Dell LBO: A Logical Move That Others Might Mimic

Investors have been speculating for a couple of years now that Michael Dell could eventually take his computer company private, after leaving the option on the table in multiple press interviews. His large stake as founder and CEO (about 15% of the company) coupled with his transformation plan and lack of respect on Wall Street (for the stock, not himself) all make a leveraged buyout seem logical. With news that a deal is being negotiated and could be finalized shortly in the $13-$14 per share range, I think the deal makes a lot of sense and others might take Dell’s lead and follow suit.

All of the ingredients required for a successful LBO are there in Dell’s case. The stock is so unloved on Wall Street that even after a premium is attached to the shares (which were hovering around $10 before news of the deal discussions leaked) the company can be had for a very attractive price. The company generates about $4 billion of cash flow annually, with $3.5 billion or so left over after capital expenditures. With a market value of around $23 billion, which excludes $6 billion of net cash on the balance sheet, Dell and his group would be paying about 4 times EBITDA.

Bears on the stock will be quick to point out that Dell still gets the majority of its revenue from desktop and laptop computer sales and that business is in decline thanks to the emergence of powerful smartphones and tablets. Indeed, that is why the stock has been pressured lately and accounts for the meager enterprise value assigned by the public market, but it also ignores the transformation plan that Dell and his team have slowly been implementing. While PC deterioration is offsetting the financial benefits of the company’s move into the corporate world of servers, storage, security, and services right now, over time that side of the business (which is both Dell’s current focus and future) will overtake the PC side and allow the company to continue to book strong profits. Once PCs dwindle to 20-25% of the business over the next several years, Dell can re-IPO and the LBO investors can cash out big time. At that time, Dell will look more like IBM than HP.

So why might other companies seen as “old tech” go down a similar route as Dell? First, it makes it a lot easier after someone else does it first, as it gives credibility to the idea. Companies heavy into PC-related businesses are not going to get respect from Wall Street going forward. Dell’s pre-deal P/E ratio of 6x proves that. After a while, the frustration mounts and staying public loses its luster. Hewlett Packard is likely going through a similar thought process right now, even though they are far behind Dell in orchestrating a solid transitional game plan. Even PC-related software companies like Symantec are being painted with the same brush and could explore the idea of going private. Anti-virus software is simply seen as yesterday’s technology and lacking growth potential.

All in all, this Dell LBO idea makes a lot of sense on multiple fronts, and while other companies might not have as many strong cards to play to make a deal like this work, I bet a finalized Dell deal prompts a lot of discussions in board of directors’ meetings across the industry in coming months.

Full Disclosure: Long SYMC at the time of writing, but positions may change at any time

Apple Shares Now Nearly As Cheap As Microsoft: Which Would You Rather Have?

That’s right. With the recent share price plunge in Apple (AAPL), from over $700 to around $525, the stock is rapidly approaching the valuation of 1990’s tech darling Microsoft (MSFT). While clearly facing near-term headwinds, both on the product side (a narrowing of their technological lead over rivals) and the financial side (fiscal cliff, tax-related selling before year-end), among others, I find it hard to make an argument for why Apple should not trade at a premium to Mister Softee. To be fair, Apple still fetches slightly more if you go out to one decimal place, with AAPL trading at 6.4 trailing cash flow, versus 5.7 times for Microsoft. If Apple shares fell another 8% or so, to around $485, and MSFT stayed around $27, both would trade at 5.7x trailing 12 month EBITDA. Still, investors are having a hard time understanding exactly how sentiment on Apple has shifted so much in just a few short months.

Now I know many people come to this blog to discover new investment ideas, and Apple definitely does not qualify. However, since contrarian investing is one of my core tenets, I think it is important to point out that Apple shares are dirt cheap right now. In order to justify a lower stock price, say one or two years from now, you have to think that Apple’s sales and earnings have peaked and are headed down from here. While that is not an impossibility, especially in the world of technology, I think it is far more likely that Apple’s market share gains slow and level off going forward. Even in that case, the end markets they serve as going to grow nicely over the next few years. As a result, I don’t envision their financials petering out from here, though for a company of this size, the hey days of rapid growth are clearly over.

For those who aren’t sure such prognostications will prove true, consider again the comparison with Microsoft. Regardless of Apple’s position relative to Google, Samsung, and the like in the coming years, is Microsoft really as well positioned? I don’t think so. Even a bet that Apple will outperform Microsoft, given their stocks are nearly identically priced, is a bet investors can make in the public market by shorting one and using the proceeds to go long the other. iPod versus Zune? iPad versus Surface? iPhone vs Windows Phone? It’s not a bad play.

Although discussing large cap tech titans like AAPL and MSFT hardly uncovers anything new for curious investors, I definitely think today’s share price on Apple is worthy of discussion. The recent 200 point decline seems very overdone to me, based on what is happening out in the tech marketplace. The last time I updated my fair value for Apple stock I got a number with a “7” handle on it. Nothing has changed since then, and for the first time in a long time, I am actually looking to add to the stock in client portfolios.

Full Disclosure: Long Apple and no position in Microsoft at the time of writing, but positions may change at any time

Does Marissa Mayer Make Yahoo Stock A Worthwhile Bet?

Granted, I am a numbers guy, so even asking whether a new CEO is enough to warrant buying a stock is a stretch for me. While quality leadership is certainly important, successful stock market investments require the numbers to work and no matter how great the CEO, they can’t magically make the numbers work all by themselves (unless you want the books to be cooked of course). Still, I am intrigued by Marissa Mayer’s hire as the new CEO at Yahoo (YHOO), even though the company is clearly not gaining relevancy on the Internet. A 1990’s darling, Yahoo has lost its lead in search (thanks to Mayer’s former employer, Google) and really only has a stronghold in a few areas of the web, such as email and fantasy sports.

Still, considering who has been occupying the corner office at Yahoo over the last decade, it is compelling that a tech person of Mayer’s caliber is now running the show. From 2001 to 2007 the company was headed by a movie studio exec (Terry Semel). From 2009 to 2011, they brought in a Silicon Valley veteran (Carol Bartz), but she previously ran Autodesk, a software company that sells products to help engineers design factories, buildings, and 3D animated characters. Is it really that surprising that Yahoo has been treading water for all these years?

Enter Marissa Mayer, Google’s 20th employee (and first woman engineer) who had been leading successful efforts in areas where Yahoo actually competes, like web search. If anyone can help reinvigorate Yahoo, it might just be her. But isn’t that taking a big leap of faith? Sure, but there is another factor, other than the CEO, that makes a bet on Yahoo shares at $16 each worth a look. The numbers.

Yahoo’s current market value is less than $20 billion. As of September 30th, the company’s stake in Yahoo Japan ($7.7 billion) and Alibaba ($8.1 billion) account for the majority of that valuation. Even if you deduct the tax liability that would be incurred if Yahoo were to monetize these stakes, the organic Yahoo operations are priced at just $10 billion. What do investors get for that $10 billion? To start, how about nearly $7 billion of net cash on the balance sheet (plenty for Mayer to begin a transformation)? That leaves a mere $3 billion valuation on Yahoo’s core operations, which generated free cash flow of $250 million in 2011. That is a low price even if the company doesn’t grow at all going forward.

Yahoo stock today looks to me like a call option on Marissa Mayer. As I said before, a CEO alone is not a good reason to buy a stock. But what if you have a unique change in leadership that could very well pay off in spades, and the meager public market valuation of the company basically affords you limited downside risk? The combination of those two factors makes the stock an interesting opportunity in my view. If Mayer, like her predecessors, fails to reinvigorate the company, then the shares likely stagnate here in the mid teens. However, if she succeeds, as her resume seems to suggest she could, there is a lot of upside to the story. It feels weird for me to say, but Yahoo at $16 with Carol Bartz running the show didn’t interest me one bit. With Mayer it’s a different story.

Full Disclosure: Long shares of Yahoo at the time of writing, but positions may change at any time

 

Apple Sets Market Value Record As iPhone 5 Debut Nears

Earlier this week I wrote a piece on Seeking Alpha that outlined why I believe investors are likely to value Apple (AAPL) shares similarly to other blue chip consumer brands, which would mean a valuation of 10-12 times trailing cash flow (defined as EV/EBITDA). Bulls on the stock have a multitude of reasons why Apple should trade at a premium, but in recent quarters the market has disagreed. In fact, even as Apple stock has broken out to new highs, setting a new market value record in the process, AAPL shares fetch about 9 times trailing cash flow (at the current quote of $665), a discount to other superb consumer brands.

If fair value is somewhere in the 10-12 times cash flow range, that would equate to $725-$850 per share. That would mean fair value is somewhere between 10% and 25% above current levels. That is why I continue to hold the stock, despite its enormous run-up lately.

In terms of future potential, I continue to be intrigued by the possible launch of an Apple TV set. When I think of the large market opportunities for Apple, those that can really move the needle for a company worth more than $600 billion, the television market is the only one they have yet to target that has real appeal. Outside of desktop, laptop, and tablet computers, phones, music players, and televisions, I am not sure where else Apple could find significant future expansion potential (although I am sure they would disagree and are looking for some already). After launching a TV, I think Apple’s strong growth days might fade. Assuming the stock traded in line with other blue chips at that point, I would likely look for an exit point.

I have not sold yet, mainly because a TV is still not here (some are even arguing they aren’t going to make one, just a set-top box) and the stock’s valuation on current products, at 9 times cash flow, is still below that of other large cap blue chips. So while I am not as bullish as some, I still see room to run for the stock.

Full Disclosure: Long Apple at the time of writing, but positions may change at any time

Bubble Bursting 2.0 (Part 2): Isn’t Groupon Worth Something?

Last November, in a post entitled “Numbers Behind Groupon’s Business Warrant Caution After First Day Pop”, I cautioned investors that the IPO of daily deal leader Groupon (GRPN) looked sky-high at the initial offer price of $20 per share, which valued the company at an astounding $13 billion:

“It is not hard to understand why skeptics do not believe Groupon is worth nearly $13 billion today. To warrant a $425 per customer valuation, Groupon would have to sell far more Groupons to its customers than it does now, or make so much profit on each one that it negates the lower sales rate. The former scenario is unlikely to materialize as merchant growth slows. The latter could improve when the company stops spending so much money on marketing (currently more than half of net revenue is allocated there), but who knows when that will happen or how the daily deal industry landscape will evolve in the meantime over the next couple of years.

Buyer beware seems to definitely be warranted here.”

A few things have happened since then. First, Groupon has cut back on marketing spending and is now making a profit (free cash flow of $50 million in the second quarter). Second, the post-IPO insider lockup period has expired, removing a negative catalyst that the market knew was coming. Third, and most importantly, Groupon’s stock has plummeted from a high of $31 on the first day of trading ($20 billion valuation) to a new low today of $4.50 ($3 billion valuation).

Here is my question, as simply as I can put it; “Isn’t Groupon worth something?” The stock market seems to be wondering if many of these Internet IPOs will exist in a few years. Today’s 8% price drop for Groupon was prompted by an analyst downgrade to a “sell” and a $3 price target. Here is a company with $1.2 billion in cash, no debt, and a free cash flow positive business that will generate over $2 billion of revenue this year. That has to be worth something. How much is another story.

I would argue that it is too early to write off companies like Groupon as being “finished.” It is far from assured that they will be around in 3-5 years, but many of them have huge cash hoards ($2 per share in Groupon’s case), no debt, and a business that is making money today. My most recent blog post made the point that many of these Internet companies are going to survive, and in those cases bargain hunters are likely to make a lot of money. Will Groupon be one of them? I don’t know, but if an investor wanted to make that bet, at $4.50 per share, they are paying about $1.8 billion ($3 billion market value less $1.2 billion of cash in the bank) for an operating business that is on track for more than $2 billion in sales and $200 million in free cash flow in 2012. And who knows, with this kind of negative momentum, the shares could certainly reach the analyst’s $3 price target in a few more days.

Bottom line: these things are starting to get pretty darn cheap. If they make it, of course.

Full Disclosure: No position in Groupon at the time of writing, but positions may change at any time.

Bubble Bursting 2.0: Coming To A Dot-Com Stock Near You

By now you probably know the poster children for the bursting of the 2012 Internet bubble:

Facebook (FB) IPO price: $38.00, Current quote $21.75 (down 43%)

Zynga (ZNGA) IPO price: $10.00, Current quote: $2.95 (down 70%)

Groupon (GRPN) IPO price: $20.00, Current quote: $6.66 (down 67%)

And as was the case in 2000, we are seeing violent selling in most any Internet company that reports a less-than-impressive quarter as a public company. We are also likely to get a repeat scenario in terms of bargain basement prices, for a time anyway, even on those companies who are able to survive and grow with a profitable business model. I think it is time to start monitoring these dot-com IPOs in search of those that might be written off prematurely. After all, unlike the late 1990’s, many of these companies do make a profit. The issue today is more that they don’t always make enough to justify multi-billion dollar stock market valuations.

Today’s disaster du jour is CafePress (PRSS), a profitable e-commerce site that has been around since, you guessed it, 1999. CafePress, which projects 2012 revenue of more than $200 million, went public in late March at $19 per share, giving it a market value at the time of about $325 million. In today’s trading the stock is falling by nearly $6, or 42%, to a new low of under $8 per share. Loss since the IPO: 58%.

So why bring up CafePress? I think it is the kind of company (a viable, profitable, and growing Internet operation) that might fall into that “written off way too early” category as the air continues to flee from the 2012 Internet company bubble. Granted, I have only spent an hour or so looking at CafePress specifically, so this is by no means a huge ringing endorsement yet, but it is the kind of stock I think warrants a closer look.

Even with reduced financial guidance for 2012 (the reason for today’s steep stock price decline), CafePress is predicting more than $20 million in EBITDA on more than $200 million in sales this year. With sales growing by about 20%, coupled with an 11% cash flow margin, PRSS is certainly a viable company. And yet, at under $8 per share, the stock price is indicating otherwise. The market value is now down to $135 million. PRSS has $60 million in cash on the balance sheet, so at current prices Wall Street is saying that the CafePress operating business is worth just $75 million, or 3 times EBITDA. That is the kind of valuation that Wall Street normally reserves for companies in a steep decline. As a value investor, numbers like these can’t help but get my attention.

Comments on the Internet stocks in general, or CafePress specifically, are always welcomed.

Full Disclosure: No positions in the stocks mentioned at the time of writing, but positions may change at any time

Values Abound in Enterprise Computing

With the European recession beginning to impact earnings guidance for U.S. companies in recent weeks, one of the sectors to really get hammered is enterprise-focused technology. While second quarter profit reports and forward guidance will likely be unimpressive this month, some of the current valuations on Wall Street make little sense even in that scenario. As a result, I would expect strategic mergers and private equity buyers to begin looking at some of these companies.

There are far too many ideas to list here, or buy for clients, so I will just point to one that looks intriguing; enterprise collaboration hardware maker Polycom (PLCM). Polycom earned $1.18 per share last year, but weakening demand has pushed forecasts for 2012 down to just $0.89 which has crushed the stock from $32 a year ago to a recent quote of just $9 per share. What really bulks up the bullish case for the stock is that Polycom has no debt and a whopping $600 million of cash in the bank, which equates to about $3.50 per share in net cash. Investors are getting the business for only $6 per share, or 5 times trailing earnings.

With such a pristine balance sheet, the odds of Polycom being acquired rises materially relative to the average hardware company. It would be a logical target for a Cisco, HP, or Dell, all of which are companies that either compete with PLCM or are looking to expand their product offerings to enterprise customers. Even without a deal, the stock should likely command at least a market multiple, which would put fair value in the high teens inclusive of cash. This is just one of many enterprise computing companies that have been decimated in recent months, which make them very attractive in my view.

Full Disclosure: Clients of Peridot Capital own shares of Polycom at the time of writing, but positions may change at any time.

The Most Surprising Thing About Facebook’s IPO? Trading Has Been Completely Rational!

Today’s Facebook (FB) IPO is the first time I can remember being completely shocked at the lack of trading excitement and volatility for a much-hyped IPO. Ironically, the reason for such unexciting, rational behavior is because of how hyped the Facebook IPO was to begin with. The share allocation to retail investors at the $38 offer price was huge. I put in orders for my larger clients at E*Trade, one of the brokerage firms that got a sizable piece of the IPO, but did not really think they would allocate us any shares (there were reports that Fidelity would not even consider giving out shares to any clients who had less than $500,000 with them). What happened? We got every share we asked for.

With that much hype, especially from the retail side, and with that many investors actually getting 100 or 200 shares, it would be completely rational that, since the supply was very large and the price was fair, a large first day surge would be unwarranted. But we are not used to seeing first day rationality for hot Internet IPOs. In hindsight, it makes sense that Facebook opened at $42.05, only up $4. With so few incremental buyers (given the huge retail allocation at the IPO price), it also makes sense that the stock would see selling at the open, which did occur, sending the stock down to $38 exactly within the first 30 minutes of trading.

So while I am pretty shocked that this IPO has been so calm, I think it bodes well for how the financial market worked. For what could very well be the most hyped IPO ever, investors are acting completely rational and the investment bankers have done a really solid job of not only correctly pricing the deal, but also letting the “Average Joe” participate. The retail brokerage customer won’t be getting rich off of this IPO on day one, but that is not the way it should work anyway. With so many people getting stock, the immediate paper gains should be modest. That is how the marketplace should work. It is all about supply and demand after all.

Full Disclosure: I received Facebook shares at the IPO price, as did a few of my clients. I was planning to look for a chance to flip them today, after a nice pop, but with this interesting trading action to start the day, we have yet to sell a single share as of the time of this post. As always, positions may change at any time.

UPDATE (5/18): I sold my client’s Facebook shares after this post was originally published, in afternoon trading at $40.09 each.

Is Priceline’s Stock Valuation Out of Whack with Reality?

Rob Cox of Reuters Breakingviews was on CNBC this morning sharing his view that the stock of online travel company Priceline.com (PCLN) appears to be dramatically overvalued with a $30 billion equity valuation (even after today’s drop, it’s actually more like $35 billion). Rob concluded that Priceline probably should not be worth more than all of the airlines combined, plus a few hotel companies. While such a valuation may seem excessive to many, not just Rob, it fails to consider the most important thing that dictates company valuations; cash flow. In this area, Priceline is crushing airlines and hotel companies.

As an avid Priceline user, and someone who has made a lot of money on the stock in the past (it is no longer cheap enough for me to own), I think it is important to understand why Priceline is trading at a $35 billion valuation, and why investors are willing to pay such a price. While I do not think the stock is undervalued at current prices, I do not believe it is dramatically overvalued either, given the immense profitability of the company’s business model.

At first glance, Priceline’s $35 billion valuation, at a rather rich eight times trailing revenue, may seem excessive. However, the company is expected to grow revenue by nearly 30% this year, and earnings by 35%, giving the shares a P/E ratio of just 23 on 2012 profit projections. Relative to its growth rate, this valuation is not out of line.

The really impressive aspect of Priceline’s business is its margins. Priceline booked a 32% operating margin last year, versus just 4% for Southwest, probably the best-run domestic airline. With margins that are running 700% higher than the most efficient air carrier, perhaps it is easier to see how Priceline could be worth more than the entire airline industry.

Going one step further, I believe investors really love Priceline’s business because of the free cash flow it generates. Because Priceline operates a very scalable web site, very little in the way of capital expenditures are required to support more reservations and bids being placed by customers. Over the last three years, in fact, free cash flow at Priceline has grown from $500 million (2009) to $1.3 billion (2011). At 27 times free cash flow, Priceline stock is not cheap, but given its 35% earnings growth rate, it is not the overvalued bubble-type tech stock some might believe.

Full Disclosure: No positions in any of the companies mentioned, but positions may change at any time

Tread Carefully, Apparently Another Mini Internet Bubble Is Here

The good news is that we are nowhere near 1999 levels in terms of Internet company hype and excessive valuations. The bad news is that we are seeing the same types of froth, just to a lesser degree, that we saw back then. More than a decade ago we were wondering how Yahoo (YHOO) was worth more than Disney (DIS) and the market eventually corrected that inefficiency (today’s values: Disney $76B, Yahoo $18B). Today we see online gaming company Zynga (ZNGA) worth $8 billion ($1 billion in annual revenue) compared with a value of $5 billion for Electronic Arts (EA) ($4 billion in annual revenue). Monster Worldwide (MWW) has $1 billion in sales and a $1 billion equity valuation, versus LinkedIn (LNKD) which has similar revenue and a $10 billion market value. These figures are lopsided in percentage terms, but at least these Internet stocks aren’t worth more than the country’s bluest of blue chips.

Facebook’s $1 billion deal this week to buy Instagram, a mobile photo service with no revenue, shines a light on another phenomenon that we saw during the last bubble; huge changes in valuations one day to the next without any change in business fundamentals. In the 1990’s a company could issue a press release announcing they were going to launch a web site and the stock would pop 50 or 100 percent. The Facebook deal is not astonishing as much for its price tag as it is for the fact that just last week Instagram raised $50 million in venture capital money at a valuation of $500 million. In a few days, Instagram’s value doubled to $1 billion without it doing anything on the business side to warrant that price. Can you imagine how giddy the VC folks who made that deal must be? It’s almost unbelievable.

To put the $1 billion price in perspective, consider than Instagram has 30 million registered users who pay nothing. Facebook is paying more than $300 $30 per user for the company. Facebook itself has about 850 million users and netted $3 billion in revenue from them last year. At the forthcoming IPO valuation of $100 billion, Facebook is being valued at just over $100 per user. Should an three Instagram users be worth three times that of a the same as one Facebook user? It’s hard to see how. Now, I understand that Facebook is paying a premium to buy the company outright, so these per-user numbers are skewed by that fact, but still, it’s the general trend of the numbers that seems unsettling.

Overall, the U.S. stock market has more than doubled from its 2009 low. The IPO market has been on fire lately and these Internet stock valuations certainly are pointing to the strong possibility that we have a mini bubble yet again. While I would never predict we will see a repeat of 1999, I do think market participants need to tread carefully with these new companies. The current environment might indicate that at least a certain part of the equity market is overheating.

Full Disclosure: No positions in any of the stocks mentioned, but positions may change at any time