gross margins. As was apparent in the scenario analysis I posted in my longer write-up, the GM % is crucial going forward in determining an ultimate valuation for the company. Should we expect GM as experienced in Q1 and Q2 FY07 (~22%), that experienced in FY04 (25%), or that we say in Q3 FY07 (29%?). Though not stated explicitly, my impression is that going forward we can expect margins between 25-29%, based largely on managements focus on releasing more higher margin products. Though I was not able to get specific gross margin numbers by product, I did get a sense of what products are high v. low margin:

High Margin

This includes hardware and software bundles (e.g. Xbox arcade game stick, real world golf, dance pad + game) and licensed accessories, including console/controller skins, and other licensed accessories like, for example, Philadelphia eagles controllers. Madcatz currently has exclusive agreements with several large sports associations for accessory rights, and is hoping to sign several companies to longer term deals.

Low Margin

Lower margin products include unlicensed 3^rd party accessories (e.g. Madcatz Xbox controller), as well as iPod accessories and cables where MCZ competes primarily based on price. Going forward, it is clear that these will not be abandoned, but that the high margin products are the focus of management’s attention.

Console Transition & FY06 numbers

Confirmed that console transition, combined with price protection terms given to retailers contributed to the abysmal FY06. As console makers slashed prices and consumers held off accessories consoles they were about to replace, there was too much inventory in the pipeline and prices fell considerably. This hit margins, though most all this product has now been sold off, contributing to the rebound in gross margins in Q3. If past trends hold true, FY08 should be much stronger, and FY09 and beyond should show the true earnings potential of this business at peak earnings.

New Opportunities

--CFO actually left Rockstar in 2006, not 2005 as I previously reported. He was not involved in the accounting issues at TTWO at all, and will be taking on a very active role at MCZ. This is an exciting opportunity, as Halpern brings with him a wealth of experience and success at one of the hottest gaming companies out there, in addition to valuable experience on the street and with the sell-side.

--MCZ is still mum on the Iniar technology and specific products to be launched from this, though they are very excited about its potential and believe they can create a very valuable business out of it. If this is a hit, its all gravy. If not, MCZ confirmed that it is a low risk/high reward play. They purchased the technology on the cheap, and will not need to outlay much capital to launch the product.

--MCZ was also mum on future licensing deals for accessories alongside upcoming major product launches. That said, a very logical, big deal that MCZ would appear to be the front-runner for would be exclusive accessories for the new grand theft auto game, given Halpern and his connections there. I think this could be a huge catalyst going forward, if such a deal were to be announced. MCZ alluded to a meeting later this week to discuss the possibility of such a deal.

Conclusion

Overall, I am very excited about this investment going forward. A combination of both short and long term catalysts, downside protection, and a cheap valuation have the possibility to make this a win over the next 6-18 months. I’ll continue to track this name on an ongoing basis.

Disclosure: I own shares in MCZ. This write-up is for educational purposes only, and not a recommendation to buy or sell shares.

Top 5 reasons why you should not manage your own money

2007-03-20T00:04:00.000-07:00

Despite my interest in investing in individual stocks, and the good amount of time I’ve put into securities analysis over the last several years, I actually have a large portion of my holdings in mutual funds. Though I enjoy investing in individual securities, I have, until recently, not been able to devote the time, nor have I had the skills, to invest in individual securities in such a way that I believed would generate risk-adjusted returns above what certain respected professionals are capable of achieving. Though many mutual funds (read: most) are no better or worse than investing in ETFs or even on your own, there are several standouts that have consistently outperformed the market over long periods of time, or that employ sophisticated, unique strategies that even the most educated of investors are likely unable to employ themselves. Before moving posting a follow-up article with my specific mutual fund holdings, I want to illustrate why I believe mutual funds are a crucial part of any do-it-yourself investor’s portfolio, particularly those who have little experience, little time, or little track record of positive, risk-adjusted returns over a long period of time. A monkey can make money in an upmarket, but it is significantly more difficult to outperform the stock market over a full bull/bear cycle.

1) As much as most of us would like to believe in our abilities to outsmart the whole of the population, the fact is that most individual investors do themselves a disservice by taking their finances into their own hands. The market is an extremely complex beast, made more difficult to beat by the fact that inexperienced investors in particular tend to be extremely emotional, and do not have the skills required to thoroughly assess the deserved valuation of a business. I wish I had bookmarked it, but I remember reading a couple years ago a study that was released which estimated that the average individual investor had returns, after transaction fees, of about 2%, vs. 12% for the market. (If anyone knows the article I am referring to, or similar studies, please e-mail me so I can footnote this).

2) If you are like most inexperienced investors, you aren’t investing in the stock market, you are gambling. Investing, in my mind, refers to an investment in the company based on a thorough, in-depth analysis of a company’s business prospects, how those business prospects are likely to translate into future cash flows, and at what multiple those cashflows are likely to be valued in the future. Investors who buy a company because they like their product make the common, deadly mistake of investing in a company, not a stock. Investing in a company has a variety of pitfalls. Most notably, it does not take into account valuation. Let’s examine a hypothetical company, “The Best Company in the World” (TBCW). TBCW makes the highest quality MP3 players imaginable—they are as cool and functional as iPods, but at 1/5^th the cost. They use the best materials, and are commited to 100% customer satisfaction. Most people are convinced that TBCW will quickly become the market leader in every consumer goods market imaginable. So, should you invest in TBCW? Not nessecarilly. If TBCW is valued at $100 billion dollars, it is unlikely to be valued at an attractive multiple of its future cash flows. Also, it is entirely possible that TBCW is losing boatloads of money, and will never be profitable. In this case, even though the product is spectacular, the stock will eventually be worth $0. Without the skills to assess valuation and basic finance, investors are gambling, not investing, their money. Just as it would be a poor strategy to go to Vegas and gamble 100% of your money at blackjack, it is similarly wise not to do the same with the stock market.

3) Perhaps the most important reason for putting a significant portion of your money with a professional is most people’s tendency to be extremely emotional with their investments. Countless anecdotes and bear markets have shown that most investors buy most aggressively at market tops, and sell most aggressively at market bottoms. In fact, most top managers have made a living playing the opposite side of the “dumb money flow”. Being able to make intelligent investing decisions requires a clear investment thesis, and a general understanding of valuation concepts and market cycles. If you have a holding that has dropped by 80% on news that you believe does not impact your long-term thesis, you can have the confidence to go ahead and double down. If are holding that same company, and bought it on the recommendation of Jim Cramer, a friend, or another questionably credible source, you have no basis on which to make a future investment decision. Chances are, if you are like most investors, you will panic and sell at the absolute bottom, and curse yourself two years later once the stock rebounds.

4) There are many experienced professionals who have devoted their whole lives to investing. Though there are many irresponsible fund managers out there, it is generally very easy to find several strong, long-term performers that have out-performed the market. What are your odds of outperforming a top manager who has vast resources, experience, and a track record of beating the market over long periods of time? Possible if you know what you are doing (and understand where individual investors with the right skills have an edge over funds), but unlikely if you are merely buying your favorite companies or on the advice of friends. This may work for a short period of time, but just as in Vegas, the house will likely eventually win. One additional point here is that even if you are experienced, you likely are inexperienced in certain types of investing that you want exposure to (e.g. commodities, bonds), or that you simply don’t have access to (emerging markets, foreign stocks, etc.).

5) Most important of all, investing is not a game. For most people, this is retirement money, a kid’s college education, or other important issues. If you want a game, start a play money portfolio on one of the many finance sites out there and try your luck. If you want to gamble, get a night at the Wynn in Vegas and gamble with a few hundred bucks (this will be a much cheaper proposition for most people long term, anyhow).

For the individual investor who does not have the time or experience to devote to their portfolio’s, mutual funds have always been a popular strategy.

So now I’m terrified—five things you can do:

I am not saying that you should not invest in stocks on your own if you have little experience. All I am saying is that you should invest with an amount you can afford to lose, and that if you are serious about investing on your own, you educate yourself on the tools of the trade (this does not mean reading this article and a couple others, this means buying (and reading) investment books, reading reputable sites (especially this one, haha), and honestly assessing your skills on a regular basis. My father is a great example of someone who should be as far removed from his money as possible. Though he is incredibly intelligent, he is very emotional about his money. He successfully timed the 2000 market top, and 2002 market bottom by moving 100% into stocks in 2000, and moving 100% into bonds in 2002. If this sounds like you, find yourself a professional to manage your investments.

When I first started somewhat-intelligently investing several years ago, I limited my allocation of individual stocks to 20% of my portfolio, and put the other 80% with external managers. As I have continued to become educated and confident in my abilities, that number has shifted to about 50/50 (my short positions complicate the actual calculation). Though I may cut this down in the future, I always expect to invest some in mutual funds. There are some incredibly talented investors out there, particularly in areas where I am not myself skilled (e.g. Foreign bonds), that I always expect to outsource to other managers.

Mutual funds are an excellent way to diversify your holdings, and invest alongside some of the more talented investment managers out there. I highly recommend Morningstar as a starting point for your research, and a subscription to get their write-ups. Here are some quick, general guidelines for choosing mutual funds:

1) Examine performance over long-periods of time; 5-10+ years. If the manager has outperformed the market in this time frame, chances are that you are in pretty good hands

2) Make sure the manager in place now was the manager that got those great returns for the prior 10 years. Many top managers have left for hedge funds recently, so make sure the guy who got those returns is still around

3) Examine the funds performance in market downturns. In general, I like to avoid volatility, as I believe investors behave badly when their funds drop a good deal. If you know you are emotional with your investments, you are better off choosing a fund that has consistently deliver 10% returns, vs. one that has delivered 15% returns on average, but with severe downdrafts in bear markets. You are unlikely to achieve those 15% returns that the fund gets, because, if you are like most investors, you are likely to sell that fund near its bottom, and buy it back on the way up. Also, I am personally bearish on the market currently, so in my mind this analysis is more important than usual.

4) If you are confident in your ability to assess the strength of other’s skills, but not to invest in individual securities, I highly recommend reading commentaries or other articles about managers who run funds you are looking at. My two favorite mutual funds, (Hussman & Fairholme), I invested in more because I thought the managers were incredibly smart and disciplined, and less because of their performance (which, unsurprisingly, was also incredibly strong).

5) One major disagreement I have with Morningstar is on the topic of expenses. Morningstar is hesitant to recommend mutual funds with high management expenses, regardless of their performance. I think this is rather silly. Below you will find the 10 year annualized returns of two funds, pre-expenses. Which one would you rather invest in?

Fund A: 10%

Fund B: 15%

Fund B, obviously. Now, lets say Fund A has a .5% management fee, and fund B has a relatively expensive 3% management fee. Which one would you rather invest in now?

Fund A: 10%-.5%=9.5%

Fund B: 15%-3%=12%

Again, the answer is B. Don’t let high funds scare you off—one of the more respected fund families (Hotchkis and Wiley), has deservedly high fees. If you outperform your peers as some funds do, you can afford to charge significantly higher fees and still be a more attractive place for investors to park their money.

Conclusion

Unless you have a strong track record of outperforming the market in both up and down markets, or over a full investment cycle, I think it is a very prudent decision to not put 100% of your money in individual securities. Limiting yourself to 10-20% of your portfolio allows you to experience the joy and excitement of investing (or gambling, if you prefer), while ensuring that your retirement, kids college fund, and other causes are well-served.

Full MCZ Write-up: A potential double or triple from here

2007-03-19T12:30:00.000-07:00

Thesis

MCZ is an attractively priced, long-term growth story in the midst of experiencing increasing gross margins, and a recovery in their business off of trough earnings due to cyclicality in the business. The company trades at 9-12x my FY07 estimates, and less than 7x my estimated FY08 earnings. I believe there is a very good probability that the stock could double or even triple if the turnaround continues as expected, and that the current valuation provides a good margin of safety in the event things do not turn out as positive as I expect them to.

Business Overview

MCZ is the leading provider of gaming console peripherals, including controllers, dance pads, steering wheels and, “cheat” software. The overall accessories market is about 12%, or $1.5B of the total US gaming market. Of this, about 60% is fulfilled through first party accessories, from Sony, Microsoft, and Nintendo. The other 40% is owned by 3^rd party manufactures, who sell accessories at price points about 30-40% lower than the 1^st party providers. Also, due to the lag of creating accessories for new gaming systems, it typically takes MCZ about 6-12 months before releasing products for new systems.

The video game market as a whole is comprised of three primary players: Microsoft (Xbox), Sony (Playstation), and Nintendo (Wii). It is cyclical in nature, and typically reaches trough earnings during a console transition (which we are in midst of emerging from right now), and peak earnings 2-3 years after new console releases. The console cycle up until recently was about 3 years on average, though going forward the major gaming system makers expect it to lengthen considerably, upwards of 6 to even 10 years. This is positive for the business overall, as it will reduce the cyclicality that can make earnings unpredictable. In other words, this current console transition (and its trough earnings effects) will likely be the last for several years to come.

Recently, MCZ has expanded into new product lines, including iPod accessories, console faceplates, their new Inair personal sound technology, and bundling licensed games with their peripherals. Revenue is split pretty evenly across consoles, and consistent with installed base trends; on products, about 50% comes from controllers, with other 10-15% from other peripheral types (dancepads, steering wheels, etc.). The business can be very hit driven—products appear to have 1 year life cycle on average; they introduce 60-100 products per year, and discontinue about as many. Somewhat comparable to a video game publisher in this regard Management believes that they will get a good lift from older consoles as companies discontinue peripherals for older consoles to focus on new ones. Company seems to be emerging from the console transition slump, and should be resuming growth that started in 05’ this year. There were no questions on the most recent conference call, which I like, as it usually signals that people aren’t paying much attention to the company

New CFO was head of finance at Take Two’s prized Rockstar games division, part of troubled take-two interactive, which I believe was the same company that had some notorious accounting issues a couple years back. From what I could tell in my research, Halpern wasn’t involved in the issues at Take-Two, and resigned the company in 05’. I like the experience in the business, and from the way he sounded on the conference call, it sounds like he will take a fairly active role in helping to shape the company’s overall strategy.

Financial Review

MCZ experienced strong, 10%+ growth in the several years leading up to FY06, the year that began the latest console transition. Below is a review of MCZ income leading up to the console transition:

	FY02	FY03	FY04	FY05	FY06	FY07 (9 months)
Revenue	$83,337	$91,657	$102,143	$112,071	$100,768	$80,367
Cost of revenue	$64,927	$70,699	$79,078	$83,644	$87,343	$60,390
Gross profit	$18,410	$20,958	$23,065	$28,427	$13,425	$19,977
GM %	22.1%	22.9%	22.6%	25.4%	13.3%	24.9%
Operating Expense (OPEX)	$14,342	$18,959	$20,248	$19,785	$22,576	$15,019
OPEX as % of sales	17.2%	20.7%	19.8%	17.7%	22.4%	18.7%
Net Income	$2,161	$1,210	$1,062	$4,326	($6,653)	$3,009
Net Margin	2.6%	1.3%	1.0%	3.9%	-6.6%	3.7%
EPS	$0.03	$0.02	$0.02	$0.08	($0.12)	$0.05

The company was in the midst of improving its product mix, gross margins, and rationalizing its OPEX, and posted significant margin improvements in FY05. Unfortunately, the imminent console transition hit the company hard in FY06. Consumers delayed console purchases as they waited for the new bread to come out. In particular, peripherals took a big hit, as people who are about to purchase a new console are unlikely to make continued investment in getting more use out of their existing ones. This trend, combined with increased pricing pressure on more mature, discounted consoles, helped contribute to the shortfall in both revenue and GM.

This year should be flat to slightly up in terms of revenue (depending on Q4 performance), though I expect revenue growth to resume going forward, roughly in line with the high single digit/low double digit growth experienced by the industry as a whole.

On the gross margins front, the company saw a successful launch of several new high margin products, including a console faceplate based on the very popular “Gears of war” Xbox 360 game. In particular, it appears as though the face plates have been a hit—just as in cell phones, this accessory appears to be becoming popular amongst younger audiences, and could present a lucrative, high margin new business line. MCZ seems to be in a good position to get licensing deals in the future to produce these for other games (in particular, in conjunction with Microsoft). The company also successfully instituted a cost cutting plan that resulted in about $2-3 million savings in annual operating expenses, further aiding net margin improvement going forward.

To see what happened to net income in FY06, which turned negative for the 1^st time in over 4 years, you need to look no further than the gross margins history of the company. Below are quarterly gross margins for the last 3 years:

	Q1	Q2	Q3	Q4	FY07
FY07	22%	22%	29%
FY06	14%	17%	15%	4%	13%
FY05	25%	24%	25%	24%	25%

MCZ has a relatively fixed operating cost base (about $20M per year), so projecting their operating income is very simple. If they generate more than $5M in operating earnings, they make a profit, and if they don’t, they won’t. This is why Q1 is typically flat to a loss (revenue rarely breaks $20M), and why FY Q3 accounts for the majority of their profit (calendar Q4). As gross margins have rebounded to FY05 levels, the company has been able to return to profitability. The business is at an inflection point. If they can grow the revenue and improve gross margins without incurring significant additional operating expenses, additional gross profit from here will fall directly to the bottom line. I expect them to be able to grow revenue 10-15% without growing needing to grow OPEX, as they did successfully in from FY04 to FY05.

YTD, FY07 earnings are $.055 per share. Based on gross margin trends, and historical Q4 revenue (which has fallen above Q1 but typically slightly below Q2 revenue), I expect earnings of between $.005 to $.015 per share for Q4, with the possibility of slightly negative earnings, or earnings of up to $.03/share depending on how margins hold up. If MCZ can maintain 29% margins, and achieve revenue on par with that achieved in Q2, then $.03 is very achievable. Below is a sensitivity of expected Q4 results based on revenue and margin assumptions. I expect revenue near the high end of Q2 revenue, based on the new launch of peripherals (including PS3 wireless controllers, and rumors of a Wii controller launch) in Q4. The wii launch in particular would be a boost, as there are still large shortages reported of wii controllers, and MCZ could capitalize as the 1^st major 3^rd party distributor to sell the product. Below is a sensitivity table with projected EPS based on different GM and revenue numbers.

Q4 rev & GM %	22%	24%	26%	28%
$20M	($0.011)	($0.004)	$0.003	$0.008
$22M	($0.003)	$0.004	$0.009	$0.015
$24M	$0.004	$0.010	$0.016	$0.022
$26M	$0.009	$0.016	$0.022	$0.029

On $.065 FY07 earnings, or $.01 FY07 Q4 EPS, MCZ is trading at a P/E of 11, for a company with strong growth prospects and improving GM. If are able to report a q4 on par with their q2 (~$26M), and at a GM % near that achieved in q3 and hit $.08 (~28%), MCZ would have a P/E of under 9.

Though this year is important, I think going forward the opportunity looks even more compelling, as the company improves margins and emerges from the console transition slump. Lets take a look at what happens to EPS in FY08 under several different revenue growth and gross margin scenarios (note--I'm having trouble getting this to display properly--see next paragraph for summary)

Scenario	Worst-case	Conservative	Likely	Aggressive
FY07 rev (est)	$102,000,000	$102,000,000	$102,000,000	$102,000,000
Rev Growth	0%	5%	10%	15%
FY08 Revenue	$102,000,000	$107,100,000	$112,200,000	$117,300,000
Gross Margin	22%	24%	26%	29%
Gross Profit	$22,440,000	$25,704,000	$29,172,000	$34,017,000
Operating Exp	$20,000,000	$20,000,000	$20,000,000	$20,000,000
EBIT	$2,440,000	$5,704,000	$9,172,000	$14,017,000
Interest exp net other income	($500,000)	($500,000)	($500,000)	($500,000)
Income pre-tax	$1,940,000	$5,204,000	$8,672,000	$13,517,000
Net Income	$1,319,200	$3,538,720	$5,896,960	$9,191,560
EPS	$0.02	$0.07	$0.11	$0.17
Probability of scenario occuring	15%	25%	45%	15%
Price @ max of 15 P/E or .5 P/S	$0.51	$0.98	$1.63	$2.54
Upside @ $.74	-31%	32%	120%	244%
Weighted Upside (probability x upside)	-4.7%	8.1%	54.2%	36.5%
Probable Upside (sum of weighted upside)	94%

Basically, what I’ve done here is assumed four different scenarios for FY08 and assigned a probability of each occurring (my best guesses). As you can see, small revenue growth on higher gross margins (26-28%), will result in strong operating leverage, and could send the stock much higher. A one basis point improvement in Gross margins over FY05, and 10% revenue growth (which is slightly below MCZ’s growth rate before FY07), would result in EPS of $.11, or a price of $1.63, or 120% above 3/16’s closing, based on a conservative 15 P/E. Even a return to slightly below FY05 gross margin and revenue levels would result in a positive upside scenario of about 32% over the next year.

A quick look at the MCZ charts supports these valuation assumptions. The company traded at $1.50 when it reported earnings if FY05 of $.09, before the bulk of the console transition, or a P/E slightly of about 17. At current levels, the risk/reward opportunity seems very favorable.

Catalysts:

-Q4 earnings announcement

-Entering new console growth phase spurred by increased production of new consoles (as supply begins to catch up with demand), and eventual price cuts that will drive new adoption, and a need for owners to accessorize their new systems.

-Improved product mix resulting in better gross margins that are more in line with those experienced in Q3 of FY07 and double digit revenue growth as the company emerges from the console transition

-Accessories for the new generation of consoles. Madcatz just released wireless controllers for the PS3, and rumors on the internet appear to show them having developed Wii controllers as well. This could be lucrative short term, as Nintendo has had trouble keeping up with demand for these controllers

-Iniar personal music technology—a recent acquisition, company is very excited about this products potential. Allows people to simultaneously get good quality sound from headsets, while also being able to interact with their environment. I could see this taking off or falling flat—younger audiences, in particular, are notorious for their ability (and desire) to do 8 things at once, and I could see this becoming a popular way for kids to listen to music. Company brought on the inventor as management. Product will launch later this year, and company thinks it has strong potential with relatively small investment.

Risks:

**Business is very hit or miss, and relies on a mix of successful new releases to propel earnings. In particular, failure of MCZ to launch successful high margin products could result in results below expectations.

**The business does not have as many barriers to entry as I would like to see, and I somewhat concerned about margin compression in new products (e.g. faceplates), and that potentially at some point specialty gaming retailers (e.g. EB games, gamespot, etc.) will make 3^rd party controllers and peripherals of their own and cut into MCZ business (this is not very difficult to do, and it seems like a logical expansion, in the same way grocery stores have their own private labeled products). This has not happened yet, nor have I heard any rumors of this, but it seems a logical step at some point.

**Failure of new product launches outside of gaming peripherals (e.g. Iniar technology) fail, or otherwise distract management from their core business. I believe that MCZ is taking a measured, conservative approach to diversifying their product revenues, which overall I view as a positive, but there is of course the risk that these ventures either fail or distract management.

Disclosure: I own shares in MCZ. This write-up is for educational purposes only, and not a recommendation to buy or sell shares.

What I'm reading this week

2007-03-17T10:02:00.000-07:00

Here are a recap of some of my favorite articles of the week

Hussman’s weekly essay—this is a mainstay in my weekly reading list. I don’t think Hussman will ever run out of different ways of saying the stock market is unlikely to return satisfactory returns over the next 5 to 10 years. Also, a perspective on the "global liquidity myth"

As a follow up on my diversification essay, a great article on how to defend against geopolitical risk, and comparisons between now and the market as it was befoe WWI.

World Beta—Very interesting write-ups and studies tracking avg. annual returns of a copycat hedgefund portfolio

Have you ever seen any of those infomercials on making 800% return in two weeks. Check out this blogger’s battle with one such company, after posting critical comments of one such company on his website

An excellent historical perspective on stock market valuation, from someone who was managing money back in the 1970s when P/Es were 7 or 8, and no one wanted to touch the stock market. Also includes a good primer on short selling, which I am a strong proponent of (when done right, to mitigate certain risks)

Reader Picks

2007-03-16T13:45:00.000-07:00

Well, it’s been four days of blogging now, and I must say this is more exciting and rewarding then I could have imagined. I’m now a regular contributor at Seeking Alpha (as referenced by that neat little seal over to your right), and have gotten some great encouragement and publicity from some of my favorite sites (Kirk Report, Seeking Alpha, and World Beta). Overall, this has been more fun and involving then I could have imagined.

Another great perk has been the quality of a couple picks readers have sent over. I’m in the very initial phases of doing work on these, but wanted to share the names.

MCZ (thanks to Steven Lobo): MCZ is a name I looked at 3+ years ago, when I was interesting in the gaming space. They make popular 3^rd party peripherals for the gaming market. Market cap is $40M. Sales pretty flat to down slightly the last 3 years. Insider recently purchased $40k in shares after the stock more than doubled in a 5 month period, which I like.

Interesting story here appears to be one of cutting out the unprofitable products, and focusing on higher margin products going forward. Revenues in Q4 were down significantly, but profitability was up substantially, which is exactly what I’d want to see in a case like this. Q4 profits were $.07, putting this at a P/E of about 10 based on that quarter alone. That said, Q4 is seasonally strong in this biz, so I need to understand likely performance in other quarters, as well as where they are in their transformation of their product line. Worth a look though.

TISA (thanks to ilan): Israeli software company in document management space. $20M in cash, making EV on this about $10M. Revenue growth of about 15% organically. Subtract out the cash, and its trading at a 10 P/E. Seems interesting and cheap, but I don’t understand the space too well, and think I’d need to do a good deal of work to get comfortable with it. Acquisition of another company (or acquisition of them by larger players, who have been actively buying out players here) could be a catalyst. Anyhow, will also add this to my list to look at.

If you have any interesting ideas, please do send them my way (especially if they are as good, at first glance, as these two). E-mail link is on the right of the page.

Bull Case for HRAY

2007-03-15T00:52:00.000-07:00

In the course of doing work on HRAY, another WVAS provider, I came across a great article on Forbes. In the last half, does a good job summing up many of the compelling parts of HRAY. I particularly like their music strategy, whereby they are experimenting bypassing the carriers by selling ringtones to people in music stores. This gets around the issues they currently face with the carriers. I listened to a few conference calls, read the latest 10K, and generally liked the managent quite a bit.

Company looks very attractive at an EV of $30M. They paid about $20M alone for interest in a few music companies. Subtract those out, and your looking at a value of $10M for the WVAS business (vs. roughly $0 for LTON's business, and over $100M for Kong's). Earnings last year were $6M. That's a 5 P/E on a cash basis, and about .5x revenue (on the $30M number). At these prices, I'm thinking that there is very little downside in both LTON and HRAY. LTON appears to be securing content by snatching of valuable television brands, while HRAY is becoming a force in China's rapidly growing online and offline music industry. I will likely initiate a small starter position in both names in the next couple days, and look to add more as I dig deeper into the names, the market, and initiate discussions with management.

I will look at doing a more detailed write-up in the coming weeks.

LTON: Another WVAS near cash value

2007-03-14T23:12:00.000-07:00

LTON is one of several Chinese internet stocks I've been looking at recently trading near cash value. Like KONG, LTON has been smacked due to increasing pressure on the WVAS providers. Shares recently dropped when LTON announced dismal earnings, and reported that it would money the next 2-3 quarter as it planned to make investments in its business.

If you believe LTON can find another profitable business, or turn around the WVAS business, the shares are cheap. LTON is trading roughly at both its book value and, after subtracting out cash and short term investments, you get the underlying business for free. The company has initiated a $20M buyback program, on which it has currently purchased $1.5M.

Financials:
Revenue increased 8% to about $80M in FY06, while net income decline 45% to $6.4M. Q4 is more representative of the real trend, however, in the business. Revenue declined to $14M from about $20M the year prior. Net income was a miniscule $.4M. About 85% of revenue was attributable to China Mobile, the largest mobile operator in china, who has been particularly aggresive with new restrictions on WVAS services. Clearly, if trends hold, it is unclear to what degree this business will be able to generate any significant revenue going forward. That said, if China Mobil continues to squeeze LTON and other WVAS providers as they are, they risk compromising WVAS revenues, which are very lucrative for the company.

Transitioning from a middle-man to a content provider
LTON has signed multiple deals with large TV providers in China to develop WVAS content based on the networks' television properties. I do not quite understand the specifics of these arrangements (and neither, apparently do most the analysts on their conference call), but it appears as though these have the potential to be extremely lucrative. In particular, an exclusive deal with Hainan Satellite seems particularly lucrative. As providers with popular content in high demand, LTON should have more bargaining power with wireless carriers to acheive more attractive margins.

Advertising Services
The company is also positioning themselves as being able to deliver advertising services accross multiple platforms--from TV to radio to newspaper to mobile. This is simmilar to Google's approach and, if its any indication, Google has been largely unsuccessful in this effort to date. LTON appears to have made some progress in this division. The company reported under $1M in revenue from this division last year, and expects margins long term to be 10%. For now, nothing to exciting to write home about.

So, what's it worth?
To be honest, I have no idea. There are lots of unkowns here right now--the company appears to be in transition from its dying WVAS services business to a new suite of products and services. Given current valuation, it seems like its the risk, given the strong margin of safety in the cash position, but I want to understand the WVAS business and new businesses better before I make any investment. Expect more work on this in the near future.

Update on NTWK: Conversation with management

2007-03-14T16:11:00.000-07:00

Netsol's CEO and CFO were in Las Vegas today to discuss their company with investors. I set up time to address some of my concerns and get more clarification around elements of my thesis. Overall, the call was mixed. Some concerns were alleviated, but I was disappointed to hear management, in my opinion, avoid several questions and revert to stock stump speeches. There is nothing that peeves me more than management who says the same canned statements every single time they talk about their business, even when asked direct, specific questions. Overall, though i was disappointed with aspects of the call. I am still optimistic on the stock--I believe this can rise based on the story alone (apparently, people in vegas thought so as well--the stock was up 5% in this afternoon). What follows is based on my notes, and includes my own subjective take on management's comments.

Netsol-TiG JV
Management confirmed that they believe 100% growth next year is feasible, and that eventually a majority of TiG's $50 million dollar business should transfer to the JV. At trailing revenue estimated by the CEO at $3 million, that would give us $6 million a year from now, 3 million in profits to the JV, and $1.5 mil to Netsol. Slap a 20 P/E on that and you get everything else for free. Division has growth to 100 employees, and they expect 200 by year end. TiG saves 70% on its labor cost by outsourcing to Pakistan, and appears satisfied with the arrangement thus far. Management hopes to replicate deals like this going forward

Punjab land contract:
I had trouble getting a clear picture from the CEO on his expectations here, but was optimistic on the deal. The world bank has granted $300M to Pakistan to get this done. The money, from what I can tell, is allocated and likely a lock. The main issue is how much, and how long, it will take to distribute that money, and what share Netsol will receive. I am afraid that there is a big gap between what management is expecting from this contract, and what investors have been led to believe. According to IR, and by simple math, a $300M contract over 5 years, split evenly between 2 companies would generate $150M in total revenue, or $25M in revenue in year. Apparently, this is not a given. It is unclear whether the $300M is all to be allocated for the specific contract that Netsol is bidding on, and what the timing of those payments would be. Initially, management said something along the lines of "we don't know how much it will be, whether its $10, $20, $30, or $40 million", which scared me some, as those numbers are well below my estimates and what I had been told by IR. I plan to adjust the my PV estimate for this contract, as it appears as though there are a wide range of possibilities here.

Dilution
Onto the fun stuff. This conversation was, in a word, sensitive. I asked management why they felt the need to give themselves about options equal to about 50% of the outstanding shares. On the plus side, management pointed to the fact that they have never sold a share, not even when the company was worth $1bil in the tech boom, so the risk of management exercising and selling is somewhat limited (in other words, they actually appear to want to hold onto the shares long-term). Management also apparently used to own 70% of the company, so I view this large options grants potentially as a way they think they can recoup the larger holding they believe they deserve. Understandable, but it still creates and overhang and dilutes shareholder value.

Paying shares in leiu of cash
Maybe I'm over-reacting, but this is just a big red flag in my mind. If you have a CEO insisting that his shares are undervalued, then why is he giving them away in leiu of cash payments? He repeated several times that he did not expect issuance of new shares, though the 10Qs continue to show may small stock payments in leiu of cash. At one rather embarrassing point, the CFO flat out said the company, as recently as 3 months ago, issued a dividend on preferred shares in stock in leiu of cash, and confirmed that this is a choice of the company's. I do believe that the CEO thinks the shares are undervalued, and I think he is giving shares as a way to satisfy the big investors who participated in the latest offering. Again, this is not friendly to minority shareholders.

Conclusion
Though I am still disappointed in management acting against the best interest of regular Joe shareholder, I think there is enough that could go right here for me to build a small position (though not as large as I would have without the management issues). I will be looking for increased traction in the licensing business, as well as continued growth in services revenue, in the months to come.

Reviewing an idea gone wrong: Madacy Entertainment

2007-03-14T14:55:00.000-07:00

Today, Madacy reported very disappointing Q4 earnings. This has been a large holding of mine for over a year now, and one on which I have been dead wrong. I still believe the name is trading at an attractive valuation (about 3.5x EBIDTA), but am more concerned now about the long-term prospects than I was one year ago. This is one of the few ideas I've sourced from valueinvestorsclub that has gone sour.

Madacy entertainment is the largest seller of discount music. Have you ever been to Wal-mart and seen oldies compilation CDs selling for $5 or $6? Chances are its a Madacy product. The company is the exclusive discount music distributor for Best Buy, and takes up most the shelf in Wal-mart and other big music stores. I bought at about $5.60, when the stock had a 19% dividend yield and was experiencing double digit growth in revenue and profits. It had been beaten down due to concerns over recorded music, but I was comfortable with the risk for several reasons:
1) Madacy's target customer is 50 year old women. I did not expect them to be flocking to the internet anytime soon to download music.
2) Madacy has been gaining share in its market
3) Profit margins for these products are very high for retailers vs. traditional music. For this reason, I did not expect them to cut floor space.
4) Despite negative trends in recorded music over the last couple eyars, sales were increasing
5) Management had been a large buyer of shares on the way down, and owned about 40% of the company.

So, what has changed?
A few months ago, Madacy reported abysmal Q2 earnings. Wal-mart, their largest customer, was attempting to reduce inventory on-hand, and as such had not ordered product from Madacy in over a month. In addition, they received massive returns on existing products. THe income trust structure requires Madacy to pay most of its income as dividends. With little cash in the bank, Madacy had nothing to pay its dividend with, and went in violation of its banking covenents. The stock dropped over 65%.

I viewed this largely as a one-time issue and an excellent buying opportunity, though I was of course rattled. Despite a decrease in sales (remember, Madacy sells to the reatilers, not to the public), actual retails sales had increased during the quarter. Companies were selling through existing inventory rather than purchasing more from madacy, resulting in this discrepency. Management again was aggressive buyers of shares. If this was truly a one time blip, and the company could re-instate dividends, then the stock would have yieled about 60% in annual dividends from these lows!

The stock has bounced about 33% from its lows. I recently took some profits just before this most recent announcement, which suggests material weakness in the business. Q4 revenues were down 15% YoY, and EBIDTA was down 38%. Madacy is selling lower margin product, and selling less of it.

What to do from here
I still believe a return to prior levels is feasible. A 5x EBIDTA mutliple,which seems reasonable, would have the name trading about 40% higher. That said, I am afraid that the name will continued to get dragged down by the digital music revolution, even though sales of its products (at least until this quarter) appeared strong. I will be listening to the conference call later this week, and likely re-evaluate from there. These have been ugly the last couple years, and I expect this on to be no exception. Mostly likely, I will be cutting my position down to something more appropriate to the new risk profile, and would consider adding on substantial weakness.

How to truly minimize risk

2007-03-14T00:43:00.000-07:00

With the rise of hedge funds and increase in hedged strategies, I have become increasingly interested in hedging my portfolio against various market risks, depending on my macro outlook. Over the past few years, investors have been able to become more diversified than ever, and although most are more diversified than ever before, there are still many points of vulnerably, and common misconceptions about what it truly means to be diversified. Conversely, strategies such as short sales, options, currency trades, and other "risky" investments are still misunderstood, and can be an important part of a hedged portfolio in the right hands. The below should not be construed as investment advice, and merely outlines my own strategy and thinking.

Common Mistakes:
1) No matter what your stock adviser tells you, a portfolio with 50% US bonds and 50% US stocks is not a diversified portfolio. You are greatly exposed to country risk (that something may happen to the US), currency risk (the dollar dropping), commodity price increases, inflation, increases in interest rates, and many other commonly ignored but important risks.
2) Investing in 300 stocks is not diversified--it is silly. I realize most people do not have the time or skills (myself included) to identify a basket of 20-25 stocks, and instead opt for options like mutual funds, etc. that are spread thin. That said, I would like to emphasize the pitfalls of over-diversification. Lets assume that there are 5 investments in which you have extremely strong conviction, and about 295 that you think are good investments, but not nearly as good as your top 5. Lets examine one scenario where we invest in 25 stocks, and one in which we invest in 300 (all equal weight). Lets also assume that our 5 favorite stocks will, on average, advance 30%, while our other stocks will, on average, advance 10%. Your upside returns in each scenario are:
A: (.2*.3)+(.8*.1)=14%
B: (.016*.25)+(.984*.1)=~10%
Because you spread your investment so thin in scenario B, our best ideas are much less influential then they are in a smaller portfolio. On the downside, though arguments still abound on the proper number of investments to acheive suitable diversification, the general consensus appears to be somewhere between 8-25 (assuming you are investing in quality businesses with a good margin of safety). Remember too that many large companies themselves are extremely diversified, with multiple businesses, product lines, operating geographies, etc. Buy purchasing 20 large cap companies, you have likely diversified in what may be the equivalent of 200 business across 20 geographies. The riskier your investments, the more need to diversify.
3) Most investors do not rebalance their portfolio, but instead let their winnings ride or, worse, double down on investments that have been wildly success (think emerging markets). Portfolio re-balancing after extreme up-ward moves is crucial to reaping the benefits of diversification.
4) Most investors do not consider truly diversifying themselves. For example, if you own a home but do not have real estate exposure in your stock portfolio, don't sweat it. If you are like most Americans (well, American's five years ago, who still had equity in their homes), your home is likely to be your largest holding. Similarly, if you are an employee of Microsoft, do not invest all your money in Microsoft stock. If the company gets hit hard, not only will your portfolio go down, but you may also lose your job, and powerful double whammy.

How to diversify beyond stocks and bonds:
1) Get foreign currency exposure. There are several ways to do this, but the easiest are to:
a) invest in large cap stocks, many of which have global operations and conduct a large portion of their business in non-US currencies
b) invest in foreign bonds or foreign stocks. Make sure that these positions are unhedged, as many funds hedge their holdings. This is particularly important, as the majority of diversification benefits are from the currency and not the different country locale.
2) Make investments with a typically inverse correlation to the stock market. These include:
a) Short exposure--Though given a bad rap recently, I always try to maintain about 25% in short positions. Short exposure has several benefits, including:
-it allows you to be more aggresive on your long side. If I am short, I can use the cash proceeds from my short sales (with some discount brokers, including interactive brokers), and invest in long positions. If for example, i am short 25% of my portfolio value, I can go long 125% without tapping margin. If my long positions earn 10% annually, and my short positions merely break even, I will have generated the equivalent of 12.5% returns, vs. 10% returns without the short. If you maintain 100% long exposure, and short 25%, then the short positions can serve to as protection from a market downturn. This of course, all assumes you short the correct kind of stocks, or hedge out specific risks from your long positions. For example, I held a long investment in RCS (a canadian payday lender), but was concerned about the regulatory environment in Canada. RCS appeared very undervalued, but I wanted to protect myself in the event of regulatory issues. I shorted DLLR (another, more expensive Canadian payday lender with strong canada exposure), to hedge out the risk of the regulatory issues. This form of shorting can be effective for hedging out specific risks.
b) Commodities
c) Gold--I always like owning a small portion of hard assets, and though I am not a gold bug myself, I too believe that the US dollar and the fiat currency in general is in for a day of reckoning at some point in the future. If an when that happens, Gold will be one of the few safehaven investments, as it historically has been.

Brazil Fast Food Corp (BOBS.OB)

2007-03-13T23:53:00.000-07:00

This was a holding of mine that I purchased back at about $2.40 and recently trimmed my position in half to let it ride. I like the long-term prospects of the stock, but am looking to try and accumulate on further weakness in emerging markets stocks.

Brazil Fast Food corp does what it sounds it does. They operate and franchise the 2nd largest chain of fast food storefronts and stands in Brazil (behind McDonalds) with over 450 locations, and growing at a good clip. About 60 are company owned, but the remainder are franchised. Though the majority of revenue (~80%), it accounts for only 33% of profits. The real segment of interest is the franchising division, which although it only accounting for about ~15% of sales, accounts for a whopping 66% of operating income. This division is also growing at about 40%, and has the benefit of insulating BOBS from commodity prices and other economic hiccups (they primarily collect franchise fees and royalty revenue).

The stock is trading at about 13 P/E, and operating income nearly doubled last year, thanks in large part to growth int the franchising business (operating income from company owned stores was roughly flat as of first 9 months of 06'). Fast food penetration in Brazil is far behind what it is in the US and other developed nations, and assuming the same trend takes hold as has taken hold in many other places in the world, we can expect continued growth for years to come. Though McDonald's and other fast food giants pose a threat, I am comfortable with BOBS for a couple reasons:
1) Each region of Brazil has varied food preferences, making it difficult to make a popular homogenized menu across the whole of Brazil (as McDonald's and foreign entrants are used to doing). The kiosk franchisee model allows vendors to easily make improvisations to the standard BOBS menu to appeal to their locale clientelle
2) BOBS already has a very strong position in the market place, and has been able to maintain competitive pricing despite foreign competitor's global scale. They also have a very strong position in the market, and are generally very well known (they provide food for the largest festival in Brazil each year).

I still maintain a strong position, and will look to buy on further weakness.

Sitting on the sidelines of Elong (LONG)

2007-03-13T23:47:00.000-07:00

Elong is the trailing Chinese internet travel company behind Ctrip. I think this space has a lot of potential going forward, and though Ctrip appears to be an excellent operator it is way to expensive for my tastes. Elong, however, is another story.

Like some of my other favorite chinese internet stocks, its got a boatload of Cash (130M). Subtract that out, and you get an EV of about 110M, or about 3.5 trailing revenue (vs. about 25x revenue for market leader CTRP). No doubt, LONG has not executed as well--its expenses appear bloated (G&A is 2mil more annually, despite 1/3rd the revenue); S&M seems bloated as well, with costs same as CTRP. It has chronically under-invested in its product development until recently, putting it considerably behind CTRP in terms of technology. Long-term, if they get their act together, their margins should not approach those of CTRP long term as the internal systems improve due to increased product development expenditure. LONG's hotel booking rate and revenue is about half of CTRP's, but its airline booking rate and revenue is much lower. LONG is working on building out this the airline booking technology better. Current ratio of hotel:air booking is 3.5:1. Over time, this should approach 1:1, which gives a nice boost to growth going forward. 80% repeat business on par with CTRP, suggesting strong loyalty.

No analysis of LONG would be complete without mentioning Expedia's position in the company. On the plus side, LONG benefits from Expedia's expertise in growing out their business in the US. But, as we all know, foreign countries are riddled with the remains of US based companies who have tried and failed to penetrate new markets. Overall, I view their stake as neutral for now.

At a 25% net margin (CTRP's is 42%), the company would generate about 8M in net profit, giving it a P/E ratio of about 13 on an EV basis at current rate. That said, I'm not comfortable with their execution currently (Update: Q4 numbers were very poor, with revenue growth reported), and am not sure how long it would take to reach those net margins (or if they are indeed attainable). I'd be much more interested in the stock if the emerging markets continue to take a beating, and if the name drops to near cash value. I believe the opportunity will come at that price (or lower) soon enough.

KongZhuo (KONG)

2007-03-13T23:28:00.000-07:00

Though I am a bit pessimistic on the prospects of China internet stocks and WVAS short term, several are beginning to trade near their cash value, which is peaking my interest (similar to how internet stocks in 2002 traded below cash).

KONG is one of the leading WVAS providers in China. WVAS refers to "Wireless value added services", such as ring-tones, games, and other neat add-ons. In the markets nascent stage, carriers were content to allow 3rd party vendors to aggregate content and distribute it through their network, but as the WVAS market has grown, mobile operators are increasingly wanting more of the pie. KONG, LTON, and TOM (recently acquired), have all bit hit recently on fears that they are going to be cut out of the market.

Most WVAS providers act as middlemen between the mobile operators and content providers. Concerns are two-fold:
1) Mobile providers will charge higher license fees, or get into the business themselves and lock out the other players
2) Mobile operators will develop their own operating systems and use this to either charge fees to developers/WVAS providers, or to control what content is allowed on their network.

Both seem to be vaild concerns, but valuation levels are starting to become so low that the reward may outweigh the risk.

KONG trades at an EV of about $130M (market cap net cash), and reported earnings last year of about $22M, making the name trade at a P/E of about 6. Perhaps justified given the WVAS pressures, but it is beginning to become attractive.

What really has attracted to me to the name, however, is the management team. In addition to starting KONG (which, until recent pressure, was a hot business), this group has also held senior positions and Sohu.com, one of China's leading internet portals. It should be of no surprise then, that the company has focused on building out its wireless internet portal, which it believes will be the future crown jewel of the company.

I am a bit skeptical of the wireless internet portal story--essentially, they want to build a portal destination for people to access through their mobile phones, which may make sense in China, given high mobile browsing, which is much more common in the US. That said, I am concerned that advertising won't hit it big in the same way it has on the internet, as people on mobile phones typically are browsing more casually and for shorter durations, which is not condusive to any advertising other than branding (which accounts for a small portion of overall internet advertising). Anyhow, I do think highly of the management team, and trust them to have a better pulse on things than I do. I am looking to buy this at or closer to cash value as a speculative play with a strong margin of safety.

Netsol Investment thesis-- a work in progress

2007-03-13T21:07:00.000-07:00

Netsol Technologies

Overall Thesis:

Netsol technologies is a US-based holding company with operating subsidiaries in the US, UK, and Asia, most of which provide enterprise software and related IT services. The company leverages its low-cost development offices in Pakistan to provide rock-bottom prices (and higher margins) then found in most IT companies. I believe this stock can become a multi-bagger over the next several years due to multiple catalysts. There are several ways of describing just how undervalued Netsol is. Take your pick:

1) You get all Netsol’s businesses for free based on the estimated PV of one contract that Netsol has a high probability of winning at the end of 2007.

2) You get a 78% stake in Netsol’s Pakistan subsidiary, with a $20M public market value (66% of the market cap), for free.

3) You buy a Worldwide IT services firm with a low labor cost, growing at 50% YoY, for 1x FY07 revenue, 15 P/E, with multiple near term catalysts that, in the next few years, could create a business with earnings power of $25M (nearly equivalent to the companies’ current market cap).

In a nutshell, this is one of the most exciting risk/reward plays I have seen in a long-time.

The Pakistan IT Labor Market—Why Pakistan?

Before diving into a description of the company, its worth giving a brief overview of the IT labor market for Pakistan. With the rising popularity of outsourcing, labor prices in many of the top outsourcing markets have been experiencing upward pressure. India, in particular, has been subject to export taxes and rising labor costs that have raised the cost of doing business there, and sent companies looking elsewhere. Pakistan is about 25-40% cheaper than India, likely even more so with the recent excise tax levied on IT export services there. Below is chart comparing the avg. cost of the average IT employee in US vs. India vs. Pakistan (pre-excise tax):

INSERT TABLE

	US	India	Pakistan
All in Expenses per employee	$58,598	11,854 (does not include 33% tax on IT export)	$9,000
Total Price in market	$58,598	$23,708 to 35,562	$18,000 to $27,000

Pakistan has a ready supply of quality, cheap labor, and is in a much earlier phase of outsourcing than India. The total revenue generated by Pakistan IT companies has grown from only $20 million in 2003 to $70 million in 2006, a CAGR of 52%. Some estimates claim that this is under-reported nearly 8x due to the numerous small companies and individuals in this fragmented market. Assuming the $70M is correct number, Netsol PK (their Pakistan subsidiary), has about 12% of the market

Many large companies have outsourced a portion of IT operations to Pakistan, including IBM, TRG, ZTE, and NCR. Pakistan has high levels of tech savy, English speaking residents, and a 15 year tax holiday on IT exports (vs. India which recently levied a 33% tax on IT services exports). Overall trends appear strongly in Pakistan’s favor, with continued high growth expected for the foreseeable future.

About the Company

For a $30 million dollar company, Netsol has an extremely complex operating structure that I believe may be obscuring some of the value in the name. In addition, several one time charges related to acquisitions, as well as significant sales investments that are just beginning to bear fruit (due to long lead times) are also hindering current profitability.

The company has won numerous recognition from the Pakistan government, including “IT Exporter of the year”, which was given to it by the Prime Minister. It also has Cmmi level 5 certification, which has been attained only by about 100 companies WW, and is considering the benchmark for quality in facilities, particularly when dealing with offshore companies. It is not a fly-by-night outsourcing outfit, but a serious, highly regarded business.

Netsol has two primarily lines of business: a suite of software products and solutions for the leasing industry (The Global products group), and a for-hire, outsourced application development and IT services group (The Global services group). In turn these two business lines are operated across a set of different subsidiaries in multiple markets. I have outlined the subsidiaries and

McQue Systems and Netsol CQ (Global Products Group):

Overview

These groups focus on selling Leasesoft, which comprises a suite of four asset-based leasing/financing software application that for customers in the lease and financing industry. The product is still in the early stages of its adoption, with the majority or revenue (70%+) coming from APAC. This group has won several large accounts and strategic agreements with division of Damien Chyrsler, Toyota, and Yamaha. The product has been particularly strong in APAC, where it has become the leading option for Chinese auto manufactures.

Acquisition Strategy

The company has spent $15.3 million purchasing McQue Systems (US) and CQ systems (Europe) in 2005 and 2006 for about 1.5x revenue and a P/E of about 15. Netsol transitioned half the staff at each location to their offices in Pakistan, resulting in immediate cost savings, and simultaneously ramped up sales efforts in both regions in order to more aggressively penetrate these markets. The company views these new operations as strengthening their core Leasesoft offering, while simultaneously allowing better access to both the US and European markets through their subsidiaries. The company also set up a UK subsidiary (Netsol UK), to pursue future opportunities in Europe.

Valuation

Long term, Netsol should enjoy improved growth and margins from these business beyond that possible in their pre-acquisition state. They expect to migrate 50% of development in the US and UK to Pakistan, which should result in labor savings of about 40% overall (all-in cost/employee is 80% less in Pakistan). This is an attractive collection of business that appears to be doing well on its own right, but not core to my analysis. I conservatively value Mcque systems and Netsol CQ business at their cost at time of acquisition in 2005 and 2006 ($15.3M). Though there is still $1-2M left on the Mcque Systems acquisition (in the form of an earnout), I will assume that this amount is off-set by the increase in value due to operating efficiencies generated by moving development offshore.

Non-Services Divisions (Netsol UK, Netsol USA, Netsol Connect, Netsol Omni):

These businesses account for a very small portion of Netsol’s revenue and profits. They include Netsol UK and Netsol USA (largely non-functioning subsidaries), Netsol connect (a $1mil/year, break-even ISP, in which Netsol owns about 50%), and Netsol Omni (less than 50k in revenue, 50% stake, break-even). Netsol UK formely was a large contributor, but appears to have moved the majority of its operations to Netsol CQ. It still is responsible for biz dev functions in the UK (e.g. future JVs), but is not a major contributor on its own right. These business are marginally profitable (less than 200k in profit). For simplicities sake, I will value them at nothing.

Net-Sol TiG JV (50.1% ownership)

Overview

Netsol formed a JV in December 2004 with TiG, a provider of claims related outsourcing in the UK. The JV gives each approximately 50% of the combined company, and calls for TiG to gradually transition the bulk of its technology development business to the JV ($50M a year in revenue). This allows TiG to significantly lowers its cost of service without the risk and struggle of setting up its own outsourcing operation. The business grew over 100% YoY in FY06, and accounted for approximately $500k in net income after adjusting for minority interest. Net operating margins are a whopping 50%.

Valuation

Currently, this business has only received about 5% of TiG’s total technology development business. If and when TiG does transfer over the whole business to the JV, this business could generate $12.5M annually in net profit for Netsol, adjusted for minority interest. Slap a 15 P/E on that, and your looking a $187M business, or 6x Netsol’s current market cap.

For now, how should we value a business that generated 500k in profit, is growing 100% annually, has 50% net margins, and has what seems to be an eventual lock on about $50M of business? Given the small size and relatively short operating activity, lets say a 30 P/E off FY06 (equivalent to 15-20x forward FY07 estimates), or about $15M.

To recap::

McQue Systems: $8.6M

CQ Systems: $6.7M

Netsol TiG JV (50.1% stake): $15M

Total Value: $30.3

Netsol Market Cap (@1.68): $30.5M

Netsol PK (78% interest)

Overview

Netsol PK is the most talked about of Netsol’s holdings. It is traded on the Karachi stock exchange, and has an estimated market cap of $23.4M (netsol’s stake is worth $18.3M), but owners of NTWK get it for free. This division sells Leasesoft and professional services to APAC, which to date has been the companies’ most successful region (it generated about 60% of FY06 revenue). This division produced $8.4M in revenue in FY06, and recently reported a blowout Q2, with revenue up 129%, and net profit margins increasing fourfold, hitting 41%. In addition to increasing success selling Leasesoft into Asia, this division has made increased inroads with the Pakistan government for a series of contracts. This division appears to be trading for about 2x trailing revenue, which appears a significant discount assuming the 40% net profit margin holds, and given the 100% growth. That said, this thesis does not rely on this subsidiary trading at a higher valuation multiple…

The $300M Punjab land records contract

On January 17^th, apparently under the radar of Netsol investors, the company announced that it is a finalist for the $300M Punjab land records contract. The day of the announcement, the stock didn’t budge. I am still perplexed as to why this announcement has had seemingly had little effect on the stock-price but, after further researched, am convinced that this announcement alone justifies the stock’s entire market cap.

The World Bank, in conjunction with the province of Punjab, selected Netsol as one of four finalists (from 9 local vendors) for the $300M land records project to manage and automate the provinces land management system. Two vendors will ultimately be selected, with expected revenues to each of $25M over the next 5 years. Netsol expects this business to be high net margins, on par with the margins generated from currently from the Netsol PK business (~40%). The final two vendors are expected to be selected by the end of the year.

So, what are their chances of Netsol winning? Well, as a baseline scenario, it would appear that they have a 50%. For several reasons, I believe the likelihood is much higher—in fact, I am more concerned that the project will be delayed or cancelled then I am concerned that Netsol will lose the deal. Here is my thinking:

1) Netsol is the largest IT services provider in Pakistan in terms of revenue

2) The Pakistan government has awarded them multiple recognitions for being the best “IT services exporter” in the country.

3) Netsol has several existing contracts with the Pakistan government on other IT projects

4) Netsol’s Cmmi level 5 facility is one of only 100 worldwide, and I believe is likely to be one of the only ones in Pakistan, given the length of the accreditation process and quality standards (note: I have not been able to confirm this).

5) Two firms will be selected and, given the scope of the project and Netsol’s leading position in the market, I’d imagine their experience will be a strong factor (even if, for some reason, the other smaller companies do a better job)

Valuing the Punjab opportunity

To determine the value of the deal, I have assigned probabilities to the following scenarios:

A: 80%: Netsol wins the deal

B: 20%: Contract is cancelled or Netsol loses out on deal

Below is the value for each scenario

A: $25M revenue @ 40% net margin = $10M/yr. 10M x 5yr = $50M. @ 15% discount rate yields PV of $32.

B: 0

Total value of the opportunity: $32M*.8 = $26M

This also does not include the benefit to Netsol of any follow on work from this deal, or the fact that winning this deal will likely lock Netsol as the go-to vendor for future large projects in the region.

Conservative sum of parts valuation

Though I believe this idea works better when you look at is as an undervalued play with many things that can go right, I’ve put together a sum of parts valuation based on the work done above, adjusted for a 20% holding company discount. Debt is minimal (and offset by receivables), so I have chosen to use market cap rather than EV.

McQue Systems: $8.6M

CQ Systems: $6.7M

Netsol TiG JV (50.1% stake): $15M

Netsol PK stake (@ market): $18.3M

Punjab PV: $26M

Holding Co. Discount: 15M

Estimated total value: $59.7M

Value/share: $3.14

Price/share (3/12/07): $1.68

Premium: 87%

I think the above uses conservative estimates, and that the long-term upside is much higher. Another way to look at this is to see the potential earnings power of the business if a couple things go right. If Netsol wins the Punjab contract, and if TiG transitioned 50% of their technology development business to the JV, then those two catalysts alone would generate $15M in net earnings in FY08. Put a 20 P/E on that, and you have a 300M market cap (10x the current market cap).

Catalysts:

1) Punjab Land contract announced (end of 2007)

2) TiG moves substantially more of technology development to Netsol-TiG JV

3) Increased penetration in Europe and US markets due to recent acquisitions

4) Improved operating efficiencies from moving development work from US and UK to Pakistan

5) Increased recognition by the street. This is worth explaining a little bit more. First, the obvious: Netsol is in a hot space, and has a great story. If the business traded at multiples anything like the Indian outsourcers, it’d be a strong double to triple in the near-term, with sustained 30-40% annual gains assuming the multiple stayed constant and performance remained strong. The second point worth noting is that management and employees are very invested (too invested; see risks) in the success of the company. The brothers that founded the company several years ago own ownership stakes, through options and current holdings, in about 44% of the company. They also referred several times, in their recently published 10-QSB, specifically to aggressively marketing the idea to the micro-cap and larger investor community

Risks

The story is, of course, not without risks, though given the multiple catalysts I believe shareholders are well compensated

1) Dilution and Entrenched Management

As of their latest 10-QSB filing, the company had 17,514,000 shares outstanding. Additionally, the company has 8.6M options outstanding, and 2.6M warrants. Most the options have a lifetime of 10 years. Clearly, this amount outstanding is egregious, and nearly initially caused me to throw the idea away. Luckily, the strike price of most the options and warrants is at or above the current stock price. I have been unable to find a detailed breakout of all the options and their strike price (so many have been issued in so many instances, that I’m not even sure such a list exists), but from what I can tell of those I did track down, the majority seem to have been issued at the price the stock was trading at at the time of issuance. The last filed 10K lists the weighted average of all options outstanding at $2.60 . From the current price, the stock has over 50% to move before it hits $2.60, and the exercise of options is likely to pick up. I think this limits the stocks potential on the extreme upside case (e.g. above $4), but that it should have minimal impact in the near term up to that point. I also don’t like the sign this sends about management, but I am comforted that they have extremely high (albeit too high) incentive to drive the stock price substaintially from here.

Additionally, I am particularly disturbed that the company pays for a good deal of services with stock in leiu of cash. This is a big red flag for me in general, though I am able to get a little bit comfortable with this since management has such a strong stake in the shares (if management was selling shares and had little/no skin in the game, I would be a lot more worried). I have calls out to IR and management, but have yet to receive more color on this issue.

Unsurprisingly, management also appears overpaid, with the top two executives receiving $250k and $280k annually, in addition to their enormous options holdings. Again, I don’t like the signal it sends, but at least large underwater options holdings provide strong incentive to move the share price.

2) Lack of focus

Clearly, this company is trying to do quite a lot for a $30M business. I have strong doubts about them executing on all fronts. Little progress appears to have been made on the acquisitions, and I would not be surprised if those fail to generate any significant benefit long-term. Luckily, I believe there is enough that is likely to go right for the idea to work out, and that the areas they are likely to fail (e.g. expanding outside APAC) are not central to my overall thesis.

3) Increased Competition & Margin Erosion

Unlike India, there is not a limitless supply of labor in Pakistan. The total population is about 160,000,000, which although large does not provide the same “unending supply” that appears to exist in India. That said, this is likely years off from becoming a significant issue, as the outsourcing trend in Pakistan is still in its infancy. Also, clearly the margins are not sustainable long-term. I expect the deterioration to be gradual, and by the time this has an impact the stock should be significantly higher.

4) Political Instability

Pakistan is not the most stable region in the world. There could be a variety of political events that could jeopardize the entire investment. If such an event were to occur, however, I’d imagine it would be part of larger global implications, which would likely beat down all equity markets. I am admittedly not an expert in Pakistan affairs, though I feel I am being effectively compensated for the risk.

Netsol -- Overview

2007-03-13T20:53:00.000-07:00

Netsol technologies is a new idea of mine that I am still researching, but in which I have built a small starter position (2%). Thanks to the Microcap-speculator for bringing it to my attention (see my recommended reading section). I have a call with the CEO tomorrow, at which point I hope to get more information, particularly around my primary concern (egregious management pay and options plan). Even with the shareholder rights issues, this appears like an interesting opportunity.

I will follow up with a more detailed, very in-depth posting, but let me provide a brief overview first. Netsol is a holding company with a majority interest in several operating subsidiaries. Most these subsidaries provide enterprise software and IT services worldwide, leveraging their cheap developers and IT staff in Pakistan. Many of their businesses are very high growth, with revenues for several operating subsidiaries growing at 100%+, and overall revenue growth for the company as a whole of around 50%. The stock is trading for 1x forward revenues and at about 15 forward P/E, but I view this as attractive mostly on the basis of 2 catalysts:
1) 300M Punjab land records contract, with an estimated PV of cashflows of around $32M, for which I believe the company is almost a lock to win. This contract is worth the entire market cap of the company.
2) Netsol-TiG, a highly profitable, high growth subsidiary that was set up to eventually manage a $50 million dollars in TiG's business. If all this revenue transfers over, it would generate about 12.5M in annual earnings for Netsol. Put a 15 P/E on that, and you have a business worth $187M (6x Netsol's current market cap)

My main issue is that management appears to be literally robbing the company, with salaries of $250k+ for top management (too much for a 30 million company), and humongous options packages that ensures management captures most the upside of the business, at the expense of the shareholders. I've been turning in my mind how to bring this up to management in the most effective way possible. Anyhow, should have an interesting call. Will update you all tomorrow.

Eyelogic Part 1--Overview

2007-03-13T15:57:00.000-07:00

Eyelogic (EYE.A on the Toronto Venture Exchange) is my most exciting current holding, accounting for approximately 9% of my personal portfolio. I have owned the name for over a year, and have compiled a good deal of research on the name. This is likely to be one of several postings. To summarize, this is a tiny ($5M US) market cap company with a potentially disruptive technology, growing at about 40% per year with a P/E ratio of ~10, and a dividend yield of 6%. It is extremely illiquid, and is suitable only for small investors with long time horizons and relatively small accounts. I view this as a private equity purchase, and do not plan on selling anytime soon. I believe this stock has the potential to increase 10 to 20 fold if its technology catches on. It is currently the most attractive risk/reward play I see in the market.

The company makes an automated refraction system, which is a fancy way of saying that they have developed a device capable of taking an accurate measure of the prescription of glasses needed by a patient. To explain how big a break-through this is, let me first provide some detail on the eyecare industry.

Overview of the Eyecare Industry
Eyecare is provided mainly by optometrists, who specialize in health of the eye. They provide a host of eye related services, including glasses prescriptions, eye check-ups, lasic surgery, treatment of cataracts, and other ailments of the eye. Though there are many ailments on the eye, the most common reason people go to the optometrist is to get a new prescription. It is estimated that nearly 90% of visits to the optometrists are for this reason.

Anyhow who has ever gotten their prescription taken can tell you how much of a joke this process appears to be. The optometrist flips a switch, asks you to compare two options, and continues to do so until the correct prescription is found. He is, 90% of the time, a glorified machinist. This knock on optometrists is not new news. Witness 1800-contacts battle with the optometrists. Most optometrists refuse to give prescriptions for contacts, instead making the customer order through them (with hefty margins going to the optometrist). 1800-contacts has spent millions battling optometrists unions, and will likely continue doing so in the future.

Unsurprisingly, the optometrists view Eyelogic and its system as a huge threat. In the fall of 2006, they pursuaded the board of Canada to classify the eyelogic system as a class 2 instead of class 1 device. This forced Eyelogic to suspend sales in Canada, until they received the additional certification (which was received in late February). A cursory view of internet message boards will also show you some resentment on behalf of the optometrists.

Anyhow, if a good system to automate the prescription process was developed, it is clear why the optometrists would be scared. Luckily, Eyelogic has a partner in their battle, in a way 1800-contacts does not:

The Optician
Opticians specialize in sales of products for the eye, mainly glasses. They have always fought the optometrist for business, as many optometrists sell glasses in their own office, providing a lucrative additional revenue stream. Many opticians have gone a similar route, bringing in their own optometrists strictly for the purpose of driving eyecare sales. Unlike the optometrist, the optician views the prescription process as a hassle. They see it as a vechile for eye care sales, not as a lucrative revenue stream (which is why this service is usually heavily discounted in most optical stores). They would love a machine that would automate the process, and drive more people to their stores instead of to optometrists. The union of opticians in Canada has lobied on behalf of systems like eyelogic, and should be a strong ally in the battle going forward.

The Market
The eyecare and prescription market is a multi-billion dollar business. According to a 2004 labor bureau report, there are over 34,000 optometrists in the US alone. Additionally, increases in computer usage, and jobs requiring computer usage, are likely to take a toll on most people's vision, requiring increasing visits for eyeglass prescription in the future. Currently, it is estimated that about 30-40% of the population has myopia, most of whom require glasses or contact lenses. In addition to thousands of optometrists worlwide, there are also hundreds of thousands of opticians who sell eyecare products to the public. Though Eyelogic has no hard numbers on the penetration of autorefractors, it is estimated to be very low (<10%). Adoption has been slow, as optometrists have largely shunned the service (it would admitting that there is no skill involved in 90% of what they do, and would negate them to specialists for more serious issues). Opticians have adopted the service more rapidly, but are still adopting relatively slowly.

According to Mark McDonald, COO of Eyelogic, there are several companies in the marketplace. Many have tried (and failed) to spend millions on high powered marketing campaigns and low-cost machines to encorage rapid adoption, but none has worked thus far. Eyelogic has taken a measured approach to growing the market, and anticipates the market to continue to expand slowly in the future, until mass adoption by a couple large optical chains or mass retailers (e.g. Costco, Wal-mart) tips the scale.

There are 3-4 companies that make this equipment. Eyelogic is the leader in the Canadian market, and sells worldwide through its distribution agreements. There are also 2-3 japanese companies that make flashier, albeit less functional products then eyelogic. Demarc, a large provider of optical equipment in the US, is the leader in the US market, though has faced similar adoption challenges as eyelogic has faced in Canada.

Next-->a review of eyelogic's operations, financials, and growth potential...

About the blog

2007-03-13T15:11:00.000-07:00

Recently, I have become increasingly frustrated with the quality of analysis available to the majority of investors--most analysts are a joke (they spend days on models, but little time or energy thinking about the inputs to those models), and most popular journalism sites (e.g. Motley fool) take such a cursory view of the markets and individual stocks that they see no more than what everyone else is seeing. In general, I think there are many people who view the market more as a game of gambling an excitement than one of intensive research and disciplined investing. Surely, this can be a lot of fun as well, but many people seem to take more pleasure in the mysterious ups and downs of a market and stocks movement rather than digging deep to understand its true causes. This includes most journalists, who often latch onto a consequence of a more fundamental issue (e.g. the subprime collapse), rather than the fundamental cause of that symptom (a high appetite for risk across all actors in the market).

The goal of this blog is to share with readers many of the websites I have found to be instrumental in my education process, as well my own thinking on sectors, individual stocks, and broader market trends. I welcome feedback on both the content and direction of the site.

About Me

2007-03-13T15:02:00.000-07:00

Eric Wolff is the founder of Flux Capital, a manager of long/short accounts for institutions and individuals. Prior to starting Flux, Eric worked for Mckinsey & Company as a business analyst. He holds a degree in Economics from Washington University in Saint Louis.