Tag Archives: fundamental analysis

ZAGG: Anatomy of a Stock Market Triple-Team Takedown

7 Jul

While the past 6-12 months have seen a marked increase in the number of “short-seller” reports (or hit pieces, depending on your perspective), seldom have we encountered situations wherein more than one participant or observer highlights warning signs at the same time, or wherein the company releases potentially troubling news concurrent with these reports.

Today is one of these rare occasions where the short-sellers stars align.  The trifecta of pain, in no particular order:

1. (In)famous short-seller-cum-analysis-shop Citron Research released a report on ZAGG, Inc, a maker of cellphone protectors and other accessories raising a number of orange and red flags.  I strongly suggest you read it in its entirety before continuing.

2. Roddy Boyd – author of the authoritative book on the rise and fall of AIGreleased a report on his website highlighting not only the shady past of ZAGG‘s executives and directors, but the firm’s reliance upon one commoditized product to generate HUGE revenue gains and margins in an industry known for razor thin ones.  ZAGG’s balooning inventory balance should be of particular concern, increasing 5-fold year over year and almost 19% in the past three months, as Roddy explains:

It even continued to spike after a sharp revenue drop from the fourth quarter last year to this year’s first quarter, something that made no sense (then or now.) Some growth in inventory is naturally warranted as sales expand but this seems to defy logic. From an investors point of view, the “beauty” of this business is that it’s easy to rapidly produce a large volume of finished product, so maintaining large inventories of raw materials and work-in-progress is unnecessary. [Actually, large inventories are counterproductive for Zagg since the cellphone/mobile-device market is evolving so rapidly that models come and go, often in little more than a year, leaving older shield models virtually worthless. Moreover, polyurethane film is hardly a rare commodity, so storing a ton of it makes little sense.]

The firm also just acquired a maker of earbuds and other similar cell phone/mp3 player accessories, for a whopping $110 million, whopping considering prior to a recent run-up in the stock, ZAGG itself was not worth much more than that (and still isn’t by reasonable comparison).  This acquisition was in no small part financed by a $45 million term loan from notoriously investment firm Cerberus Capital Management and PNC (a $45mm revolving credit facility was also arranged concurrently).

While not unparalleled, firms that are growing revenues 200% and net income 300% per quarter generally don’t 1. (need to) make transformative/material acquisitions, and 2. need significant debt financing (cost of capital discussions aside for the time being).  This is unless, of course, they are hemorraging cash (usually from operations), as ZAGG appears to be doing, specifically in that inventory balance.  In fact a cursory look at their last 10-q indicates had the firm not monetized its receivables, it would have lost significantly more cash than it did.  

3. The company filed a statement of an offering of exempt securities (form D), stock issued to help finance the aforementioned acquisition.  Again, while not unheard of, this filing is sufficiently vague to raise an eyebrow, after all, they disclosed neither the amount of (proceeds from) securities sold nor the investors who bought them, only mentioning that there were 5 investors.  Perhaps there’s some fair explanation in other filings I missed in my cursory read, but considering the warnings raised by Citron Research and Roddy Boyd, I wouldn’t be so quick to just ignore it.

There are possible explanations for these flags, however I don’t think any prudent investor should give the firm (and its management) the benefit of the doubt, quite the contrary you should take a deeper look into the firm’s SEC filings and ask a few questions.

Why, for example, is a firm with such huge revenue and income growth also growing inventories so fast (+19% in q1), while fixed assets (Property, plant & equipment) bare budged (+3%)?  They say they outsource high-volume precision cutting and even some packaging of their products, which makes me wonder what exactly the firm does in its “manufacturing” facilities (which are leased), and what equipment (computer and otherwise) it really needs, short of a few dozen PCs and some relatively affordable warehouse equipment.  $500,000 in computer equipment & software and another $930,000 in “Equipment” at year-end seems a bit high for a firm that doesn’t actually do any real manufacturing or even assembly, no?  Did the firm buy five dozen licenses for every product made by Autodesk (CAD, etc software) instead of the 1 or 2 programs and 5-10 licenses – at most – it needs?  (Perhaps this is how they have – allegedly – products for >5,000 different mobile devices, an absolutely stupid number if true)  Maybe they told their IT guy to go wild and order servers & network equipment capable of supporting a firm 10x this size?

The firm also acquired PP&E of $175,000 in the first quarter of 2011, >30% annualized increase over their gross 2010 year-end balance.  The firm does not provide any further explanation as to what assets it actually acquired.

As Roddy mentioned, their raw materials (primarily polyurethane) aren’t exactly scarce last I checked, and their relationship with what appears to be their sole supplier (repeated use of supplier, singular, in their 10-k) is “on excellent terms,” neither of which necessitate the firm’s raw materials account increasing almost 25% in the first quarter. 


All things considered, I spent about 15 minutes perusing a few of the firm’s recent SEC filings and found more orange and red flags than I’ve seen from any firm I’ve looked at since China MediaExpress Holdings.

Curiously, the stock is up over 1% on the day after being down around 10% earlier.  I’m chalking this up to much of the daily volume being from technical/momentum traders, and not fundamental/value investors.  If I’m one of the institutional investors with millions of dollars in this stock though, you bet your ass I’m scouring over my previous work and seriously considering hedging my long exposure by buying some puts (if I haven’t already).  Maybe the company is legit, but there’s more than enough anomalies in the financial statements – combined with the Boyd and Citron reports – to warrant a much more skeptical look.

Caveat Emptor

Some Perspective on YOKU’s Warner Brothers Deal

28 Jun

While something akin to Netflix is still a relatively new concept in China, I think we’re in serious need of taking a step back from today’s ridiculous reaction (judging by the stock rising 35% today) to YOKU’s new deal with Warner Brothers.

China’s Youku Inc (YOKU.N) has agreed with Warner Bros Entertainment’s local joint venture to offer pay per view movies on its newly launched online paid content platform, Youku said on Tuesday.

Under a three-year agreement with Warner Bros, Youku will add 400 to 450 Warner Bros movies to its Youku Premium library.

“People are increasingly willing to pay for high-quality content, and we take the growth of Youku Premium as a sign that the market is improving for paid services,” Dele Liu, Youku’s chief financial officer, said in a statement.

Great, so YOKU is paying (paid) a lot of money for content it now has to try to sell into a market that may or may not exist.  Let me rephrase that: In order for this deal to be break even (let alone be profitable), YOKU has to convince users not accustomed to paying for “premium” content to…pay for it.  Has this strategy worked anywhere in the world?  I can’t think of any examples of any similar size/scale.

Youku Premium, officially launched on Tuesday, began beta testing in October 2010. Since then, the service has processed 200,000 paid transactions for its library of more than 300 movies and 3,880 educational programs.

According to YOKU’s annual report, they had roughly 280 million monthly visitors.  In 8 (or 9) months then, assuming this number hasn’t changed, they’ve had 2,240,000,000 visits. Two point two BILLION.  In that time, their “beta” test of Youku Premium resulted in 200 thousand transactions.  I’m not entirely sure of the scale of the beta test, but only 0.009% of site visits resulted in a transaction. That’s only 8 or 9 out of every 100,000.

While this number will surely increase significantly when Youku Premium is rolled out across the site, I’m FAR less optimistic than other participants.  I’ve been privy to semi-confirmed reports of illegally-hosted copyrighted content not just on YOKU’s competitors’ sites (of which there are many), but on YOKU’s platform, too.  Ultimately, there are two questions investors must ask themselves:

  • Why would Chinese users accustomed to getting content for free pay for it, when it can still be accessed for free with minimal effort/inconvenience?
  • YOKU hasn’t filed a 6-k yet, but from the myriad of news reports I’ve read, this is NOT an exclusive deal, i.e. the content will still be available elsewhere and Warner Brothers is still free to strike similar deals with YOKU’s competitors.  This isn’t even the first such deal Warner Brothers has struck!  Is Youku’s brand strong enough to keep users coming back?

The company is growing revenues at an incredible rate (so they claim), and the market is growing.  But in evaluating how much to pay for the stock, we have to consider more than just headlines.  Is a company worth 35% more because they signed a non-exclusive to sell content into a market not accustomed to paying for it?  I highly doubt it.

At Goldman Sachs, Chinese Tech Companies Apparently Have the Same Risk As U.S. Ones

24 Jun

I’ve been analyzing YouKu.com (YOKU) for the past three weeks, and as I said most recently, I can’t possibly see how the stock could be worth more than about $21/share, using what I think are pretty optimistic assumptions.  I read Goldman Sachs’ – YOKU’s lead cheerleader underwriter – report before I published, and I’m still going through it and finding data, figures, conclusions and other “analysis” I find very puzzling, to put it nicely.  I’d made a note to myself during my first read-through to go back and check GS’s WACC calculation, since their Cost of Capital was only 12%, which seemed pretty low to me considering we’re trying to value a high-growth, relatively high-risk company in China.

Today, I finally went back and checked GS’ work, and what I found is at the very least EXTREMELY confusing, and at worst, deeply, deeply troubling.

Here’s why:

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Project YOKU-zuna: Downgrading to Conviction Sell (Again)

20 Jun

Last week Goldman Sachs (Asia) LLC (YouKu.com’s lead cheerleader underwriter) upgraded YOKU to a buy with a $55 12-month target price.  I’ve read the report, and I think the GS analysts are even more bullish than some of the silliest blind China bulls I’ve encountered.  The report is also riddled with non sequitur, stating, for example, that smaller competitors must be profitable in order to continue operating and that firms are under U.S. sort of obligations to pay for content (like TV shows and movies).  Such naivete aside, I’ve re-worked much of my model and assumptions, in many cases giving the company significant benefit of the doubt, but I still can’t rationalize the current stock price (~$29).  My analysis suggests the stock is STILL significantly over-valued, even after declining ~45% since my initial report.

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Project YOKU-zuna: Failure to Execute

15 Jun

While his legacy is still being written, YouKu CEO Victor Koo has achieved success seen only by a very select group of revered business leaders, visionary CEOs with an ability to not just dream it, but do it.  His previous effort, Sohu, is one of the most successful internet firms in China, and if the past few years are any indication, he’s well on the road to a repeat performance with YOKU.

I’ve been analyzing this company (stock) for the past two weeks or so trying desperately to essentially over- value the firm.  When I started, the stock was trading around $43/share, and even with aggressive assumptions for revenue growth, margin expansion, and other measures of management effectiveness, I couldn’t figure out how the company could be worth more than mid $20’s/share (for whatever its worth, the stock closed yesterday at $29).  Investors should make no mistake: Just because a firm operates in a major growth sector in a major growth market, profits are far from guaranteed.  Running a several billion dollar company is NOT an easy task, and while some have been able to handle it (and then some), the path to sustainable success is littered with the carcases of corporate failure.  Many and myriad are the chances to slip-up, while those to achieve lasting prosperity are fewer and farther between.

That being the case (like it or not), this week I’m playing around with my original assumptions to see how the valuation changes if the company – led by Victor Koo – fails to attain the lofty goals I set with my assumptions.  I’ve made some relatively small changes/fixes/improvements to my model and its assumptions too nuanced and numerous to mention here (those with financial modeling experience should understand, model is now more consistent/accurate/flexible, formulas less clunky, etc), but the cumulative result is that the DCF value is now higher –  17% higher in fact or $27.77 – than the $23.76 from my initial effort.  Using this new, higher value and the assumptions driving it, let’s see what happens when we make some changes.

Here is the income statement along with growth rates and margins:

As you can see, that $27.77 valuation is predicated on some serious revenue growth – 58.1% CAGR – and gross margin expansion – 75.5% CAGR –  over the next decade.  It is these two assumptions that I want to address today, to see what happens if YOKU fails to grow as fast as projected.  We should be publishing more in-depth report on YOKU’s operating costs soon.

I use comps (SOHU, Tudou, etc) and industry reports (e.g. the iResearch data cited by both YOKU & Tudou) to help generate my assumptions for revenue growth and gross margin expansion/contraction, which is what I’ve done here (see my last post on revenue growth assumptions).  I then use a multi-step approach – to reflect the business (growth) cycle – et voila, an oversimplified explanation of where these numbers come from.  For YOKU’s top-line growth and gross margins, though, I focused primarily on the rates for the next year or two and assumed those rates degrade constantly over time, i.e. for 2011, I assumed a 110% growth rate, which decreases 10% each year, and cost of goods (services) of 75%, which similarly declines 10%/year.  While this is not very likely to reflect the firm’s actual performance over time, it makes it far easier to sensitize the valuation to changes in growth rates.

I think using 10% decay for both of these figures is fairly generous; I’d be surprised if YOKU management can get costs in line that well, even as the business scales and matures, considering significant wage growth and inflation in China.  If we adjust the decay rate for cogs to -7.5%/year from -10%/year, all else being equal, the valuation drops from $27.77 all the way down to $19.37!

If we assume cost of goods decreases 10%/year, but that revenue growth will come up a little short of my initial estimates, say this year will still be 110% growth, but that will decay by 12.5%/year thereafter, the value drops all the way down to $19.02!

If we assume that both revenue growth and gross margins will be strong this year, but will be increasingly less so going forward, lower than my initial assumptions (of -10% sequential decay), say -12.5% for revenue growth and -7.5% for cost of goods, the value goes all the way down to $13.14!

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Project YOKU-zuna: The Good, The Bad, and The Very Ugly

1 Jun

As many of you know, I’ve spent the past two weeks analyzing “the Netflix/YouTube of China,” Youku.com.  From the first second I looked at the Yahoo! Finance summary page for the stock, I was EXTREMELY skeptical that a firm hemorrhaging money had a ~$5bn valuation.  When I looked at the competitive landscape, I became even more skeptical.  Sure, the company has experienced massive triple-digit revenue growth in the past few years (assuming, of course, you trust the financial statements, which may or may not be made-up) and appears to be one of the top two firms in the Chinese internet video space, but with incumbent sites like BIDU, SINA, and SOHU developing and rolling-out their own web-based video services, I find it hard to believe growth is going to continue for much longer at anything even close to those lofty rates.

I’ve encountered a number of hurdles in attempting to value this company, for instance, the lack of any half-decent comps, public or private.  I checked out as-yet-to-go-public competitor TUDU, but for all I know and care, their financial statements are just as uncertain (read: made-up) as YOKU’s, so in establishing my assumptions for the model, I tended to rely more on larger, more established firms’ financial statements, even if their businesses don’t really line-up very well with YOKU’s.  Think BIDU, SOHU, etc.

Thus, I developed 5 separate cases for P&L (income statement) and capex growth rates (% sales, % cogs, etc) none of which are really THAT conservative.  All assume the company’s financial statements are not only free of material misstatement, but will continue to be so over the course of the forecast period.  Personally, considering the ridiculous amount of (apparently) fraudulent Chinese companies we’ve seen over the past 6-12 months, I find this assumption hard to make, but I’m giving the firm the benefit of the doubt, deserved or otherwise, for the purposes of this exercise.*  Here are my assumptions for the income statement and capex:

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Did Microsoft Overpay For Skype?

18 May

When the Valuation Doctor (literally!) says so, there is a very, very good chance the answer is “yes.”  If you don’t know who Aswath Damodaran is, you need to find out, NOW.  I would not bet against him with your account.

What is the value of Skype? The question is rendered more difficult to answer because Skype is a private business and we know little about the insides of the financial statements. It is widely reported, though, that Skype had operating losses of $7 million on revenues of $ 860 million in 2010. Taking those numbers as a base, I tried to value Skype, making what I thought were very optimistic assumptions:

– Continued revenue growth of 20% (which was what they had last year) for the next 5 years and a gradual tapering down of growth to 3% in ten years.
– A surge in pre-tax operating margins to 30% over the next ten years; this margin is at the very upper end of the technology spectrum (where companies like Google reside).
– A decline in the cost of capital from 12% now (reflecting the uncertainty associated with young, growth businesses) to a cost of capital of a mature company in ten years
With those assumptions, I estimated a value of $ 3.8 billion for Skype. It is entirely possible, however, that I am wrong on my key assumptions – revenue growth rates and target margins. In fact, changing those base inputs gives me the following table:

$3.8 billion.  Microsoft paid $8.5.  Or overpaid by 2.2x.

What we don’t know is whether any other buyers expressed interest in Skype, and if so, how much they were willing (and able) to pay, or if they even existed.  Remember, a little over a year and a half ago, Ebay sold Skype for $2.75 billion.  If we assume Microsoft paid a fair price for the acquisition, then we’re accepting that Skype has increased in value by over 200% in 18 months.  Seldom do firms grow so fast, in so little time.  If we use Damodaran’s valuation, the increase is about 38% or about 25% annualized, which sounds far more reasonable to me, even for a high-growth business.

Some have (attempted to) make the case that while the price Microsoft paid may be a little rich (to put it gently), once MSFT integrates Skype’s offerings with its existing products/services, the “synergies” and “strategic rationale” will be more than apparent.  Whether that happens is another conversation for another time, but given MSFT’s less-than-spotless history of squeezing value out of acquisitions, and to say I’m skeptical would be a bit of an understatement.  Remember Web-TV? What about Hotmail?  Anyway…

Damodaran, for his part, has this to say (generally speaking):

It has always been my contention with acquisitions that it is not the strategic fit or synergistic stories that make the difference between a good deal and a bad one, but whether you buy a company at the right price. Put in more direct terms, buying a company that is a poor strategic fit at a low price is vastly preferable to buying a company that fits like a glove at the wrong price.

Unfortunately – unless Skype’s private financials paint a different picture – it looks like MSFT may have screwed this acquisition up on both fronts…