After recently receiving a recommendation from a friend to buy into memory chip maker Qimonda AG (QI), I began doing a survey of many of the companies in the industry. It seems like there are certain industries that I am able to gain a very good understanding of in a short time and other industries that I struggle to learn. Semiconductors fit into the latter category, but I do know how to analyze cost and business structures, so I examine Spansion (SPSN) mostly from that perspective and will possibly take a look at some of the other semiconductor stocks in upcoming blogs.
It doesn’t take a market guru to tell you that SPSN’s recent performance has been weak. They lost 85 cents per share in Q1 of 2008 and 63 cents per share in Q2, meaning that FY 2008 is shaping up to be even worse than already bad FY 2007 when they lost roughly $1.90/share for the year. Their margins are poor, but not completely terrible by industry standards; they had a 17.8% gross margin and a -12.6% operating margin (still better than some others I've seen). All the same, you can’t stay in business if you are losing money --- unless of course, you can outsurvive similarly situated competitors. Looking at SPSN’s situation, I’d surmise they would need to see prices rise to a level high enough so that they could achieve 30% operating margins before they could actually begin churning out any significant GAAP income. From their current revenue figures, I'd estimate that they would need to see around a 15% increase in prices to achieve that. Mind you, this would not necessarily put them in good shape; it should merely get them near a break-even point. That info alone suggests to me that this company might have some rough tredding ahead. [more]
Vocus (VOCS) is an on-demand software company providing public relations and government relations products. The company has been growing rapidly and is led by telegenic CEO Rick Rudman. Rudman has the charm and skill of a Bill Clinton or Ronald Reagan. Every single earnings announcement is filled with positive adjectives about the incredible revenue growth or Vocus's unlimited potential and people buy it without so much as batting an eyelash. It's difficult to criticize Rudman in his role as spokesperson for the corporation; he's done a masterful job at selling his company to just about everyone. Just because Vocus is well-run, however, does not mean it is a good buy.
In the latest press announcement, Steve Vintz mentions that things are going so well, that they needed to hire more sales staff to keep up. That sounds very positive, except while revenues have been increasing in absolute terms, the rate of revenue growth has not really increased; all the while, Vocus seemingly needs to hire more salespeople, more general staff, and do more R&D in order to maintain the same level of growth.
In spite of this, analysts have been giving glowing reviews to the company and commenting on its nearly unlimited growth potential. Every single quarter, the company beats "consensus estimates" and talks about their strong performance. One analyst mentions that Vocus is 'poised to perform well even in an economic slowdown, since it does not require up-front capital commitments and helps companies cut costs.' Yet, I'm not totally convinced of the later and the former hardly seems like a selling point so much as a basic recognition of the fact that Vocus has a highly variable cost structure. Of course, there's nothing wrong with having variable costs; there is less risk for a company in such a situation, but there's also less reward. While the bad times are not as bad, the good times are likewise not as good and the current market price seems to be indicative of a belief that the company will eventually earn enormous profits; yet in order to earn those enormous profits, how much would revenues have to increase? 100%? 200%? 400%? 1000%?
Unfortunately, finding the answer to this question is a rather difficult exercise. If Vocus's revenues increase 500%, how will that affect their other costs? The only thing that seems relatively constant is that VOCS's "cost of revenues" line item stays around the 19% range. The rest of their costs are rapidly increasing as a percentage of revenue (and in general).
Due to the uncertainties inherent in the situation, I've analyzed it a number of different ways and have established a goal of obtaining a (forward) P/E ratio of 35:
Scenario 1: Costs as a % of Revenue Stay the Same
If we assume that VOCS is able to get its costs in a steady state, with 19% costs of revenues, 45.8% sales and marketing expense (as a % of revenues), 6.8% R&D (ditto), and 26% G&A (ditto again); then assume amortization for tangible assets is at $100,000 (lower than their average) and $700,000 for intangible assets (slightly lower their current figures), and then increase "other income" to $1 Million (about 70% higher than they made in Q1 of 2008), and assume a low tax rate of 25%, the results are as follows:
If they make $100 Million in revenues, they will have EPS of about $0.10/share. Multiply that by four and you get $0.40/share to give them a P/E ratio (based on current market price) of 85. That seems a bit high. In order to get my desired P/E ratio of 35, they have to pull in about $260 Million in revenues. To put that in perspective, that's a roughly 1250% increase over what they are doing now. With revenues increasing at 9% per quarter, how long do you think it would take them to reach that point?
Scenario 2: Costs Based on Average Rate on Increase
Ok, so maybe using costs as a percentage of revenue is a bad way to try to forecast the future for Vocus. Let's try plotting out costs based on the average rate of increase instead (the exception being the "cost of revenues" line item which we already determined stays around 19%). Using this method, Sales & Marketing increases 8.4% each quarter, R&D 6.8%, and G&A 9.7%. We use the same figures for amortization as we did for the previous scenario and assume the same optimistic results for "other income." With out 9.4% growth in revenues each quarter, how long does it take to reach the magical EPS of $0.25/share and give us a P/E of 35?
Admittedly, this yields much better results for a bullish argument. It takes a mere 14 quarters to reach an EPS of $0.24/share ($67 Million in revenues). So maybe I'm totally wrong about everything and this stock is poised for takeoff. Only problem is that I used average rates of growth in costs when the rates of growth have been increasing over time.
Scenario 3: Costs Based on Average Rate on Increase Over Past Four Quarters
If I used an average of the last four quarters rather than the last 3 years, I end up with much higher costs. If we make the same $67 Million in revenues after 14 Quarters, we suddenly have a $0.01 loss per share rather than the phenomenal $0.24 gain. Despite the fact that G&A expenses went down measurably, those sales and marketing expenses are a real pain as they totally offset our former gain. In fact, using this method, our profits continue to decrease no matter what we do. Perhaps then, this is a bad method of evaluation as well, but there is one important takeaway; VOCS's rapid rise in revenues is not coming without a cost. As revenues increase, sales and marketing expenses seem to increase even more rapidly. In other words, while Vocus's press releases boast about "record revenues" every single quarter, perhaps the bigger issue should be how those "record revenues" were achieved because if they are hiring more and more people to establish the same pace of increasing revenues as they were before, they're not necessarily better off.
In any case, there was one thing I didn't like about this scenario: R&D costs almost doubled from the prior scenario. I didn't think that was realistic, so let's re-do this scenario with a closer focus on R&D
Scenario 4: Modified Scenario 3 with R&D Analysis
While this entire exercise should illustrate the difficulty of predicting VOCS's costs, R&D in particular is extremely hard to ascertain. At 7%, it takes us about 20 quarters ($115 in revenues) to reach our result, as we get $0.26/share at that point. It's still not that bad, though. You could argue that the stock was appropriately valued or even undervalued (assuming it could continue this phenomenonal rate of growth) into the future.
If I jump the increase in R&D to 9% per quarter, it takes 24 quarters (and $165 Million revenues) to get a $0.24 EPS figure. Not awful, but not quite as good, either. It would be interesting to plot this all out in detail and throw in a discount factor as well, but this is getting to be rather complicated as it is; I'm not sure I want to throw even more uncertainty into the equation.
Scenario 5: The Optimist
I wanted to do both an optimist and pessimist scenario because you could make a case that things aren't nearly as bad as they could be (with rapidly increasing costs) or that the increase in costs is only temporary and that the company will be able to consolidate and reduce costs at some point. Unfortunately, a pessimistic scenario is almost pointless to do. Using the 1st Quarter of 2008, VOCS has a 2% operating margin (if you exclude amortization on various assets). Based on that cost structure, VOCS will never justify the current stock price and any further increases in costs will only make their operating margins negative. Hence, we'll only do the optimistic scenario.
For this scenario to be valid, we have to assume that VOCS has less room to grow (hence, they quit hiring more sales staff) and decide to focus on their current customers. They achieve a lower, more stable growth rate and sales and marketing becomes a much smaller percentage of revenue. However, if this were the case, their G&A and R&D expenses would probably increase even more to maintain their market position. The current operating margin is around 2%, so for the optimistic scenario, we'll go with a 10% operating margin. This isn't totally unrealistic, as according to my figures, they have achieved 7% and 8% margins before (Q3 in 2007 and Q4 in 2006 respectively). While the reasons for these drops are a bit confusing (I can see where costs were reduced, but it's not exactly clear why or how it would be sustainable), maybe it's not out of the question for them to replicate and improve on these performances more regularly.
With a 10% operating margin, VOCS only needs $65 Million in revenues to reach the magical $0.25/share figure (of course, I have to question whether the P/E multiple of 35 would be a correct way to value a non-growth stock). If we lower the operating margin to a more easily achievable 7%, we need about $90,000 in revenues to reach our goal, which would take about 17 quarters to achieve using our current growth rate of 9.4%. All in all, that's not so bad, even if I believe it's an unlikely result.
There are a lot of conclusions to draw from our analysis of VOCS. For one, it's really difficult to predict where this company is going. I've analyzed numerous firms based on their costs and revenues; despite seeming relatively straightforward, Vocus is anything but! The second takeaway should be that growing revenues is not necessarily a good thing.
Vocus is not a bad company by any stretch of the imagination. They seem to be fairly well-run and there's nothing to suggest they are in danger of any sort of imminent collapse. Even if they simply maintained the status quo, they could eventually become a fairly profitable company. However, just because a company is good does not mean it is receiving a correct valuation by the market. If we take a little trip into the WABAC machine and set the dial to the year 2000, we find Cisco Systems (CSCO) trading at $66/share, Red Hat (RHT) trading at $148/share and Sun Microsystems (JAVA) at $257. All three would eventually fall victim to the bursting of the tech bubble, yet I would make the argument that all three are good companies. Their stocks, however, were greatly overvalued. Is the same thing going on with Vocus? Is a second (more minor) "tech bubble" burst possible?
I don't believe that VOCS is nearly as overvalued as many tech companies in early 2000, but I do I feel as if this stock is a bit overvalued. Their operating margins have historically been dismally low and there's no evidence that this will change with increasing revenues. In fact, it could be argued that the company wants to emphasize its revenue growth and has embarked on a deliberate strategy of increasing revenues even if it means sacrificing margins. Unfortunately, as a few of my scenarios highlight, this might mean that even five- and ten-fold increases in revenues still might not justify the current stock price. Until the company shows some ability to rectify its cost issues, it seems overvalued to me.
There's certainly a counter-argument to be made and of course, I'd be interested to hear anyone who has a different opinion on VOCS. [more]