Divested Rosetta Stone

My quarterly report will come out sometime after the end of March, but I have divested myself out of my position in Rosetta Stone (NYSE: RST). My average in was around 8.50, while my average out was around 13.40. I had written about them in the past on this site, albeit not in any comprehensive detail. I’ll give a little bit of my research here.

The reason for this sale is because although at current valuations the company appears to be cheap (2012 revenues at $273 million, cash at $148 million, no real debt, decent free-cash flow, diluted market cap of $316 million), and operationally they seem to be successfully executing their original plan which was to reduce the sales and marketing “bite” per dollar of revenue, my perception is that their revenue generation ability in absolute dollars-and-cents has flat-lined and that their initial attempts to get costs down are successful, they will be running up against incrementally more difficult decisions with respect to getting the expense side of their ledger under control.

For example, examine this chart (S&M = Sales and Marketing, R&D = Research and Development, G&A = General and Administrative):

  Total Revs Bookings S&M S&M / Revs R&D G&A
31-Mar-09  $ 50,284  $        –  $   23,612 47.0%  $     4,843  $      9,887
30-Jun-09  $ 56,460  $        –  $   27,147 48.1%  $   10,101  $     23,167
30-Sep-09  $ 67,216  $        –  $   32,263 48.0%  $     6,125  $     11,914
31-Dec-09  $ 78,311  $        –  $   31,876 40.7%  $     5,170  $     12,207
 2009:  $252,271  $ 114,898 45.5%  $   26,239  $     57,175
31-Mar-10  $ 63,014  $ 60,768  $   28,361 45.0%  $     5,470  $     13,643
30-Jun-10  $ 60,648  $ 64,033  $   29,441 48.5%  $     6,100  $     12,416
30-Sep-10  $ 60,926  $ 73,305  $   34,093 56.0%  $     6,030  $     12,048
31-Dec-10  $ 74,280  $ 81,814  $   38,984 52.5%  $     5,837  $     14,548
 2010:  $258,868  $279,920  $ 130,879 50.6%  $   23,437  $     52,655
31-Mar-11  $ 56,978  $ 55,580  $   37,820 66.4%  $     6,484  $     14,808
30-Jun-11  $ 66,743  $ 66,711  $   40,535 60.7%  $     6,354  $     13,809
30-Sep-11  $ 64,202  $ 66,062  $   39,821 62.0%  $     4,991  $     14,115
31-Dec-11  $ 80,526  $ 84,834  $   43,316 53.8%  $     6,389  $     19,300
 2011:  $268,449  $273,187  $ 161,492 60.2%  $   24,218  $     62,032
31-Mar-12  $ 69,449  $ 65,267  $   38,404 55.3%  $     6,273  $     13,657
30-Jun-12  $ 60,812  $ 63,043  $   35,125 57.8%  $     6,493  $     12,919
30-Sep-12  $ 64,279  $ 72,125  $   37,113 57.7%  $     5,177  $     14,474
31-Dec-12  $ 78,701  $ 84,327  $   41,005 52.1%  $     5,510  $     14,211
 2012:  $273,241  $284,762  $ 151,647 55.5%  $   23,453  $     55,261

Management has expressed its intentions of having revenues grow to about $400 million in the year 2015 and “low double digit EBITDA margin”. If they can actually achieve this (which would represent about 14% revenue growth compounded over the three years) then yes, they are grossly undervalued.

I just don’t think they will realize this. In particular, they have already trimmed a good portion of the “empty calorie revenues”, as they like to call it, and indeed they have: in 2011 they spent 60.2% of revenues in sales and marketing, while in 2012 they spent 55.5%, so they have made fairly good progress in this. They should be able to get this down to somewhere close to 50% before they run into real difficulty. In their seasonally-low (with respect to their sales and marketing to revenue ratio) 4th quarter, this went to 52.1%.

Assuming no revenue growth and roughly equivalent profitability, if they did manage to find another 5% in cost savings, leaves the company with an extra $13.66 million pre-tax and applying a 30% tax rate, a $9.56 million post-tax increase to the bottom line in relation to their 2012 results. Pro-forma, applied to their 2012 results (which you have to adjust to account for their tax accounting decisions) would leave a $7.8 million pre-tax profit, or about $5.5 million after-tax, or about 25 cents per share.

Management has done a good job to this point getting the company in a position where they can actually make profits again. I just don’t think they will be able to get to the point where they can generate huge profits because they are locked into a very discretionary part of the software market and other factors.

Another positive is because they are shifting from traditional to subscription-based software, they have the benefit of racking up plenty of deferred revenues on the balance sheet, which translates into cash on the asset side (and the deferred revenues get converted into revenues as subscriptions continue). In this respect, they have done a masterful job of piling on cash from 2011 to 2012, with about $32 million extra packed onto the balance sheet.

Management does scare me when it openly talks about wanting to make strategic acquisitions and anybody in the software industry will tell you that integration of software is a pain in the rear end operationally. It takes a lot longer than top level executives usually appreciate.

This is a type of company that really should be private, but because they have already gone through the private-then-public route, I doubt there is much appetite within their insiders to go through the whole transformation again. Any strategic acquirer would be a consumer-oriented software provider.

Management has performed well under the circumstances. Valuations (especially the $168 million enterprise value) still look relatively cheap. I have just unsubscribed from my original investment reason that the company will be able to generate excessive profits through further cost cutting. It looks like the market has already priced most of this in with the 2014 analyst estimates of 28 cents per share.

I could be wrong with my rather flat revenue projections for RST, but whoever bought the shares from me will be their risk and reward if they believe in the growth story.

Cyprus and another wall of worry

Remember the phrase “fiscal cliff”? Whatever happened to that?

My answer to anybody that asks is that we already fell off of it, so there’s no more cliff anymore.

The financial press is always trying to find the next crisis and today’s is the calamity hitting the EU regarding Cyprus’ confiscation of people’s savings accounts.

I wonder if you had an active line of credit whether they’d pare that back, but I digress.

The point of this post is that there will always be some new crisis in the news and the question of the investor is whether these are relevant to decision-making with more localized securities.

While I believe the fiscal situation of the US government is quite frightening in the medium and long-term, in the short term, if it is out of sight, it is out of mind. Until it comes back in sight again – that time is impossible to tell.

In the meantime, we continue to get this:

spx

A quick read of George Soros’ theory of reflexivity applies in this case – the broad market will keep going up until it stops going up. I know this sounds like very lame analysis, but sadly in the market context, it is the only real explanation of what is going on (in addition to all of the financial asset inflation being promoted by most of the world’s central banks).

There is very little to mention in terms of trading on my side other than that due to the release of a quarterly report, I have started to pare one of my positions. The quarterly report itself was roughly in expectations, but my fair value adjustment has been downgraded to what the market value is currently. If the share price goes higher my position will be exited and I will subsequently report this. I am not looking to redeploy the proceeds because of the existing margin position.

Ideally, market valuations will rise to the point where the decision to deleverage will be somewhat easier to make. My present degree of uncomfort is actually quite good in this respect – usually the markets work such that easy decisions are punished.

Canadian Interest Rate Expectations

Today, the Bank of Canada announced it was keeping the target short-term interest rate steady at 1%. This was not a surprising announcement. The big concern on the minds of the bank is the escalation of household credit. It will blow up eventually (especially whenever interest rates rise again) but in the meantime, conditions continue to be very ripe for future borrowing.

I guess the financial tip of the day is to make sure to start deleveraging before everybody else does!

Month / Strike Bid price Ask price Settl. price Net change Open int. Vol.
Open interest: 651,369 Volume: 128,687
March 2013 98.715 98.720 98.720 0 87,081 3,000
April 2013 0 0 98.705 0 0 0
May 2013 0 0 98.720 0 0 0
June 2013 98.750 98.760 98.760 0 117,907 18,450
September 2013 98.800 98.810 98.800 0.010 140,414 30,685
December 2013 98.810 98.820 98.810 0.010 126,676 26,022
March 2014 98.790 98.800 98.790 0.030 85,272 21,108
June 2014 98.750 98.760 98.750 0.010 53,319 16,547
September 2014 98.690 98.700 98.690 0.030 17,236 8,173
December 2014 98.610 98.620 98.610 0.010 13,242 2,706
March 2015 98.520 98.540 98.530 0 5,555 1,051
June 2015 98.430 98.450 98.440 0.030 1,559 566
September 2015 98.340 98.350 98.350 0 1,723 149
December 2015 98.250 98.280 98.270 0 1,385 230

BAX Futures state that rates are not going to rise again for the remainder of 2013, and there is the expectation of a chance (but not certainty by any means) of a quarter-point hike around March 2015.

Canada Airlines – Westjet, Air Canada, Transat

The words from Warren Buffett resonate within my mind when I recall him saying that the cumulative retained earnings out of the airline sector is negative.

This brings us to Westjet’s (WJA.TO) and Air Canada’s (AC.B.TO)’s relative good performance over the past year – shareholders are up 150% and life is good:

wja

acb

I won’t examine Air Canada because there are a whole bunch of other messy variables to take into consideration (pension liabilities, special government regulatory business, the fact that it is Air Canada, etc.) but we will take a very superficial look at Westjet.

Looking at their year-end results, the corporation has an existing market capitalization of $3 billion, $1.46 billion in cash, $739 million in debt (thus enterprise value of about $2.3 billion) and delivering about $452 million in free cash flow to its investors – a multiple of about 5 times free cash flow. What is not to like about this?

The profits were generated through high seat loading factors (Westjet did 82.8% of seats filled in 2012) and fare rates being sufficiently high, in addition to fuel costs being moderate through the year.

In other words, everything is going quite well for Westjet and they had a banner year. It looks like this is continuing in 2013 – in February they announced a load factor of 86.1%.

An investor will ask – what is the upside from here? The only upside I see is through sheer trading momentum – this is why I would not want to short the stock at present. The higher the stock price goes, the more tempting the short case may seem under the inevitable basis that eventually competition will eventually catch up to the airline and there will once be some overcapacity in the industry. Until then, there is no reason for the stock to not go higher – they could reach $30 or even $40 a share and you could make a “numbers” case for the company’s valuation just based off of free cash flow. The lack of solvency risk (i.e. cash higher than debt at present) is also another bullish case.

Interestingly enough, Air Transat (TRZ.B.TO) has not exhibited the same trajectory, so some inferences can be made on the vacation destination market vs. regular North American travel.

Market musing while being inactive

I hate to sound like a broken record, but I’ve still been doing nothing other than research but nothing worth investing in at the moment except for one illiquid play mentioned in an earlier post.

Here is a series of miscellaneous observations:

* I note that Apple (AAPL) continues its slide down to the point where I am wondering if they are pricing that the company is not going to be able to keep its premium pricing strategy. On paper, they are still massively profitable, but if competition continues to chip away at their product line (mainly through Samsung on the phone front and a variety of other realistic competitors on the tablet front), they might run into revenue growth problems. The company in their last fiscal year (ended September 2012) made $156.5 billion in revenues and this year the analysts are projecting an average of $182.8, which is a $26.3 billion increase year-to-year. This is a huge amount of growth and the law of large numbers will likely be catching up to Apple in short order.

* CP Rail (CP.TO) is trading at absurdly high valuations at present. They performed a change in management and the market is giving the new CEO a lot of credit, but the railroad business is very mature and I don’t have a clue why they are giving the equity such a huge premium at the moment. I’d be a seller at this price range (the C$130 mark).

* Anybody remember the big scare about rare earths a couple years ago when China started restricting the supply and most of those stocks went crazy? The big play here, Molycorp (MCP) has continued to slide into the gutter now that the market reality of the perceived shortage has completely gone away. The substitution effect is very powerful and MCP shareholders are holding the bag.

* Likewise, most other fossil fuel commodity companies, including my favourite company that has been so overrated by many, Petrobakken (PBN), are continuing to suffer. It is similar to how most gold mining companies are not faring nearly as well as the underlying commodity – it costs an increasing amount of money to extract the resource, so even if the commodity price is increasing, if your costs are increasing, you are not going to make much money. Even Crescent Point Energy (CPG.TO) is starting to lose its lustre.

* The other commodity market that is continuing to get my curiousity up is currency trading – the US dollar has continued to outperform most of the other global currencies. The only way that I play this is that I try to hedge my portfolio by having some US-denominated securities rather than using leveraged speculation.

* The two Canadian Real Estate financing proxies, Home Capital (HCG.TO) and Equitable Group (ETC.TO) warrant a further look. HCG has faded somewhat off of its 52-week high, but Equitable is still there. If people are still hyper-bearish on the Canadian real estate market, these two companies should be the first on anybody’s short selling list. Non-performing loans are still around the 0.3% level and currently still do not show any real signs of distress in the market. I am still riding the wave on Genworth MI (MIC.TO) and believe there is still a reasonable percentage gain to be realized from current price levels. The loan companies, however, are hugely leveraged and I’m finding it difficult to see value there when book values are so significantly below market prices.

* Long term interest rates have also taken a nose dive – the Canadian 10-year bond was skirting at the 2% yield a month ago, but now they are back down to 1.8%. The world is awash with capital and there are few places to deploy it where you’ll generate yield at an acceptable risk level. Eventually the leverage party will end and the fallout is going to be very brutal. Whether this happens in 2013, 2014 or later, nobody knows. But there will be fallout, and figuring out how to brace yourself for the fallout will be a big financial challenge over the next decade.