An Update on Our Picks

January 30, 2007

Since I’ve been doing this for a couple weeks now I’d like to update everyone on some of the stocks I’ve written about.

On January 12th, I wrote about Netflix and how I think that the long-term story may be better than the Street percieves. Its down about $1/share since then due to some selling before earnings, and then a quick pop afterwards. They reported another big increase in subscribers and rapid growth in profits. What remains to be seen is whether more new subscribers will choose Blockbuster over Netflix which will hurt margins, lower prices, etc.

My January 15th piece on YRC Worldwide came right before a Barron’s positive article about the company and a Wachovia upgrade to outperform. Combine these two factors with recent data showing that the US economy is “trucking” along fine, and the stock has had quite a nice move, up almost $4 since then. I don’t really see any reason to sell this stock- investors still think that it’s cheap and I think that the risk/reward profile is heavily in our favor.

Electronic Arts hasn’t done much in the past few weeks. Recent concern about slow PS3 sales have hurt the stock a little, but I’d like to reiterate my position that any weakness should be used as a buying opportunity.

Both Paychex and Warner Music Group have stalled recently. I’m still researching these companies and will write more about them when I learn more…

So thats it for now. I’ll probably write about Blue Nile soon, I think its a great company.

-Da Stock Geek


Warner Music Group-Look Beyond the Headlines

January 25, 2007

To most people, when you say that you think that Warner Music Group (nyse: wmg) is a great investment, they’d laugh at you. But I wouldn’t. I love the idea. Warner was spun off from Time Warner (makes sense…) in may 2005. The physical side of the business, which accounts for about 88% of revenue, is declining, but the real “magic” in this company comes from the digital side (12% of revenue). Last year, digital, which comprises both ringtones and music on websites like iTunes, sales doubled. This is the real growth driver for the company, and the management knows this- on the last conference call they talked about their “laser focus” on the digital side and on signing new artists. Warner increased their digital market share by 300 basis points to 20.5%. The reason why digital is so important is because it has much higher margins than physical sale. The management team at Warner knows that the music business is changing rapidly, and they are insistent that they remain on the vanguard of the “music revolution.” They just signed a new deal to have their music videos published on YouTube. They also signed deals to have music video’s published on Google and Brightcove. Warner is also persuing strategies in international markets, with sales in Japan, for example, up 50% YoY.

I want to emphasize that there are many risks with Warner. Because physical sales are so important, price and unit declines will hurt the bottom and top lines. But, I would buy this stock on any weakness, because I think that the management really understands that technology is changing and they are moving this company towards faster-growing, higher margin businesses. Besides, they pay a 2.5% dividend yield while you wait.

Paychex-The Bull Story

January 20, 2007

You probably have heard of Paychex-they are the company who your company outsources their countless paperwork and staffing needs for things like 401(k) plans, HR administration, and payroll. A majority of their business comes from small businesses, who have no (or little) pricing power and time to do this stuff. They also act as a PEO, or Professional Employer Organization for larger companies, which means that they act as the employer and then lease the employees to the company.

These businesses all have extremely high barriers to entry, and as a result, the market is dominated by a small handful of larger players. Paychex has a 10% share in this market, which places them in “second place” to ADP, who has a 30% share. Paychex has 543,000 clients (98% less than 100 employees), which means that no single customer contributes a material amount of revenue, limiting risk if a client leaves. According to their latest 10-k, Paychex has a client retention rate north of 80%, with most of the attrition attributed to customers going out of business, not switching providers.

Paychex projects that they can achieve 15% income growth over the forseeable future, in line with past growth rates over 5 and 10 year periods. Right now they are trading at 30x past earnings, a 2.0 peg. The company’s share are expensive, but that is because they have such a wonderful business model, unique competitive advantages (a large moat) and recurring revenue from customers. As their clients grow, so does Paychex, and probably your portfolio as well.

I’ll be writing about this company and the staffing outsourcing industry as I learn more about it.

Electronic Arts – Thanks, Citigroup

January 19, 2007

Electronic Arts, the publisher/developer of the Madden series and much more, just got a much needed upgrade from Citigroup this morning. You all know the story so I won’t dwell on it too much, but here it is.

  1. There are 3 new video game systems that just came out, therefore
  2. Consumers are going to spend a lot of money on them, therefore
  3. We need a way to make money off of this trend, and game developers seem attractive, so
  4. We look at the four companies (activision, thq, take-two, and ea) and decide which to buy

Investors have pretty much decided that Activision and THQ are the two best companies and EA and TTWO are worse. But I digress. Activision’s success has come as a result of two games: Call of Duty and Guitar Hero. I don’t think that there is much long-term value in either of those games .

EA, on the other hand, has games that will be played on any system in 2, 5, and 10 years from now. They own the exclusive rights to use the NFL team names, and have games like NHL live, NBA live, the Sims, Fight Night, which have long term sustainability. People will always love sports and will always play sports games, especcially EA’s.  The problem with EA is that its release slate is very PS3-focused, and that system is the least popular among the “big 3” (the Wii, Xbox 360, and PS3). The main reasons behind the PS3’s success (or lack thereof)  are a) it’s too expensive and b) there isn’t much supply. The price is a function of supply, so as supply increases, the cost to manufacture each PS3 decreases and Sony will cut prices. Last cycle, when the PS2 was introduced, there was also a delay and Electronic Arts was hit hard. This is what happened then

If you switch PS2 to PS3, you have whats happening now. Look at Yahoo! Finance and you’ll see that the stock traded at $18, split adjusted.  You would’ve made almost 300% on your money if you invested on this hugely important, cataclysmic delay.

Turning to valuation for a moment, the stock looks expensive at 86x this year’s earnings. But this is the bottom-of-the-cycle year which always carries the highest P/E. If you let EA grow half as much over the next 3 fiscal years as it did during the 3 years from bottom to top of the last cycle, EA is trading at 13x 2009 earnings, well below its 20% growth rate. I think that bad numbers are priced into this stock and I’m looking to buy on future weakness.

– The Stock Geek

    Why Yellow Roadway can make you serious green

    January 15, 2007

    For those who don’t know, Yellow Roadway Coorporation is the largest less-than-truckload (LTL) transporter in the US. Basically they transport another company’s goods from point A to point B using their drivers and fleet. With $10 billion dollars in annual sales, YRC has the economy of scale to purchase fuel and trucks at a cheaper prices than competitors. As you can imagine, the trucking industry is extremely cyclical, demand for trucks picks up when the economy, both US and abroad, is strong and slows down in weak economies.

    Investors in LTL companies are primarily investing in them for two reaosns: a) they think that the economy will be strong and/or better than expected and b) they think that the management has the ability to protect the company and protect margins in future slowdowns.

    I’m going to be the first to tell you that I have absolutely no idea what the economy will do over any period of time. So that rules out “a.” Lets talk about “b” The trucking industry has been consolidating over the past few years, and YRC has definitely not been left out. With the acquisitions of USF and Roadway, YRC has the ability to carry and size of goods for any time frame across any region. In addition, management believes that there will be tremendous synergies between the three companies due to a larger economy of scale and reduced overlap between the routes of the three companies. Besides the core trucking porftfolio, YRC has initiated two new “projects:” Meridian IQ and the China initiative. The former is YRC’s entry into the non-asset based 3rd party logistics service (abbv. 3PL). Using YRC’s extensive knowledge and technology, they plan other companies’ logistics needs. Because there are no assets involved, they are protected from much downside in slow macro environments as they don’t have any idle equipment or drivers. This segment is a primary beneficiary of globalization because companies are outsourcing the production of a lot of work and they need to move it from country to country safely and timely. The china initiative will bring YRC into the highly lucrative Chinese market, where there are 1.3 billion people and an economy growing 10% a year.

    Turning to valuation for a moment, the stock is trading at less than 5 x cash flow and 8x earnings, compared to its 5 year average of 18 x earnings and 5.5x cash flow. At these rates, a slowed US economy is priced into the shares already and any strength in the economy will bring upside to shares of YRCW

    With the addition of USF and Roadway, and the company’s foray into logistics and China, YRC’s management is commited to growing the company even in a slow US economy. Even though the company’s results may not be stellar during this time, significant cost reductions should limit bottom-line impact.

    Why JP Morgan is Wrong on Netflix (NFLX)

    January 12, 2007

    I should probably correct the title- I’ll be the first to admit that I have no insight whatsoever about this quarter theyre going to report this month. However, I believe that the fundamental Netflix bull story is great and see the recent drop in price as an oppurtunity to buy Netflix.

    The Business

    Netflix sells movie rental plans from its website, Prices range from $6 – $48 per month depending on the number of movies you want out at a time. Under these plans, consumers choose the movies they want and they are sent out when previous movies are returned. Currently there are 5.7 million subscribers and a collection of 70,000 different DVD’s. The only direct competitor is Blockbuster, and also compete with Apple’s iTunes download-to-own movie platform.

    The Numbers

    Sales have grown from ~$150 million in 2002 to a projected $1 billion in 2006, a compound annual growth rate of 46%. Management projected in their latest conferance call that EPS will grown at a 50% annual clip over the next “few” years. Analysts are more pessimistic, however, and only project a 32.5% annual growth rate. Return on equity, assets, and capital have increased from barely 3% a few years ago to 26% for ROE and ROC and 18% for ROA.

    The bull case

    The bull case for Netflix is simple: Netflix has a great brand and a great product, so with broadband penetration increasing and HDTV’s getting cheaper, their service will become more popular. In addition, Netflix is building a downloadable movie platform that they will unveil later this month. Netflix built a great website and I see no reason why they couldn’t do it with downloading as well. Churn was only 4.2% which means that a very high percentage of customers stay on-board and use Netflix every month.

    The bear case

    The reason why Netflix has grown subscribers so rapidly is because of much higher marketing (and as a result,subscriber acquisition costs) costs. In addition, there is a clear shift going on from the higher priced plans to the lower priced ones, which is hurting margins. Blockbuster is returning from the dead and have stolen market share as well. iPod users are choosing to download movies from iTunes instead of Netflix.

    My take

    Both sides of the argument really make a lot of sense. High marketing costs have hurt margins but have also lured in subscribers. It’s the same problem that Costco faced: members or margins? Netflix chose the former while Costco chose the latter. There is so much pessism around Netflix, and I think that if it can grow anywhere near their own projects, and with $6 per share in cash to use to build out the online platform, the Company is well positioned for the future.

    An Introduction

    January 10, 2007

    The goal of this blog is for me, The Stock Geek, to write an in-dept analysis of a company every week or so. I don’t intend on posting every  day but am commited to keeping this blog active, especcially if I get some readers. I love writing about stocks and doing in-depth research on them . I love getting comments and talking to readers, so please do comment. Thanks for stopping by and stay tuned!