your mileage may vary...

Aug 02

Tales from the Short Side

Company X is consumer electronics company that has a razor/blades model where they sell you a piece of hardware that allows you to connect with their internet service. They include a year of service in the selling price and then seek to sign you up for long-term contracts on their service. They also sell related add-on packages. Since Company X’s management has a history of aggressive behavior, fairly deep pockets, and has demonstrated a willingness to engage in frivolous lawsuits to get what they want, they shall remain nameless.

Because their services are paid for in typical contract terms of one to three years, they take in a lot of cash as the business is growing. Since the product is not delivered when the cash is received, this gets booked as deferred revenue on the balance sheet. Since the business is relatively new, the deferred revenue growth has been impressive.

To value this company, you would want to know three things:

The company’s filings provide very little help in that regard. The income statement is riddled with one off gains from a whole host of activities, including speculative bets on the company’s stock. There are no comments about unit sales of the product. Customer churn numbers are not mentioned at all. The only figure you can glean from any of the company filings are total cumulative product sales rounded to the nearest million. By my estimates they sell around 1.5mm units/year, so that level of rounding is not very helpful quarter to quarter.

Since management claims their product is revolutionary, you would expect the customers to be ecstatic about it. Looking at the subscription revenues, it appears that the retention rate of customers is around 33%. So 2 out of 3 customers leave the service every year. Not very impressive when you consider that just buying the product locks you in for a year. Given that some of these customers have signed multi-year contracts, that retention rate is abysmally low. It’s the kind of retention rate that would suggest that the service is not at all revolutionary.

Consider the sales growth of SolarWinds (SWI), a tech company that does enterprise infrastructure management software. The company has made some acquisitions, but the trend is reminiscent of a company that is changing the way its customers conduct their business.

Now consider Company X’s product sales figures over the last few years.

If you start hunting around for an explanation for the poor customer acceptance, you quickly stumble across a whole host of review sites that grumble about poor customer service, bad billing practices, and trouble with the technology itself. A number of the positive reviews you read appear to be fake; either left by anonymous users or using similar phrasing to the press releases put out by the company.

That of course, doesn’t make this a good short. Shitty products can exist for a long time. And most managements believe their products walk on water regardless of how good they really are.

What makes this a good short is the fact that this company has been piling up cash for several years now and have amassed a good cash hoard that should now be used to provide service to this declining user base. The service should be reliable, and they should be making sure that as sales dwindle, the customers they do have stay with them as long as possible and provide an annuity business. At the very least they should make sure they have enough cash on hand to provide the service the customers have signed up for.

Instead they are taking that cash and putting it into the stock market. Over the last few years cash and investments have fluctuated between $25 and $50mm, and at any given time more than half of that has been invested in a mix of equities, derivatives, and investment funds, as well as stocks that they have sold short. In fact, this investment scheme was so complicated that the CEO charged the company an advisory fee of over a million dollars one year. Also, judging by the returns on this investment, the holdings are highly volatile.

Company X began buying back shares on a massive scale this past year and has continued into 2012. And the CEO has been selling.

At some point, the company will need cash to create the next product, or to keep the lights on. And it won’t be there.

That is why this is a good short.

Jul 24

Being a Texan, I feel it’s my civic duty to point out that the Chuy’s IPO went well today.

Being a Texan, I feel it’s my civic duty to point out that the Chuy’s IPO went well today.

Jul 23

Spain Bans Short-Selling For Three Months -

It amazes me that regulators actually think this is a solution to their problems.

Jul 20

We currently expect to see a modest reduction in earnings exclusive of one–time charges for the third quarter of 2012. Continued slow domestic growth, coupled with continued or worsening global economic uncertainty may both become increasing negative factors. The construction market continues to be very challenging.

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Nucor Corporation’s Second Quarter Earnings Release

That seems to be the theme for earnings season. Anyone who knows the steel industry knows two things. First, steel is highly leveraged to economic activity and the manufacturing industry. Second, Nucor is one of the more flexible companies in the industry and they run a very tight ship. Consider this passage from Ken Iverson’s autobiography Plain Talk: Lessons from a Business Maverick:

When Nucor acquired a bearing products plant about ten years ago, the first thing we did was sell off the limousine, the second was to get rid of the executive parking spaces. All it took was a little black paint.

Or this story about the productivity gains from one of their plants:

Last year, Tim calculated that we were spending about $1.5mm annually to lubricate and maintain a series of supporting screws under the Nucor-Yamato rolling line. He noted that shims (tapered pieces of metal) would require no lubrication, and that they might work even better than the screws designed into the equipment by the manufacturer. Turned out to be a pretty smart suggestion. It cut our downtime significantly and is saving us more than a million dollars a year in maintenance costs.

So, when a company like that is telling you they are starting to see a slowdown in business, and increasing concern about burdensome regulation, it might just mean that business is slowing and that regulation is getting burdensome.

Jul 17

Samsung said in a statement the acquisition will help strengthen its mobile chip business, as it will obtain rights to CSR’s intellectual property related to wireless technologies such as Bluetooth, Wi-Fi and Global Positioning System.

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Samsung Buys U.K. Firm’s Mobile Business - WSJ.com

Looks like patents are becoming increasingly important in the mobile space as everyone looks for ways to implement competitive feature sets and prevent lawsuits.

Jul 16

Barton Biggs, Morgan Stanley’s former chief global strategist and co-founder of one of the first hedge funds, has died at age 79. He died Saturday after a short illness, a bank spokeswoman said.

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Ex-Morgan Stanley Exec Barton Biggs Dead - Yahoo! Finance

My sympathies go out to his family. I didn’t know Biggs personally, but after reading his book, Hedgehogging I thought he was one of the few who lived and breathed investments while also being able to take a step back and realize how absurd this business can be at times.

I’m saddened that I won’t be able to read any more of his books or see him on CNBC or Bloomberg anymore.

Chesapeake’s agents tell landowners that they will be shut out of the oil and gas boom if they don’t agree to the changes, according to landowners interviewed by The Wall Street Journal, which reviewed more than 100 property records in Ohio filed over the past year detailing the changes.

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Chesapeake Energy Seeks to Renegotiate Shale Drilling Lease Contracts in Ohio - WSJ.com

From where I sit, the only way that could be true is if no one wants to come in and develop the land after Chesapeake’s leases expire. This would imply:

Given the position that Chesapeake is in, I hardly think the rest of the industry is going to mind snatching up leases from under them as they expire undeveloped. Especially, if Chesapeake has already gone through the trouble of verifying the deposits underneath.

Jul 13

Infosys said it sees revenue in dollar terms rising 5 percent to $7.34 billion in the fiscal year to March 2013, down from its April estimate of 8-10 percent growth. Most analysts were expecting Infosys to trim its growth forecast to 6-8 percent. “Infosys’s guidance is bad and it will have implications for the sector as well. It clearly reflects a slowdown in Europe and in the United States and (problems with) the company’s internal policies,” said Paras Adenwala, a fund manager at Capital Portfolio Advisors.

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Infosys cuts outlook; TCS profit tops forecasts - Yahoo! Finance

Still seeing positive growth, but not as much as they previously thought. Still, the fact that the low-end of the tech spectrum is still holding on to 5% global growth while the rest of the world putters along at 1-2% shows you the resilience of IT spend.

Jul 12

Visualizations of banks thru the financial crisis

I did a quick survey of banks over the last few years at my new dataviz tumblr.

The city is hamstrung by a decades-old, voter-approved amendment to its charter that disallows the mayor or City Council from negotiating salaries with its police and fire unions. Those salaries instead are based on salaries of police and firefighters in cities of similar size—except the cities used for comparison are much more affluent. City unions have agreed to concessions and salary cuts over the past two years, city and union officials said.

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San Bernardino, Calif., to Seek Bankruptcy Protection - WSJ.com

Disintermediating costs from revenues is almost always bad policy. Sure you can delay the day of reckoning, but it will come eventually.

This may just be the canary in the coalmine. If Europe and China’s slowdown starts to bleed back into the US, the domino-effect to municpals may be too much to bear. A number of them are already hanging on by a thread.