Barnes & Noble Stakes Its Fortune to Digital Market

Filed Under (Company Research, Newsletter) by Ockham Research Staff on 29-06-2010

Barnes & Noble (BKS) booksellers was trounced in Tuesday’s market action as the finished the day 19% lower on three times its average daily volume.  The reason for the decline is clear as the company reported a wider than expected loss in their fiscal fourth quarter, and in the guidance for the current quarter as well.  Sales improved in all three distribution channels (in-store, online and digital delivery) and they expect to continue to increase sales 20% to 25% in the coming year.  However, they are growing capital expenditures just as quickly as they look to expand their digital bookstore presence as well as their Nook eReader device.

Our primary concern with Barnes & Noble’s current strategy is the strength of their competitors in the digital book market.  The Apple (AAPL) iPad has sold extremely well in a relatively short amount of time, and Amazon’s (AMZN) is a formidable competitor and was the original eReader device.  BKS’s traditional rival Borders Group (BGP) is also looking to make a dent in this rapidly expanding market, and they plan to rival the Nook at the lower end of the price spectrum (Borders Banking on the Low End of the eReader Market).  There are other smaller players in the market, and there is always a chance that the market gets even more crowded with new entries.  All of this competition makes one wonder if Barnes & Noble would be better served focusing their attention on selling physical books.

It is clear that the highest growth potential is in digital book sales, but that is also because it is still a new phenomenon.  People have been buying books at bookstores ever since the advent of the printing press, and we have to believe that will continue in spite the rise of the eReader.  We cannot say that BKS should have denied the current trend in book sales towards the digital, but maybe that they should not be devoting such a large investment in that direction.  Only time will tell whether bookstores will go the way of Blockbuster (BBI), Hollywood Video, et al, which have been forced to shrink or close bricks and mortar stores in the face of new technology and distribution.  Some of this has already been prevalent in some areas as bookstores begin to disappear, but I have to believe the appeal of a physical book to consumers may be worth the fight and BKS is probably best positioned in that arena.

Coming into the week, we had a Fairly Valued rating on BKS, and the sell off today does make the valuation look more appealing.  The dividend yield is an eye-popping 7.4% after the huge decline, but cash flow will have to be strong enough to support that payout and that increasingly demands growth in digital sales.  With that said, the significant ramp up in spending to fight against the other big guns in the eReader market is a tough sell to us at this time.  We will likely reaffirm our neutral stance on BKS in our upcoming report despite the much lower price level.

Coinstar’s Redboxes Remain Red Hot

Filed Under (Company Research, Newsletter) by Ockham Research Staff on 03-05-2010

Coinstar (CSTR) leaped almost 20% higher on Friday after a very solid earnings report and upwardly revised guidance, as the rest of the market slipped nearly 2%.  It would be entirely understandable for a stock to take a little bit of a breather after such a day, but on Monday afternoon the company had tacked on another 7.7% in heavy volume.  At the time of writing, the stock has surged 72% higher year to date, and may not be finished yet according to our valuation.

Coinstar’s first quarter was stronger than expected as earnings of 21 cents per share easily topped estimates of 13 cents per share.  Sales of $350.1 million were 47% higher than a year ago and also topped expectations on Wall Street.  The DVD rental business was the clear driver of results as their other divisions experienced revenue declines.  Clearly, they have found their niche as they place their Redbox kiosks in high traffic consumer spots like grocery and drug stores.  For the second quarter, the company was a little more cautious than consensus analyst expectations, but their outlook for the full fiscal year was well ahead of estimates.  For the year, Coinstar expects revenue of $1.53 to $1.63 billion, EBITDA of $275-$290 million and earnings per share of $1.82 to $1.94.  Consensus analysts had pegged 2010 results to be EPS of $1.60 on sales of $1.51 billion, so clearly the company expects strong performance through the balance of the year.

Part of the reason for the stock’s recent performance is likely due to a short squeeze situation, where short sellers are confronted with a much stronger earnings report than expected and they must quickly cover their position in order to avoid further risk.  With the struggles in the DVD rental industry recently, it is not hard to imagine why so many bet against this relative newcomer in the industry.  Blockbuster (BBI) once the industry’s titan has been plagued with bankruptcy rumors and their stock has languished below $1 for some time.  Over the weekend, Movie Gallery announced that they would shutter their remaining stores as the once proud Hollywood Video bites the dust.  Furthermore, Coinstar must contend with the super hot Netflix (NFLX) as well as other means of rental such as through a cable provider.  Coming into their earnings release, Coinstar had about 28% of its shares held short as some traders doubted their business model.  The combination of their solid earnings, great guidance, short covering, and now a competitor closing its doors has given the stock an extremely impressive run.

Value investors may want to wait for a pullback after such a hot run, but according to our methodology Coinstar’s price is not out of line with fundamentals.  We are maintaining our Undervalued stance as of this week’s report, as the stock edge closer to our fair value estimate of around $53.  If the company is only able to meet the low end of its 2010 guidance it still trades below its historically normal valuation ranges.  For example, at the low end of the estimate CSTR would trade for .97x sales per share, while the market has historically been willing to pay between 1.14x and 2.03x times sales per share.  Price-to-cash earnings for CSTR over the last ten years has historically ranged from 15.5x to 28.0x, our current estimate for cash earnings (excludes non-cash events) for the full year is about $3.25 per share, which we believe is conservative.  So CSTR is currently trading for 14.6x price-to-cash earnings, another sign that the stock remains undervalued in spite of the recent rally.

Coinstar’s business model is proving effective as some competitors struggle to hold market share.  A stock that has appreciated as much as CSTR has recently is generally not a typical value play, but with this one we do not think the price has gotten too far ahead of fundamentals.  We see further potential for gains in this stock as it expands its reach and grabs market share.

GameStop Surges and Proves It is No Blockbuster

Filed Under (Company Research, Newsletter) by Ockham Research Staff on 18-03-2010

“There has been a lot of buzz lately that GameStop might be acquired…It reported results that blew away street estimates.” — Bloomberg TV’s In The Loop 3/18/2010

Readers of this blog by now have probably heard us beat the drum about GameStop (GME) being an extremely attractively valued stock, and today we feel somewhat vindicated and will continue to beat that drum following an impressive fiscal fourth quarter report.  The last year has been a difficult one for the video game industry, and as the world’s largest video game retailer, GameStop has clearly fallen out of favor with the market.  Same store sales dropped nearly 8% as spending on consoles was especially weak. 

Critics argue that GameStop will go the way of Blockbuster (BBI), which is teetering on the verge of bankruptcy, because video game sales will increasingly go digital.  The theory goes that bricks and mortar will be an anchor on results and it is only a matter of time.  However, as we see it, there is one extremely important difference between GameStop and Blockbuster: profit.

Recall, if you will, Blockbuster has not turned an annual profit in six long years, and the losses have widened for the last 4.  Even when Blockubster was in its heyday around the turn of the millennium, profits were hard to come by, which doesn’t speak well of management.  In contrast, GameStop reported a fiscal fourth quarter 2010 (ended Jan.) net income of $215.9 million or $1.29 per share, which is better than Wall Street estimates of $1.27 per share.  That means for the year the company earned $2.28 per share, so even after today’s 9% rally the stock trades for 9.5x trailing twelve month earnings.  The midpoint of 2011 EPS guidance comes in at $2.63, which is 15% growth in the next year.  Overall sales grew by 3.1% over the past year, which hardly warrants the catastrophic tone that some have taken towards the video game industry.  Management said they expect a decent rebound in sales growth next year, calling for growth of 4% to 6%.  The midpoint of the guided sales range would equate to $9.53 billion or $150 mln better than consensus analysts’ estimates.

Are the headwinds for GameStop? Of course.  The threat of aforementioned mentioned digital distribution may cut out distributors like GameStop completely, as game developers may connect directly to consumers.  There is growing competition particularly in used game sales from some of retail’s heaviest hitters like Walmart (WMT) and Amazon (AMZN), but as of yet GameStop has effectively managed to maintain and even grow profits in the face of competition.  At least up to this point, gamers like the feeling of physically holding a highly anticipated game purchase and GameStop instantly gives this to them while Amazon and Walmart do not. 

Will a service like Gamefly pester GameStop like Netflix (NFLX) has Blockbuster?  This one is doubtful, in my opinion; games are different from movies in that they are used repeatedly rather than a single use at a time.  One great thing about Netflix is sending a just-viewed movie back in order to get another one that you have been waiting to see.  Gamers however invest time in the game, and while Gamefly will attract some serious gamers looking to test out games for their next purchase, we think it has less appeal for the average gamer and have less of an effect on GME.

By looking at historically normal valuations, it is clear that the market has priced in a substantial amount of downside has been priced into GameStop already.  For example, GME’s price-to-cash earnings of 5.7x is well below the historically normal range of 8.3x to 19.1x.  Furthermore, price-to-sales over the last ten years has historically ranged between .46x to 1.08x, but the current multiple is .37x with sales expected rise in the year ahead.  We currently have an Undervalued rating on GME, and based on the market’s normal valuation of this stock, we think it could trade in the high-$20 without any concern over valuation give current fundamentals.

So, with strengthening fundamentals and an extremely strong balance sheet, we believe long term investors have not missed the up-trend in GameStop after today’s nice bump.  Management has delivered consistent performance and the underlying fundamentals will eventually be recognized by the market.  With the current valuation, it is no surprise to that there have been rumors in the past week of a potential private equity acquisition looming around this company.

Take-Two Interactive: The Icahn Turnaround Begins

Filed Under (Company Research) by Ockham Research Staff on 03-03-2010

Shares of video game maker Take-Two Interactive (TTWO) are surging in after hours trading following a much better than expected fiscal first quarter.  Earnings per share came in at a loss of $.31 per share, which was twenty cents better than the consensus of analysts’ estimates.  Perhaps more impressive was revenue of $163.2 million which easily topped TTWO’s guidance of $90-$140 million (although analysts thought it was overly conservative at the time).  Also announced, the company will be cutting up to 15% of headcount to save $8 million this year and $15 million annually in what they termed as “targeted restructuring.”

Take-Two has streamlined its focus in the quarter as the sale of Jack of All Games to SYNNEX (SNX) was completed in the quarter, and netted the company up to $44 million.  For the quarter ahead, Take-Two is looking for sales of $250-$300 million with profit of 20-30 cents per share.  That guidance compares favorably to analysts’ expectations for EPS of 7 cents on $267 million in revenue.  For the full year, TTWO still sees losses of 40-60 cents per share, while the Street has estimated a loss of 56 cents.

The recent performance by Take-Two is a notable improvement from where they have been the past few quarters.  The troubles of Take-Two attracted the attention of activist investor and hedge fund manager Carl Icahn, who has progressively increased his stake in the company.  As of just a few weeks ago, Icahn owned more than 10.5 million shares or in the neighborhood of 13% of floated shares.  He has flexed his muscle already by placing three handpicked directors on the board, and even the incumbent Executive Chairman of the Board Strauss Zelnick has worked closely with Icahn at Blockbuster (BBI).  There is no doubt that Icahn is a voice of authority for the direction of the company, and thus far the results are mixed for shareholders.  The stock has not performed well at all, but the last quarter was an operational improvement.

It is easy to see why shares are indicated higher after the earnings results, but we would urge investors remain cautious at this point.  From our standpoint, TTWO is still Overvalued even after the improved revenue and earnings outlook.  Remember, they still anticipate losses of $.40 to $.60 per share, and the more optimistic revenue forecast of around $825 million is still 46% lower than sales totals from fiscal 2008. 

We can appreciate that things are finally starting to move in the right direction as refreshed management restructures the business, but the fundamentals have fallen so far that we need to see a more substantial recovery to find TTWO attractive again.  We would not bet against the team of Zelnick and Icahn, but for us the stock still needs to prove it can become profitable in a challenging video game environment before we can get too excited about TTWO.

Coinstar and Time Warner Strike a Deal on DVD Rentals

Filed Under (Company Research) by Ockham Research Staff on 17-02-2010

With yesterday’s announcement of new terms with Time Warner’s (TWX) Warner Brothers studio, Coinstar (CSTR) has removed one major uncertainty in their business model.  Coinstar’s Redbox division, which operates self-service DVD rental kiosks, has been locked in legal battles with movie studios regarding terms for the availability of their films.  The problems arose from Coinstar buying large quantities of DVDs on the day of release at wholesale prices and offering them for rental for $1 per day.

This situation was unacceptable to the studios as this threatened a key source of revenue: initial sales of popular movies.  This is especially critical to studios as DVD sales have already been in decline for some time.  So, the studios refused to sell at wholesale to Coinstar, and forced Redbox to invent a “workaround”.  Essentially, they would send employees to buy as  many copies of new releases as possible from big-box retailers.  Even though this was less cost effective, there were few alternatives to filling the company’s 22,000 kiosks.  However, a recent limit on quantities by retailers sent Coinstar back to the drawing board, and was a major cause of concern for investors.

Coinstar’s new deal with Time Warner has a 28-day window in which Redbox will have to wait after a new release.  Furthermore, Redbox has agreed to destroy the DVDs after their popularity slows rather than sell the used DVDs at a huge discount.  In exchange, Redbox will get sufficient supplies for each film at wholesale prices.  This is a very similar deal to the one that Time Warner made with Netflix (NFLX) recently, although Netflix has the added ability to offer streaming rentals on some titles.  Both sides are heralding this as a win-win and this may provide a roadmap to settle the ongoing disputes with other studios.

As for our valuation on these companies, we have CSTR as Undervalued and TWX as Overvalued.  We consider this as a more significant deal on CSTR’s end because Redbox, their fastest growing and most promising business line, had become very strained by the legal battles with studios.  This breakthrough has caused at least one analyst to upgrade the stock, and in general the analyst community is bullish on CSTR.  For example, the analyst at Merriman Curhan Ford said that the stock may be worth $59 to $77 in a note penned following this deal.

At Ockham, we have a positive outlook on Coinstar shares also, and based on the market’s historical valuation we think it could reach the high $40’s.  For example, in the past the market has been willing to pay between 7.9x and 13.9x cash earnings, while the current price-to-cash earnings is only 5.3x.  Similarly, price-to-sales is currently only .72x, which is well below the historically normal range of 1.15x to 2.07x.  It is clear that recent legal standoffs have held the stock down and made it fall out of favor with the market, but now there is a light at the end of the tunnel.  We expect the other studios to follow Warner Bros. lead and soon Redbox can put the capital it was using on legal fees towards growth.  The market is ripe for this solution, as it presents an alternative to disappearing bricks-and-mortar stores and it requires no monthly fee like rent by mail options.  Competitors such as Blockbuster-licensed kiosks owned by NCR Corp. (NCR), but Coinstar’s Redbox has the lead on them and will look to expand on that.