ABTL – more detail

A number of you have asked me for more color on my thoughts on ABTL since my last short post about it.  I wrote a more detailed article on my thesis for seeking alpha.  you can view here: http://seekingalpha.com/article/1860311-autobytel-a-potential-triple-1x-sales-for-double-digit-profitable-growth-is-rare?

Please see the Disclaimer associated with this blog. The author and/or others he advises hold shares in ABTL at the time of publishing this article. The author may make trades in securities mentioned without notification. The information contained in this article is impersonal and not tailored to the investment needs of any specific person. You should consult with a professional where appropriate. The author shall not be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

The opinions expressed in this blog are for informational purposes only and should not be construed as investment advice. The blog is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy or investment product. The research for this blog is based on public information that the author considers reliable, but the author does not represent that the research or the blog is accurate or complete, and it should not be relied on as such. The views and opinions expressed herein are current as of the date of this article and are subject to change. Any projections, forecasts and estimates contained in this blog are necessarily speculative in nature and are based upon certain assumptions. In addition, matters they describe are subject to known (and unknown) risks, uncertainties and other unpredictable factors, many of which are beyond the author’s control.  No representations or warranties are made as to the accuracy of such forward-looking assumptions. It can be expected that some or all of such forward-looking assumptions will not materialize or will vary significantly from actual results.

ABTL: Underfollowed Growth at a Very Reasonable Price

Please see the Disclaimer associated with this blog. The author and/or others he advises hold shares in ABTL at the time of publishing this article. The author may make trades in securities mentioned without notification. The information contained in this article is impersonal and not tailored to the investment needs of any specific person. You should consult with a professional where appropriate. The author shall not be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

The opinions expressed in this blog are for informational purposes only and should not be construed as investment advice. The blog is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy or investment product. The research for this blog is based on public information that the author considers reliable, but the author does not represent that the research or the blog is accurate or complete, and it should not be relied on as such. The views and opinions expressed herein are current as of the date of this article and are subject to change. Any projections, forecasts and estimates contained in this blog are necessarily speculative in nature and are based upon certain assumptions. In addition, matters they describe are subject to known (and unknown) risks, uncertainties and other unpredictable factors, many of which are beyond the author’s control.  No representations or warranties are made as to the accuracy of such forward-looking assumptions. It can be expected that some or all of such forward-looking assumptions will not materialize or will vary significantly from actual results.

This is a short post but we wanted to let our readers know about a small cap stock that we have been involved with for sometime but are enthusiastic as ever about.  Autobytel, Inc. (“ABTL”) is a small cap internet company that does lead generation for auto dealers and auto original equipment manufacturers (“OEMs”). 80% of people that buy a car spend time researching on the internet and Autobytel.com is one of the leading sources of information for those looking to purchase a car. Because of ABTL’s superior methodology of understanding each consumer’s buying intent, ABTL’s leads are 3x more likely to result in a closed sale than the average internet generated lead (according to research by R. L. Polk & Co.).  Despite its superior close rates, ABTL has historically priced its leads at the same rate as the rest of the industry. This is changing. We have checked with auto dealers and OEMs who have confirmed that ABTL is successfully raising prices per lead by up to 20%. The auto industry is still at a very early stage of transitioning its marketing spend towards the internet and we believe that ABTL has a good chance to emerge as the leader in this fragmented industry. In many ways, ABTL reminds us of Priceline.com Inc. (“PCLN”) several years ago. PCLN took significant share of the hotel bookings market over the last several years. We believe it did this because its superior algorithms and content caused it to have higher conversion rates on the traffic that went to its site. Better conversion rates meant that PCLN was able to outbid other competitors to acquire traffic. For example, PCLN could afford to pay more to Google for travel related keywords and over time, as it gained more mindshare, consumers increasingly went straight to Priceline.com instead of entering the site through search. We believe that ABTL’s revenue growth will be well into the double digit range for many years. Moreover, operating leverage should be high as many of its costs are fixed. Based on our estimates, ABTL trades at about 10x 2015 free cash flow. It also trades at just less than 1x sales versus most other lead generation internet companies that trade for well over 4x sales.  We believe that its shareholder base, which is mainly comprised of small-cap value investors has the potential to transition to growth and even momentum type investors over time.  ABTL will report earnings after the market closes on November 7th.  While we have a positive bias towards the short term results, it is important to note that this is not a call on the quarter. We have held shares in ABTL for several months and plan to be long-term holders of the stock.  We have also sized the position so that we will have room to buy more on any short-term weakness.

ESI: Misunderstood with Short Term Catalysts

One of the analysts who works with me just wrote up our long thesis on ITT Educational Services Inc. (ESI) on Seeking Alpha: http://seekingalpha.com/article/1661092-long-itt-educational-services-misunderstood-with-short-term-catalyst.  Seeking Alpha “Pro” subscribers have access to the article today and it will be available to all tomorrow.

Please see the Disclaimer associated with this blog. The author and/or others he advises hold shares in ESI at the time of publishing this article. The author may make trades in securities mentioned without notification. The information contained in this article is impersonal and not tailored to the investment needs of any specific person. You should consult with a professional where appropriate. The author shall not be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

The opinions expressed in this blog are for informational purposes only and should not be construed as investment advice. The blog is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy or investment product. The research for this blog is based on public information that the author considers reliable, but the author does not represent that the research or the blog is accurate or complete, and it should not be relied on as such. The views and opinions expressed herein are current as of the date of this article and are subject to change. Any projections, forecasts and estimates contained in this blog are necessarily speculative in nature and are based upon certain assumptions. In addition, matters they describe are subject to known (and unknown) risks, uncertainties and other unpredictable factors, many of which are beyond the author’s control.  No representations or warranties are made as to the accuracy of such forward-looking assumptions. It can be expected that some or all of such forward-looking assumptions will not materialize or will vary significantly from actual results.

Air Lease Corporation (AL)

One of the analysts who works with me recently wrote up our long thesis on AL.  Please see: http://seekingalpha.com/article/1552702-air-lease-trading-at-10x-earnings-1x-book-growing-eps-30-with-superstar-management-and-110-upside

Please see the Disclaimer associated with this blog. The author and/or others he advises hold shares in AVG at the time of publishing this article. The author may make trades in securities mentioned without notification. The information contained in this article is impersonal and not tailored to the investment needs of any specific person. You should consult with a professional where appropriate. The author shall not be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

The opinions expressed in this blog are for informational purposes only and should not be construed as investment advice. The blog is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy or investment product. The research for this blog is based on public information that the author considers reliable, but the author does not represent that the research or the blog is accurate or complete, and it should not be relied on as such. The views and opinions expressed herein are current as of the date of this article and are subject to change. Any projections, forecasts and estimates contained in this blog are necessarily speculative in nature and are based upon certain assumptions. In addition, matters they describe are subject to known (and unknown) risks, uncertainties and other unpredictable factors, many of which are beyond the author’s control.  No representations or warranties are made as to the accuracy of such forward-looking assumptions. It can be expected that some or all of such forward-looking assumptions will not materialize or will vary significantly from actual results.

AVG: Stale Short Interest = Great Opportunity

Please see the Disclaimer associated with this blog. The author and/or others he advises hold shares in AVG at the time of publishing this article. The author may make trades in securities mentioned without notification. The information contained in this article is impersonal and not tailored to the investment needs of any specific person. You should consult with a professional where appropriate. The author shall not be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

The opinions expressed in this blog are for informational purposes only and should not be construed as investment advice. The blog is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy or investment product. The research for this blog is based on public information that the author considers reliable, but the author does not represent that the research or the blog is accurate or complete, and it should not be relied on as such. The views and opinions expressed herein are current as of the date of this article and are subject to change. Any projections, forecasts and estimates contained in this blog are necessarily speculative in nature and are based upon certain assumptions. In addition, matters they describe are subject to known (and unknown) risks, uncertainties and other unpredictable factors, many of which are beyond the author’s control.  No representations or warranties are made as to the accuracy of such forward-looking assumptions. It can be expected that some or all of such forward-looking assumptions will not materialize or will vary significantly from actual results.

For reasons I will explain below, I think there is a good short term long opportunity in this stock as its very high short interest is likely to come down meaningfully and relatively quickly.  Even if I put in very conservative assumptions into a DCF, I cannot generate a valuation that is not AT LEAST 100% upside from here (assumptions for DCF highlighted in the last paragraph below).

AVG Technologies (AVG) is a consumer and enterprise software company that operates using a “freemium” model.  In 2012, the company grew Adjusted EPS 37% on 18% sales growth.  Despite this growth and consistently beating expectations (the average EPS beat vs Street over the last 5 quarters has been close to 50%), the stock currently trades at less than 10x NTM Street Adjusted EPS.  Free cash flow per share has historically been higher than EPS primarily because of the company’s growing deferred revenue balance (subscribers generally pay ahead of revenue recognition).  As of the middle of June, the short interest as a % of the float stood at 33%.

The company’s main product offering is free antivirus for desktop computing.  AVG primarily monetizes its user base by upselling subscriptions to a portion of its users and through a product called “secure search.”  Users of the antivirus software can download a toolbar so that AVG becomes the default search provider.  As users click on advertisements, AVG gets a revenue share with the search engine company that is providing the search results.  The bear thesis largely revolves around this search business.  A good writeup that summarizes the bear thesis can be found here:

http://seekingalpha.com/article/1147451-avg-feb-1st-google-policy-updates-threaten-avg-s-growth-engine-signals-steep-downside

Immediately after this article came out, AVG’s short interest jumped from just 751k shares at the end of January to over 8.5m shares in mid-April.  The Company significantly beat Q1 expectations when it reported results on April 24th and as I will argue below, the short thesis seemed to have largely played out but the short interest remains very high at 7.9m shares.

In q4 2012, almost all of AVG’s search revenue came from its Google partnership.  In February, Google made a policy change so that all new downloaded toolbars needed to be “opted in.”  Bears were correct in concluding that this change would force AVG to move all new users to Yahoo, which still has an “opt-out” policy.  However, they were incorrect in the financial impact this would have.  Bears argued that since Yahoo monetizes search significantly (up to 50%) lower than Google, AVG’s search related revenue would have a sharp fall.  This argument made sense at the time, but the evidence does not support the bear case.  In Q1, the company reported that Yahoo represented 9% of search related revenue.  Moreover, AVG said that Revenue per Thousand Searches (RPM) stayed flattish sequentially and guided for this to be the case for Q2.  The bears are failing to recognize the fact that while Yahoo likely monetizes less, Yahoo’s new management views getting increased scale in search as strategic and is very likely giving up more in revenue share than Google was.  I estimate that AVG’s revenue per search is only about 15% less than what it was getting with Google.  If it is much lower than that, then RPM would not have stayed relatively flattish sequentially.  This estimate has also been confirmed by talking to other toolbar companies.  Moreover, if one looks back to the 1st half of 2010 when almost all of AVG’s search business was with Yahoo, the RPM was in the $16-17 range vs the $21 RPM it had with Google in q4 2012.  Based on conversations with several people in the industry, I think it is highly likely that AVG’s current RPM with Yahoo is much better than it was in the first half of 2010.  First, Yahoo has improved monetization since then.  Second, AVG has much more leverage since it has many more users. Third, Yahoo has new management who wants to take share from Google and who views increased scale in search as strategic.  While it is true that AVG would have been economically better off if Google did not do the policy change, it does not appear that the lower monetization with Yahoo is enough for the company to miss estimates and at sub 10x FCF, the company needs to miss estimates significantly for the shorts to make money.  When the company beat EPS expectations in q1 by over 50%, AVG left full year guidance largely unchanged.  This effectively brought down search revenue expectations for the rest of the year and was the impact of the Google policy change.  This should become even clearer when the company reports results for Q2 which will be the first full quarter following the Google policy change.  Perion Network (PERI) and InteractiveCorp (IACI) are impacted by the same Google policy change and both also still guided for growth.

While the new Google policy has already impacted Street numbers, there are several sources of large upside optionality that will also become clearer to bears as we progress through the year.

1)      AVG has 36m mobile users as of q1.  These mobile users grew 100% y/y (83% organically if you adjust for an acquisition).  The company is currently not monetizing these users and the Street does not seem to be incorporating any revenue from mobile even for next year.  AVG has said that it will start to monetize these users in q4.  AVG’s mobile products have gotten great reviews for products such as AVG Security (http://bit.ly/avsec) and AVG Battery Saver & TuneUp (http://bit.ly/avtuneup), both of which received 4.5 out of 5 stars on Google’s app store. In addition, given the privacy climate created by the government’s PRISM project, AVG’s Do Not Track (DNT) functionality has attracted a lot of users to their mobile offerings. I estimate that the company could have close to 95m mobile users by the end of the 2014.  In q1, 2013, the company generated $56.6m of subscription revenue from an average of 117m desktop users or close to $2 in annual subscription revenue per desktop user.  Even if the company can monetize mobile users at just 10% of the rate it does on desktop, this could imply at least 3% upside to Street revenue in 2014 and because the incremental margin on this revenue would be extremely high, it could imply well over 10% upside to Street 2014 EPS.

2)      AVG continues to do well with improving its monetization of desktop users.  The company’s desktop subscription revenue growth has accelerated over the last 5 quarters and was 54% of total revenue in q1 2013.  This happened despite the fact that desktop users declined sequentially over the last 2 quarters as Google’s toolbar policy change also impacted customer acquisition.  I expect that desktop user growth will go back to growing sequentially.  After all, AVG is offering a good free alternative to existing Antivirus products on the market and still has a relatively low share of the total PC installed base.  PC sales have been weak which is great for AVG as new PC’s are often loaded with trial antivirus from Symantec or McAfee.  An aging PC installed base is also good for AVG’s newer Tune-Up products, which appear to be doing well.  The company plans to break out Tune-Up users on its next conference call, which implies that it has become material.  In q1 2013, the average paying desktop subscriber paid the company at an annualized rate of $15.09, which was up from $12.43 in q1 2012.  Given that the company seems to be pushing its security suite, which is priced at $40, there seems to be a fair amount of room with this variable to continue to rise.

3)      The company recently made an accretive acquisition of LPI which will add $5m of revenue in the 2nd half of 2013.  This deal further diversifies the company away from search related revenue and also does not seem to be factored into Street estimates yet.

4)      Finally, since the company is domiciled in the Netherlands and has such a large and growing user base that can be cross-sold other products, it is possible that it could be an acquisition target for one of the many Technology and Internet companies that have a lot of overseas cash.

I am not arguing that many of AVG’s users likely unknowingly opt-in to AVG’s secure search products.  However, while the company may do some unpopular things with its search related business, the short thesis appears stale and the short interest has surprisingly stayed high despite obvious evidence that point to the fact that the overall revenues should continue to grow quite healthily.  This should become clearer after the q2 results and if shorts have not covered by q4, they will likely cover as we get closer to the big upside optionality of monetization of mobile users.  The CEO’s resignation is concerning but the company is likely past its hyper growth phase and it seems like he just wants to do something more entrepreneurial.  He has not sold any shares and has not even initiated a 10b5-1 plan.  Moreover, he will stay on at the company as an advisor.

In my DCF, I assume that 2014 search related revenue declines slightly as we cycle through the lower monetization from Yahoo vs Google (I model a 25% per quarter churn rate for Google toolbar users vs the 15% churn rate used by the bearish analyst in the article mentioned above).  However, search revenue should then go back to growing at least in the low single digits in 2015 and beyond.  The company has said that it plans to generate platform revenue in other ways than just search such as ecommerce and advertising.  I have not factored any of this.  I model desktop subscription revenue growth to decelerate from 21.5% y/y growth in q1 2013 to the low teens in 2015 and single digits thereafter.  If you play around with the key variables (% of active users that pay and revenue per paying subscriber), it is very difficult to even envision this level of deceleration given historical trends.  I expect that by 2018, they get to the same number of mobile users as desktop users today – again a very conservative assumption given the current growth rates of mobile users.  I also assume that by 2018, the company generates about 40c in subscription revenue per active mobile user (vs about $2 and rising in subscription revenue per active desktop user today).  I use a 30% operating margin in my terminal year vs the 37% operating margin that was reported in q1 2013 and 33% historical operating margin.  Finally, I use a 10% discount rate and a 10x terminal multiple.  I think a 10x terminal multiple is very conservative especially since I expect in just a few years, the vast majority of revenue will be coming from subscription revenue.  The company’s auto renewal rate on subscriptions was at 77% last quarter and has been consistently rising (it was just 44% in 2011).  With all these conservative assumptions, I still get AT LEAST 100% upside to the stock.

I welcome any comments from people who are short to understand what I may be missing.

ROVI: Compelling Reward to Risk

Please see the Disclaimer associated with this blog. The author owns shares of ROVI at the time of publishing this article. The author may make trades in securities mentioned without notification. The information contained in this article is impersonal and not tailored to the investment needs of any specific person. You should consult with a professional where appropriate. The author shall not be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

ROVI Corp. (ROVI) is a compelling long trading at about 11x forward EPS.  This valuation is very attractive relative to management’s guidance for 20% long term operating profit growth.  ROVI has dominant market positions and a relatively high mix of high margin, recurring revenue.  The company’s growth is tied to several secular trends including growing media consumption on mobile devices such as tablets, smart-phones and laptops and the growth of Over-The-Top (“OTT”) video services such as those offered by Netflix (NFLX), Amazon (AMZN) and Hulu.

Business Description

ROVI is a technology company focused on the discovery, delivery, display and monetization of digital entertainment.  It is best known for its discovery intellectual property which almost all North American pay TV service providers such as Comcast (CMCSA), DirecTV (DTV), EchoStar (DISH) and Time Warner Cable (TWC) license in order to offer their customers an interactive programming guide (“IPG”).  Licensing agreements vary but several sell-side analysts estimate that ROVI receives at least about 20c per month per subscriber for their IPG patents.  The company also sells advertising inventory within these guides and its “metadata” which allows its customers to include cover art and information such as a short blurb about what a specific show is about.  ROVI also does business with consumer electronics companies.  These customers also license ROVI’s IPGs as well as several other technologies such as DivX, a high quality video compression-decompression software library.

Investment Highlights:

  1. Increased number of use-cases will drive higher licensing revenue from new and existing customers.  ROVI licenses its technology by use-case.  Pay TV service providers have historically paid ROVI for the TV use-case.  Now that consumers have a desire to be able to watch TV from any device that has a screen, service providers are being forced to pay ROVI more for the “TV Everywhere” use-case.   The increased range of devices for video consumption has also increased the potential number of consumer electronics customers for ROVI.  For example, Apple (AAPL) signed a licensing deal in 2010.  Time Warner Cable has recently been advertising “In any room on any screen.”  In case you missed their Superbowl advertisement, you can see it here: http://www.youtube.com/watch?v=rLgzdnfQej4
  2. OTT is a great opportunity.  ROVI recently signed a licensing deal with Hulu.  While Hulu is a relatively small service provider with only about 3 million subscribers, the deal shows the strength of ROVI’s patents and increases the probability of a favorable outcome for  the company’s litigation with Netflix and Amazon.  ROVI also has developed new IPGs that incorporate OTT that it is up-selling to its existing customers.  It calls this “TotalGuide.”  For example, with TotalGuide, you can search for a specific show and get back not only when Comcast may be airing it, but also if it is currently available through your subscription with Hulu.
  3. Recent licensing agreements with LG and Hulu in Q1 de-risk 2013 estimates.  When it gave 2013 guidance, the company was not counting on any revenue from Hulu.  Management also guided for the LG licensing agreement to happen in the 2nd half.  Bears are quick to point out the fact that management reiterated 2013 guidance following the LG deal.  The company also reiterated the fact that 53% of the 2013 revenue will be recognized in the 2nd half.  While it is possible that there is some deal slippage, I hypothesize that management reiterated guidance in order to have maximum negotiating leverage with customers for upcoming contract renewals and new licensing agreements.  I find it very surprising that Street  revenue estimates for Q1 at $152 million have been left unchanged when the LG agreement will likely represent close to $20 million of sales (since it includes a catch-up payment from previous shipments).
  4. Comcast and EchoStar agreements not currently being captured in earnings.  Before it was acquired by ROVI, Gemstar signed a very large 12 year licensing agreement with Comcast and EchoStar for a total of $440 million.  Since Gemstar was desperate for the cash, this was paid up-front and was supposed to be recognized as revenue over 12 years.  However, when Gemstar was acquired, all this deferred revenue was written off.  Consequently, ROVI currently has very large contracts with 2 large customers that it is not recognizing in its income statement.  These deals are up for renewal in 2016 and should be renewed at much higher values because (i) ROVI will not be as financially desperate as Gemstar was in 2004 and will therefore likely not push for an upfront payments, (ii) the ARPU and number of digital subscribers at these customers is up significantly since 2004, and (iii) ROVI’s patent portfolio is stronger.  I estimate that EPS is currently effectively understated by anywhere from 30c to $1 and it is only a matter of time until the earnings from these two important contracts get reflected in ROVI’s price.
  5. New management and improved capital allocation.  At the end of 2011, the company replaced its CEO.  A new CFO came on board in Q2 2012.  Previous management significantly overpaid for an acquisition which was one of the main reasons the stock did so poorly in 2011 and 2012.  While the company is still looking for acquisitions, the company appears to be being much more selective and focused.  ROVI is actually in the process of divesting a small, money–losing business.  Management took advantage of the weakness in the stock last year to accelerate a buyback and reduced the share-count by 5%.  The CEO also bought stock in September of 2012.
  6. International service provider opportunity. The company has relatively lower penetration into the international service provider market.  As ROVI increasingly goes after monetizing its patents internationally, its penetration in these markets should increase.  Moreover, cross-border mergers can help ROVI’s business.  For example, Liberty Global’s (LBTYA) recent announced acquisition of Virgin Media (VMED) will likely bring in a new customer if Virgin opts-in to Liberty’s existing agreement with ROVI.
  7. Growth set to accelerate.  The company has a couple of declining legacy businesses that are offsetting growth in other areas.  The good news is that these legacy businesses are going to be very small this year just in time for revenue from new OTT customers and increased revenue from new products, increased international penetration and new use cases to accelerate growth.  Management is guiding for 2014 revenue growth of 7 to 12% with the Street at the low end of this range.

A dream but not unreasonable scenario is that the stock’s forward EPS multiple rises 50-100% to 15-20x and EPS also grows 60-100% over the next few years for a potential 100-300% return.  At the same time, risk appears relatively limited given (i) the company’s low multiple on EPS that is arguably not even including revenue from 2 of the company’s large customers and (ii) the fact that the LG and Hulu deals were signed earlier than expected.

Please see the Disclaimer associated with this blog.

Facebook – At a Positive Inflection Point

See my article exclusively written in November for SeekingAlpha on why I like Facebook as both a long term and short term investment. The popular short thesis on the stock is flawed. I am expecting relatively large upside to consensus expectations.

I also wrote a follow up article on Facebook in Dec in which I reiterate my view after carefully analyzing public statements made by management and board members.

Equinix: A Great GARP Stock With Short Term Catalysts

Please see the Disclaimer associated with this blog.  I own shares in Equinix and may trade in and out of it without posting new information.  You should consult with a professional where appropriate.

Those familiar with my work know that with growth stocks, my main concern is about momentum in fundamentals continuing.  Not only do I believe this to be the case with Equinix (EQIX), but I also think fundamentals and positive earnings surprises are now set up to potentially accelerate.

Equinix operates data centers.  The company divides up space in these datacenters into cabinets. Customers effectively pay monthly for space and power.  Customers also pay a monthly fee for each connection they make with other Equinix customers. The beauty of Equinix’s business model lies in the fact that it has the leading position in almost all of its markets.  When Equinix opens a new datacenter in a given market, it makes sure to tether that new building to all of its existing datacenters in that same market.  Because customers prefer to be located close to other customers, they usually are willing to pay a premium to be in an Equinix data center versus the space offered at competitors.  The significant bandwidth savings most customers get from being able to cheaply interconnect to other Equinix customers more than offsets the premium they pay.  Furthermore, once a customer goes through the trouble of placing its servers, storage and Telco equipment in an Equinix data center, the costs and potential disruption involved in switching to a different provider is very high.  All this gives Equinix a strong competitive advantage and pricing power that only grows as the company gains even more scale.

The Company has consistently beaten its guidance.  In early 2011, EQIX said that 2013 revenue would be greater than $2b when the Street was 9% below this figure.  Consensus for 2013 is now at $2.25b and (as I will argue below) is still too low.  EQIX is now guiding for 2015 revenue of at least $3billion.  Like in early 2011, the Street remains skeptical and is well below management’s long term guidance.  Equinix is planning to convert to a REIT in 2015.  REITs are typically valued using Adjusted Funds From Operations (AFFO), which is a proxy for operating cash flow less maintenance capital expenditures.  Other datacenter REITs like Digital Realty (DLR) currently trade at about 16x 2013 AFFO.  Wireless tower companies like American Tower (AMT) trade at over 20x AFFO.  I estimate that at $3b of sales, Equinix can generate AFFO of at least $21 per share in 2015.  At 15x, this would imply an end of 2014 target of at least $315 or over 64% upside from current levels.

The Company guided for Q3 revenue of $492-498m and the Street is currently modeling $494.5m.  This represents a sequential increase of $16.5m versus Q2 excluding the impact of acquisitions.  This compares to the $14m sequential increase in revenue from Q2 versus Q1.  The Street does not appear to be modeling much improvement in new revenue generation in Q3 versus Q2 despite several positive changes:

1)      Lower churn.  Last Q, customer churn was higher than normal at 3.2%. Most of the increase in churn was because of Equinix’s “optimization efforts.”  In hot markets, Equinix tries to proactively churn out older customers who may be less profitable.  It then quickly sells out the newly available space to higher paying customers.  Eqinix’s CFO stated on its last quarterly conference call that churn would “moderate down to between 2.4% and 2.8%” in the 2nd half of the year.  I estimate that a 0.6% lower churn rate implies at least $2m of incremental revenue in Q3 versus Q2.  Moreover, because some of the vacated space will likely be quickly filled as per the company’s plan, Q3 should have an additional $1m+ or so revenue from new bookings associated with that available inventory.  The Company has done these optimization efforts in the past, and each time the vacated space was sold very quickly to much more profitable customers.   On the Q2 conference call, President of North America Charles Meyers stated, “Typically, we are able to resell capacity quite quickly… these are into high-demand assets with high levels of fill in.”

2)      Significant Capacity Additions and Sales Force Productivity.  Equinix expanded its sales headcount by about 50% over the last 18 months. The Company said that bookings last Q were the 2nd highest in its history.  Q1 bookings were the highest.  Nevertheless, the sequential growth in recurring revenue was actually higher in past quarters.  I believe the reason for this discrepancy is because some of the bookings in Q1 and Q2 were for pre-sales of space in new datacenters.   On the EQIX’s investor relations page, the company offers a PDF that details its expansion plans. 7 new datacenters were scheduled to open in Q3 making the quarter one of the most important for capacity expansion in the Company’s history.  I don’t remember a time when this many new data centers opened in a single quarter.  To put this into even more context, the same sheet only shows that only 2 new data centers opened in the entire first half of 2012.  It takes time for new sales people to become productive and it appears that Equinix may have perfectly timed productivity increases from new sales people hired over the last 18 months with the significant new capacity.  Even modest assumptions of new sales associated with this new capacity should lead to upside.

3)      Currency.  When the Company gave guidance at the end of July, management said they expected currency to be a sequential drag of about $4m in Q3 after being a $3m sequential headwind in Q2.  At the time, the Euro was 1.21 to the Dollar.  It currently is over 1.30.  Other currencies have also appreciated.  I estimate that instead of being a $4m sequential headwind, currency will actually be a slight tailwind in Q3.  Therefore, all other things being equal, currency effects alone would imply over $4m revenue upside.

4)      Acquisitions.  In July, the company closed a couple of important strategic acquisitions in markets outside of North America.  Equinix’s CEO stated that Q3 would have about $13-15m of revenue associated from these acquisitions.  However, this figure does not take into account cross-sell opportunities.  Many of Equinix’s customers do business globally.  When the company made foreign acquisitions in the past, it was able to sell some North American capacity to newly acquired foreign customers.  It was also able to sell the newly acquired foreign capacity to existing Equinix customers.  “Revenue synergies” take some time to materialize, but it is another positive variable for Q3 that was not in Q2.

Given the factors above, I am fairly confident in Equinix delivering short term revenue upside.  And, given the very high operating leverage of this business, even small top line upside can yield very large upside in earnings.  Moreover, due to the high recurring nature of Equinix’s revenue, any upside in the short term would flow through to upside for future quarters.  Finally, improved sales force productivity and a higher pace of capacity additions will not be unique to Q3.  Q4 is expected to have 5 new data centers and Q1 is also expected to have 4 new centers.  This new capacity combined with synergies from recent acquisitions and lower churn will likely drive an acceleration of growth over the next few quarters.

A stock price is a function of earnings and the multiple applied to its earnings.  Earnings estimates are likely to be revised upwards and, in my experience, growth stocks that show accelerating fundamentals typically get rewarded with improved earnings multiples.

Risks to monitor are changes in the Company’s schedule for new datacenter openings, currency movements and competitive industry pricing.  There is also the risk that the IRS will deny Equinix’s application to become a REIT although I think the probability is low and the IRS is unlikely to even comment until the middle of 2013.

Corning: Short Term Catalysts / Long Term Value & Optionality

Please see the Disclaimer associated with this blog.  I own shares in GLW and may trade in and out of it without posting new information.  You should consult with a professional where appropriate.

Those who are familiar with my work know that I like it when investment ideas remind me of prior decisions that have worked out well.  Corning (GLW) reminds me of other cyclical stocks that have done well once earnings estimates first start to get revised upwards.  A year ago, the Street was expecting Corning to earn $2.00 per share in 2013.  Today, the consensus expectation for 2013 EPS is $1.43.  In early 2011, Corning was trading above $22.  It is now below $13 which puts it at 9x 2013 EPS and below book value.  The company recently increased its dividend (yield of close to 3%).

Corning is involved in several businesses, but most of its earnings currently come from LCD glass.  The LCD glass industry went into oversupply, because of two simultaneous events.  First, the weak economy caused demand to be weaker than expected for LCD TVs, computer monitors and laptops.  Second, the industry started a transition to using thinner glass, which effectively increased supply.  The industry is currently half-way through this transition.  The oversupply caused pricing pressure and market share loss for Corning and was the primary reason for the dramatic cut in earnings expectations for the company.

Corning responded by taking close to a quarter of its own capacity offline.  Since Corning has about half of the industry’s supply, this move resulted in a moderation of pricing pressure.  On the company’s Q2 earnings call, CFO Jim Flaws stated, “Our quarter two price declines for LCD glass were indeed much more moderate than the previous two quarters.”  During the question and answer session of the call, Flaws also stated, “I’m delighted by the Q3 pricing that we basically have reached agreement with almost all of our customers already.” With pricing more of a known variable, the company appears to be set to beat earnings expectations in the short term for several reasons:

1)      Demand has turned out to be better than expected.  Since Corning’s last earnings call, there have been many industry data-points that imply strengthening business conditions.  AU Optronics (AUO), one of Corning’s largest customers, reported September quarter revenue that was better than expected.  When AUO initially gave Q3 guidance at the end of July, it expected large panel shipments to be flat sequentially from Q2.  Actual shipments wound up being up close to 5% sequentially.  A couple of weeks ago, Nippon Electric Glass (NEG), the number 3 manufacturer of LCD glass, also revised upward its expectations for the September quarter.  Retail TV Demand from China during its Golden Week Holiday appears to have been better than expected.  This is important since Corning’s CFO specifically highlighted Chinese demand as the biggest risk-factor during the Q2 earnings call.  He stated, “I feel our biggest risk is our television forecast is China.”  Despite all these positive industry data points, consensus estimates for Corning’s Q3 have barely changed.

2)      Currency has gone in Corning’s favor.  Something many people usually miss is that the company prices much of its LCD glass in Japanese Yen.  The Yen has strengthened versus Q2.  The stronger Yen will not only help the company beat short term expectations, but it will also give even more confidence to bulls who are looking for continued moderation in pricing pressure.

3)      The company has become more aggressive with returning capital to shareholders.  It recently increased its dividend by 20%.  Corning also bought back close to 2% of its total shares outstanding in Q2.  This was at a faster pace than Q1.  The Street does not appear to be accurately modeling Corning’s share buyback going forward.  Most expect the company’s share count to increase going forward when it should be decreasing.

People who are bearish on Corning will point out how the stock has recently risen from slightly below $11 to about $13 per share in a couple of months.  They will affirm that recent data points are already “priced in.”  The problem with this point of view is that it is fails to take into account the larger context.  While the stock has done well recently, it has still underperformed massively over the last couple of years.  A large portion of industry supply has been taken off-line and the most painful part of the transition to thin glass is in the rear-view mirror.  At the current valuation, the stock is not priced like a company that is expected to beat earnings expectations.  The price-to-earnings multiple at 9x can only go up from here and it should go up given the improved certainty around industry pricing and the return to growth.  Q4 should be the first quarter in a long time when revenue and EPS inflect back to positive year-over-year growth.  This is usually a positive for the multiples of cyclical companies.

Longer term, there are several potential positive scenarios for the company.  I do not necessarily have a strong view about any of these, but at the current valuation, I think of the stock as a cheap call option (Actually, it’s better than a call option, because instead of paying premium, I get paid close to a 3% dividend to wait).  The positive scenarios:

1)      Large new business opportunities and diversification should help the stock’s price-to-earnings multiple.  Corning is an R&D company that has regularly reinvented itself over its long history.  During the dot-com bubble, it was primarily known as a supplier of fiber optics and it is currently viewed as a manufacturer of LCD glass.  The company’s labs are constantly churning out new technologies.  It is only a matter of time until one or more of these new products become another big business for the company.  Furthermore, because some of the technologies Corning is working on leverage its existing manufacturing facilities, there is the potential that its success leads to better industry supply conditions and pricing for LCD glass.  The company’s effort in glass for solar panels is one example.  Corning is working on lightweight glass that would protect solar panels but also would make them much more efficient at generating electricity.  Since the Street is not modeling anything from this new business, any success in this area would be a source of earnings upside.  Moreover, since solar glass would be made with LCD glass factories, success in solar glass could also lead to upside in pricing for LCD glass.  Even without a large new explosive business, corning’s earnings should become more diversified over time as other businesses are expected to grow faster than LCD.  In an upgrade note published in mid-September, Goldman Sachs noted that it expects Corning’s LCD business to account for 74% of earnings in 2013 down from 96% in 2009. The diversification should lead to less cyclicality and increased predictability over time.  This, in turn, should improve the stock’s multiple.

2)      Replacement demand and a housing recovery could drive an upturn in LCD TVs.  According to the company, the average LCD TV is replaced about every 6.5 years.  This replacement rate implies that a very small amount of current TV demand is for replacement.  However, that will change in a couple of years.  In 2008, there were about 118 million LCD TV units sold.  Replacement demand for these units could drive an upturn in overall TV demand in 2014.    Furthermore, while many expect housing to recover, current TV demand expectations assume little to no correlation to housing. Therefore, any positive correlation could lead to upside.  I hypothesize that the correlation is higher than people think.  I personally bought a new TV when I recently moved into a new apartment and I know several other people where this was also the case.  Since industry supply has been taken off-line, any significant upside surprise in demand could cause pricing to actually go up for a short-period of time.  This has happened in the past and there is no reason why it can’t happen one day again if demand improves.

3)      Windows 8 could drive an improvement in PC demand.  While most believe that the PC market is secularly challenged, there is an argument that PC demand is also cyclically depressed ahead of the launch of Windows 8.  Any significant cyclical improvement could lead to upside to industry demand projections.

Of course, there is also the risk that Christmas demand for TVs and PCs is very weak.  Retail demand will be the main variable to monitor.  The Japanese Yen is another variable to keep an eye on.  As of now, channel inventories appear to be in good shape and I feel relatively confident with the stock’s risk / reward.  A stock’s price is a function of earnings and the multiple applied to its earnings.  Both the earnings and the multiple are more likely to be revised upward than downward after Corning’s Q3 results are reported.  I am apparently not alone in thinking this.  A few corporate insiders have bought stock at around this same price over the last several months.

 

Why Stocks Tend To Decline Much Faster Than They Rise

The chart of Caterpillar (CAT) stock from 2002 to 2008 is an example of a cyclical stock that people became enthusiastic about and then subsequently sold in a panic.  Notice how the stock steadily rose from the end of 2002 to the beginning of 2008 and then gave up a substantial portion of those gains in less than a few months.  People generally feel twice as much sadness or pain when something is lost than when something of equal value is gained.  Humans have evolved to be this way, because when the world was more resource constrained, our ancestors’ survival depended much more on keeping what they had than getting something new.  The emotions that arise from loss are from parts of the brain that evolved much earlier than the parts responsible for rational thought.  This is the main reason why stocks go down faster than they go up.  People tend to get depressed and want to capitulate much faster than the time it takes for them to get euphoric.  Furthermore, as a stock rises, many people quickly sell to lock-in their gains.  The shareholder base gradually transitions from distressed and value investors, who contest momentum, to growth investors, who typically invest hoping to ride a trend.  When a stock goes down and its momentum shifts, the only people that would be interested are the distressed or value investors.  Since these types of investors tend to be less impulsive and generally more risk averse, they are usually slow to accumulate shares.  After all, they know that betting against a current trend often results in initial losses.   Distressed or value investors are in no rush to build fully-sized positions.

The above is an excerpt from my book: The Emotionally Intelligent Investor: How Self-Awareness, Empathy and Intuition Drive Performance