Thursday, June 28, 2007

Oracle's blowout quarter

I've owned Oracle for just over five years, which probably means I'm biased toward favorable information about the company. Oracle had an almost perfect 4th quarter this year. I couldn't really find much to complain about, so I was interested to read about "Oracle's Mixed Message" in BusinessWeek. Here is the meat of the current bear case in the article:

Oracle's fourth-quarter sales of new business applications licenses, a predictor of future sales, rose just 5% in the region that includes the U.S., to $415 million. Excluding Oracle's $3.3 billion acquisition of Hyperion Solutions on Apr. 23, U.S. sales were essentially flat. "That's where people are a little concerned," says Peter Kuper, an analyst at Morgan Stanley (MS).

During the conference call, Ellison blamed slow U.S. applications sales growth on a tough comparison with the fourth quarter of 2006, when Oracle reported particularly strong results.

Oracle's overall new license sales for applications rose 13%, to $726 million. UBS (UBS) analyst Heather Bellini said in a research note that new applications license sales fell short of her expectation for 14% growth, and she wants to see more numbers from Oracle's recent acquisitions to figure out how quickly it's picking up share from SAP. Bellini expects SAP to post 10% new license growth for applications in its current quarter.

Oracle announced five acquisitions during the fourth quarter, including Hyperion Solutions, a maker of business-intelligence software, and Agile Software, which helps companies manage product portfolios (see, 3/2/07, "Oracle: Consolidation Catalyst?"). Oracle said Hyperion contributed $43 million in fourth-quarter sales, but there's concern on Wall Street that chief information officers signed discounted multiyear contracts with Hyperion before the acquisition closed, leaving Oracle with less green field now. "The big question around this acquisition will be, did Hyperion drain the pipeline?" says Brent Thill, director of software research at Citi (C), in an interview earlier in June.

Peter Kuper's concern (5% increase in new application license revenue in the Americas) is nitpicking at its finest. Year over year quarterly results are valid numbers to look at for most companies, but it doesn't work quite so well in a business that is driven by a relatively small number of deals. It isn't unusual for a sale to finish just before the beginning of the quarter or get delayed past the end of a quarter. The problem gets exaggerated by looking at fine slices. Here's what the line looks like for the last two years:

                 Fiscal 2006           Fiscal 2007
                 Q1  Q2  Q3  Q4  TOTAL Q1  Q2  Q3  Q4  TOTAL
US Applications 150% 41% 61% 73%  67%  69% 19% 69%  5%  26%
Clearly growth was incredibly lumpy. Somehow I don't think Mr. Kuper wasn't highlighting the 69% growth a quarter ago or the 73% growth a year ago. Looking across all geographies, as Heather Bellini did, smooths the data somewhat:
Applications     84% 24% 77% 83%  66%  80% 28% 57% 13%  32%

But there is a deeper problem since analysts are focusing on new licenses, which are increasingly less important to Oracle's profitability. Since 2002 or so, renewals have accounted for the majority of overall revenue:

                2007   2006   2005   2004   2003   2002
Renewal share  58.61% 57.50% 56.58% 56.12% 54.58% 50.19%
Renewal revenue carries a much higher operating margin, since you don't need to woo customers with expensive sales calls to convince them to continue paying for software they've already installed. Also, renewals are less likely to be discounted. Overall, it's just a lot cheaper for Oracle to retain a customer than to sign a new customer. The easiest way to measure renewal rate is to compare the current period's "Software license updates and product support" line to the previous period's total sales:
Renewal rate   72.17% 70.44% 66.05% 62.91% 55.71% 
Although this number might not strictly reflect the rate that customers are retained from one year to the next, it's likely to be a pretty good approximation. It shows that Oracle is getting better and better at holding onto the customers it has already won, which will improve profitability in the long run.

Now, I know why analysts focus on new licenses. The above quote makes clear that they are "a predictor of future sales". The last five years shows this to be at least somewhat true:

New licenses   19.92% 19.90% 15.53%  8.29% -6.92%
Revenue growth 25.15% 21.87% 16.18%  7.19% -2.05%
On the other hand, by focusing entirely on new licenses, Wall Street is missing the potential growth in revenues, which are growing beyond what would be expected by looking at licenses alone. The difference is customer retention.

Friday, June 22, 2007

My first five years

As of today, I've been actively trading in my IRA for five years. It has been one of the better periods of time to be invested in the US stock market. Five years is a pretty standard span to measure performance, but I'll feel better about my record after looking at it from trough-to-trough not just trough-to-peak.

Here is my year-by-year performance updated to the market close today:

Date      S&P 500  Delta     IRA   Delta BRK A  S&P 500   NAV    BRK A
06/23/02                                         992.72 10.00  72,200.00
12/31/02   -11.37% 42.32%  30.95% 30.18%  0.76%  879.82 13.09  72,750.00
12/31/03    26.38% -1.49%  24.89%  9.08% 15.81% 1111.92 16.35  84,250.00
12/31/04     8.99% -2.16%   6.84%  2.49%  4.34% 1211.92 17.47  87,910.00
12/31/05     3.00%  3.23%   6.23%  5.42%  0.81% 1248.29 18.56  88,620.00
12/31/06    13.62% 14.88%  28.50%  4.39% 24.11% 1418.30 23.85 109,990.00
06/22/07     5.94% -1.58%   4.36%  6.35% -1.99% 1502.56 24.89 107,800.00
Total Gain  51.36% 97.54% 148.90% 99.59% 49.31%    
Annualized   8.64% 11.36%  20.01% 11.66%  8.35%    

And here is the graphical version: IRA performance

The green line labeled "Inflation+10%" represents a benchmark suggested over at Controlled Greed. To measure inflation, I'm using the Bureau of Labor Statistics Series CUUR0000SA0. As you can see, that's a pretty tough benchmark to beat. I don't find it to be quite as helpful as the other two benchmarks I use. I'm beating it now, but what would I do if I weren't? With the index and Berkshire, I could decide after a few years of under performance to give up stock picking and just buy the benchmark. But I can't do that with inflation + 10%.


I took a quick look a the funds my 401(k) plan offers and the only ones that would have beaten my IRA's return over the last five years are First Eagle Overseas (20.91%) and Dodge & Cox International Stock (20.81%). I have positions in both funds, but I only started buying them recently. The performance difference is well within the margin of error, so there's no real incentive to switch even if I weren't having fun managing my own portfolio. Also, I have confidence in my own selections, but I don't have any particular insight into the stocks those funds are holding.

How I made a small profit on Kaiser Group Holdings

As it turns out, I did make a small profit on the busted Kaiser Group Holdings deal. This afternoon I sold my 19 shares for $28 a share and netted a $4.59 profit. After commissions, I would have lost $23.83 if I'd bought the S&P 500. (Not counting commissions, I would have broken even on the index, but that's not cricket.)

Besides luck, which is the overwhelming reason I made a profit, I credit this result to waiting for a good price before buying and not panicking before selling. If I'd sold immediately, I would have been out almost the cost of two commissions. On an annualized basis, my return was 6.69%, which is nothing to write home about, but better than if it had stayed in cash. Remember that these short-term deals are intended to beat the rate I earn in my sweep account.

More importantly, I've kept my streak of profitable closed positions alive. (That a joke, actually. I got lucky on a bad decision. Sometimes, it's best to sell a bad decision at a loss.)

Thursday, June 21, 2007

Eveillard's tax device

I just came across an interview with Jean-Marie Eveillard, who manages one of my 401(k) mutual funds—First Eagle Overseas. There is one little answer that immediately caused me to open the spreadsheets of each of my core holdings.

Fortune: You pay a lot of attention to companies' tax rates. Why? Particularly in the U.S., I don't like companies with very low tax rates, because it's a sign either that the Internal Revenue Service will catch up with them someday or that the profits they report are overstated. The average corporate tax rate is 35%. Any company that has a tax rate of 15% or 20% looks suspicious to me.

This suggests a simple device for estimating how much risk a company has because of trying to game the tax system. Companies with overly low tax rates are like ticking time-bombs. There aren't a lot of positive reasons for a company to pay low taxes. The device also warns of companies that exploit the US system that allows companies to use two sets of books. Oracle has the highest rating and it isn't exactly a blaring fire alarm.

Company        Tax     Device     
-------        ---     ------
Oracle         29.71%   5.29%
Canon          34.52%   0.48%
Select Comfort 37.78%  -2.78%
Berkshire      32.81%   2.19%
Sally          38.82%  -3.82% 
Marblehead     38.51%  -3.51%

Raytheon       31.79%   3.21%

Monday, June 18, 2007

Why I sold a call option on Select Comfort

I already mentioned my intension to sell a covered call option at $17.50 a share and today the order was filled at 45¢ a share. I sold July contracts and the underlying stock ended the day at $16.68. Over the next 31 days, there is a 42% or so chance the option will be exercised.

Odds of 4.9% or greated gain of SCSS over 31 days

The odds that I will break even are approximately 62%.

Odds of 7% or greater gain of SCSS over 31 days

It's important to note that I've only written an option for a portion of my holdings, which means I can still profit from price increases over the next month. I might sell another option at a higher strike or an option that expires later in the year. It's also possible that I will sell shares outright if their price jumps unexpectedly. On the other hand, I could have sold options more cheaply if I'd sold more contracts.

Is seems to me that Select Comfort is undervalued because of a convergence of events that management has some control over. At a recent Analyst Conference, CEO Bill McLaughlin pointed out that the current marketing campaign does a good job addressing the "need" portion of Select Comfort's message, but not the "solution" portion. He mentioned at least twice that consumers don't always know where to buy the Sleep Number bed, which I found a bit surprising. He also said that the housing downturn has had an effect on sales since Labor Day last year because people tend to buy beds when they move into a new house and because the "wealth effect" has been reduced. He also revealed that Select Comfort has seen significantly more cannibalization than expected when it expand from 100 Retail Partner Doors last year to 800 this year.

Fortunately, management has committed to fixing these problems and to borrowing cash to buyback shares. They have a significant amount of control over the marketing and distribution of their own product. Also, there was an announcement today of upgraded products, which gives me encouragement that R&D efforts are starting to pay off.

Why I bought Kaiser Group Holdings (and wish I hadn't)

On May 5th, I bought 19 shares of Kaiser Group Holdings because of this preliminary proxy. I paid $26.50 a share in hopes getting cashed out at $36 a share. As of this 8-K, I will be forced to sell for much less than that. Today's closing price was $26.85, so I don't foresee making a profit on this position. I broke my rule of waiting for a definitive proxy, so I only have myself to blame.

According to Eric J. Fox and Eric Schleien, Kaiser Group is trading below NCAV. I get a liquidation value of about $33 a share, much of it in cash. Unfortunately, it's hard to know what management intends to do with that cash. Going private seemed like a reasonable choice for all the usual reasons—especially since there's no real operating business here. Since the company was unable to get the deal done over the last few years, it's hard to believe shareholders will get relief anytime soon.

Friday, June 15, 2007

Select Comfort's problems deepen

According to their second quarter update, Select Comfort management is questioning the new marketing strategy. Rather than revive sales, as I anticipated, the company expects sales to decline 5% from a year ago. If that happens, Select Comfort will need to find ways to cut expenses to avoid reporting an EPS loss this quarter. For the year, management is projecting 87¢ to 93¢ a share compared to 85¢ in 2006. They have also lowered sales projections to be 4% to 7% growth over last year, which seems optimistic given the very slow start to the year.

On the flip side, the release also suggested management has found expenses to cut, plans to release upgraded products, and is committed to buying back significant numbers of shares. Also, the Motley Fool points out, it is encouraging that management is taking responsibility for the problem. I had missed this Financial Times article from a few days ago that suggested management is weighing acquisition of businesses that would expand Select Comfort internationally or into bedding accessories. My guess is that these plans are on hold for now, but those are obvious paths to growth in the future.

If Select Comfort doesn't cut Sales and Marketing costs, which would be difficult given their focus on fixing marketing, I'm guessing they will lose 15¢ this quarter and only earn 55¢ this year. I'd consider this to be a fairly conservative estimate. Management's low end 87¢ a share might be more realistic given their insight into the problems, but it's hard to give them much more benefit of the doubt. Given the various growth opportunities and that we are likely at a trough in sales, 15% growth over the next ten years is not unreasonable. Beyond that, I'll assume no more than 3% (or slightly more than inflation) growth in the terminal value. I always use a discount rate of 11%, which is the long-term average of the S&P 500.

Given those assumptions, my DCF model results in fair value between $15.67 and $24.58:

EPS                 0.87    0.55
Historical Growth   2.50% -34.65%
5-year Growth      17.73%   9.11%
Growth             15.00%  15.00%
1                  $1.00   $0.64
2                  $1.15   $0.73
3                  $1.32   $0.84
4                  $1.52   $0.97
5                  $1.75   $1.12
6                  $2.01   $1.28
7                  $2.31   $1.48
8                  $2.66   $1.70
9                  $3.06   $1.95
10                 $3.52   $2.24
Discount rate      11.00%  11.00%
NPV growth        $10.62   $6.77
Stable growth       3.00%   3.00%
NPV terminal      $13.96   $8.90
Total             $24.58  $15.67

Select Comfort traded up to $17.13 at the close, so the market is definitely leaning toward the lower estimate. (Not that I think any market participant uses anything like my estimates. More likely, investors are using management's EPS estimates and knocking the growth rate down a notch or two.) Back in December, I predicted this scenario as a possibility when I bought more shares at $18. Obviously, I'd prefer results were better—especially given the change in advertising. Due to this news, I'm going to try selling a covered call at $17.50, which would be a 4% loss on my recent purchase if exercised. I still like the long-term prospects of the company, but I like the prospects of First Marblehead even more.

Wednesday, June 06, 2007

First Marblehead raises dividend and buys shares

First Marblehead just announced a substantial increase in dividend to a yield of about 2.6%. In the same announcement, the company reported purchasing about 1.39% of its own shares. If I use a dividend discount model to value FMD, I get a ridiculously high figure—as in 3 to 4 times more than the market price. Earlier in the week, the company released results of the most recent securitization, which were quite encouraging given the current point in the financial aid cycle.

It's hard to stand pat without any cash to add to my current position. But I don't know what I'm willing to sell. I suppose this is a good problem to have.

Canon sells to a better class of customer

Every time I think about cutting back on my Canon position, I see an article like this one. Essentially, Canon has created a more efficient customer base than its competitors. It isn't completely clear how they were able to do this, but I have a few theories:

  • Canon does not have a personal computer business like HP does. Some of the printers bundled with PC systems will be heavily used, but consumers who purchase unbundled printers seem more likely to use them. Brother, Lexmark, and Epson printers also tend to get bundled with PCs.
  • Canon does bundle photo printers with digital cameras. Consumers may not be any more likely to be heavy users of these printers, but if they do, they will likely be using more costly color ink and photo paper.
  • Canon has a long history of supplying HP with the print engine for the LaserJet series of printers. This arrangement would artificially increase HP's market share number and decrease Canon's, and therefor alter each measure of efficiency. On the other hand, if Canon sells to HP with a greater profit margin than HP sells to the consumer, which seems likely, the aberration isn't that big a deal.
  • In the past, color printers used one cartridge to hold all three ink shades, so when you ran out of cyan (probably because you printed too many Word documents with random phrases underlined as if they were email addresses or web links), you had to throw out half a tank of yellow and red. Canon was fairly early in switching to separate cartridges for each color tank, which intuitively would make one think they sell less ink. But I suspect the opposite occurred. Rather than feeling ripped off by a printer company, Canon users felt free to print Word documents with lots of cyan because they knew they wouldn't be wasting a bunch of red and yellow ink.
  • I don't have any hard and fast evidence, but I feel like Canon printers are easier to use—especially if you want to print directly from a camera or memory card. It would be easy to assume that usability is most important as an initial selling point, and that customers are locked in, but that ignores how easy it is to get a new printer at a low cost.
  • Brand loyalty thanks to years of producing professional and "prosumer" cameras might encourage consumers to buy genuine Canon consumables rather than generics. I know for my family, we gladly pay more for Canon supplies on the assumption that they will produce better results.