HAWK: Strategic Alternatives Update

This past Tuesday (11/2) after market hours, Seahawk Drilling announced "[it[ has initiated a process to explore and consider possible strategic alternatives for enhancing shareholder value. These alternatives could include, but are not limited to, transactions involving a sale of assets, a recapitalization, or a sale or merger of Seahawk"  (Full release here).


I wrote about Seahawk on my blog back on September 12.  With a grossly undervalued asset base as well as high cash balance, I believed that shares were moderately to severely undervalued even in the very dire conditions that existed at the time.  A number of catalysts have occurred that have pushed shares over 30% higher from the day I published my analysis.  While it was difficult at the time to place a timeline on the occurrence of these catalysts, shares were so cheap at that point that you could have practically melted the rig steel and found more value than the market was giving credit.  Below are summaries of a few of the recent developments that have helped move shares higher since my writeup:


1. Immediately after my article was published, the BOEMRE and Ken Salazar issued a notice to lessees that all non-working wells in the GoM would need to be permanently capped.  This amounts to approximately 3,500 wells that will need capping over the next few years.  Starting October 15, companies with non-operating wells have 120 days to submit proposals on capping and work should begin following approval.  Because these cappings are just work overs that will take days to a few weeks to complete, lower spec rigs like HAWK's should end up getting utilized and would help provide much needed cash flow.

2. Early Lifting of Deepwater Moratorium:  While this did not directly affect HAWK as a shallow water driller, the move restored confidence that eventually the GoM would return to normal drilling, even if it would be more difficult to get a permit going forward.  While the BOEMRE is still an unorganized mess according to a source, there is at least hope now that things can return to normal faster than expected.  


3. Seahawk entered into a Memorandum of Understanding with Essar Oilfield Services to sell the Seahawk 2025 drilling rig for $14.55MM, subject to Essar being awarded a tender on or prior to February 8, 2011.  If the deal closes, Seahawk will also receive $135K for training and services on the new rig.  While this may be a nice win from a cash flow perspective, more importantly it helped rationalize the market value of their entire rig base to a certain degree.  Since the announcement, shares have climbed significantly as the market mulls whether there will be further rig sales as well as whether the cash may be used to acquire a rig outside the US GoM that may be accretive to cash flow.  For a more fulsome explanation of the the sale and the tax effects, check out Longterm Investing.


4. Announcement of Strategic Initiatives:  Since late spring, HAWK has been at the center of a perfect storm of bad industry trends.  Just about the time of the Macondo blowout, things were just getting going in the GoM after a sluggish previous year.  Rig counts were increasing and HAWK expected to climb out of the operational hole that was most of 2009.  However, the ensuing moratorium, while not affecting shallow water, caused the pace of permits to slow to almost nothing, as mentioned in my previous article.  Coupled with a steady decrease in the price of natural gas, demand for HAWK rigs has remained sluggish and the company has been burning cash at an alarming rate.


While I welcome the exploration of strategic initiatives, I would argue this latest piece of news is somewhat of a non-event.  Clearly, with the sale the 2025 rig, HAWK has been actively exploring ways to work through these tough times and maximize shareholder value and have done a pretty good job at making this clear since the share price lows in August.  


I sincerely hope their new strategic advisor, Simmons & Co., is able to help HAWK think outside of the box and come up with a solution to sell rigs, raise cash or merge the business at a price that is commensurate with the fair value of their rigs and operations.  It is unfortunate that the company has come to this conclusion when they are still in a tight spot operationally and time is of the essence to stop hemorrhaging cash; however, these moves should at least help put a floor on the share price in the near term.  HAWK may not be able to get top dollar for their rigs and their current book of business is extremely thin, but even with the recent increase in share price, an outright sale or a sale of individual assets could provide further upside to shares.  If you are bold enough to base the valuation on the 2025 sale, shares could be worth closer to $20/share...but I'm not sure I'd hold out hope, there's still a steep hill to climb.


3Q earnings next week will help provide a better picture into plans going forward as well as upcoming rig activity and the all important cash burn, which will allow investor to make a fresh determination of the value the market is placing on HAWK's rig fleet.


Disclosure: Author is long HAWK

Dialog Semi 3Q: Record Revenue, Thesis Still Strong

Last week I wrote an article on Dialog Semiconductor prior to their reporting of 3Q results.  Based on strong earnings of several of DLG's largest customers, shares had run up into earnings in anticipation of a strong report.  Analyst estimates had also accelerated to well above management guidance.  Prior to earnings, I believed shares were fairly priced and would only see upside if numbers were truly explosive.  With analysts getting ahead of themselves immediately leading up to the report, the risk was certainly to the downside.

Dialog reported a record revenue quarter, but predictably it did not meet analyst expectations and shares sold off almost 8% the day of the report.  I used the opportunity to pick up some additional shares since I had been trimming my holdings around €13.50-13.70 leading up to the report.

Despite not hitting analyst numbers, this was a great quarter for the company from a revenue, margin and product development perspective.  Revenue came in at $79.5MM, above the top end of management guidance for the quarter and a record for the company.  Revenue could have been even higher, but due to other supplier constraints at some of their customers, some Dialog inventory went unused this quarter.   Margins were also solid, with gross margin coming in at 46.3%, which was 1.0% higher than last year.  According to my conversations with management, gross margin could have been even better, but because of higher manufacturing costs in Asia due to lower available capacity, they were not able to wring out some additional volume discounts.  Despite comments on the call about overstretched capacity utilization, Dialog was on time with all shipments to customers for the quarter.

Dialog maintained a very healthy balance sheet with no debt and a cash balance of $145.6MM.  Inventory was a little bit higher than expected, but not alarming given the typical elevation going into Q4 holiday season and due to capacity issues.  This need for secure supply is evidenced by the higher finished goods segment of inventory.  Below are the summary results for Q3 and a projection for Q4 based on historical results for margins and my expected top line growth:

Based on latest discussions with the Company, I learned that the pricing analysis provided by iSuppli (main supplier of consumer gadget part pricing to the finance community) that tends to drive analyst projections for Dialog tends to be higher than actual pricing.  As these prices are a closely guarded secret, I was told some of the prices provided by iSuppli can be materially higher the customer cost, because iSuppli does not take into account volume discounts and contract arrangements.  As such, I have pulled back on my 4Q assumptions as well as Apple’s contribution to top line.  Below are the new summary numbers for 4Q.

Due to analyst’ tendency to get ahead of reality, Dialog gave guidance for 4Q gross margin, expecting it to remain roughly similar to 3Q based on their conservative stance in the face of capacity constraints.  On the revenue side, the company was equally conservative, almost to a fault in my opinion.  Revenue guidance was maintained at $290-295MM for the year, representing a growth rate of 34% YoY for the full year.  While this is strong growth overall, the Company has already earned almost $210MM in revenue through 3Q.  At the high end of guidance, 4Q revenue growth would be only 10.7% YoY compared with around 50% growth for the prior years.  For this reason, I am projecting revenue at ~$105MM, or a 36% growth rate YoY.

On the new product (or free option) front, Dialog is making good progress with its low power audio codec, with one customer shipping a consumer device utilizing the chip as well as another product that is in development with the chip.  There will be some revenue from the chip in 4Q10, with a more material impact on revenue starting in 1Q11. 

On PMOLED, the first products being developed by TDK utilizing the smartXtend chip were debuted at a trade show in Japan this quarter.  Dialog is also working with another yet-unnamed partner to develop similar technology that is expected to be revealed in 4Q10.  The Company is managing expectations on the product, stating that product tests and supply chain development will be ongoing for the remainder of 2010.  Early-adopters (2^nd tier consumer products companies) will likely bring products to market in late 1Q11 and assuming successful adoption, larger tier 1 players could adopt on a large scale in late 2011. 

Finally, the Company announced a key partnership with Intel and a design win regarding its recently launched DA6011 companion chip, which is primarily intended for industrial and automotive usage.

Overall, a great quarter operationally with financial results held back slightly by some capacity constraints at the customer level.  Because analyst expectations had been ratcheted up in the weeks prior to earnings, shares fell almost 8% the day of the report, although they have mostly recovered to what I would again call a relatively fair value based on existing operations.  Looking forward, Dialog has bright prospects as it takes advantage of top-tier customer relationships while it works to diversify revenue streams and develop new, innovate products.  At any level below the current prices, I would look to continue to accumulate shares as long as positive developments continue.

Disclosure: Author is long DLG

Dialog Semiconductor: The AAPL derivative you've probably never heard of...

Dialog Semiconductor (Xetra: DLG) is a high growth mixed-signal semiconductor company with strong management and several free options that could be blockbuster sources of additional earnings.  Based in Kirchheim Germany, Dialog trades on the German DAX.  With a market cap of $900MM, it is a fairly liquid stock, trading around 300-800K shares/day.  However, because of minimal coverage from US brokerages and being on a foreign exchange, most people outside of the tech world and/or hedge funds do not know the name.  This may change in the coming 6-8 months as more U.S. investors are becoming aware of the Company's performance.

DLG has grown revenues at a 56% CAGR over the past 2 1/2 years and EPS has grown even faster.  However, Dialog trades at only 25x current earnings and ~14x analyst's 2011 forecast.  Though near fair value on this year's earnings, Dialog continues to announce customer wins on a frequent basis and has several additional growth platforms (discussed later) for which shares are not given credit.  Over the next 12-18 months, growth in the existing business as well as new product developments should provide catalysts for upside performance.

Company Overview

Dialog operates in the niche area of power management (PM) chips and has extensive tier-1 OEM relationships.  DLG operates in three business lines: mobile devices, lighting & display and automotive.  They have exhibited phenomenal growth over the past several years, driven by top customer wins, improvements in efficiency and a focus shift from lower volume/margin chip solutions to high growth mobile platforms.  

The Company has an interesting competitive moat in that it utilizes mixed-signal technology (meaning the chip can run both digital and analog functions), for which there are a very limited number of researchers and engineers; fortunately, Dialog has many of the most talented engineers in the business (Example here).  This has allowed Dialog to produce chips that have greater functionality and smaller footprints within their respective devices and is why they have become very important to the mobile device space, most notably being featured in the iPhone 3GS, iPhone 4, iPod and iPad.  Because their chips work alongside device baseband chips, the Company is agnostic as to whom they partner with and have therefore made relationships with many of the major baseband and mobile device OEM players (Apple, Marvell, NVIDIA, LG, etc.).

Customers

Dialog's top 5 customers make up about ~85% of sales.  While this level of concentration may seem like a potential risk, Dialog has long relationships with each of their top customers.   In the case of Apple, DLG chips have been placed in every new mobile device since the iPhone 3GS.  Because Dialog chips provide high levels of functionality, along with space and power savings at a low cost, I believe replacement by any of their top customers is unlikely in the next several years.

SonyEricsson is the only medium-term potential risk as Dialog provides power management to EMP (Ericsson Mobile Platform) phones.  This particular piece of business will remain for 2-3 more years, at which point ST Ericsson (Sony JV with ST Micro) will likely begin to encroach.  In the interim, Dialog will continue to grow business with SonyEricsson via audio only and lower function PM chips.

Apple 

Apple is Dialog's top customer and one with which they maintain a strong partnership.  DLG has been in all of Apple's blockbuster launch mobile products since the iPhone 3GS.  The below chart details estimates of Apple's contributions to Dialog revenue for the first half of 2010 as well as estimates on performance for the second half of the year.  In the last couple of months, the iPad has been released to great fanfare in several foreign countries, including China, where reception has been very strong.  With iPad projections of 25-30MM units next year, I believe my estimate of 10.1MM for 2H10 should be beatable.  

For iPod, Apple does not break out the types sold.  I've backed into an estimate based on Dialog's first half chip sales to AAPL, iPhones sales numbers and the price of the chips sold during 1H10.  Given the rising product mix of the iPod touch as well as Dialog's new appearance (!) in the 6th generation iPod nano (with a similar ~$1.30 chip to the old iPod touch) I have raised estimates on the back half of the year for sales of these chips.  Given that the new iPod Touch is functionally similar to the iPhone 4, pricing for iPod chips is elevated in 2H10.  Note: below projections are calendar quarters, AAPL fiscal year ends 9/30.

With Apple having just reported another blowout quarter on 10/18, we have a pretty good window into a large portion of Dialog's revenue.  

Important to note for the upcoming iPhone 5 (rumored in development) is that because Dialog is agnostic as to the provider of base band chips, it will not matter whether Qualcomm (rumored to be replacing Infineon) or Infineon is featured in upcoming versions of the iPhone or other Apple mobile devices.  Dialog's power management chip can work with both and is a very cheap (but important) piece of equipment in relation to Apple's total cost of their mobile products.

Free Options

In addition to their primary chip lines, which will continue to produce strong revenue growth, Dialog currently has free options not priced into shares that could be very important to future growth.

Class D Audio Codec - In March, Dialog announced the release of their latest audio chip (class D chip), a stand-alone that can be combined with a PM chip or stand by itself as a speaker driver for audio enabled devices. With a tiny footprint that allows it to be placed near the speaker, the chip will reduce heat buildup and be twice as power efficient as the alternative class AB driver technology.  The Company is currently working with several  tier 1 partners and will likely begin to deliver the chips to customers in 4Q10.  This stand-alone chip should be attractive to OEMs that either don’t want or need a PM chip in their device and will help to diversify Dialog’s revenue sources.

DA6011/Intel partnership - In mid September, Dialog announced a new chip partnership with Intel's newest Atom processor that integrates power management and clock driver functions and was developed in partnership with Intel.  The Atom chip primarily runs automotive computers.

PMOLED - DLG is developing a smart power management chip for a technology called PMOLED (passive matrix organic light-emitting diode).  PMOLED is designed as a low cost display alternative to high-end AMOLED (active-matrix) screens like those offered on Android smartphones, for example.  PMOLED is currently at a disadvantage as it uses significantly more power than it's AM counterpart, but has the advantage of being significantly cheaper to produce.

However, Dialog has designed a smart chip that could change the smartphone game and help PMOLED offer competing quality and power usage at a fraction of the cost to manufacturers.  This would allow much cheaper devices to offer touchscreens similar to those currently found in expensive smart phones.  With lower end phones still dominating the emerging markets, the adoption of PMOLED by tier 1 OEM suppliers could help make smartphones significantly more economical.  With a price point of $1.50-2.50/chip, analysts believe PMOLED could be a $100MM revenue opportunity in 2-4 years. Dialog has already formed an early partnership with TDK in Asia and expressed they are working on other tier 1 client partnerships to come later in the year and in 2011.

Competition

1) Maxim Integrated Technologies is a competitor that has developed similar power management technologies, but they have not achieved Dialog's superior level of function integration (display, keyboard backlight, battery power, etc.).

2) Wolfson is a UK based company that competes in audio semis specifically, but their quality and clarity is not near Dialog and they have been losing market share to DLG.

3) As mentioned earlier, Sony/STMicro JV has also developed power management technology that will likely take business from Dialog in the next 2-3 years, but Dialog has continued to win other business with Sony in other chips that should continue to grow over the next couple of years.

Management

Over the past 5 years, Dialog’s management team has successfully disposed of or divested several low margin, high R&D products and helped the Company navigate from what was a loss producing business to one concentrated on high growth/demand mobile segments.  

Much of this turnaround is due to leadership by Jalal Bagherli, who joined Dialog as CEO in 2006, leading the spinout of loss generating Dialog Imaging Systems (which took Dialog's former CEO with it).  Additionally, he dropped Sharp's LCD driver business which had high R&D costs, yet only produced around 10% gross margin.  Finally, he helped change the product design process by subcontracting testing services to Malaysian and Taiwanese partners with oversight by Dialog employees.  This squeezed savings and time from the development process.  Since these initial steps, Bagherli has continued to focus the business on high growth opportunities in power management, as well as establishing partnerships with Apple and others. Under the leadership of Bagherli and other senior management, Dialog has now reported nine consecutive quarters of profitability and two full year profits after seven years of losses.

Risks

1) Customer concentration: approximately 85% of the company’s revenue comes from top five customers (Apple, RIMM/Marvell, Sony, TridonicAtco, Bosch). A loss of any of these could materially affect sales and earnings.  

2) Dialog operates in competitive markets in which, while protected by patents and proprietary technology, it is always at risk of losing customers to competitors that have a better product.  To this time, Dialog has protected itself with top-tier relationships and technology that offers superior solutions in power management, functionality and audio to its competitors.

3) DLG is marginally exposed to currency risk due to its global operations.  This is largely mitigated by the fact that they sell to customers and buy from suppliers in $USD. Only employee pay is in Euros, which they hedge 6 months out typically.

4) Large non-US investor base can tend to react oddly to news, or lack thereof.  Anecdotally, during early summer, shares tumbled for seemingly no reason.  When I spoke to management, they had received feedback from some of their German institutional holders that they were selling simply because there had not been many recent press releases.  A few press releases later in August and September and shares are flying high again.

Second Half 2010 Projections

While I believe that much of 3Q earnings has been priced into shares, if DLG is able to approach my top line projections (which are significantly above street estimates due to strong AAPL results) and keep margins steady, shares still have upside potential.  It should be noted that taxes are always an unknown from quarter to quarter because Dialog has ~$37.5MM of off balance sheet net operating losses that can be applied to taxes.

Below, I have projected 3Q and 4Q top customer sales based on conversations with management and analysts about customer concentrations.  Due to the success of the iPad and the iPhone 4, AAPL will likely become a larger percentage of total sales;  other customers are projected to grow 10-15% based on Dialog's historical revenue growth characteristics:

I have projected what FY10 may look like based on historical margins, assumptions on taxes and utilization of NOLs.  Due to a "one time buy" from an automotive customer last quarter, gross margins were higher than expected - I would not assume this for 3Q.  Assuming continued strength of AAPL product offerings in 4Q, I think analyst estimates are low and will likely have to be revised upwards after 3Q is announced.  This could also provide upside potential to the current share price.      

Conclusion

Although 1H tends to be weakest for Dialog, 1H10 provided a strong start compared to years past due to strong sales from Apple and other top customers.  The Company is also working successfully to further diversify their customer base and product offerings.  

Having successfully navigated through the credit crisis with a large cash balance, no debt and a high growth product portfolio, Dialog should continue to grow at a healthy clip.  The numerous free options currently in development and moving towards launch will also have a meaningful impact on Dialog's top line.  

While I believe DLG shares are near fair value at these levels, there is certainly room for upside surprise.  If the market provides an entry point at a lower price in the near term, I think Dialog's future prospects make the shares a worthwhile purchase.

Disclosure: Author is long DLG

Daily Deal updates

I've gotten a lot of questions about sharing data on TZOO and OPEN since I posted my articles several weeks ago on my blog, so I wanted to provide a brief update.  I was cautious on both TZOO and OPEN due to their enormous runs prior to my posts, although I had taken a small position in TZOO to get a play on the deal hype at a significantly cheaper valuation (there was more analysis than this, but for simplicity sake, let's leave it at that).  At that time, I was more impressed with the deals and the promotion I had seen out of OPEN as they had quickly ramped up their high-end restaurant offerings to a number of cities and had been expanding their city base at the rate of about 1 new city per week.  They also started sending spotlight deals to anybody that was registered on their OpenTable website to help grow the offering by word of mouth.

As of a month ago, TZOO had been lagging pretty substantially.  They were offering new deals very sporadically, running in only a few markets where they had not been selling very impressively.  It was also nearly impossible to even find their "local deals" on their website homepage (www.travelzoo.com).  While the local deals service was highly complimentary to their existing travel offerings, they were not promoting it well and it wasn't exactly "snowballing" very fast.

What a difference a month makes!  About a week after I wrote the two articles, I spoke with another analyst that was more bullish about TZOO and their offerings; he got me thinking more about the value proposition that TZOO offered and their ability to grow above and beyond the purely restaurant offerings that OPEN brought to the table (no pun intended).  I maintained, and still do, that it will be tough for OPEN to widen their offerings past higher end restaurants, but what I had not considered as thoroughly is whether diners would get high-end restaurant fatigue.  Although still too early to tell definitively, with 8-12 full weeks of data from many OPEN cities, it appears this may be the case.  In every city where spotlight is offered, except NYC, the average revenue/week has been dropping since they started offering deals in the city (all spotlight deals, except one week in Chicago, have been $25, making the data easy to track).  Several cities have dropped sequentially every week since spotlight began, with the losses between week 1 and the current week being between 30 to 40%.

In the meantime, TZOO has gone on a complete assault on the daily deal space, launching to several new cities and having blowout week after blowout week.  With an e-mail distribution list that boasts over 22 million subscribers, not only are people used to getting e-mailed by TZOO, they are now becoming more familiar with the daily deal space as the Groupons and Living Social's of the world become more well known (anecdotally, my mom asked me if I had "heard about these Groupon things" the other day, so the word has officially gotten out).  TZOO has also been offering a wide array of deals, similar to Groupon...everything from Mani/Pedi deals to indoor skydiving and wine & cheese classes.  Because of the price lumpiness of TZOO deals, it's not as easy to get an average deal stat, but there has been noticeable growth in the very successful deals (those selling +$50K gross revenue).

What has this done for TZOO from a revenue perspective?  Since their first deal was offered in Des Moines on July 29th through the end of Q3, they sold ~$850K (gross rev.) of deals.  Through not even three weeks of Q4 and into several more cities, they have made over $1MM in gross revenue with seven deals grossing over $50K each.  It will be an ongoing experiment through the rest of the quarter to see how many more cities they launch and if the deals keep selling as well as they have been, but the first few weeks of Q4 have been extremely encouraging, to say the least.  From a valuation and (less) hype perspective, as well as an offerings and distribution perspective, I still believe the best way to play the trend in the daily deal space is TZOO.  If they can continue at their current rate in just the cities in which they currently operate, assuming a 30% net margin, TZOO should have an additional $0.10-0.12 of EPS for the quarter.

Disclosure: Author has a long position in TZOO; no position in OPEN

SFLY: A Value Investment? Not In My Book

In last week's edition of Value Investor Insight, the newsletter featured a bullish piece on Shutterfly, Inc. from investor Mario Cibelli of Marathon Partners.  Cibelli made a compelling case for NFLX in a 2006 edition of VII when everyone else said that the DVD-by-mail model could never compete in an industry that would quickly move to streaming movies and put the company in direct competition with AMZN, Blockbuster and others.  He saw NFLX as a "disruptive" business with a competitive advantage that would succeed.  He was correct, and as you may know, shares of NFLX have soared to around $150 as of writing this article.

Cibelli sees SFLY as his next big "disruptive" bet in an industry that "is in the early stages of significant growth...[in which] it is Shutterfly's business to lose..."  Cibelli believes that SFLY has been "the most aggressive innovator" in the space based on their moves from low margin 4x6 prints to higher margin photo books and the "Simple Path" method of uploading pictures to photo books that takes a fraction of the time it takes to create an entire custom book.  He also believes that as times goes on, if SFLY is able to maintain their "30% share of the [photo printing] business - the company would more than double revenues" based on what US consumers spend annually on greeting cards, photos and photo books.

However, Cibelli's argument fails to make take into account some very important aspects of the business that not only don't make it a value investment, but at these levels, I believe it to be a decent short candidate.
1. SFLY makes what is essentially a commodity product on the internet with paper thin margins;
2. Their "innovations" have been and can continue to be copied by competitors (both existing and new) that are constantly engaged in pricing and promotional wars with each other;
3. The Company produces minimal to no cash flow outside Q4 (holiday season);
4. Primarily has machines that don't run 3/4 of the year (w/ the exception of small commercial printing biz);
5. Trades at a current 110x earnings and 50x next year's earnings (admittedly SFLY has high depreciation expense, but almost equally high CapEx, so cash flow is only marginally positive from an accounting perspective);
6.  Analyst projections are far too high.

Commoditized Product
While I believe that SFLY offers a quality product and has thousands of satisfied customers, every one of their existing products as well as recent "innovations" on their site are easily copied.  This is the most important part of the SFLY short story in my mind; if there is no competitive moat, how can an investor expect historical growth to continue AND how will they grow margins?  If they can't do this, why pay a premium multiple for the shares?

For a starting example, look at a site such as picasa.com (popular google service for online photo sharing).  Shutterfly is undifferentiated from the other listed printing options, leaving price as the only differentiating factor in this equation if you are not already an SFLY customer.  Additionally, there are OVER 100 similar online photo printing sites like those below:

When asked what differentiated their products from the competition, SFLY management told me that their product has a better feel - the fact that the pictures (or photo books) come in a higher quality, heavier duty box when delivered.  Prodded further, the stated that site innovations (such as "Simple Path") have also differentiated them from their competition.  While I respect the fact that SFLY tries to differentiate with a higher quality product, they don't hold patents in their photo processing, their delivery method nor their other services and as a result, have seen margins on 4x6 printing erode significantly.  There have been constant price wars in the 4x6 print space, with competitors undercutting SFLY's price.  Here's a good synopsis of developments in the 4x6 price war that has ensued over the last several years.  With prints as low as 5c/print, there's not a lot of room for margin...add in free shipping to that (as advertised above by American Greetings) and you're practically giving them away...it should be noted that in 2009, shipping accounted for 14% of SFLY's revenue.  Continued attempts to undercut shipping costs are a further threat to SFLY.

As innovators, SFLY has attempted to find a growth engine beyond the low margin 4x6 business by introducing the personalized photo book as a way to store memories in a more customized, lasting manner.  Over the last several years, custom products like photo books, greeting cards and  calendars have become increasingly important to SFLY as seen in the revenue breakdown below:






However, there is also nothing to keep competitors out of the photo book and customized space either and SFLY runs a high risk of these albums becoming yet another commodity product.  You can see HERE that there are already several competitors in the space at a lower price point than SFLY, including Snapfish (HP), the main driver behind the 4x6 price wars that eroded margins to where they are today (here, here and here are some direct examples of the competition, congrats if you can spot the differences...).  As these personalized products are brought down in price by competition, SFLY's margins on these products will erode just as they did in the 4x6 prints.

Although only anecdotal in nature, SFLY is offering non-holiday related 20% discounts on ALL photo books right now.  As of two weeks ago, this deal was supposed to end Sept. 29, but has been extended through October 13.   According to Morgan Keegen, which covers SFLY, photo book pricing has been decreasing steadily over the past several weeks.  While this may be a positive in bringing new customers, it's still a negative when it comes to margins.

Speaking of margins, they're paper thin.   While they have increased markedly over the last two years since the economy began sinking, gross margin, EBITDA, EBIT and net margins are all flat to down significantly since 2004, a result of continually squeezed margins of a commodity product.  While SFLY's 5 year Revenue CAGR as of YE2009 was over 35%, EPS had grown at barely half that rate. Cibelli says in the article that he "honestly believes this is a $1 billion revenue business" and "at that revenue level, his price target for the shares goes to $100."  Let's do the math with max margins from 2004 as well as current margins and see where that business would trade:

At current margins, SFLY is certainly no value.  If the company can somehow keep out the competition, which has only grown more numerous over the years, innovate and grow all margins by 50-200%, there is a chance that shares could be reasonably priced on an EV/EBITDA basis, but still expensive on earnings to be called "value".  At today's margins, Ben Graham would spin in his grave and Warren Buffett would have a cardiac episode if you tried to pitch this as a "value" name.

4th Quarter or Bust
SFLY has negative EPS and earns almost no cashflow outside of their fiscal 4th quarter, where revenues triple from the other quarters and positive EPS covers the losses of the previous 4 quarters in order to make SFLY have a positive P/E.  It also produces enough cash flow to cover the other quarters and make SFLY trade at a high, but not ghastly 17.5x FY09 FCF (For simplicity sake, I'm using a calc of CFO-CapEx).

While this in itself is not a huge problem, it means the 4th quarter is very important to the business and any sort of hiccup is problematic.  On the 2Q conference call, CFO Mark Rubash described "moderation in activity" in late 2Q and into early 3Q.  While the site's traffic appears to have picked back up somewhat (according to compete.com), current non-holiday related discounts being offered on their highest margin products do not bode well for a strong 3Q and given current consumer confidence, this also may not be the merriest of holiday seasons either.  According to management (and common sense), SFLY's performance is highly correlated to consumer sentiment and confidence, which has been wanning over the last several months.

To solve some of their fixed cost issues, SFLY has begun a fledgling commercial printing business, although management has admitted it is taking longer to get off the ground than expected.  While they think the business can do $30-40MM in sales, the sales would be lower margin than the core picture printing business.  SFLY only has a few sales people devoted to this effort, which will likely keep revenue growth slow; slim margins due to fixed costs will likely remain in this business line for the foreseeable future.

Valuation and Expectations Too High
Currently trading at around 110x current year expected earnings, SFLY is expensive on an earnings basis...even next year's consensus earnings puts them at a P/E of 47.  Given the company's high depreciation asset base, high P/E will continue to be an issue for SFLY.  Although not unreasonable on an EV/EBITDA basis at around 14.5x, it's still not exactly a "value" discount.  Additionally, growth has been continually slowing over the past several years as both two year and three year CAGR in revenue, gross profit, EBITDA and net income have declined since the company went public.


In addition to an already expensive valuation, analyst estimates are far too high based on historical performance as well as what will ultimately remain a highly competitive market for online photo printing.  Although covered by several major houses (JPM, MS, Lazard, etc.), many analysts only put out one report each quarter at earnings time, so SFLY is generally neglected by the analyst community.   As a result, sell-side estimates contemplate top line growth that may (emphasis on "may) be attainable, but margins that unlikely based on how business has trended over the last 5 years.   Below are street consensus estimates for the next 5 years:

In order to meet these estimates, there is going to have to be both substantial growth in order prices as well as growth in household penetration.  To give you a macro picture of what this would look like, assume that SFLY has 33% mkt share (last number I've heard from Company) and an average order price that grew 8% (average of '07-'09) over 2009 (and continues to grow at this level), this would mean that based on growth expectations of total US households, one in every 4 to 5 houses would need to be placing a photo order per year and for SFLY, these orders and the prices would need to be growing at a steady clip as well.

While this level of growth may not seem overly taxing for SFLY, consider that the competition is fierce for these dollars, household penetration would need to grow almost 40%, keeping other things constant and one in every 10 households would need to make an "average" price order from SFLY.  Then consider that their core customer base is women, age 25-45 with $95K household income.  Unless they can broadly expand the demographic base of their highly discretionary and pricey item or get their core demographic to really up their order values per year, it's going to be tough to meet these estimates.

Risks to Short Idea
SFLY has a pristine balance sheet with $5.83 in cash and no debt, which serves as a support to the shares.  Under circumstances with a business I felt more attraction to from a valuation and competitive moat perspective, I would be lauding their balance sheet, but with a "growing" tech company such as SFLY, it is doubtful this cash would ever be put back into shareholder's hands as dividends or share buybacks...in fact, shares outstanding have been steadily increasing since the company went public due to their egregiously large SBC plan.  At best, they keep the cash, at worst, they make a "strategic" acquisition.

SFLY's market cap makes it vulnerable to be bought out by a competitor (like Snapfish).  I highly doubt the company would be a target for either private equity or management led buyout due to their lumpy earnings and cash flow that is almost wholly dependent on one quarter of operations.  I also doubt that a PE firm could get comfortable with the competitive "advantages" that SFLY claims to have.

For all the reasons above, I believe that not only is SFLY not a true value, but I am short the shares at these levels with expectations that analyst estimates are going to be tough to beat going forward.  While Cibelli may have knocked it out of the park with his call on NFLX, what made that business "disruptive" is that they did something nobody else had ever done - create a profitable subscription based DVD service that ended up not being threatened as quickly as expected by existing titans of the rental and online business.  SFLY is different in that they are doing something that 100 other competitors are doing right now and in a manner that can only be differentiated for a short period of time before competitors cross the moat.  Imagine if there were 100 other DVD subscription services out there right now...the competition would be fierce, price wars would be commonplace and you certainly wouldn't pay the 60x earnings attached to NFLX these days...now imagine paying 100x earnings for that business; that is SFLY.

Disclosure: Short SFLY

Molycorp: Overpriced on Rare Earth Excitement

Molycorp, Inc. is a company based just south of Denver, CO engaged in the exploration of production of Rare Earth Oxides ("REO").  For the purposes of this article, I will assume you either know what REO(s) are or if not, see here for a fulsome explanation by the Company.

The Company went public in late July in a broken IPO in which the price had to be chopped from the originally marketed $15-17 range to $14/share ($394MM) based on lack of interest in the offering.  Since the IPO, shares are up over 100% to ~$29 as of writing this article, or a market cap of ~$2.4Bn dollars.  The proceeds of the offering will be used to to refurbish equipment and facilities in it's open pit mine in Mountain Pass, CA - the company's only mine.  Mountain Pass was formerly a property of Molybdenum Corp. of America, which was purchased by Union Oil of CA, which was subsequently purchased by Chevron in 2005.  Operations at Mountain Pass were suspended in 2002 due to softening prices in REO and a lack of additional tailings disposal (waste from the production process).  The mine was formerly the largest producer of rare earth minerals in the world before operations were suspended and now still has large deposits of the minerals, although MCP will not be fully operational to mine them until at least late 2011/early 2012.  You may ask then, what are they doing in the mean time to warrant a multi-billion dollar valuation such as this?  Well, quite a bit, but with still over a year of work in front of them before the market can really discover if they warrant this valuation, it's hard to justify a long at these levels and for the reasons below, I would propose a short of MCP.  

First, valuation is getting lofty based on the mine assessment done by SKM (which can be seen on pages 72-76 of their S-1).  By looking at the proven and probable reserves that could be pulled out over the life of the mine, assessing costs and pricing assumptions, SKM came to a net present value of $2.02Bn for the mine, or approximately 20% below the current market valuation of MCP.  Prices for rare earths have run up further since this assessment was priced on June 15, but at the current market cap, one would need to assume that MCP could a) fully extract the proven reserves to meet that NAV and b) that no other REO capacity was to come on line and cut pricing back to a more normalized level.

Second, the market does not seem to be assessing the risk of the operation currently.  While the government has made it clear these rare earth metals are extremely important to national defense and I believe will do all in their power to get this mine running again, there is still a lot to be done in front of operations beginning again.  This is basically a greenfield project that is being provided a brownfield base on which to start.  

Third, they are spending (A LOT) to refurbish the aged, rusted and unusable equipment currently at Mountain Pass.  They are also buying new equipment and in the process of building a plant on-site to produce chemicals (used in production process) and a co-generation facility to provide natural gas power to the operations.  The Company has said they will need in the range of $500-600MM to bring the facilities on-line, which is likely a conservative estimate given they expect to only spend $53MM of that in 2010.  There are also numerous environmental costs before production can begin as well as ongoing after operations commence.  The Company plans to spend $187MM alone on environmental-driven capital projects between now and 2012.    

Fourth, they are not earning any material revenue.  MCP is currently only earning revenue by selling remaining stockpiles of rare earth that they have at the Mountain Pass mine, although they are generating a minuscule amount in comparison to their market cap -  $14MM since inception in June 2008.  They currently have a two customer concentration of 89% of revenues for the six months ended 6/30/10 and generate 90% of sales from two products: lanthanum concentrate and lanthanum oxide.  MCP is also burning through cash, not at an alarming rate currently, but they have only begun to refurb their operations, which will greatly accelerate the cash going out the door.

While the share price run up since the IPO has been due partially to the market's realization of the value of the FUTURE OPERATIONS of the mine, primarily I believe the move is based on a large retail presence (and here) in the name, spurned on by the constant front page headlines regarding China's not-so-generous trading of their rare earth resources (of which, they have about a 97% market share on all rare earths currently produced). If you are not convinced of this being any sort of retail led run up, type "china rare earth" into Google and see the number of articles that have been written on the subject in the last two weeks.  You could also watch the erratic nature in which the stock trades, many times taking 4-6% round trips more than once a day and a 40% round trip last week (down 20% Monday to mid-Wednesday and returning to almost flat by Friday).   We will see for the first time in this quarter's 13-F filings if there are many hedge funds in the name, although I don't suspect that will be the case.

The issue the bulls make here is that rare earth elements are very important to a number of industries including green tech, mobile telephony and defense.  The Mountain Pass mine is currently a front runner in meaningful production outside of China given its history as a producing mine and the remaining resources available there.  The US government wants to see this mine begin operating and will do what it can to make that happen, including a $280 million loan guarantee which has not yet been provided, but will likely go in their favor.  When this mine gets up and running and if Molycorp proves it can be one of the lowest cost operators in the industry and in fact extract the proven reserves in Mountain Pass, there can be a case made that their current valuation is not even excessive and according to their margins may be downright cheap as seen below:

But until that can happen, I see a lot of mines in the field before MCP finds the clear path to the finish line.  Becoming fully operational is clearly the biggest and first hurdle.  Past that, demand and pricing needs to stay high to realize the revenue and profits to justify their valuation and finally, competition outside of China needs to stay low.  The final point is going to be tough given that "rare" earths are not actually as rare as the name would lead you to believe and based on the economics of the situation, others are beginning to get wise (and here).  Japan has even found a solution of recycling the rare earths out of electronic goods and other items.

The bottom line is that while MCP will likely eventually be a fully operational rare earths producer, the market is not currently pricing in the risk that goes along with what is essentially a greenfield mining project and the hype around the company and it's products is at a fever pitch right now.  While the momentum trade may continue to take MCP a little higher from here, there is a lot of risk to the downside if you get caught up in the hype.  We may look back in 2 years and realize that adding "rare earths" to a company's mining credentials was like adding a ".com" to a company in 1999.  The result for shareholders could be the same as well.

Disclosure: Author is short MCP

OPEN: Update On Daily Deals

As a follow up to my previous article on Travelzoo (TZOO) from Monday, Sept. 13 (which is up +25% as of writing), I put together some recent deal data for OpenTable that I think is pretty interesting.  Getting a little more detailed on the deal services each company offers, Travelzoo has a much more erratic timing on their deals, they may last 3 days or 1 week according to whatever hurdle they are trying to clear on sales, which is unclear and the Company is notoriously hard to reach (I even spoke to one of the few analysts that cover them and he said he communicates mainly via e-mail with IR).  TZOO deals tend also to be lower end ($10 of cupcakes on TZOO vs. $25 off at Gordon Ramsey restaurant on OPEN).  Thus far, OpenTable has had a more stable one deal a week schedule that tends to be at higher end restaurants and all have sold very well.  See below:

During the first week of launch in a new city, activity tends to be very strong, which has been no different in D.C. this week, where OPEN sold 1,992 deals in the first week.  What is most encouraging in their data vs. TZOO is how many deals they are selling and the consistent price point.  TZOO, while having done daily/weekly deals since mid-July, has managed to sell approximately 12,000 deals at prices from $10 to $99, while OPEN, having just launched it's first deals in NYC and Boston in early August, has managed to sell well over 26,000 deals at an average price of ~$25, netting them almost $700K gross additional revenue in a month and a half, in only 7 cities.  The reason I have harped on this again after only one week is that they have only launched in 7 large markets (netting an annualized gross revenue of ~$5.4), while there are probably an additional 20 or more markets that could easily bring in these number of deals each week if they can maintain the quality of restaurants and another 30 in smaller markets that could bring in 1/3 as many deals.  

While you may look at this as a skeptic and say the market is crowded and there are 200 daily deal guys out there offering a similar service/product, I would retort that there are not many that are peddling the high-end like OPEN and there aren't any that have the same diner brand recognition, restaurant relationships and distribution that OPEN does in this particular space.  If you're still skeptical and you think the fad will go away, ask yourself: if you got a 50% off deal one week for a favorite restaurant nearby, then the next week you got a similar offer from another restaurant you really like, would you pass on the second one and say, 'nah, I already saved money last week, no reason to do it again'.  Of course not...recession or not, people like to save money and you'd buy a deal every week if you were presented with quality, desirable restaurants and that's what I believe OPEN aims to do.

Since I published this piece originally on Friday afternoon to my Blog, Barron's came out with a full story over the weekend regarding the rich price of OpenTable shares.  The piece makes several good points that have been harped on by every short seller or naysayer on the stock, mainly that it's expected growth (or lack thereof) does not justify it's high multiple.  Barron's says, "it's valuation, at 110x this year's estimated earnings of 59 cents a share, and 75 times next year's forecast of 87 cents, could lead to sever indigestion."  While I don't disagree that it may be time to take some profits off the table if you own and probably not the best time to get in if you do not, the article neglects to properly highlight the basis for the recent moves in the shares - the Spotlight deals.  With only one brief mention towards the end of the piece, Barron's doesn't seem to grasp the growth potential of this new revenue source.  

I'll leave the conversations of valuation to another forum (expensive for my blood given the recent run up), but keep in mind that if they can earn $5.4MM gross revenue on 7 cities, what happens when that is 25 cities or 50 cities?  Below is a conservative snapshot of the impact of daily deals for this year (2 cities, ramping to 14) and 2011 at only 25 cities.

Disclosure: Small Long position in TZOO, no position in OPEN

HAWK: Former Value Trap Becoming an Actual Value

Seahawk Drilling has been an "on the radar" stock for me for several months as shares have been plummeting from a high of around $35 in September 2009 to a low of under $7 in late August.  For a quick background, Seahawk was spun out of Pride International in 2009 and operates 20 jackup rigs in the Gulf of Mexico (of which 4 are currently working, 1 has a permit pending, 1 is cold stacked/in repairs and contracted for the remainder this year, 3 are actively available and 11 are cold stacked).  These rigs are primarily used for shallow water drilling of natural gas in the US Gulf of Mexico (GoM).

While shares have recovered  almost $1 of value since their recent lows based primarily on an initiating coverage report from Wells Fargo, Seahawk will likely continue to see headwinds in shallow water drilling in the Gulf of Mexico in the near/mid-term or until they are able to increase utilization (via higher demand for shallow-water gas drilling and/or an end to the deep-water moratorium) and/or execute possible asset sales.  As I see it (as does Wells Fargo's analyst), these moves would help steer the company through these tough times to an eventual return to profit.

As I have been watching shares fall, I have been reading other pieces by value investors around the blogosphere arguing the value of the rigs based on scrap value or scrap + rig equipment to basically say, here is the floor for the shares because their equipment is worth more than this.  In addition to the rig value, HAWK also has over $3.50/share of NET CASH (as of last reported 10Q).

Despite the valuation argument, a number of factors have been weighing on shares for the past several months:

1. Uncertainty about the GoM after the BP disaster - Although this has effected all companies in the oil&gas drilling business that have operations in the GoM, HAWK already carried a fair amount of uncertainty due to the large number of rigs they have cold stacked, the age of their rigs and their quarterly cash burn...all problems that are largely derived from the decline in utilization since 2008, when the GoM was running on all cylinders with oil & gas at record highs.  While the moratorium on drilling does not effect shallow water drilling (all of Seahawk's rigs are shallow water), the resulting fallout and confusion within the BOEM has made it extremely slow to nearly impossible to get permits even for shallow water drilling, according to CEO, Randall Stiley.

2.Quarterly cash burn has been running high, with no real end in sight given HAWK has only one of their rigs contracted past the end of October (Seahawk 3000) and even then, it's not certain as to when it will begin work given the fair amount of repairs to be done to make it ready for operation (HAWK draws credit line for repairs).

3. HAWK's shallow water day rates have not recovered and I'm not going to pretend to be an expert on all the reasons for this, but this is due to a number of things such as GoM rig overcapacity, the aforementioned moratorium, the age of HAWK's rigs as well as the abundance of gas reserves and drilling that is now going on onshore due to fracking the enormous finds of the barnett, haynesville, etc shale fields.

4. HAWK currently has a complicated tax issue with the Mexican authorities, a remnant of their time as a part of Pride International.  The headline number for this liability is a whopping $229MM, which dwarfs the Company's cash on hand and would be burdensome even if they managed to sell several of their rigs with liberal valuation applied.  However, the news may not be as bad it seems due to a tax sharing agreement between Pride and HAWK.  For a more fulsome explanation of this situation from a tax lawyer that certainly understands the situation better than I, see this article...

I have stated these risks as a forewarning that there is some chance that if management cannot contract HAWK's rigs at a higher rate, sell certain assets and/or figure out a way to diversify the rig base by purchasing assets outside the GoM that would be immediately accretive to earnings and cash flow, there is further downside risk to shares.

However, at these levels, I believe it may be time to at least dip the toes in the name as the downside protection is notably more significant than it was just a few months ago when shares were trading at $10-12.  I'm probably going to get some disagreement here despite the fact that mr. market seems to have proven this out, but I don't think HAWK's rigs are worth as much others think they are under the current scenario and I think they are worth even less in a liquidation scenario.  While you can point to scrap value or equipment value as a floor valuation, there are much better places to get scrap steel than melting down a rig and there are much better places to get equipment than spending money to buy a rig for the equipment or pay to tear it off a rig.

$7-9MM may be a good fire-sale comp amount under a more normalized scenario, but we are far from normal right now and also talking about rigs that are either cold stacked and require repairs to get working and at very least we're talking about very old rigs with low desirability across the portfolio....I was told by one industry expert "there just aren't a lot of people that want their rigs in this environment"...so, for conservatism sake, let's halve those numbers:

So, even at the low end of our conservative valuation, shares look to have upside potential of 23%!  In another way of putting it, the market is valuing HAWK's rigs at a little less than $2.5MM per rig if the company were never to earn another dollar and ceased to operate.  For comps, Hercules Offshore recently managed to sell 2 of its retired rigs, the Hercules 191 and Hercules 255, for $5MM each.  Although the sale was negotiated at the end of 2009 when the 2010 economic outlook was notably more rosy than has played out today, the 191 sale is still notable because of the transaction closed in 2Q10 and was for a retired rig that had been cold-stacked for about 9 years and has a shallower depth capability than all but one of HAWK's rigs (the Seahawk 800).

So, as far as rigs go, it is pretty clear that HAWK's, even in a dire scenario are likely being grossly undervalued, a fact that should give comfort for downside protection.  A second fact is that, despite not having a solid backlog going through the rest of the year after October, HAWK does have several rigs that are currently operating.  Additionally, backlog for shallow water drills tends to be relatively short in nature and not necessarily planned many months or years in advance, so there is still decent likelihood that HAWK could get contracts for the remainder of the year lined up.

*Chart sourced from HAWK management presentations


Now with greater clarity on downside risks and protection via discounted rig valuation, let's look at a few further upside potential points:

1. Mexico's state owned oil company, PEMEX, recently announced an expanded budget for 2011 as well as a $1Bn loan from the U.S Imp-Exp Bank to be used primarily for shallow water drilling.  Although it is unlikely HAWK will benefit from this spending directly due to PEMEX's reticence of using the mat jackup rigs that HAWK has, any shallow water contracts with other operators could take some of the competing capacity out of the US GoM by moving it to Mexico, which should help HAWK in the event of a drilling revival in the US GoM.  Fair warning is that PEMEX is notoriously corrupt, inefficient and difficult to work with, so a lot of this spending may not come to fruition, but they have at least received a loan and indicated a desire to spend on production, which is a positive and will be even more so if it actually goes through in the next year.

2. HAWK has massive positive leverage in the event that they can survive this storm and return utilization to +50% and day rates improve to some degree.  The below chart, provided by HAWK, details incremental EBITDA improvement given a starting point of average day rates of $40K with operating expenses of $26K.

With 16-18 rigs contracted back in 2008, HAWK was able to generate $300MM in EBITDA for the year.  Assuming that the Company could even maintain half as many jackups with lower rates, HAWK could at least return to positive EBITDA and slow cash burn.  Above this, operating leverage is significant.

3. Gulf certainty and/or a lift in the moratorium, either early or even by the current November 30 deadline, would be a big positive for HAWK and the drilling industry.  If not lifted early, I believe shares might begin to run up in anticipation of the end of the ban and if lifted earlier than expected, you could see a substantial (albeit likely brief) pop in the shares as that load on their shoulders is at least lightened if not completely lifted.

Overall, at these levels, I believe that HAWK has a relatively attractive profile based on its discount asset valuation, cash on hand (albeit burning) and the eventual lift of the GoM moratorium.  If management can make moves to shore up their cash burn through moves like asset sales or an acquisition of immediately accretive assets outside the GoM, I believe the thesis could play out faster.

Disclosure: Author is long shares of HAWK