Jeffrey Walkenhorst's  Instablog

In recent months, we've heard a refrain from some professional investors that it's "time to go to cash". The premise is that the Market has gone too far too fast amidst a still struggling economy and is now set for a major decline this week, or next week, or the week after (or maybe next month?).

One such prognosticator is Robert Prechter, who we mentioned back in August. He was back again in the media on 11/5/09 with a headline interview on Yahoo! Finance's TechTicker that "Stocks are 'Dangerous Place to Be'" - video link here. Mr. Prechter has more on his Web site about "How to Prepare Yourself for the 'Serious Event' Ahead". We understand that many traders follow Mr. Prechter's commentary closely, which could potentially lead to a self-fulfilling Market decline if sentiment becomes overwhelmingly bearish once again.

We don't disagree that the Market rally from the bottom has been incredible. Of course, the speed of the fear and liquidation driven decline last fall and into early 2009 was also incredible. We also don't disagree that economic fundamentals remain challenging with many things to worry about (unemployment, real estate, deficits, health care, energy, war - take your pick). Moreover, any sustainable, upward Market movement needs to be driven by improved underlying business fundamentals (i.e. growth). If the U.S. economy languishes and a Japan-style no-growth period ensues, stocks could also languish or decline as creative destruction continues to reshape industries. Finally, Mr. Prechter's "sell call" is likely on the money in one area: anything trading on thin air should be reduced or sold from portfolios, especially low quality businesses. Even more dangerous than an egregious valuations are weak balance sheets coupled with poor fundamentals = more reasons to sell.

However, as we've noted in our "How's the Economy Doing" series (update coming soon), we're cautious but don't think the sky is falling, particularly since we'll be bouncing up against easy Y/Y comparisons. Easy "comps" should lead to stability and even pockets of growth. Moreover, our buy/sell decisions for our businesses is based on our estimate of intrinsic value and not related to where the Market happens to be trading.

With respect to easy comps, the other week, many retailers released sales data for the month of October and, as reported and illustrated by the WSJ (link here), results were somewhat of a "mixed bag":

For the most part, discount/value oriented stores fared better than more discretionary retailers, although Nordstrom (JWN) delivered a 6.5% Y/Y increase in same store sales. Overall, sales were higher relative to October 2008 (when bank crisis shock and awe was gripping the world):

• Sales at stores open at least a year, or same-store sales—a benchmark of the industry's health—rose 1.8% from October 2008, according to an index of 30 retailers compiled by Thomson Reuters.
  
• Retail Metrics Inc., a retail research firm that uses a slightly different methodology, reported an increase of 2.2% for its index of 31 retailers.
  
• Neither index includes Wal-Mart (WMT), the world's largest retailer, which stopped reporting monthly sales earlier this year.

So, at least some persons are no longer hiding under a rock and returning to the mall and/or other local retailers. This, plus the fact that public and private equity, as well as debt deals are happening on Wall Street -- that is, companies are successfully raising capital -- are good signs. Further, our conversations with various C-level executives and other contacts indicate that many businesses are, in fact, stabilizing (although timing for a return to growth remains cloudy).

Accurately predicting short-term economic or Market performance is near impossible. Yet, our gut tells us that we simply won't return to the level of fear or economic paralysis that previously halted economic activity and led to the 2008-09 Market carnage (compounded by momentum shorting, in our view). Things remain difficult and the indices may well partially retrace upward moves, but indications are that we're in a different place today. From shock and awe, people move into realization, acceptance and new beginnings.

As before, we remain disciplined with respect to the types of businesses we own and their fair values. We're not going to cash.

Disclosure: none.

American Oriental Bioengineering's (AOB) 3Q09 results missed expectations and prior guidance as key risk factors came to bear. The company also announced a relatively small restatement to prior results following the engagement of Ernst & Young as its auditor (some minor housekeeping is okay, in our view). We noted in our post last week that short interest was elevated, but we hoped the shorts would be wrong this time.

We include more details on our blog, but a few key figures:

• 3Q09 revenue increased 11.7% Y/Y to $78.8 million, well below a Wall Street consensus expectation of $89 million and full-year revenue guidance for +30% Y/Y implying 2H09 revenue of $228 million (+95% H/H). Last year's 2H revenue was up 70% H/H and 2H is typically stronger with normal seasonality.
• Operating income was $15.0 million (19.0% operating margin) compared to $21.6 million in 3Q08 (30.6%).
• Adjusted for certain items, EPS was $0.13 per diluted share versus a consensus expectation for $0.17 and $0.21 in 3Q08.

Management attributed the top-line weakness to the following: "we are witnessing uncertainty around product pricing related to healthcare reform, and this has caused select disruption in purchasing patterns."  However, we wonder whether necessary price reductions (forced or otherwise) are also eroding revenue and margins. Further, we expected management to have a better handle on revenue performance, especially after reiterating guidance at the recent investor conference in mid-September.  The large revenue miss calls into question our (and management's) ability to understand and forecast the business. Granted, 2009 is a year in transition as China is pushing through sweeping regulatory changes.

A friend who is also long AOB aptly raised the paramount question: what is the true earnings power of the business? In this regard, perhaps we made a mistake as we prefer to own businesses with high visibility into operating results and primary drivers. We would like to believe that our initial parallel between buying AOB and Berkshire Hathaway's long-standing investment in Sanofi-Aventis (SNY) holds true: Sanofi-Aventis as a leading pharma company (1) with products that people need/want and (2) that throws off huge free cash flow, thereby allowing Berkshire to become comfortable with operating/regulatory risks. Yet, the jury is still out.  Results indicate that risk factors in a rapidly emerging market such as China are difficult to assess, particularly when regulatory changes are involved.

Alas, there is some good news: at 9/30/09, AOB had $115.9 million in cash and generated $44.3 million of operating cash flow during the first nine months of 2009 (per 10-Q, down 9% Y/Y). Capital expenditures YTD are small (AOB prepaid some funds in 2008 for certain expenditures this year). As a result, the company's net debt position declined $42.3 million during 9M09 to $13.6 million at 9/30/09 from $55.9 million at 12/31/09. So, the business continues to generate meaningful, consistent free cash flow.

Fortunately, negative Market sentiment toward AOB in recent weeks appears to have already priced in an earnings miss and the company's cash generation should provide a backstop. Shares are already inexpensive on a price to free cash flow basis (even with reduced FCF):

• Market Capitalization (MC): $320 million ($4.29 times diluted shares of 74.5 million, excluding out-of-the money convertible notes of $115 million convertible at $8.08 per share, or 14.2 million shares)
• Plus Net Debt as of 9/30/09: $14 million
• Equals Enterprise Value (EV): $334 million
• Reduced, conservative 2009E Free Cash Flow: $50 million (divided by MC = FCF yield of 16%, or only 6 times FCF)

We find some comfort in the low FCF multiple and expect cash to keep piling up on the balance sheet even if growth is lower than anticipated. On a relative basis, other Chinese pharmaceutical companies such as Simcere Pharmaceutical Group (SCR) trade at higher multiples but have lower growth and margins than AOB. We think management credibility remains the key issue. How will it manage the business and use excess cash to enhance shareholder value?

Disclosure: long AOB.

As we waited for Youbet's (UBET) 3Q09 conference call to begin yesterday, a surprise press release crossed the wire: Churchill Downs Incorporated to Acquire Youbet.com, Inc.

For all of the reasons detailed in our prior posts, we didn't expect to see a near-term sale to Churchill Downs (CHDN). That said, YB's results came up short versus our expectations with the economy and other risk factors somewhat derailing our thesis.

• Instead of Y/Y handle growth on the back of new content relationships, handle of $121.3 million was flat Y/Y. Moreover, margins came in lower than we anticipated on "an increase in player incentives and track fees". The latter is no surprise, but we suspect the former is creeping higher as YB's battles other ADW players to acquire/retain customers (*management cited success: 14% Y/Y increase in new customer acquisitions and a 6% Y/Y "in the average number of active weekly wagerers on the platform").

• G&A is running higher on "increased legal fees and other costs related to the investigation of various strategic and business development opportunities."

• Online (ADW) segment EBITDA was $2.4 million, down 40% Y/Y. For the total company, EBITDA from continuing operations was $2.9 million versus $5.5 million in 3Q08.

• Finally, although the company's net cash position increased to $8.4 million ($0.19 per share, +$5.7 million Y/Y) from $5.6 million at 6/30/09 and $2.7 million one year ago, free cash generation is running below our reduced expectations of $10-12 million this year. The company did not repurchase shares during the quarter as we'd hoped, presumably because of discussions related to today's news.

The results stand in contrast to a more aggressive Churchill Downs, which previously reported 3Q09 Y/Y revenue and EBITDA growth of 33% and 31%, respectively, for the company's online segment. In the report, Churchill cited a 43% Y/Y increase in handle wagered through TwinSpires.com "driven by access to new racing content that was not available in the third quarter of 2008, an increase in customers and higher average daily wagering". Based on the 43% increase, Youbet's 3Q handle, and assuming flat Y/Y ADW handle (versus overall industry decline 10%), we estimate Churchill's share increased to 21% from 14% in the year ago with Youbet holding steady at 31%.

Thus, YB's relatively new management team is seemingly waving the white flag of surrender to join forces with Churchill, which was late to the online game and only built a foothold by purchasing AmericaTab in mid 2007. At that time, Churchill paid $86 million (assuming $6 million earn-out was paid) for properties generating annual handle of $175 million (purchase multiple of 0.49 times) and revenue of $44 million (1.97 times).

The proposed Youbet acquisition carries the following terms:

• CDI would acquire all of the outstanding shares of Youbet in a transaction valued at approximately $126.8 million based on the Tues. Nov. 10, 2009, closing price of CDI common stock.
• Under the terms of the transaction, Youbet shareholders would receive a fixed ratio of 0.0598 shares of CDI common stock plus $0.97 in cash for each share of Youbet common stock they own.

At an implied $2.84 per share, the deal represents approximately 2/3 CHDN stock and 1/3 cash as of 11/10/09. Assuming no movement in Churchill's share price, the company is paying 0.26 times Youbet's 2009E handle of $480 million (our estimate) and 1.41 times 2009E revenue of $90 million (ADW only, our estimate). These multiples appear substantially below the levels paid for AmericaTab and include no value for YB's $0.19 of net cash per share, United Tote segment, or optionality for potential legalization of other forms of online gaming (where YB has been spending lobbying money). With regard to the last point, Youbet obviously has a highly desirable domain name that other gaming companies might covet.

Still, the stock component provides an equity kicker assuming we believe Churchill Downs is currently mispriced by the Market. Prior to the company's 3Q09 report, CHDN was trading in the high $30s and, over the past five years, generally traded between $40 and $50. Churchill Downs is a larger, more profitable business today than it was five years ago. Further, we're certain that management will explain on the conference call tomorrow how the acquisition of Youbet will make Churchill even more of a powerhouse by owning and operating even more irreplaceable assets. We don't disagree -- hard to deny the scale benefit of garnering 50% of the online wagering (combined) market. Of course, one natural question is what happens to existing wagering platforms and prior investment therein (goodbye = one problem with Internet companies is that prior investment often falls by wayside through M&A or obsolescence).


Here's the implied value to Youbet shareholders under different CHDN scenarios:

We're still digesting the news. Let's see how things develop.

Disclosure: long UBET.

We've been meaning to provide slightly more color on Youbet (UBET), which reports 3Q09 results tomorrow afternoon. So, here we go -- following up on our brief post regarding Breeders' Cup and Equibase data last week, and our online gaming update the other week.

We actually met briefly with Youbet management back on October 1st at the Thomas Weisel Consumer Conference in New York and watched CEO Goldberg's presentation - link to PDF here. The presentation and our conversation emphasized several key points:

1. Horse racing industry content disputes should be thing of past (we noted previously in initial post) and improved relations now sets stage for increased online penetration
2. Addressable market opportunity remains large, particularly relative to other online market segments where penetration is significantly higher
3. Youbet is working toward the launch of "casual" horse betting games in an effort to expand reach

Related slides from management presentation (click to enlarge) -- 2Q09 online (ADW) penetration jumped to 13% from 10% in 2008 (prior to content resolution):

Casual games will have a simple user interface:

Most points are not new information, but represent key parts of our thesis: that online wagering growth would return in 2009 on the back of new content relationships. Moreover, Youbet is well placed to capture more than its fair share of increased wagering while generating significant excess cash flow. We still think this is the case, but note that Y/Y handle (and revenue) comparisons among industry participants are not comparable as some players (e.g. Churchill Downs - CHDN) benefit from especially easy Y/Y comparisons. In addition, one caveat was/is potential margin pressure related to new content and customer retention/acquisition, which remain risk factors to monitor.

In tomorrow's report, we look for continued handle growth with somewhat better margins Q/Q (net yield at/north of 7.0% with an operating margin north of 10% for the ADW segment) and break-even results for the economically sensitive United Tote segment. For reference, we discussed 2Q09 results 2Q09 results here.

With regard to points 1 and 2 above, potential to capture increased market penetration represents a key opportunity for Youbet. While acknowledging that horse racing market dynamics are arguably different than other online segments, we see no reason not to expect incremental penetration over time. Importantly, as noted in prior posts, Youbet's established franchise should allow the company to at least maintain market share. We estimate that if ADW penetration increased to 20% from an estimated 13% in 2Q09, the earnings power of Youbet's online segment might increase by 50% holding margins steady (risk factor, although top-line yields could compress slightly while realizing bottom-line operating leverage).

Recall that in both 2Q09 and the seasonally weak 1Q09, Youbet's ADW segment delivered earnings of $0.06 each quarter (untaxed because of large NOLs, which should offset taxes over time despite some vagaries in California tax law). Annualizing this figure, we have current year earnings of $0.24 for the ADW segment and, at 20% penetration, we have $0.36 per share. We can't help but mention that shares of Youbet are trading at only 9 times the former figure, assigning no cash value to the tote segment and no value to potential growth (e.g. higher penetration, new product launches, international opportunities, or changes in U.S. online gaming laws).

Finally, we continue to view Youbet's online segment as a predictable cash generating business. Even the tote business would be fairly predictable under different operating conditions. Although our current estimate of Youbet's 2009 free cash flow is lower than at the outset of the year, we expect the company to generate at least $10 million of excess cash this year, followed by another $10 million next year, and so on. Put another way, the the company's net cash position of $5.6 million at 6/30/09 should be at least $15.6 million at 6/30/10 assuming no share repurchases. Cash should keep piling up on the balance sheet (even with no growth), which we like.

Per our September post, we hope the company was finally active in 3Q09 repurchasing shares on the cheap. Aside from reinvesting cash in the core business to enhance growth (captured in operating and capital expenditures), we believe share repurchase remains a top priority for excess cash and we certainly expect to see buyback activity over the coming year (if able to repurchase at accretive levels). Strategic acquisitions are another potential cash use, yet we don't necessarily expect to see deals as Youbet already has an excellent platform from which to expand organically. Thus, we're left with one other potential use: paying a dividend, similar to PetMed Express (PETS). We expect to see more cash rich Internet businesses initiate dividends over time and Youbet could seemingly join this club.

Separately, for those interested in recent, relevant industry news, please see our blog.

Disclosure: Long UBET, PETS.

A WSJ/Dow Jones article is reporting that a bill to lift online gambling is making progress in Congress and viewed as a means to help fill empty government coffers:

• Online gaming could "raise nearly $42 billion for the U.S. Treasury over the next decade, according to an analysis conducted by a non-partisan congressional scorekeeper."

Along with other gaming companies, Youbet.com (UBET, $2.08) supports the measure as a means to expand the company's Internet platform (and clearly valuable, apt domain name) into new areas beyond horse racing. While some investors are concerned about potential cannibalization for Youbet's core horse racing business, we see somewhat distinct market opportunities that should lead to a much larger addressable market for the company. Thus, any news on this front could prove a positive catalyst for the stock, although timing/ execution related to potential new business lines remain unknown and, therefore, not factored into our valuation.

We'll come back to Youbet. We want to touch on an AP article that summarized recent results/ commentary from Wynn (WYNN, $54.00), Boyd (BYD, $7.91), and Harrah's (private), highlighting negative industry trends. The key message was as follows:

• Gamblers are wagering less than a year ago, visiting casinos less often and holding back on extras when they do, continuing trends that left the industry struggling in the third quarter.

Other points:

• Industry leader Harrah's Entertainment Inc. lost $1.6 billion, including a $1.33 billion drop in the value of its assets. Harrah's said its revenue fell abroad and in each U.S. market where it operates. Overall revenue dropped 13.7 percent to $2.28 billion from $2.65 billion a year earlier.
• Boyd Gaming Corp. said its profit fell and will wait at least three years before finishing building its $4.8 billion Echelon casino, which looms empty over the Las Vegas Strip.
  
• At Wynn Resorts Ltd., where lower spending by leisure travelers and businesses pushed down profit for the second quarter in a row, billionaire CEO Steve Wynn said his company won't expand in the U.S. until the business environment improves. "The landscape in Las Vegas is troubling and it's rife with uncertainty," said Wynn, whose company is based across the Strip from the Echelon. "It's tough to understand what's going on; my 40 years in Las Vegas is not serving me very well at the moment."

Not surprisingly, the still negative operating fundamentals and commentary are pressuring shares just as the Market digests renewed economic fears and numerous pundits warn investors (or traders) to "go to cash" because the Market has gone too far too fast.

The sudden shift in gaming sector sentiment follows the impressive hope driven rally that was especially kind to cyclical, asset heavy companies over the past nine months (magnified by the bounce off of oversold lows). Giving some credit to the pundits, we agree that selective stock sales might make sense for holdings in this category. Below, we include a six month stock chart for the companies also including Las Vegas Sands (LVS, $13.17), MGM (MGM, $8.91), and Youbet.


Unfortunately, shares of Youbet (illustrated by gray colored line) are also being thrown out the window despite largely not participating in the recent hope rally and staying profitable. Moreover, Youbet operates an asset-light business model unlike the asset heavy hotel/casino companies have tremendous negative operating leverage in tough times given huge fixed cost structures.

Nonetheless, gambling on horse racing is also discretionary and the weak consumer is impacting the sector. Churchill Downs (CHDN, $34.60) reported an earnings miss today (Wednesday), with revenue of $101 million versus a consensus expectation of $104 million and a net loss versus an expectation of $0.25 (the loss was related to income tax provisions resulting from an IRS audit). Churchill's President and CEO Robert Evans stated:

• “Total pari-mutuel handle for the U.S. thoroughbred industry, according to figures published by Equibase, declined 10 percent during the third quarter compared to the same period in 2008. While we outperformed the industry, with our total pari-mutuel handle down only 3 percent during the third quarter, gains in our other business segments didn’t offset the decline in racing."

However, the company's online segment delivered Y/Y revenue and EBITDA growth of 33% and 31%, respectively (slight margin compression). As discussed previously, new industry content arrangements are improving 2009 results for advance deposit wagering (ADW) players such as Churchill and Youbet.

Within the next week, we may share a bit more on Youbet. For now, suffice to say that we believe our core thesis remains intact: the company owns an established, asset light business model with a leading online wagering franchise – brand, customers, platform, marketing partners, and track relationships – that is difficult to replicate. With an implied 2009E free cash flow yield of 12% (assuming FCF of $11 million), we believe shares are trading well below the value an informed private market buyer would pay for the entire company.

As an aside, we scratch our head over valuations realized by certain of the gaming companies (no doubt short covering / trading driven), including Wynn. We understand that some well-known value investors place great emphasis on the franchise, management, normalized earnings power, and growth potential in Macau. Still, even giving credit for "normalized" earnings of $2.00 (versus consensus 2010E EPS of $0.89) , shares are trading at 27 times a non-discounted $2.00 estimate. Even if the number is an even more generous $3.00, we're looking at 18 times.

Disclosure: long UBET.

A WSJ article regarding Netflix (NFLX, $55.10), "Netflix's Stock Buybacks: Money to Burn" by Martin Peers, caught our attention. Mr. Peers opens with, "In the corporate world, there are savers and then there are spenders. Apple, for instance, has hoarded $34 billion in cash and investments with no dividends or stock buybacks. At the other extreme is Netflix." He then goes on to correctly summarize the following:

• Netflix is spending cash more than it generates to repurchase shares at a very high multiple.
• Management thinks buying even at current levels are a good "value" (*per CEO Reed Hastings on call).
• Forward free cash flow growth is not a certainty in a competitive marketplace.
• As excess cash is depleted, Netflix plans to borrow money to fund more share repurchases.
• And, many companies made ill-timed repurchases in recent years.

Let's dig a bit deeper and look at the details. Some commentary from the conference call transcript (sourced via Seeking Alpha here):

• Since inception of our first buyback program in Q2 of 2007, we repurchased a total of 17.8 million shares for a net reduction in total outstanding shares including stock option grants of 18%. In total, we have spent approximately $545 million, which is more than we have in total assets at the end of the third quarter [= average price per share of $30.62].
  
• In Q3, we repurchased 3 million Netflix shares at a cost of $130 million [= average price per share of $43.33]. In the process, we completed the buyback authorized in December of 2008 and began repurchasing shares under the $300 million buyback authorization we announced in August.
  
• Under the $300 million authorization, we have repurchased a total of 2.7 million shares at a cost of $122 million, including 1.2 million shares purchased Q4 to date [= average price per share of $45.19].
• Last quarter, we announced plans to modestly leverage our balance sheet to fund future share repurchases and that remains our objective. We recently closed $100 million revolving credit agreement with Wells Fargo and BOA to begin the process of leveraging the balance sheet, and we will likely consider additional debt financing.

Here are the non-GAAP free cash flow figures reported by Netflix (essentially cash flow from operations less capex and necessary content purchases):

Based on weighted average fully diluted shares outstanding of 58 million during the September quarter, trailing twelve month free free cash flow as $2.03. Thus, during the quarter, Netflix repurchased shares at 4.7% FCF yield (21 times multiple). On an earnings basis, estimated 2009 EPS (midpoint) is $1.86, implying a repurchase yield of 4.3% and a multiple of 23 times. This is very different from Bidz (BIDZ, $3.00) or Youbet (UBET, $2.36) potentially repurchasing shares with FCF yields north of 10% (please see prior posts here and here, respectively).

As indicated in numerous prior posts (e.g. this Apple post), we view a powerful franchise trading at a FCF yield of 5% as fairly valued and prefer to purchase at yields north of 10%. Assuming Netflix is a powerful, durable franchise -- we know customers love the service and we like subscription business models -- Netflix was buying fairly valued equity in 3Q09 at $43 per share. If repurchases continue in the $50s, the company would arguably be buying overvalued shares.

Why would management do such a thing? Any yield higher than the 1-2% they can earn on cash balances should theoretically be accretive. Borrowing costs are also quite low -- per the new credit facility agreement, Netflix pays either a base rate plus a spread of 1.75% to 2.25% or an adjusted LIBOR rate plus a spread of 2.75% to 3.25%.

Clearly, the business continues to scale and deliver impressive growth. Management appears confident that growth can continue indefinitely. Still, at current levels, increasingly slim FCF yields leave little room for error (no margin of safety), especially in view of price volatility through the years:

Moreover, insiders and institutional holders are aggressively selling into strength:

We can't help but think Netflix might be better served by retaining a large net cash pile (unlevered balance sheet) for a better entry point. If such a point doesn't materialize in due course, then management could initiate a dividend to return capital to shareholders. Despite what corporate finance theory teaches about optimal equity/debt capital structures, we don't think a large, growing cash hoard is necessarily a bad thing.

Disclosure: long BIDZ, UBET.