This week’s 90th edition of the Festival of Stocks is at Circle of Competence. Be sure to check out this week’s articles!
My article Authentidate Remains Undervalued was included in this week’s edition.
I recommend taking a look at some of the posts on Circle of Competence. It’s a new blog launched by Jeff Annello a couple months ago, and he has written some terrific material in short time. Mr. Annello focuses on Value Investing and its icons, such as Warren Buffett.
You can catch up on past editions by visiting the Festival of Stocks homepage. There you can also find out how to submit an article for next week’s Festival or learn about how you can volunteer to host an edition of the Festival of Stocks on your own blog.
Thursday, May 29, 2008
Friday, May 23, 2008
Authentidate (ADAT) Remains Undervalued
Authentidate Holding Corp (nasd:ADAT)- $.43-This is an update to previous notes (1.CF Break-Even 12 months 2. Traction in Germany 3. Attractive Speculative Play). I remain optimistic towards ADAT given management’s forecast of cash-flow break-even in the December or March quarter. ADAT announced this intention earlier this year, and has continued to reiterate its guidance. I truly believe management would not provide this guidance unless they were very confident that it could be accomplished.
ADAT is trading for less than its $.53 cash/share and $.90 book value/share- and it has no debt. Thus, ADAT’s share price reflects the expectation that it will soon burn through its cash and close its doors. Management believes they can reverse the burn rate well before cash dries up. There is little doubt that significant revenue potential exists, rather doubt has been cast on its timing. The key issue facing investors is whether ADAT will run out of cash before revenues amass to a break-even level. In short, Management believes (so do I) that break-even will be achieved with cash to spare. When ADAT becomes cash-flow positive, I think we could easily be looking at a $2-$3 stock.
The business model is promising, but has been slow to gain traction. The introduction of the Inscrybe platform has accelerated adoption and generated impressive revenue growth. Due to the ~70% gross margins and amount of leverage in the model, there is considerable upside potential in profitability. After attaining sufficient revenue volume to cover fixed expenses, a very large portion of incremental revenue falls to the bottom line.
In my opinion, Authentidate is undervalued. Granted, there are significant risks, but the share price doesn’t reflect ADAT’s true value. Authentidate is unknown to many investors, and its low share price and trading volume make it difficult for institutions (and individuals) to invest. On average, 50k shares, or 25k in dollar volume, change hands daily.
Without analyst coverage, investors look to ADAT for company news. Management has been hesitant in providing details on business. Back in 2003-04, ADAT shot up to $20/share, and when expected sales traction failed to occur, the share price plummeted. Of course, this invited every ambulance-chasing law firm on Wall Street to file class action lawsuits. Even though those suits never materialized, it drained Authentidate’s strategic focus and checkbook. I believe this has led management to be more guarded in its statements to investors. The irony is that ADAT is claiming cash flow break-even in CY08. Given ADAT’s history of not providing much guidance, logic suggests that management would not make such a claim unless it was highly certain it will be achieved. The company also hinted that once progress begins to appear in the financial statements, that it will be much more involved with the investing public. In essence, the share price is not a product of broad based opinion, rather transactions of a few, thus ADAT is inefficiently priced.
About Authentidate:
Taken from Authentidate’s Press Release
Authentidate Holding Corp. is a worldwide provider of secure workflow management software and web-based services. The company's automated and trusted workflow solutions enable enterprises and office professionals to employ rules-based electronic forms, intelligent routing and transaction management, electronic signing, content authentication, identity credentialing and verification and web and fax based communication capabilities. Customer benefits from the company's offerings include reduced costs, improved productivity and service levels, automated audit trails, enhanced compliance with regulatory requirements and the reduction of paper-based processes. The company has offices in the United States and Germany. In the United States we offer our patent pending content authentication technology in the form of the United States Postal Service® Electronic Postmark® (EPM). See USPS EPM
ADAT plans to achieve break-even through cost reduction and revenue acceleration.
Revenue Growth:
Authentidate will need a run-rate of 4 million-plus per quarter for cash flow break-even. Revenue in the March quarter was 1.7 million with US segment revenue (Inscrybe) increasing 18% sequentially. Growth Yr/Yr was 33%, thus accelerated in the recent quarter. Most of Authentidate’s customers are still in the initial – intermediate stage of implementation, thus revenues will continue to increase just from roll-out.
My thinking is that the current customer base is likely sufficient to generate the required level of sales for break-even. My theory is this is why ADAT is comfortable with stating its goal of break-even in the coming quarters. If they know a customer’s billing is (x) amount at (y)% implementation, then that ratio should hold as implementation nears 100%.
The major customers are Apria, American Home Patient, Lincare, Liberty Medical, and several others. These healthcare providers’ business models are largely driven on working-capital management. There is a long delay from the time services/products rendered to patients until reimbursement from Medicare/other insurers. Much of this delay stems from extensive paperwork and physician signatures that must be completed and collected before these agencies can be reimbursed. Authentidate’s services aid in drastically reducing days sales outstanding (DSO), hence working capital requirements.
Home medical equipment providers, such as Apria and American Home Patient, benefit significantly from using Inscrybe, in turn, they persuade physicians to sign-up. Some physicians using Inscrybe have then turned to agencies not using Inscrybe, and have recommended that they start using Authentidate’s platform. That illustrates a powerful, viral process in which adoption can easily and rapidly spread. (see MD interview).
Doug Guy, SVP at American Home Patient commented about incorporating Authentidate’s solution (ADAT PR 4/23/2007) "We are realizing significant operational efficiencies as a result of deploying the Inscrybe eCMN capabilities in our billing centers and branch locations. Over the past 12 months, we have seen a 65% reduction in turnaround time of documents processed by physician offices through Inscrybe, a significant reduction in unbilled dollars, and a marked improvement in internal document processing throughput. Besides a direct impact on our bottom line, it has improved the service experience for our physician and patient communities."
Market Potential:
The market potential is massive. Enormous. The state of Indiana has been using Authentidate’s technology for DMV and court-related documents. In Germany, firms are authenticating electronic invoices for VAT tax compliance standards. The legal, financial, real estate, medical, and likely almost every other industry could benefit from using ADAT’s document security solutions.
The core issue is developing a critical mass of users, since adoption spreads virally. Hence, a user wanting to send documents requires the counterparty to use the technology as well. Think of a fax machine. The first fax machine was useless since it requires another fax machine to receive. Yet, as fax usage increased, more and more people purchased fax machines so they could correspond with those already using fax machines. Thus, adoption rates begin at a slow pace but accelerate quickly resulting in exponential growth.
Authentidate is expanding its addressable market. Over $500 billion are spent annually administering healthcare. $10’s of billions are spent handling business and legal documents. Document-intensive industries are stuck in a paper-based world, however, Authentidate provides solutions for migrating to a more efficient, electronic based environment. The following table is from Authentidate’s May 2008 shareholder meeting. It highlights the potential markets and revenue streams available to Authentidate.
Cost Reduction:
Operating expenses have been averaging $5-6 million per quarter, but have been trending down. Costs should continue to fall as ADAT recently cut 20% of its workforce, mostly mid-senior level positions. In addition, severance costs and legal fees will soon go away, further decreasing Authentidate’s expenses. Management is highly focused on cost control, and it should be able to continue to make progress in this area.
Operating Performance History:
Authentidate sold its DocStar and DJS marketing group to focus solely on security solutions. Looking at historical financial statements doesn’t represent an accurate picture of Authentidate’s current operations. For example, income statement found on Yahoo Finance shows sales of $17.5m-2005, $16.5m-2006, and $5m-2007. These figures include revenue from discontinued business segments. Revenues from continuing operations only, are illustrated below.
2003: 950
2004: 1250
2005: 2822
2006: 3870
2007: 4998
Sales growth for the past 5 years has averaged 56% per annum. Management declined to give specific guidance, but insinuated that Inscrybe (August release) will accelerate customer adoption and usage rate causing a significant increase in sales growth. Gross margins have historically ranged 60-70%. SGA expenses have been the primary problem, totaling $16.8m fro FY07. For the 3 quarters already reported for FY08, ADAT recored 4.4 million in sales.
Conclusion:
Authentidate is on pace to achieve cash flow break-even in the next 6-9 months, and subsequently become profitable on a GAAP basis. The stock trades for less than cash, hence no value is attributed to ADAT business nor as a going concern. The stock is undervalued because very few know about ADAT and its prospects. The scant trading volume confirms this, thus if more investors knew the facts surrounding ADAT, it would be trading higher, in my opinion. As ADAT moves to profitability, we will see increased interest in ADAT shares accompanied with higher prices.
Disclosure: Long ADAT
ADAT is trading for less than its $.53 cash/share and $.90 book value/share- and it has no debt. Thus, ADAT’s share price reflects the expectation that it will soon burn through its cash and close its doors. Management believes they can reverse the burn rate well before cash dries up. There is little doubt that significant revenue potential exists, rather doubt has been cast on its timing. The key issue facing investors is whether ADAT will run out of cash before revenues amass to a break-even level. In short, Management believes (so do I) that break-even will be achieved with cash to spare. When ADAT becomes cash-flow positive, I think we could easily be looking at a $2-$3 stock.
The business model is promising, but has been slow to gain traction. The introduction of the Inscrybe platform has accelerated adoption and generated impressive revenue growth. Due to the ~70% gross margins and amount of leverage in the model, there is considerable upside potential in profitability. After attaining sufficient revenue volume to cover fixed expenses, a very large portion of incremental revenue falls to the bottom line.
In my opinion, Authentidate is undervalued. Granted, there are significant risks, but the share price doesn’t reflect ADAT’s true value. Authentidate is unknown to many investors, and its low share price and trading volume make it difficult for institutions (and individuals) to invest. On average, 50k shares, or 25k in dollar volume, change hands daily.
Without analyst coverage, investors look to ADAT for company news. Management has been hesitant in providing details on business. Back in 2003-04, ADAT shot up to $20/share, and when expected sales traction failed to occur, the share price plummeted. Of course, this invited every ambulance-chasing law firm on Wall Street to file class action lawsuits. Even though those suits never materialized, it drained Authentidate’s strategic focus and checkbook. I believe this has led management to be more guarded in its statements to investors. The irony is that ADAT is claiming cash flow break-even in CY08. Given ADAT’s history of not providing much guidance, logic suggests that management would not make such a claim unless it was highly certain it will be achieved. The company also hinted that once progress begins to appear in the financial statements, that it will be much more involved with the investing public. In essence, the share price is not a product of broad based opinion, rather transactions of a few, thus ADAT is inefficiently priced.
About Authentidate:
Taken from Authentidate’s Press Release
Authentidate Holding Corp. is a worldwide provider of secure workflow management software and web-based services. The company's automated and trusted workflow solutions enable enterprises and office professionals to employ rules-based electronic forms, intelligent routing and transaction management, electronic signing, content authentication, identity credentialing and verification and web and fax based communication capabilities. Customer benefits from the company's offerings include reduced costs, improved productivity and service levels, automated audit trails, enhanced compliance with regulatory requirements and the reduction of paper-based processes. The company has offices in the United States and Germany. In the United States we offer our patent pending content authentication technology in the form of the United States Postal Service® Electronic Postmark® (EPM). See USPS EPM
ADAT plans to achieve break-even through cost reduction and revenue acceleration.
Revenue Growth:
Authentidate will need a run-rate of 4 million-plus per quarter for cash flow break-even. Revenue in the March quarter was 1.7 million with US segment revenue (Inscrybe) increasing 18% sequentially. Growth Yr/Yr was 33%, thus accelerated in the recent quarter. Most of Authentidate’s customers are still in the initial – intermediate stage of implementation, thus revenues will continue to increase just from roll-out.
My thinking is that the current customer base is likely sufficient to generate the required level of sales for break-even. My theory is this is why ADAT is comfortable with stating its goal of break-even in the coming quarters. If they know a customer’s billing is (x) amount at (y)% implementation, then that ratio should hold as implementation nears 100%.
The major customers are Apria, American Home Patient, Lincare, Liberty Medical, and several others. These healthcare providers’ business models are largely driven on working-capital management. There is a long delay from the time services/products rendered to patients until reimbursement from Medicare/other insurers. Much of this delay stems from extensive paperwork and physician signatures that must be completed and collected before these agencies can be reimbursed. Authentidate’s services aid in drastically reducing days sales outstanding (DSO), hence working capital requirements.
Home medical equipment providers, such as Apria and American Home Patient, benefit significantly from using Inscrybe, in turn, they persuade physicians to sign-up. Some physicians using Inscrybe have then turned to agencies not using Inscrybe, and have recommended that they start using Authentidate’s platform. That illustrates a powerful, viral process in which adoption can easily and rapidly spread. (see MD interview).
Doug Guy, SVP at American Home Patient commented about incorporating Authentidate’s solution (ADAT PR 4/23/2007) "We are realizing significant operational efficiencies as a result of deploying the Inscrybe eCMN capabilities in our billing centers and branch locations. Over the past 12 months, we have seen a 65% reduction in turnaround time of documents processed by physician offices through Inscrybe, a significant reduction in unbilled dollars, and a marked improvement in internal document processing throughput. Besides a direct impact on our bottom line, it has improved the service experience for our physician and patient communities."
Market Potential:
The market potential is massive. Enormous. The state of Indiana has been using Authentidate’s technology for DMV and court-related documents. In Germany, firms are authenticating electronic invoices for VAT tax compliance standards. The legal, financial, real estate, medical, and likely almost every other industry could benefit from using ADAT’s document security solutions.
The core issue is developing a critical mass of users, since adoption spreads virally. Hence, a user wanting to send documents requires the counterparty to use the technology as well. Think of a fax machine. The first fax machine was useless since it requires another fax machine to receive. Yet, as fax usage increased, more and more people purchased fax machines so they could correspond with those already using fax machines. Thus, adoption rates begin at a slow pace but accelerate quickly resulting in exponential growth.
Authentidate is expanding its addressable market. Over $500 billion are spent annually administering healthcare. $10’s of billions are spent handling business and legal documents. Document-intensive industries are stuck in a paper-based world, however, Authentidate provides solutions for migrating to a more efficient, electronic based environment. The following table is from Authentidate’s May 2008 shareholder meeting. It highlights the potential markets and revenue streams available to Authentidate.
Cost Reduction:
Operating expenses have been averaging $5-6 million per quarter, but have been trending down. Costs should continue to fall as ADAT recently cut 20% of its workforce, mostly mid-senior level positions. In addition, severance costs and legal fees will soon go away, further decreasing Authentidate’s expenses. Management is highly focused on cost control, and it should be able to continue to make progress in this area.
Operating Performance History:
Authentidate sold its DocStar and DJS marketing group to focus solely on security solutions. Looking at historical financial statements doesn’t represent an accurate picture of Authentidate’s current operations. For example, income statement found on Yahoo Finance shows sales of $17.5m-2005, $16.5m-2006, and $5m-2007. These figures include revenue from discontinued business segments. Revenues from continuing operations only, are illustrated below.
2003: 950
2004: 1250
2005: 2822
2006: 3870
2007: 4998
Sales growth for the past 5 years has averaged 56% per annum. Management declined to give specific guidance, but insinuated that Inscrybe (August release) will accelerate customer adoption and usage rate causing a significant increase in sales growth. Gross margins have historically ranged 60-70%. SGA expenses have been the primary problem, totaling $16.8m fro FY07. For the 3 quarters already reported for FY08, ADAT recored 4.4 million in sales.
Conclusion:
Authentidate is on pace to achieve cash flow break-even in the next 6-9 months, and subsequently become profitable on a GAAP basis. The stock trades for less than cash, hence no value is attributed to ADAT business nor as a going concern. The stock is undervalued because very few know about ADAT and its prospects. The scant trading volume confirms this, thus if more investors knew the facts surrounding ADAT, it would be trading higher, in my opinion. As ADAT moves to profitability, we will see increased interest in ADAT shares accompanied with higher prices.
Disclosure: Long ADAT
Thursday, May 15, 2008
Comparing Valuations: Yahoo vs Google
Comparing price-earnings multiples and expected growth rates of Yahoo and Google several items become apparent. Yahoo is extremely overvalued as an independent company with its current share price reflecting the likelihood of a buy-out. Google is the better value of the two, but Google alone is fairly valued.
First, let’s run through the numbers I gleaned from Yahoo Finance and Nasdaq.com
First, let’s run through the numbers I gleaned from Yahoo Finance and Nasdaq.com
Yahoo Valuation:
Yahoo shares currently trade 57.7x FY07 EPS of 47 cents. Looking forward, Yahoo trades 59x FY08 EPS estimate of 46 cents and 48.5x FY09 estimate of 56 cents. These EPS estimates translate into Yr/Yr growth of -2.1% (FY08) and 21.7% (FY09). Yahoo’s annual growth rate has averaged 23.3% the last 5 years.
Taking a slightly different perspective, Yahoo’s combined EPS for the last 4 quarters is 48 cents, and consensus estimates for the next 4 quarters total 52 cents. This represents 7.3% growth. The P/E multiple using EPS for the next 4 quarters is 52.7x. Using a PEG ratio to standardize value with respect to forecasted growth (Multiple/Growth), Yahoo has a PEG of 7.23.
Google Valuation:
Google shares currently trade 37x reported FY07 EPS of $15.59. Looking forward, Google trades 28.6x FY08 EPS estimate of $20.14, and 23.3x FY09 estimate of $24.74 . These EPS estimates translate into Yr/Yr growth of 29.2% (FY08) and 22.8% (FY09). Google’s annual growth rate has averaged 75.4% the last 5 years.
Taking a perspective of last 4 quarters versus upcoming 4 quarters, Google’s combined EPS in the trailing 4 quarters is $16.74, and consensus estimates for the next 4 quarters total $21.23. This represents 26.8% growth. The P/E multiple using EPS forecasts in the next 4 quarters is 27.2x. Using a PEG ratio to standardize value with respect to forecasted growth (Multiple/Growth), Google has a PEG of 1.01.
The difference in the two’s valuation is stark and quite apparent. Google’s forecasted growth is higher than Yahoo’s, yet it trades at lower multiples. That suggests Yahoo is overvalued relative to Google. But, does that mean Google is undervalued and should be bought? And that Yahoo is overvalued and should be sold?
Yahoo Analysis:
In my opinion, Yahoo is certainly overvalued as the company exists today. Its current valuation hinges on a business combination, most likely with Microsoft. Of course, this is the reason that Yahoo shares are trading at such high levels. It’s not a surprise why Ballmer balked at Yahoo’s $37 asking price since colossal synergies would have to be extracted from a combination to justify that high valuation.
Even at $33, $31, or Yahoo’s current share price, a suitor would really have to leverage Yahoo’s assets to unlock value. Now, common thinking concedes the value in Yahoo’s assets already exists, yet management and its strategy have been poor- leading to weak performance. Hence, strategic synergies and proper management may quickly boost Yahoo’s cash flow to a level that would justify such valuations.
The fact that Yahoo shareholders are irate that the board was holding out for $37 shows that they believe that valuation to be unreasonable. $31-33 is better than $27. If it weren’t for the possibility of a deal, the share price would be much lower, perhaps a teenager. However, Carl Icahn reportedly will launch a proxy battle to replace Yahoo’s current board. Such attempts are generally difficult to execute since ownership is fragmented and diffuse, however shareholders are angered and Icahn has established a track record.
In summary, under Yahoo’s current strategies, analysts don’t foresee much growth. Yahoo’s lackluster performance the past several years is not expected to change going forward, pursing the same course. Yet, shareholders and Carl Icahn believe Yahoo’s potential value is much greater than what historical performance and earnings projections would suggest- value contingent on business combination or management change.
If no deal (of some sort) ever comes to fruition, then YHOO shares would likely be cut in half. Ostensibly, there is inherent value not recognized in Yahoo’s performance, but if Icahn is not successful in removing a stubborn board, then it’s unlikely anyone else would be either.
Independent Yahoo- nearly all of Yahoo’s revenue comes from search and display advertising. Yahoo has been losing share in search; Google’s superior algorithms boosted its share into the mid sixties. In the English lexicon, Google has become a verb “Google xyz,” meaning to perform an internet search. Yahoo is still the second most popular search engine, but I believe most yahoo searches are secondary events. Yahoo’s content attracts users, who in the course of their visit, become compelled to search for a particular item and do so on yahoo, instead of navigating to Google. Conversely, users not on Yahoo’s portal choose to navigate to Google opposed to Yahoo to perform a search query. Hence, some of Yahoo’s search traffic is a matter of circumstance, and not necessarily one’s usually first search engine choice. Hence, the content from the portal aids in generating search traffic, but without a superior search engine, search depends heavily on traffic the portal attracts.
53% of Yahoo’s revenues come from advertising on its own properties, and segment revenues increases 18% in Q1. Yahoo attracts traffic through its news, finance, sports, and mail content/services. There isn’t anything proprietary about the content Yahoo provides, thus can be duplicated. In addition, Yahoo is buggy. Yahoo Mail doesn’t work right (search & spam filter), sometimes pages don’t render correctly and tables fail to populate. Groups and message boards are filled with spammers.
In my opinion, there are many things that have gone down hill on Yahoo’s site. Social networking sites and blogs are gaining traffic, traffic that could be going to Yahoo. Much of what Yahoo has now, could be duplicated, perhaps by Google. Google provides similar content and services, such as mail, messenger, maps, etc. and in my opinion, is better. In sum, Yahoo is dependent creating content and services that will attract visitors to its website.
Yahoo also provides advertising to third parties or affiliate sites, but segment revenue (33%) and margins have been declining. In Q1, segment sales fell 7%, after accounting for the drop in margin (shares more with partner), net revenues declined 13%. Yahoo’s total net revenue increased 9% for Q1. Google’s revenue growth was 42%.
Google Analysis:
At $576 / share, Google is fair-valued. In mid-March, I was bullish on Google when it was trading around $440. In my Google valuation analysis, I pegged Google’s fair value at $540 / share. I think, given the take-over turmoil engulfing Yahoo, and the ensuing distraction and departures, has boosted Google’s lead further. Thus, a $600 share price for Google is reasonable, but not attractive.
I am reluctant to place a valuation higher than $600 on Google due to its spending. GOOG has very high profit margins, but absent from the income statement is capital spending. Capex as a percentage of total revenue has been in the mid-teens for the past several years. R&D as percentage of sales has increased as well, from 10% (FY05) to 13% (FY07). Headcount has also significantly expanding leading to declining sales/employee & income/employee ratios. The significance- On the margin, each incremental dollar of revenue growth is accompanied by higher costs and investment. Hence, Google’s prospective growth generates less incremental corporate value compared to its past growth. Nothing new here, just the law of diminishing returns taking hold.
Conclusion:
Owning Yahoo at these levels is purely a bet on an acquisition. There is some upside to $31 or perhaps $33, but there is some downside risk as well. Owning shares of the acquirer (whoever that may be) is a bet that synergies will enhance value and that the purchase price was not excessive. Owning Google is a pretty safe bet with the upside potential balanced with downside risk.
Yahoo shares currently trade 57.7x FY07 EPS of 47 cents. Looking forward, Yahoo trades 59x FY08 EPS estimate of 46 cents and 48.5x FY09 estimate of 56 cents. These EPS estimates translate into Yr/Yr growth of -2.1% (FY08) and 21.7% (FY09). Yahoo’s annual growth rate has averaged 23.3% the last 5 years.
Taking a slightly different perspective, Yahoo’s combined EPS for the last 4 quarters is 48 cents, and consensus estimates for the next 4 quarters total 52 cents. This represents 7.3% growth. The P/E multiple using EPS for the next 4 quarters is 52.7x. Using a PEG ratio to standardize value with respect to forecasted growth (Multiple/Growth), Yahoo has a PEG of 7.23.
Google Valuation:
Google shares currently trade 37x reported FY07 EPS of $15.59. Looking forward, Google trades 28.6x FY08 EPS estimate of $20.14, and 23.3x FY09 estimate of $24.74 . These EPS estimates translate into Yr/Yr growth of 29.2% (FY08) and 22.8% (FY09). Google’s annual growth rate has averaged 75.4% the last 5 years.
Taking a perspective of last 4 quarters versus upcoming 4 quarters, Google’s combined EPS in the trailing 4 quarters is $16.74, and consensus estimates for the next 4 quarters total $21.23. This represents 26.8% growth. The P/E multiple using EPS forecasts in the next 4 quarters is 27.2x. Using a PEG ratio to standardize value with respect to forecasted growth (Multiple/Growth), Google has a PEG of 1.01.
The difference in the two’s valuation is stark and quite apparent. Google’s forecasted growth is higher than Yahoo’s, yet it trades at lower multiples. That suggests Yahoo is overvalued relative to Google. But, does that mean Google is undervalued and should be bought? And that Yahoo is overvalued and should be sold?
Yahoo Analysis:
In my opinion, Yahoo is certainly overvalued as the company exists today. Its current valuation hinges on a business combination, most likely with Microsoft. Of course, this is the reason that Yahoo shares are trading at such high levels. It’s not a surprise why Ballmer balked at Yahoo’s $37 asking price since colossal synergies would have to be extracted from a combination to justify that high valuation.
Even at $33, $31, or Yahoo’s current share price, a suitor would really have to leverage Yahoo’s assets to unlock value. Now, common thinking concedes the value in Yahoo’s assets already exists, yet management and its strategy have been poor- leading to weak performance. Hence, strategic synergies and proper management may quickly boost Yahoo’s cash flow to a level that would justify such valuations.
The fact that Yahoo shareholders are irate that the board was holding out for $37 shows that they believe that valuation to be unreasonable. $31-33 is better than $27. If it weren’t for the possibility of a deal, the share price would be much lower, perhaps a teenager. However, Carl Icahn reportedly will launch a proxy battle to replace Yahoo’s current board. Such attempts are generally difficult to execute since ownership is fragmented and diffuse, however shareholders are angered and Icahn has established a track record.
In summary, under Yahoo’s current strategies, analysts don’t foresee much growth. Yahoo’s lackluster performance the past several years is not expected to change going forward, pursing the same course. Yet, shareholders and Carl Icahn believe Yahoo’s potential value is much greater than what historical performance and earnings projections would suggest- value contingent on business combination or management change.
If no deal (of some sort) ever comes to fruition, then YHOO shares would likely be cut in half. Ostensibly, there is inherent value not recognized in Yahoo’s performance, but if Icahn is not successful in removing a stubborn board, then it’s unlikely anyone else would be either.
Independent Yahoo- nearly all of Yahoo’s revenue comes from search and display advertising. Yahoo has been losing share in search; Google’s superior algorithms boosted its share into the mid sixties. In the English lexicon, Google has become a verb “Google xyz,” meaning to perform an internet search. Yahoo is still the second most popular search engine, but I believe most yahoo searches are secondary events. Yahoo’s content attracts users, who in the course of their visit, become compelled to search for a particular item and do so on yahoo, instead of navigating to Google. Conversely, users not on Yahoo’s portal choose to navigate to Google opposed to Yahoo to perform a search query. Hence, some of Yahoo’s search traffic is a matter of circumstance, and not necessarily one’s usually first search engine choice. Hence, the content from the portal aids in generating search traffic, but without a superior search engine, search depends heavily on traffic the portal attracts.
53% of Yahoo’s revenues come from advertising on its own properties, and segment revenues increases 18% in Q1. Yahoo attracts traffic through its news, finance, sports, and mail content/services. There isn’t anything proprietary about the content Yahoo provides, thus can be duplicated. In addition, Yahoo is buggy. Yahoo Mail doesn’t work right (search & spam filter), sometimes pages don’t render correctly and tables fail to populate. Groups and message boards are filled with spammers.
In my opinion, there are many things that have gone down hill on Yahoo’s site. Social networking sites and blogs are gaining traffic, traffic that could be going to Yahoo. Much of what Yahoo has now, could be duplicated, perhaps by Google. Google provides similar content and services, such as mail, messenger, maps, etc. and in my opinion, is better. In sum, Yahoo is dependent creating content and services that will attract visitors to its website.
Yahoo also provides advertising to third parties or affiliate sites, but segment revenue (33%) and margins have been declining. In Q1, segment sales fell 7%, after accounting for the drop in margin (shares more with partner), net revenues declined 13%. Yahoo’s total net revenue increased 9% for Q1. Google’s revenue growth was 42%.
Google Analysis:
At $576 / share, Google is fair-valued. In mid-March, I was bullish on Google when it was trading around $440. In my Google valuation analysis, I pegged Google’s fair value at $540 / share. I think, given the take-over turmoil engulfing Yahoo, and the ensuing distraction and departures, has boosted Google’s lead further. Thus, a $600 share price for Google is reasonable, but not attractive.
I am reluctant to place a valuation higher than $600 on Google due to its spending. GOOG has very high profit margins, but absent from the income statement is capital spending. Capex as a percentage of total revenue has been in the mid-teens for the past several years. R&D as percentage of sales has increased as well, from 10% (FY05) to 13% (FY07). Headcount has also significantly expanding leading to declining sales/employee & income/employee ratios. The significance- On the margin, each incremental dollar of revenue growth is accompanied by higher costs and investment. Hence, Google’s prospective growth generates less incremental corporate value compared to its past growth. Nothing new here, just the law of diminishing returns taking hold.
Conclusion:
Owning Yahoo at these levels is purely a bet on an acquisition. There is some upside to $31 or perhaps $33, but there is some downside risk as well. Owning shares of the acquirer (whoever that may be) is a bet that synergies will enhance value and that the purchase price was not excessive. Owning Google is a pretty safe bet with the upside potential balanced with downside risk.
Monday, May 12, 2008
Advantages to Controlling Hardware Selection and OS Development
PC Magazine contributor Sascha Segan shares his insight on Microsoft’s recent missteps with Vista and Mobile OS in this month’s edition (June ’08). His primary thesis is that there is a disconnect between Microsoft’s OS and the capabilities of hardware components. Microsoft develops software on the assumption that the hardware installed-base would contain the latest, most powerful processors and graphic cards. This became problematic for MSFT when chip and device makers chose to keep costs down by utilizing lower powered circuitry. In short, Microsoft OS is built for the hardware of tomorrow as opposed to that of today.
Firms such as Apple (AAPL) and Research In Motion (RIMM) control the OS and hardware for their products. In my opinion, this gives them an advantage over Microsoft who must tailor its OS to the hardware of multiple manufacturers.
According to Segan, Intel needed to contain its costs, thus it opted for motherboards that included non-Vista-friendly integrated graphics as opposed to a dedicated chip set. Even though Vista operated poorly integrated graphics designed PCs, Microsoft approved its operability. This hardware-software gap caused significant performance issues for consumers.
Eventually, PCs become more powerful thus performance catches up to the needs of the Microsoft’s OS. In past years, this wasn’t a significant issue. However, today, consumers have a more viable alternative as evidenced with the populatity of Apple’s Macintosh. Consumers may not wait for performance to catch up, rather they may be inclined to purchase a Mac instead.
Segan also claims that MSFT has made the same mistake with Windows Mobile OS. It’s designed for processor speeds not found in the majority of mobile handsets. Segan adds “given a choice of making it faster or making it cheaper, most manufacturers will pick cheaper”
We have seen that Vista has had a rocky introduction, and Microsoft recently announced that a “downgrade” to XP would be available for less powerful machines. Mobile OS has been less than stellar as well, albeit improving. My experience with Mobile OS was horrible. I finally ditched the device after becoming fed up with the “spinning hourglass” popping up when trying to answer a call.
I believe Segan’s article illustrates the advantage Apple obtains from controlling both software and hardware functions. This gives Apple total control over the user experience as well as making it very difficult for competitors to duplicate.
I was dismayed when PALM decided to go with Windows Mobile OS for its Treo handsets. This creates several problems. First, MSFT Mobile OS places constraints on PALM’s innovation of its mobile devices. The user experience is dependant on MSFT not necessarily on PALM. Second, it limits PALM’s ability to differentiate its handsets. There isn’t much difference between PALM devices and others running Windows Mobile OS, given that the hardware is the easiest component to replicate. Even if competitors are able to replicate Apple’s or RIM’s devices, the software is still different and protects from “knock-off” models.
Apple has a distinct advantage; it’s devices run seamlessly. Vista’s troubles may partially be responsible for the surge in adoption of Mac computers. The simplicity of Apple’s iPhone OS may prove to be a huge weapon against Windows Mobile OS devices, especially when the iPhone become more price competitive.
Apple recently agreed to purchase PA Semi, a private boutique microprocessor design company known for robust, low-power designs. The true nature of Apple’s plans for the acquisition is unknown; however, PA Semi would aid in creating chips that are optimal for Apple’s OS. In addition, instead of licensing CPU architecture, Apple's proprietary, in-house chip design differentiates itself from competitors who use "off the shelf" chip architecture. With unique OS and CPUs, both aspects can be designed around each other, optimizing performance.
Apple and RIM will continue to outshine other mobile handset device makers using Windows Mobile OS. Even if Mobile OS drastically improves, these manufacturers lack differentiation and will have to compete on price. This increases pressure to utilize less powerful components, which will affect performance. RIM and Apple select the hardware needed to support the OS and do not have to make sacrifices detrimental to performance. MSFT, on the other hand, must design its OS according to the specs of the available hardware. However, since MSFT doesn’t control which hardware will be actually used by manufacturers, it faces a more challenging task.
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