Allow me to get right to the point. Here’s an example of a well-run, well-financed company that I really admire, but for which the price just clearly isn’t right.
“CEB,” as it’s known, provides research, support, education, and best-practice studies to corporate executives. The model is interesting in that it also allows executives to learn and benefit from one another through shared problems and guidance. Because much of the work CEB does is shared and almost “templated” so that many clients can benefit from the same solutions, the company benefits from a certain economy of scale, and can pass this to its customers and offer extremely low prices relative to its peers.
Despite its low prices, the company enjoys huge margins and fat returns. Dependent on its intellectual capabilities, the company is not at all capital intensive, yet earns high returns on equity with no debt. The balance sheet is pretty, cash flow is strong, and management is phenomenal.
Which brings me to my next point. I and some colleagues had the good fortune to meet the company’s CEO, Tom Monahan, a few days ago and spoke with him about the business. Mr. Monahan is clearly talented, vibrant, and passionate about his work and CEB. He and the management of CEB are a far cry from the wildly overpaid executives elsewhere who do little to increase shareholder value.
Mr. Monahan discussed the firm’s competitive advantage, which would have been a concern for me had I not understood it a bit better. Because the company (cost-effectively) serves around 80% of the Fortune 500, it can offer its shared solutions for a wide array of business problems, and retains a pitching point enjoyed by virtually no other firm of this kind. This moat allows for easier and easier sales as it grows, and provides immediate legitimacy for potential new clients. Furthermore, the company has over a 92% renewal rate from its customers, demonstrating that CEB’s offerings are adding value for its customers. On the most basic level, it would be difficult for a competitor to displace CEB in its market.
As should be obvious from a quick glance, the company has grown extremely rapidly over the past years. Of course, past performance is no indication of the future, which brings me to the future growth and the (unfortunately high) price. As the company continues adding to its “portfolio” of clients, marginal growth potential must, by mathematical law, diminish. While they certainly haven’t saturated their potential market, 80% of Fortune 500 companies is a good indication that growth is unlikely to be as explosive as in the past, and certainly should not accelerate.
The way I see it, growth can still be driven in a few ways: continue adding clients, tap into previously untapped pricing power (as the “moat” grows, CEB may realize that its prices, which are around a quarter of what some competitors offer for consulting sevices, do not fully capture their customers’ willingness to pay), and adding to the portfolio of smaller clients who otherwise couldn’t afford more pricier traditional consulting services.
That said, the price, at around 48 times earnings, is very high and makes me uncomfortable. For instance, the company would need to grow free cash flow at something like 20% over the next ten years and 3.5% ad infinitum thereafter just to justify its current pricetag. Granted, this can happen and the company does have a low cost of capital, but it’s simply not a big enough margin of safety.
Nonetheless, this one’s on my radar screen, and I’d be thrilled to scoop some up at a better price.
First, a disclaimer: I personally know little or nothing about where most companies in the biotechnology or pharmaceutical industries are headed and likely would never recommend buying any company within these industries. Naturally, then, I do not personally endorse or recommend buying any shares in what follows.
Second (and on the otherhand), after that dull and gloomy preface, a special thanks to reader Edward Dostillio who has kindly offered perspective where I can’t on one such company, Ciphergen Biosystems, Inc. Edward notes that the company is beginning to see institutional interest, so below is his research piece from a few months back which may help in your own due diligence:
CIPHERGEN BIOSYSTEMS INC (CIPH)
Shares Outstanding: 36M Recent Price: 1/30/07 $1.57
Float: 25M Current Market Cap $43.50
SIGNIFICANT DEVELOPMENTS IN LAST 18 Months:
1) PARTNERING WITH QUEST DIAGNOSTIC (DGX)
On July 22, 2005, the Company entered into a strategic alliance agreement with Quest Diagnostics covering a three year period during which the parties will strive to develop and commercialize up to three diagnostic tests based on Ciphergen’s proprietary SELDI ProteinChip technology. Pursuant to the agreement, Quest Diagnostics will have the non-exclusive right to commercialize these tests on a worldwide basis, with exclusive commercialization rights in territories where Quest Diagnostics has a significant presence for up to five years following commercialization. As part of the strategic alliance, there is a royalty arrangement under which Quest Diagnostics will pay royalties to Ciphergen based on fees earned by Quest Diagnostics for applicable diagnostics services, and Ciphergen will pay royalties to Quest Diagnostics based on Ciphergen’s revenue from applicable diagnostics products.
To date, no such royalties have been earned by either party. Quest Diagnostics and Ciphergen have also entered into a supply agreement under which Ciphergen will sell instruments and consumable supplies to Quest Diagnostics to be used for performing diagnostics services. In addition, for an aggregate purchase price of $15 million, Quest Diagnostics purchased 6,225,000 shares of Ciphergen’s common stock, or approximately 17.4% of shares outstanding after the transaction, and a warrant having a term of five years to purchase up to an additional 2,200,000 shares for $3.50 per share
2) PARTNERING WITH BIO- RAD
On August 14, 2006, the Company signed a definitive agreement with Bio-Rad Laboratories, Inc. related to Bio-Rad’s purchase of the Company’s proteomics instrument business, which includes the Company’s SELDI technology, ProteinChip® Arrays and accompanying software. The Company would retain exclusive rights to the diagnostics market. In addition, upon closing the Company would agree to purchase SELDI instruments and consumables from Bio-Rad for the continued development of its diagnostics business. Subject to approval by the Company’s stockholders, and other customary closing conditions, Bio-Rad will purchase this business for approximately $20 million in cash and will make a $3 million equity investment in Ciphergen Bio-Rad will make and sell the laser technology to life science companies. Ciphergen keeps rights to the diagnostic uses of the products.
3) ESTABLISHED A SCIENTIC ADVISORY BOARD
Scientific Advisory Board (SAB). — The SAB will meet regularly with Ciphergen’s senior management to help evaluate the Company’s ongoing diagnostic programs and prioritize them towards commercialization. Members include the following distinguished members of academia and industry: — Robert C. Bast, Jr. MD - Vice President for Translational Research and the Harry Carothers Wiess Distinguished University Professor for Cancer Research at the University of Texas M.D. Anderson Cancer Center. — Daniel W. Chan, PhD, DABCC, FACR - Professor of Pathology, Oncology, Urology and Radiology, Director of Clinical Chemistry Division, Department of Pathology, and the Director, Center for Biomarker Discovery at the Johns Hopkins University School of Medicine. — Ian Jacobs, MD, FRCOG - Director of the Department of Gynecological Oncology and of the Institute of Women’s Health at University College London. — Joyce G. Schwartz, MD - Vice President and Chief Laboratory Officer of Quest Diagnostics. — William Wallen, PhD - Senior Vice President and Chief Scientific Officer of Idexx Laboratories.
4) SIGNIFICANT R&D DEVELOPMENTS
Ovarian Cancer Diagnostic Progress.
– At the 2006 Annual Meeting of the American Society of Clinical Oncology (ASCO) held in early June, Ciphergen announced results of the first ever large-scale multi-institutional independent validation study of biomarkers discovered through current clinical proteomics efforts. As in previous studies, an index derived from the seven markers tested demonstrated improved specificity for discriminating ovarian cancer from benign pelvic masses, as well as for the detection of early stage cancer. — The biomarkers demonstrated statistically significant power to differentiate ovarian cancer patients from women with benign disease (p<.00001). This study is part of a comprehensive program being conducted with several leading collaborators at The Johns Hopkins School of Medicine, the University of Texas M.D. Anderson Cancer Center, University College London, and the University of Kentucky. In addition to developing assays designed to distinguish between benign and malignant pelvic masses, studies are underway to predict recurrence of ovarian cancer and to provide additional tools to aid physicians in triaging women considered at high risk of ovarian cancer
.Prostate Cancer Program Progress.
– At the annual meeting of the American Urological Association (AUA) held in late May 2006, researchers from Johns Hopkins presented data on two proprietary biomarkers that may aid in the management of prostate cancer, including detection, staging and prediction of recurrence. These markers, a fragment of protein C inhibitor (PCI) and complement factor 4 (C4a), were identified in a multi-center study of 400 men and a five-year longitudinal study following 104 patients after radical prostatectomy. These studies demonstrated that PCI provides information useful for the detection and staging of prostate cancer, and the combined use of pre-surgery PCI, PSA, and C4a is predictive of prostate cancer recurrence.
On August 14, 2006, CIPHERGEN’S CEO clarified the mission statement of Ciphergen moving forward.
“Today we announced a significant strategic milestone that accelerates our transformation into a leading specialized diagnostics provider,” stated Gail S. Page, President and CEO of Ciphergen. “We have a dedicated management team and the financial resources to build an exciting, attractive diagnostics business for long-term growth and sustained shareholder value.”
Partnering with 2 giant well established and well respected multi-billion dollar companies, offers CIPH the economies of scale necessary for the mass commercialization of SELDI ProteinChip technology and allows CIPH to focus its attention on developing and licensing the Specialized Diagnostic Tests utilizing the SELDI TECHNOLOGY on a larger scale commercial level. The Partnership with DGX gives CIPH a distribution channel for the Diagnostic Test and the Partnership with BIO gives CIPH a distribution channel for the SELDI Technology. By divesting the Instrument business CIPH receives an infusion of cash that will double its cash position on hand while simultaneously reducing its cash burn rate. These partnerships will allow CIPH to focus its attention on developing more specialized diagnostic tests and allowing them to bring the tests in the pipeline to the market on a larger scale and in a shorter time period then if these partnerships did not exist.
CIPH is a significantly different company than the one that went public 6 years ago at price level that is significantly higher then where it trades today. It has a new CEO that has transformed CIPH into leaner more focused company with some very strategic partners and a healthy pipeline of specialized diagnostic tests. This is a great story stock that no one is following, but if and when the story on the transformation of CIPH gets more widely disseminated on the STREET. CIPH’s stock will certainly no longer trade at a market cap that endangers its continued listing on NASDAQ especially with such a small float.
Statements above are the personal opinions of Edward Dostillio. Edward and his family own shares of CIPH.
In light of recently seeing the Disney/Pixar flick Cars and, of course, Ford’s (F) huge loss coupled with Toyota (/TM) and Honda’s (HMC) anticipation of larger profits, I thought it appropriate to say some words on the automotive industry and its major players.
First things first. It’s no news that American car manufacturers are suffering and suffering mightily. Stagnant sales coupled with rising costs, stiffer price (and quality) competition from lower cost, more efficient foreign makers, and mounting liabilities make for an extremely difficult hand. Both GM and Ford are in the midst of restructuring processes, looking to cut jobs, close factories, improve efficiency, and shed some legacy costs.
Whether or not these initiatives will be successful is out of my (and probably many an investor’s) circle of competence. What I do know is that the challenge is immense and difficult to understand. Part of the difficulty is due to the off-balance sheet nature of the obligations, and the rest is due to huge uncertainties regarding the future of the companies’ operations.
For instance, let’s consider GM’s pension status and healthcare obligations. While pension plan accounting is quite arcane and sensitive to a number of actuarial estimates (like life expectancy, wage increases, discount rates, etc.), I’ll do my best to keep it simple for demonstration’s sake. Basically, the company made some unfortunate agreements with the UAW years back which were based on a much brighter expectation for GM’s future. As we’ve seen, that has now backfired bigtime. I liken the company’s obligations to the US Social Security problem — it is “underfunded” in the sense that more money in benefits will be paid out than is currently being brought in.
For every current employee, GM is paying benefits to roughly 2.5 retired workers. All said, the “funded status” (that is, pension plan assets minus estimated benefit obligations) of GM’s obligations was around negative $63 billion at the start of 2006. And, again, that is not really reflected on the balance sheet. And as the company tries to shed its workforce to cut costs, this deficit could grow (provided that some other solution is not reached).
This becomes an even bigger problem when contrasted with the fact that companies like Toyota and Honda are sitting relatively pretty. Both of these companies are supporting pension plans with an employee base far larger than their retiree base. GM has cut its workforce over the last 20 years while TM and HMC have done the reverse. Given its financial difficulties, poor capital structure, and competitors’ financial success this, in plain English, ain’t good for GM.
Oh, and Ford? Not too much different: with a funded status of -$43 billion, there’s not much to be gleeful about.
Another terrible obligation bearing down on American manufacturers is, of course, their heavy debt loads. GM is paying around $4.5 billion a quarter in interest expense and Ford is a bit better at around a $2 billion run-rate. Both companies’ liquidity positions are troublesome, and barring some drastic, successful measures, credit ratings will worsen and the situation will continue spiraling downward.
Contrast this, for instance, with Toyota, whose debtload is but a small fraction of its American counterparts’. Furthermore, Toyota enjoys triple A credit ratings and extremely low cost financing.
Furthermore, some argue (perhaps rightly) that American manufacturers, in addition to suffering from a classic case of the lower cost competitor blues, are selling products that offer less value than foreign cars. Despite pretty positive ratings for some Ford and GM models, there does seem to be a perception of generally greater affordability, quality, safety, fuel-efficiency, and durability from Japanese cars especially. Naturally, this doesn’t do much for Ford or GM’s performance, and provides an operating and marketing edge for companies like Toyota and Honda.
So what will come of all this?
Well, like I said, I don’t think I can predict the success of current restructuring efforts. But, for starters, whatever does happen should be interesting. It’s difficult to imagine two American icons with still tremendous market shares going out of business anytime soon. And, realistically, I don’t anticipate that happening with high probability. Granted, GM and Ford have been steadily losing market share to foreign rivals, and that trend could continue. But entirely displacing such big players is difficult to accomplish, and, if there is a death, it’ll be a slow death.
I also feel the managements of both Ford and GM are doing a pretty good job considering the awful economics of their businesses. For example, CEO Mulally at Ford is top notch in the restructuring area and I don’t see it impossible that he can repeat his success at Boeing. He has and will probably continue bleeding the company of its ills, and shareholders might well be better off for it.
Obviously, handling the mounting liabilities and inherent institutional cost difficulties is the key concern. But surprisingly, I also believe alot may end up depending on both companies’ willingness to be entrepreneurial. My (admittedly bold) prediction is that an ability to adopt technology like clean, fuel-efficient vehicles and embrace change could not only help them compete, but, if done skillfully (and perhaps with some luck) propel them back to their glory days. Clearly, this is no easy task, but should remain somewhat of a priority in a world of shifting preferences.
This may be controversial, but I find that the average car buyer is more willing to switch brands if given good reason than are consumers in other industries. Today’s Toyota owners might well be tomorrow’s Ford owners if, hypothetically, Ford can develop an image as an innovator on the frontier of clean, cheap fuel technology. How likely that is to happen, I have no idea. Naturally, they’d have to be a step ahead of financially sounder enterprises trying to do the same thing. But on the bright side, a company like Ford has the government subsidiaries and research pipeline that has been proving somewhat successful, and it’s not entirely out of the question that American manufacturers can do what I call “pulling an Apple” and really reinvent themselves and their image.
But, to end sadly on a more dour note, doing any crazy, sexy innovation campaign in the midst of a restructuring effort is probably a HUGELY unlikely one-two punch. As much as I’d love to see American car manufacturers pull off one hefty task, let alone both, the odds are stacked heavily against them. If you’re one for supporting the underdog, so be it. But when it comes to a Ford or a GM from an investing standpoint, the risks are too great and the rewards are not entirely clear. Bottom line: if you absolutely MUST buy an auto stock, consider looking outside the old US of A.
Note: I do not own shares in any companies mentioned in this article.
It’s no mystery that a company with an established and trusted brand name maintains a hefty competitive advantage over current and would-be competition. A strong brand gives the company “market share of mind,” as I call it, while simultaneously giving the added benefit of pricing power. Brands may also reinforce switching costs, making it unlikely that regular customers will leave quickly. Just ask a Marlboro smoker to switch to Camels. Or a Coke drinker to start up on Pepsi.
As a quick exercise, here are what I consider some of the top brand names, which benefit from pricing power, switching costs, customer trust, and/or wide recognizability.
Shares of PetMeds Express (PETS) plummeted today on news of a quarterly earnings shortfall. Sales were a better-than-anticipated $31.4 million, with a shift toward greater online sales (63% of revenue vs. 57% last year).
[So I don’t reinvent the wheel from here, feel free to check out my initial post on PetMeds.]
From a business perspective, I find the increase in online sales to be both good news and bad news. The bad news is simple: the market for online pet pharmaceuticals is fragmented and competitive, making targeted keywords increasingly more expensive and search engine rankings more difficult to build.
As more pet pharmacy retail operations try to steal market share, online customer acquisition costs will increase and price competition could further erode margins.
The good news is a bit counterintuitive. Allow me to explain.
What is somewhat striking about the online increase is that the company’s website traffic is down significantly from a year ago. The company has seen website traffic decline noticeably year-over-year, which is disappointing given the more than 50% increase in advertising expenses. My guess is that they are doing one or both of the following things to accomplish a sales increase in light of lower traffic:
1) Targeting their advertising better, leading to higher conversion rates from visitors.
2) Getting visitors to spend more money at the site, whether through upselling, cross-selling, a broader product offering, etc.
3) Getting customers who initially purchased via telephone to place orders on the web instead
All of these are good things (#1 and #2 for obvious reasons, and #3 due to the lower administrative expense to complete an order on the web vis-à-vis on the phone with a representative). Unfortunately, the aforementioned bad news may largely offset these benefits, and presents some looming challenges in building the PetMeds brand success. But more on that later.
Looking further into the numbers, PetMeds traffic was around 7.4 million visitors for the quarter, based on the Alexa.com statistics. With 130,000 new orders (presumably around 63%*130,000=81,900 from the web), 1.1% of the visitors were new customers. This conversion rate alone is higher than the standard retail website and probably industry averages, and given that a large chunk of traffic probably represents returning customers that need not be “acquired,” the conversion for new visitors was likely substantially higher.
So even while online acquisition costs are increasing, it appears the advertising money is being well spent.
Furthermore, investors shouldn’t lose sight of the PetMeds television marketing campaign. I believe the company is the only of its kind to do this (and maybe the only able to actually afford a national campaign), which gives it an added leg up. So while online marketing costs are increasing and competition stiffens, PetMeds has an extra edge through this media while all must suffer equally under the online sphere.
With greater financial resources, a stronger brand recognition, and successful television ads (including the new Betty White campaign), I still believe that PetMeds will come to dominate the industry and be the trusted, go-to source for pet owners. And now, with the shares having suffered what I would consider a correction, the stock may be at bargain levels (refer to my last post for more info).
First, I apologize for being a bit unprolific in the past week or so. I’ve been spending some time settling back into school, etc.
I’ve had a few stock suggestions from readers, and I’m doing some work on the analysis before I write on them. Hopefully will have something solid tomorrow.
