Travelzoo has seen a rising tide of interest over the last few months based on stronger than expected Q3 results, the launch of Local Deals and most recently with Google’s failed attempt at acquiring Groupon for $6Bn. While the Street has become more aware of TZOO as a result of these events, the Company is still generally viewed as an expensive comp of Priceline or Expedia, when they are in fact more of a comp to a hybrid of google and a newspaper due to their dependence on ad revenue, but their revenue and margin growth that is derived from greater circulation.
As a result of these comps and a misunderstood business model, the Street seems to view TZOO as overvalued. Short interest in TZOO over the past few months has grown substantially as a raw number (990K shares on 10/15 to 1.6MM shares on 12/31), although much higher trading volume since last quarter's earnings has lowered the days to cover the short position. With only two analyst estimates of $0.18 EPS (Wedbush) and $0.22 (Craig Hallum) for Q4, TZOO should beat these estimates handily, which may force another wave of short covering like that which pushed shares up 18% the day of last quarter’s earnings report and almost 70% since that report. Based on my estimates, I believe shares are actually trading at a more reasonable 20-25x 2011 EPS as Local Deals and a profitable European business should help fuel additional EPS growth.
Business Description
Travelzoo is a global media company with distribution to over 21 million subscribers worldwide as well millions of website users each year. Their core product is an e-mail service that alerts travelers about special deals on flights, hotels, rental cars, etc. They also operate fly.com, which is a travel search engine similar to Expedia or Kayak (though this is a small part of their business currently).
The Company’s main source of revenue is ad sales in North America and Europe via their websites as well as their e-mail newsletters. This past summer, they began to capitalize on the daily group buying phenomena by creating ‘Local Deals’, a service that runs short term Groupon-style deals with big discounts on local restaurants, attractions and services.
Local Deals
While the Street has clearly recognized some of the revenue potential from the daily deal space, Groupon-like deals are still a relatively small amount of TZOO’s revenue, but have been growing exponentially, with significant upside yet to be realized. Since launching their Local Deals in a few test markets in July, TZOO has sold north of 150K deals through their website and earned gross revenue of over $8.4MM. Although it is hard to gauge exactly what the revenue share is on TZOO deals, marketplace comps would indicate around 40% of gross revenue goes to TZOO top line.
Although Q3 only included a handful of cities and not even so much as an advertisement for Local Deals on the main homepage, TZOO managed to sell over 22K deals for north of $750K in gross revenue (~$300K net). Since launching to several other cities in Q4 as well as making it easier to find the Local Deals page (and some PR), they have sold ~$7.6MM in gross revenue, leading to ~$3MM of additional revenue to TZOO (at 40% revenue share). Because the Local Deals are a high margin product and don’t require a large sales force, around 75% of this revenue makes it to operating income (due to the frequency at which TZOO is currently running deals, a large sales force is not yet required, though this would change as they grow and may impact operating margins). At a conservative tax rate of 38%, this should mean Local Deals will add ~$1.4MM, or $0.09 EPS. The below data can all be found via TZOO's website for Q4:
DEALS
Oct. – 35,346 Deals
Nov. – 46.441 Deals
Dec. – 59,357 Deals
GROSS REVENUE
Oct. - $1,528,920
Nov. - $2,801,644
Dec. - $3,394,431
Today, TZOO is serving 27 markets, and has annualized gross revenue of $16.8MM in Local Deals, although I believe that it is not out of the question that TZOO could earn as much as $30-40MM in 2011 revenue on Local Deals. The keys for 2011 are going to be: 1) launching to several more large cities in both the US and Europe, 2) higher ASP/deal, 3) running deals more than the average of once a week for large markets and once every 2-3 weeks in smaller markets.
I believe it will be no problem at all for TZOO to be in 25 large markets (13 now) and 25 medium/small markets (14 now) by the end of this year. In fact, they have already launched to 5 new small markets in January alone and I would expect 2-3 large city launches in the next 6 weeks. By simply hitting the first tier US cities in which it does not currently operate (Atlanta, D.C., etc.) as well as several large European centers (Paris, Barcelona, Munich, etc.), this will be no problem at all. TZOO is in fact already hiring for Local Deals managers in several European cities as seen here. What is also very smart about TZOO expansion strategy is the hub and spoke model they seem to be employing. For example, Miami was the first major city launch in FL and from there Orlando, Tampa, Jacksonville and Ft. Lauderdale have followed. TZOO launched London right before Christmas and just launched Gloucestershire this week...likely places such as Liverpool, Manchester, Leeds, etc. will follow.
The second goal is going to be to increase ASP/deal. For example, Q4 ASP (excluding the December 99 hour special) was ~$60.50. There were several higher priced deals that sold very well during the quarter as well as a number of large city additions, which pushed this average above the ~$35/deal average in Q3. While a growth in cities and an ASP consistent with Q4 will guarantee earnings growth, to push TZOO to become a portfolio double at this point, ASP is going to need to grow substantially.
A good way for this to happen would be moving into more high priced travel deals such as Living Social is doing now in their LS Escapes or Gilt's Jetsetter.
Finally, TZOO certainly has the ability to run more than one deal a week; whether they end up doing it is another question. For conservatism sake, let's assume they stay with an average of 1 deal per market, per week and look at the economics for 2011...
If Local Deals was to expand to 25 large and 25 small markets by FY2011 at it's current ASP, economics would be as follows (Realize that markets will be added throughout the year, so some markets will not have full year of revenue...i have remained conservative to compensate by keeping ASP and number of deals run conservative):
50 (cities) x 52 (1 deal/wk) x $60 (ASP) x 500 (coupons sold/deal) 40% (Revenue share) = $31.2MM in net revenue to TZOO
$31.2MM x 75% (Op Mgn) = $23.4MM Op Income
$23.4MM x 38% tax rate = $14.51MM Net Income or $0.88 EPS
On an important note, at $75 ASP, Local Deals is worth $1.10 EPS in 2011
At a conservative 25x multiple on these earnings, Local Deals is worth between $22-28/share
Core E-mail Business
The e-mail distribution business is still Travelzoo’s bread and butter and where they get the majority of their earnings. With over 21 million subscribers worldwide, TZOO’s distribution list is a powerful advertising tool as well as a good barrier to entry against all but their largest 'competitors'. As of Q3, TZOO earned annual revenue of about $6.20/subscriber in North America and $2.83 in Europe. Historically, TZOO has been able to acquire NA users at a substantially lower price ($1.60 in Q3), while European subscribers have averaged around $3.70 over the last twelve months ($2.90 in Q3).
TZOO management has been very focused on growth of the European market and as such, costs have been higher in the past several quarters; however, Q3 marked the first time that the European business generated a profit for TZOO as users reached critical mass and both sales & marketing as well as G&A costs were controlled. Over the past 7 quarters, TZOO has added 300K net users in Europe each quarter and with their push for growth in Europe, there is no reason to believe this cannot be repeated in Q4. Assuming around 4.5MM European users in Q4 with higher sales and marketing costs (but lower as a % of revenue) and G&A roughly in line from Q3, the Europe business should earn around $7MM in revenue and $1MM of income from operations. Along with conservative net user growth of around 140K in the NA region, TZOO should earn almost $29MM in revenue from core operations for Q4.
European user acquisition costs tend to be difficult to predict from quarter to quarter as they differ according to markets all over the EU, but the general trend should be +/- flat or lower as TZOO gets larger. Generally, as an organization grows, it gets easier to acquire users and the cost should decrease as a function of click-thru and signups. Think Facebook vs. internet startup, Facebook’s brand recognition helps derive a higher click-thru rate and more people are likely to end up signing up as users. Under this assumption, Europe’s user base growth and lower user acquisition costs should help grow operating income and produce results at least in line with last quarter. My estimate is the core e-mail business should conservatively earn around $23MM in operating income in 2011. At the assumed 38% tax rate, this will result in ~$1.40 of 2011 EPS. If we apply a 20x multiple to these earnings, the core e-mail business is worth about $28/share.
In addition to the normal earnings growth of core e-mail, I could see a scenario in which the more viral nature of the daily deal product could result in core e-mail user growth above the normal rates that TZOO has experienced in the past. This could result in a higher multiple being applied to core e-mail earnings as well.
Based on the conservative assumptions above, TZOO shares are currently slightly below fair value based on a 22-23x multiple applied to earnings. If shares trade at a growthier multiple, legitimized by much higher ASP or greater growth in core e-mail, shares have significant upside from here. Either way, I believe this quarter could be a blowout for TZOO and give the Street notice to the earnings power of Local Deals and TZOO as a whole.
Risks to Thesis
1. Significantly higher user acquisition costs would cut into margins. According to how many users are added and how other costs are controlled, this may or may not have a major effect on earnings. This is somewhat mitigated by the general rule that standard user acquisition costs should decrease as TZOO gets larger and has more brand recognition. Either way, unless acquisition costs are grossly higher, an EPS beat should still be achievable.
2. If Local Deals fails to grow past its current distribution or if the daily deal phenomenon loses significant steam, TZOO may not meet my forecasts in 2011. Lower ASP would also negatively affect the thesis. This is mitigated by the higher ASP in Q4, which has sustained in Q1 thus far as well as avenues of higher ASP growth such as travel packages.
3. A double-dip recession, significantly weaker economic environment or a terrorist attack/threat that causes airline and leisure travel to slow significantly would likely cause shares to trade down despite potentially little effect to the underlying ad-revenue based business.
Other Items/Conclusion
While they provide additional positives to the thesis, I have left out the financial metrics of growing cash flow and a strong, debt-free balance sheet, the Company's ability to re-acquire the licensed Asia business which was sold in 2009 and any upside provided by Fly.com as those are less important to TZOO as a whole (currently, at least) than the new Local Deals vertical. Based on the core operating model as well as the newly launched Local Deals vertical, I believe that not only will TZOO significantly outperform analyst estimates for Q4, but has significant growth potential going forward.
Disclosure: Author is long TZOO
Wednesday, January 26, 2011
Friday, November 5, 2010
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
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
Thursday, November 4, 2010
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 (2nd 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
Monday, October 25, 2010
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.
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.
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.
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
Wednesday, October 20, 2010
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
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
Thursday, October 14, 2010
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
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
Tuesday, October 5, 2010
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
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