Friday, March 11, 2011

Things that don't make sense

So, much talk of the market being overvalued has me wondering - might it not simply be a few insanely priced stocks?

How does a company with returns of 5% on Equity trade at 13x that equity?  I mean, seriously?  The P/E is a .com bubble era 268.  I hear the siren call of the investment banker saying - "it's not like one of those companies - it has earnings!"

I found it so odd, I had to dig - turns out, of course, that has been increasing revenue smartly, and generally, net income has also trended in the right direction.

But with such low ROE, I figured that revenue growth of that level still doesn't justify such a price.  After all, even AAPL, which has ROE of 35% and growth rates better than CRM, only trades at 6x equity.

So then I figured, well, let's look at operating margins.  Software companies often have high operating leverage, so maybe "investors" can expect that profits will grow much faster than revenues.

Sure enough, there is a positive story to tell - the core SaaS system, the subscription service, has gross margins of 87%.  Better yet, the share of revenue from this core system is increasing, so gross margins have increased by 4 percentage points over the past four years.  This margin expansion is likely to continue for a while longer, which means operating income should benefit from both a growing top line and a greater share of that top line filtering down to profits.

Let's assume that revenue doubles over three years and gross margin continues to expand by 1% per year.  All else equal, the company would earn $268m, good for $2.25 a share (at todays outstanding common).  At todays bargain price of $127, good for a P/E of only 56.

And against that are a few pieces of bad news.

First, the limits of margin expansion may be arriving.  For, in the year ended Jan 2011, in spite of rapid revenue growth, profits declined.  Gross margins may have improved, but SG&A is rising fast, driven by R&D and marketing costs that are higher, as a share of revenue.

Much of this higher cost seems related to higher costs of equity compensation, not higher advertising spend.  In fairness, some of it is related to headcount increases, which should increase capacities.

Given the fact that some of these additional costs are also related to an acquisition, perhaps there will be some improvement on the SG&A side.  If management were to squeeze another margin point out of SG&A, it would reduce our hypothetical P/E from 56 to 50.

Second piece of bad news - there is lots of phantom equity.  Management has issued convertible securities and warrants that provide for a combined increase in shares of 13.4m.  At current valuation, the stock trades well in excess of the conversion price (strike price) of the convertible notes and the warrants, respectively.  In other words, these will convert.

Likewise, there are over 10m options outstanding.  At current prices, all options are in the money.  Management can issue 7m more, though at this price, I wouldn't object...until management needs to have them reloaded in the future (it'll happen when the stock drops to 30, trust me).

Finally, there are 1.8m restricted stock units that have been granted, but have not yet vested.  These can also expect to be issued.

In short, there is phantom common equity in the amount of 25m additional shares on the balance sheet.  That would swell the shares outstanding from 130 to 155, that is, by about 20%.  Once this is factored in, even all of that margin improvement can't get the P/E to below 60 in three years of rapid growth.

In short, this valuation is not simply speculative, it is insane.

With ROE of 5%, we would expect a stock to trade at a DISCOUNT to book value of $9.5 per share.  That is, assuming normal revenue growth of 5-7%, we would expect the stock to trade at around $5.

Book value per share is likely to increase, however, because equity issued for warrants, conversions and options is priced higher than current book and because the company is profitable and retains all earnings.  Back of the envelope, from equity issuance alone, we would see BVpS increase to 18.30.  With all earnings retained, BVpS should increase to about 21.50.

The company should be earning about 10% on Equity at that point, good for trading at book value.  It will likely be growing pretty rapidly however, so let's be generous and assume it deserves 2x book.  That is a price of 42, good for a PE of about 20.  So, that's my price target.  Anyone have shares to lend me?

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