What is the Goal of Investment Research?

Someone recently asked us to discuss the goal of investment research - what is it? Clearly, there is a wide range of answers to this question, but here's our view:

To see the forest through the trees. A sound investment research process should: (1) diligently put the pieces of puzzle* together to consistently find 50 cent dollars which (2) have a high probability of returning to one dollar within a reasonable time horizon. Coupled with portfolio management, disciplined investment research should mitigate risk and preserve capital by (3) recommending a group of holdings that, together, generate favorable absolute and relative performance per unit of risk. Over time, expected asset returns should be realized as temporarily irrational market prices move toward a reasonable range of expected fair values for each of the portfolio holdings.

*Pieces of the puzzle: to learn everything possible about a potential investment.

We believe this approach, along with an emphasis on high quality, cash generating businesses, should lead to attractive returns over a full market cycle. That is, a sound research process leads to a sound investment outcome.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: n/a.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Mediasite Adoption Continues = De Facto Global Standard - See "MUG" Presentation

A major part of our Sonic Foundry (SOFO, $5.00) thesis is that Mediasite reliably addresses a clearly defined market need with efficacy. As a result, customers love the solution and Mediasite is becoming the de facto global standard for rich media capture and Webcasting. That is, the Mediasite franchise is growing.

An excellent "window" into Mediasite customer and product happenings are quarterly Mediasite User Group (MUG) meetings (MUG link here). Here's the description and link for last week's meeting:

December 9, 2009 @ 11:00am Central
Don’t have Silverlight? Download it here or watch with classic player.

How cool would it be to have an "Easy Button"? One click and everything happens by itself? Bob Hillhouse, from University of Tennessee-Knoxville, shows us the concepts and how-to's behind the highly automated Mediasite deployment at UT. Colleagues from MediaMission in the Netherlands and Mediasite KK in Japan share how Mediasite is being used internationally. Octavio Heredia from Arizona State University School of Engineering gives us a behind-the-scenes virtual tour of his facilities which have recorded more than 10,000 Mediasite presentations to date. And Sonic Foundry previews what's next for Mediasite. Your host: Helder Conde, Atitude Digital Media – Brazil

We're not going to relay all of the highlights, but the meeting is worth watching for current investors in Sonic Foundry and/or anyone interested in Mediasite. Here are a few noteworthy items:

• MediaMission, a Mediasite reseller (not a bad business idea for A/V integration companies), is busy spreading Mediasite throughout the Netherlands:

• First ever User Group Conference in Japan, including presentations from major organizations/companies (link to four minute overview presentation here) -- more than 160 Mediasite customers in Japan per head of Mediasite KK, with 65 customers attending the inaugural conference:

• On related noted, Mitsubishi used Mediasite at the L.A. Auto Show - link here.
  

• Finally, Sonic Foundry announced another new Mediasite release with additional features requested by customers (recall positive feedback loop discussed in our original thesis).

Separately, Sonic Foundry filed a "shelf filing" with the SEC yesterday to issue more equity "from time to time". Although shares are under pressure today, we think the apparent panic in the Market presents a buying opportunity. Companies usually file "shelfs" to have "on file" (sometimes for years) and prepare to "press the button" when share price is at the right level (usually higher). We note that management indicated on the last call that the company may seek additional debt financing for working capital needs related to large deals expected in mid-2010 and has no desire to issue equity at current "depressed prices".

As mentioned in prior posts, we continue to believe shares of Sonic Foundry could fairly fetch at least several multiples of current levels based on private market value supported by recent M&A transactions. We believe Sonic Foundry might consider issuing additional equity at the right price, presumably at or above our estimate of fair value ($20-27) at some future point. We prefer no dilution, but don't mind slight dilution if issued at an appropriate price to finance anticipated, significant growth.

Please stay tuned. We'll come back in the next week or two with how we're making sense of Sonic Foundry's guidance.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long SOFO.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

AOB: Management or Cash Generation More Important?

Shares of American Oriental Bioengineering (AOB, $4.04) have held up well since missing our and consensus 3Q09 expectations in mid-November. We were disappointed by the results and stated that we may have made a mistake, yet we still hold shares with a view that intrinsic value is closer to $7 - $8 per share than $4. Here is AOB's one-year stock chart:

We noted at the time that "negative Market sentiment toward AOB [appeared] to have already priced in an earnings miss and the company's cash generation should provide a backstop." Further, at this point, we surmise that the short story for AOB (e.g. potential 3Q miss, regulatory changes, competition, margin compression, management credibility, etc.) has run its course given the large expectation "reset" in November. Based on recent short interest data, "S/I" did tick lower in the most recent period:


Following the same approach applied in our prior post (excluding out-of-the-money convertible shares), we estimate AOB is trading at six times (16% yield) estimated 2009E free cash flow of $50 million (conservative). We continue to find comfort in the low FCF multiple and expect cash to keep accumulating on AOB's balance sheet even if 2010 growth is lower than anticipated. Moreover, we still believe that AOB's products and growing franchise are difficult to replicate -- we sure couldn't do it and also think Western pharma/biotech companies would find the task challenging because of cultural and language barriers.

Thus, even with risk factors (e.g. regulatory, execution, competition), we find the 16% FCF yield very compelling. As with our Weight Watcher's (WTW) post on Friday, we ask ourselves a Warren Buffett-like question, if we could, would we purchase the entire business at the current price offered by the Market? Our answer: YES. Imagine owning the whole company and reinvesting one half of free cash flow to grow the business and paying yourself the other half (8%) as a perpetual dividend -- we'd take that any day.

We also note that other Chinese pharmaceutical companies (e.g. Simcere Pharmaceutical Group - SCR) trade at higher multiples but have lower growth and margins than AOB. Simcere is trading at 21 times consensus 2010 earnings estimate of $0.40 while AOB trades at only 6.5 times a reduced 2010 estimate of $0.62 (only slightly higher than 2009E's $0.58). Our intrinsic value estimates are always based on absolute measures. However, if AOB garnered SCR's 21 times forward multiple, the stock would trade at $13.00 today.

Finally, with regard to management credibility let's share a quote from the Fairholme Fund's Bruce Berkowitz featured in the Winter 2009 issue of Graham & Doddsville:

• "The management factor is important. But, the ability of a company to intrinsically generate cash is probably more important."
  

We think Mr. Berkowitz makes a good point, which is somewhat related to a point made by other well-known investors -- something to the effect, "it's best to own a business any fool can run because someday a fool may well be running it" (tongue in cheek as clearly management stewardship of shareholder capital is important).

We'll continue to watch how AOB's management deploys excess cash flow to enhance shareholder value. As noted in our pre-3Q09 results post, only "modest improvement in the Market's perception of management credibility should lead to multiple expansion". We still think this is true.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long AOB, WTW.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Barron's Calls Out Amazon - Cites Perils of High Valuation

On 10/23/09, we noted that Amazon (AMZN, $134.15) was a powerful franchise with impressive growth, free cash flow, and returns on capital. Yet, we also said that the stock, then at $93.45 with an implied TTM free cash flow yield of 4.7%, was in a fair value range and expensive for our liking. With shares up 44% (versus S&P 500 up only 1%), we find the valuation even less attractive and prone to disappointment (no margin of safety).

Still, the Market includes all kinds of participants, including a large number of momentum traders who keep buying or selling something because "it works". For example, on 12/2/09, Cramer discussed a momentum based valuation approach (i.e. apply a P/E of two times estimated earnings growth of 30%, or 60 times next year's estimated earnings) to derive a $216 target price with a view that current consensus estimates are 20% too low.

We think his analysis probably is inline with that of some momentum based investment funds and some sell-side analysts. News of favorable E-Commerce trends further feeds momentum. Meanwhile, more "shorts" who keep saying the valuation is insane and isn't sustainable, cover positions as patience runs out and short-term unrealized losses increase (dangers of a valuation-based short thesis).

Barron's has a feature story this weekend on Amazon that highlights risks and includes interesting tables. The article draws a parallel to Wal-Mart (WMT, $54.65):

• Wal-Mart Stores, the archetypal discounter, was the retail growth story of the 1990s. As that decade ended, its shares traded at 69, or for 57 times its 1999 profit of $1.20. Since then, Wal-Mart has slid to 54, even though its earnings have tripled and revenue has more than doubled. The Wal-Mart experience shows that investors can lose money in the shares of a great company if they pay too much.

Also from the story, comparing Amazon to Walmart and Target (TGT, $46.93):


While Amazon benefits from an asset-light business model, we concur that the recent run prices in significant future growth. As valuation multiples further expand, the probability of disappointment increases. We retain a preference for online retailers such as eBay (EBAY, $22.70) and PetMed Express (PETS, $17.85), as well as the completely unloved Bidz (BIDZ, $2.28). We submit that the probability of the share price for any of these companies doubling before that of Amazon is quite high.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long EBAY, PETS, BIDZ.
© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Watching the World's Weight with Weight Watchers (WTW)

NutriSystem (NTRI, $29.45) has had an amazing run over past several months on news of expanded distribution with major retailers, which should lead to accelerated growth. Here is the three month stock chart:


We looked at the company in the mid-teens last summer but didn't purchase shares. Although we like the business, we didn't expect shares to move so sharply in the near-term and wanted to keep following the company. It appears the stock responded in similar fashion to the overall market this year, albeit even more quickly -- some good news yields a sentiment shift and concurrent short squeeze that leads to a meaningful upward move. Here's short interest data from Nasdaq.com:


While we missed NTRI (*momentum may yet push shares higher, but we're not in that game), we did recently initiate a small position in Weight Watchers (WTW, $27.81). We see a favorable risk/reward profile given a high quality business model and free cash flow generation. At a 10% TTM FCF yield, we wouldn't mind buying the entire company, and, further debt reduction should enable a higher dividend in two to three years. This, along with slight earnings growth, makes at least slight multiple expansion plausible over the medium term.

Here's a summary thesis with more detail from an analysis we completed in early November (valuation data updated for NTRI and WTW comparison):

Consistently high margins/ROIC and excess cash flow indicate that Weight Watchers operates a high quality business model with durable franchise characteristics. On balance, strengths and opportunities appear to outweigh key weaknesses/threats such as growth concerns, competition, and debt levels. Importantly, a baseline forecast that assumes stable Y/Y revenue in fiscal 2010 (easier Y/Y comparisons and stable economy) followed by slight growth in fiscal 2011 implies that net debt to EBITDA will decline to 2.2x at year-end 2011 from an estimated 3.3x at year-end 2009 (and 3.6x at year-end 2008), providing more than adequate cushion for lenders and the current dividend. At that point, Weight Watchers may finally be able to initiate annual dividend increases, which could lead to higher valuation multiples.

• The baseline forecast produces a valuation range between $17 (earnings power value) and $40 (private market value)
• Applying historical 5-year median P/E, P/FCFE, and TMV/EBITDA multiples to forward estimates implies approximately 100% upside at year-end F2009/F2010
• Even haircuts to historic multiples imply substantial upside
• On a comparable basis, as of 12/11/09, NutriSystem was trading at 38x TTM earnings and 21x consensus 2010 earnings (5% earnings yield), compared to Weight Watchers at 10x both TTM and consensus 2010 earnings (10% earnings yield)

Conclusion: while growth remains a critical question and multiple expansion is not guaranteed in the current environment, the prospect of a high quality business model once again garnering discounted historic multiples (at minimum) seems a high probability event with a three-year investment horizon. Investors collect 2.6% per year while waiting and potentially more in several years. Assuming normalized earnings growth in the mid-single digits (4-6%), investors should collect a total return of 7-9% over time assuming no multiple expansion.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long WTW.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

What is the Relationship Between Total Employment and Productivity?

Based on various government and media reports in recent months, we know that economic productivity (output per unit of input) is surging as companies squeeze more effort from smaller workforces. For example, from the Department of Labor's 12/3/09 report:

• Nonfarm business sector labor productivity increased at an 8.1 percent annual rate during the third quarter of 2009, the U.S. Bureau of Labor Statistics reported today (tables A and 2). This was the largest gain in productivity since the third quarter of 2003, and reflects a 2.9 percent increase in output and a 4.8 percent decline in hours worked. (All quarterly percent changes in this release are seasonally adjusted annual rates.)
  
  
• Manufacturing sector productivity grew 13.4 percent in the third quarter of 2009, as output rose 8.4 percent and hours worked fell 4.4 percent (tables A and 3). The third quarter gain in manufacturing productivity was the largest in the series, which begins in the second quarter of 1987. Over the last four quarters, manufacturing productivity grew 3.0 percent. Manufacturing unit labor costs fell 6.1 percent in the third quarter of
  2009, but rose 3.0 percent over the last four quarters.
  

While improved productivity is nice, the key question is how lean can companies truly operate, or when will employment growth return? We don't have the answer to this question, but came across an interesting article and graph in an 11/16/09 Forbes Magazine article, "Look Who's Hiring Now: Inquire Within". Here's the graph worth a look:

The graph shows that, historically, "total employment" and productivity tend to track each other fairly closely, with the latter recovering slightly prior to employment. However, this time around: productivity zoomed ahead while employment declined. The good news today: as in the past, based on the recent unemployment report, total employment is possibly now forming a base before again growing.

Of course, many people may say "it's different this time", but time will tell. We think the historic relationship bodes well for improved employment trends in the not-so-distant future.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: n/a.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

CHDN and UBET Keep Nudging Higher - Implied UBET Value Now $3.11; Potential Fair Value $3.70-4.00

Since news of Churchill Downs' (CHDN, $35.79) proposed acquisition of Youbet.com (UBET, $2.99) on 11/11/09, shares of both companies have moved higher. As a reminder, the proposed deal is 2/3 CHDN stock and 1/3 cash. We included a summary table of potential upside/downside values to Youbet shareholders in our post about the merger. Here's the one month relative stock performance from Nasdaq.com:


On Churchill's conference call the morning after the announcement, one of the analysts asked: "I do wonder about the timing of the transaction and the use of stock considering that you guys are basically trading at what seems to be an all-time low valuation?" (transcript here). Management didn't directly answer this question, yet the the ensuing dialogue essentially highlighted where Churchill sees value in Youbet for the combined company.

We subsequently looked at Churchill Downs's historical, ten-year average and median TTM (trailing 12 months) multiples of cash flow (EBITDA), operating income (EBIT), and earnings multiples . Based on our review, CHDN was, in fact, trading at all time low valuation at the time of the transaction, with multiples at only 60-70% of historic median multiples. Thus, if we subscribe to reversion to the mean over time (we do) and also believe that Churchill Downs is solid, durable franchise (we do), then it's reasonable to expect CHDN to once again trade at historical multiples (at some point).

On this basis, we estimate that CHDN is worth $45-50 per share, which puts UBET's value at approximately $3.70-4.00 per share assuming deal terms remain unchanged. We don't think this view is lost on Churchill or Youbet management, which likely explains why the latter company's board (and JB Pritzker's New World Opportunity Partners as well as investor Lloyd Miller III) agreed to the transaction. Also, we note that the less liquid shares of Churchill Downs tend to move quickly and were in the high $30s just a few weeks prior to the announcement. Finally, Churchill Downs currently pays a $0.50 per share annual dividend, which appears sustainable even after expected dilution from issuing new shares to Youbet shareholders (i.e. Churchill will benefit from Youbet's free cash flow generation).

In a way, Churchill Downs reminds us of International Speedway Corp. (ISCA, $28.04), which owns many NASCAR "speedways" and is a favorite of many "value" investors. The margin (and free cash flow) profile is higher for International Speedway, yet both companies own and operate irreplaceable brands/assets.

Although we've slightly reduced our Youbet position to reallocate into other names, we presently retain the lion's share and expect that the implied UBET value may keep nudging higher.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long UBET.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer