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

My Aversion to Semiconductor Stocks Explained

I recently took over an existing stock portfolio for a new client and proceeded to liquidate a small cap, Taiwanese semiconductor company in favor of other tech stocks I preferred. Since the sale the stock has risen about 10% and the client emailed me wondering why I sold and what my outlook on the little company was. My answer was not as company-specific as it could have been (I knew very little about it and instead preferred to avoid small, non-U.S. chip stocks in favor of other stocks I have spent hours researching), but I did admit that I have an aversion to semiconductor stocks in general (although exceptions sometimes do present themselves).

I find the semiconductor space quite difficult to analyze and even harder to make money in as a long term investor. The industry is very cyclical, certain chips are always being replaced by a next generation product (often from a competitor), and with such high fixed costs required to manufacture chips, profit margins often rise and fall like roller coasters, making for a very volatile stock price environment. Even when you can identify solid semiconductor companies with below-average competition, in growing markets, making money on their stocks can prove quite difficult.

For example, consider flash memory manufacturer SanDisk (SNDK), a current favorite of many hedge fund managers. SNDK is a good company and with demand for flash memory soaring in recent years due to increased penetration of consumer electronics products, sales have been going through the roof. Over the last five years, in fact, SanDisk has seen its annual revenue grow more than 70% from $3.2 billion to $5.6 billion. It would be logical to assume that SNDK stock has been a great investment over that period, but you might be surprised to learn that five years ago today the shares closed at $44.50 each. Yesterday’s closing price was $44.51 per share. I know this is only one example, but chip stocks can be tough nuts to crack from an investment standpoint.

In SanDisk’s case they actually have done a great job at maintaining their strong position in the flash memory market, as opposed to many chip companies who often find themselves supplying Apple with a chip for one iPod only to see them be cut out of the next generation product in favor of a competing chip. The problem that SanDisk faces, as do most in the sector, is falling prices. If you have bought your fair share of memory cards, you know that every year prices drop. You can either buy the same amount of memory a year later for much less money, or you can spend the same and get a much larger card. There is no pricing power in the industry, which is great for consumers but not good for investors.

The problem is that huge demand and the corresponding unit growth that comes with it can often largely be eaten away by price erosion. Consider a market where prices drop 30% year-over-year for the same chip (not uncommon if you ever shop for digital camera memory cards and similar products). In order to keep your revenue in dollar terms steady, you need to grow units 43% per year. If you want to grow revenue, say 15%, over the prior year, you need to ship 64% more units! SanDisk actually has been fortunate that demand for flash memory has been so strong, as other areas within the chip space have not been nearly as robust.

So while I agree with many smart money managers who have been accumulating the stock that SanDisk is a good company that is serving a growth market, and that its stock does appear to be cheap, I do not share the same optimism about its long term prospects as an investment. It is just really hard to sustain stock price appreciation in an industry with these types of market dynamics. While there are certainly plenty of success stories within the semiconductor stock universe, I suspect for every long term stock market winner there are five or ten big losers, and I personally do not care for those kinds of odds.

Full Disclosure: No position in SNDK but positions may change at any time

Apple Stock Hitting New Highs: Where To From Here?

It has been a little over a year since I wrote that Apple Stock Can Easily Reach $450 last January, which at the time was more than $100 above where the shares were trading. Thanks to an absolutely stunning fourth quarter earnings report, Apple pierced that level late last month and closed yesterday at a new high of $464 per share. So, where to from here?

The company continues to defy expectations on the profit front, and after crushing numbers for the holiday quarter, analysts now expect $42 of earnings per share in fiscal 2012, up from just a $35 consensus figure a few weeks ago. In addition, cash continues to build on the balance sheet, reaching $98 billion at year-end, up 50% from a year ago.

An interesting thing has happened with the stock, though. As management has continued to hoard cash unnecessarily, and the company reaches a size that many believe makes it prone to a stumble in the not-too-distant future (investors expect this $100 billion a year company to grow 45% this year), the P/E ratio of the stock has tumbled. In fact, Apple now trades at a discount to the S&P 500 index on a trailing earnings basis (13x vs 14x). Looking out at 2012 profit expectations, the gap widens further as Apple’s P/E drops to about 11x. And that does not even include the $100 per share of cash Apple is sitting on.

As far as the cash goes, Apple is essentially getting no credit for it in the public market. The stock trades for about 8.7 times 2012 earnings ex-cash, which tells me that if they did pay a huge one-time special dividend ($50 per share would be my recommendation, not that anyone has come asking), the stock would likely not drop as would be the case in most similar instances (doing so would mean the discount to the market would get even larger). This is one of the reasons I am not selling Apple shares yet.

In terms of earnings, it appears that the days of Apple commanding a premium in the market are behind us. Even with a ridiculously positive earnings surprise for the fourth quarter, Apple stock popped just 6%. That compares with an earnings beat of 35% and an upward revision for 2012 profits of some 20%. Given Apple’s size, extreme bullish sentiment, and awful capital allocation practices, investors are not going to give them a rich valuation, which limits upside to a certain degree by taking multiple expansion off the table.

Given these new parameters, how can we value the darn thing? First, I will assume they do not change their cash management strategy this year (a painful thought). Since I do not see the market giving Apple more than a market multiple, I would multiply $42 in earnings for fiscal 2012 by 13 (market P/E) and that gets us to $546 per share. There are plenty of Wall Street analysts with year-end price targets that have a six in front of them, but I just do not see that happening. So, my best case guess is 17-18% upside from here, and maybe a bit more if Tim Cook eases up the company’s death grip on their cash. As a result, I am not a seller yet, even though the stock reached my $450 target price from last year.

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

More on Netflix’s Valuation and How the CEO Doesn’t Own a Single Share

Netflix (NFLX) CEO Reed Hastings has certainly done a wonderful job running the company if you look at his entire body of work, despite recent slip-ups, but his handling of the stock leaves much to be desired. Buying back stock over $200 per share only to raise capital at 1/3 the price a few months later shows he is losing the pulse of his business, at least temporarily.

So exactly how much stock of his own company does Hastings own? Believe it or not, none. Hastings has been cashing out Netflix stock options to the tune of tens of millions of dollars, but he does not actually own a single share. This year alone he exercised options (strike price: $1.50) to the tune of over $1 million per week, or more than $43 million. He halted those sales in early October after the stock cratered. It should be troubling to investors that the company’s founder and CEO does not appear to have any real skin in the game here. He has just given himself millions of options at prices that essentially ensure he can continue to cash out at will as long as the stock stays above $1.50 per share, which is assured as long as the company remains in business.

All of that said, there does appear to be potential value here with the stock breaking $70 per share, providing Hastings can make the streaming business model work financially. Netflix’s enterprise value today (about $4 billion) is attractive if the company can continue to grow and make money at their $8 per month price point. Assume for a moment that Netflix can earn a net profit of $1 per subscriber per month and maintains its current base of 25 million customers. That comes out to a profit of $300 million per year. Netflix could fetch a $4 billion valuation with its existing customer base alone. Any further subscriber growth from here would be icing on the cake for investors.

I think that is the main reason why T Rowe Price, TCV, and others find the stock attractive at current prices. There are definitely sizable risks, mostly the question of whether they can continue to grow with intense competition, and even more importantly, if the company’s business model will allow it to reach something on the order of that $1 per month profit on a per-subscriber basis. Given all that we know today, Netflix is a high risk, high reward investment opportunity, but one that many people are betting on.

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

Netflix Makes New Moves to Try and Regain Momentum

Shares of Netflix (NFLX) are getting slammed today (down $4 to $70) after announcing $400 million of financing transactions last night, consisting of $200 million in new equity at $70 per share to T Rowe Price and $200 million in convertible zero-coupon bonds to venture capital firm Technology Crossover Ventures. This move comes on the heels of the company’s recent deal to be the exclusive home to new episodes of the comedy series Arrested Development, which was canceled after a three-year run on Fox despite a cult-like following and strong critical acclaim.

Netflix may be facing headwinds after customer backlash from their recent price increase, but CEO Reed Hastings is certainly not standing still. Getting the exclusive for Arrested Development is a smart move, as it will be harder and harder for Netflix to compete strongly without original, unique content. Amazon, which offers a similar streaming service through Amazon Prime, along with Apple, which will likely launch a TV product sometime in 2012, are serious competitors to the Netflix streaming business.

While Wall Street clearly does not like these equity and bond deals, I think it is really the best possible way for them to finance the costs of deals like Arrested Development. Selling zero-coupon bonds gives Netflix 0% financing and the bonds don’t convert until 2018, which is a long time for Netflix to build up their business.

I would also point out that TCV, the investor in this bond deal, is making an interesting bet here. By taking convertible bonds that pay no interest, they are making a large bet on the direction of Netflix stock, plain and simple. TCV’s break-even point on these bonds is $86 per share, 16% above the market price when the deal was announced and more than 20% above the current quote of around $70 per share. While investors are selling off the stock today, the fact that TCV is making a pure stock bet here could be viewed as quite bullish (as would the move by T Rowe to buy new stock at $70). If Netflix was really in dire need of this cash and few investors were willing to lend it to them, you can bet that TCV or any other possible financier would be demanding a bulky interest rate.

With Netflix stock down more than 75% from its high of $300+ earlier this year, this one is surely one to watch. Of course, it is very concerning that Netflix was buying back stock in the 200’s earlier this year and now finds itself needing money and selling new stock at $70 per share. Investors likely won’t tolerate this “buying high and selling low” set of actions again down the road. The future for Netflix really depends on whether they can continue to grow the streaming business and make money on it at $8 per month. If they can, there is plenty of upside here. If not, TCV and T Rowe are going to have some losses on their hands a year or two from now.

Full Disclosure: Long Apple and no positions in Amazon or Netflix at the time of writing, but positions may change at any time