Since MF Chiros' posts in the Motley Fool have become subjects in this forum, here is his latest.
Subj: Comments on Secondary
Date: 96-06-06 04:48:33 EDT
From: MF Chiros
I want to offer a bit of perspective into the secondary priced at 35 per share. Is this fair price for Iomega? No. Is Iomega/KE content with this price(and a good deal for the shareholders)? Yes. To explain, let me give a brief historical perspective. When Iomega first tried to offer a secondary at around 8-9 dollars a share back in Feb., Wall St. media started a comprehensive bombing of negative reports about Iomega. Dorfman predicted that Iomega will fall to 3 dollars a share. Abelson wrote 2 lead articles in Barron's accusing Iomega of cooking the books--therefore accusing Iomega of being a sham company. Herb Greenberg of SF Chronicle wrote 5 articles blasting Iomega's share price, predicting 3 dollars a share in a matter of days. This barrage of skepticism led to stock declining to 6 dollars a share, and cancellation of the secondary. Wall St. media did all this without any serious investigation into the fundamental underlying business of Iomega (which would be shameful and unacceptable journalism in any other arena of reporting). Also, they claimed high moral ground in the name of protecting prospective investors. Well, they protected the investors from 800% gain in 3 months. The long-term shareholders of Iomega thank you, the shorts, for derailing the secondary then. You gave 125 million more dollars to the company through your efforts... The irony... :)
At any rate, it's fairly clear that Wall St. professionals have been by and large skeptical of Iomega since the share price was at 3 dollars per share last year. Iomega attempted to sell 5 million shares to this largely un-informed and skeptical crowd. I think 35 dollars was needed to convince this group. Now, could we have gotten 60 dollars a share if we just waited 3-6 more months? Most probably. However, Iomega needed the money now. 175 million dollars now is worth more to Iomega than 300 million dollars 3-6 months from now. This is because Iomega can do a lot of good for the company with 175 million dollars, now. It's kind of like seed-money. At the beginning of a great business change, even small amount of money makes all the difference. And, we're talking 175 million dollars here. Time is important in establishing market dominance and brand-name recognition. Now, Iomega won't have to come to Wall St. again until almost everything is clear and visible.
Now, there are a lot of posts recently which have made un-informed and surface jabs at the viability of the Iomega's market cap at 5 billion dollars. They question whether the current market cap. is sustainable even if Iomega takes the next generation floppy standard. One wonders if Iomega has to sell to Martians to justify the current market cap. I am almost mystified by this sentiment. MSFT makes less than 2 Billion dollars net, and it's market cap. is at 72 billion dollars. If Iomega takes the next floppy standard, Iomega can easily make 1 Billion dollars net (if not more), with recurring revenue/earnings guaranteed. And, who knows what Iomega can do to exploit their dominant position? What do you think the stock could rise to, then? The stock can easily rise 500% from here under that scenario. Therefore, I am at a loss to find people who dismiss so easily the value of owning the next floppy standard.
I have warned the shorts in the past that they are standing in front of a freight train. Shorts have not listened. I would hope that there is some respect for my analysis now. I warn again. There is great possibility that the stock can explode upward again. If you understand the cutting-edge industry analysis from the likes of IDC, you are facing grave danger.
At any rate, apart from the Holy Grail of replacing the floppy, let me give my thoughts on what is a sustainable stock price, given the visible strength of Iomega's business prospects right now in the next few posts.
To describe various business scenarios that would sustain the current valuation, let me start with the current estimates of Iomega's business prospects according to JP Morgan and H&Q. (All numbers will be adjusted for splits.) H&Q was the underwriter of Iomega's bond offering in Feb. Back then, Todd Bakar at H&Q estimated that Iomega will do 866 million in revenue in 1996. He estimated 149 million for 1st quarter, 165, 216, and 275 for 2, 3, 4th quarters. Considering that Iomega did 325 million for the entire 1995 and that H&Q was underwriting the bond offering, there were rampant accusations that H&Q was hyping Iomega's prospects. The stock was at 6-7 dollars per share. (Incidentally, this was a very difficult time because the Wall St. media expressed so much skepticism of Iomega and it's secondary--Dorfman predicted a fall to 3 dollars a share, Barron's had 2 articles accusing Iomega of cooking the books, Herb Greenberg wrote 5 articles attacking Iomega. All this led to cancellation of secondary, and Iomega offered bond instead). I was predicting 1.1 Billion in sales for Iomega for 1996.
The actual 1st quarter results were 222 million dollars, higher than the H&Q estimate by 50%, and surpassing Bakar's estimates for all but the 4th quarter. Promptly, Bakar upped his estimate to 1.1 Billion. At this juncture, I wrote a piece concerning the sustainable stock price given the underlying business.
<<Date: 96-04-29 01:14:05 EDT
I see that someone posted my projections from Dec. 10, 1995 about 'reasonable' forecast for 1996. It appears that I estimated 1.1 Billion in sales for IOMG in 1996. Most Wall St. types probably thought me crazy then... :) Ironically, H&Q estimates now stand at 1.1 billion. :) I am now forecasting 1.5 billion in sales for Iomg in 1996. I agree fully with Waverunner's channel checks which show that internal Zips installed in OEMs are a huge hit. Evidence: HP machine with the Zip is so popular that salespeople are already predicting that HP will enlarge Zip throughout HP lines. This conclusion is corroborated by the fact that Power Computing is now offering Zips as standard in their machines after checking it out as an option.
It was a question to me whether Zip as an OEM add-on will be a hit with the consumers on the level of external Zips. The early indication is that it is a blow-out hit with the average Joe Americans. HP machine with the Zip is the lowest priced Pentium machine with 16 MB ram in the Pavilion(HP) line. This is the machine for the ordinary folks. The overwhelming popularity at this level indicates to me that Zip is a huge hit with the ordinary folks(not early adopters) who just wants a cheapo Pentium machine that can run Win95.
People who know and care only about brand names like Pentium and Win95. This should be a huge sign to the marketers. For this reason, I predict that other OEMs will join the bandwagon as time passes by. Even 1.5 billion prediction may get surpassed. We shall see. But, taking 1.5 billion dollars in sales for 1996 as the reasonable case, what can we say about the fundamental valuation of Iomg? Well, a rapidly growing company like Iomg which is spending a lot of money on Advertising and Capital Expenditure should not be properly valued off the multiple of earnings. It should be valued off the multiple of sales. Sales number gives us the proper perspective on the future profitability of rapidly growing companies. Now, commodity Hard Drive manufacturers like Seagate commands market cap. approx. equal to 1 times sales. Keep in mind that they are stuck in industries that have stabilized. Minimal growth(at least compared to Iomega) with cutthroat margins.
But, more significant is the fact that Iomega is in razor/razor blade business. The future annuity income flow from the disk sales once the drive is sold is significant. In fact, the true profitability implied in the current sales number is probably double(at least) the visible income for this year. To repeat, since a drive sold generates income(from disk sales that follow) for years to come, the revenue recorded this year does not reflect the true profitability of the underlying business. In contrast, when Seagate sells a drive, the profit is in that drive alone. That's it. In contrast, Iomega will realize only half(at most) the ultimate profit from that drive in that initial sale. This means Iomega should command at least 2 times the sales coming off of comparison with Seagate.
Now, add to that the fact that Seagate has less than 20% gross margin in a cutthroat environment that's growing at less than 10-20% a year. Iomega will register 500% growth this year in sales, plus another 100% easy for another year. Plus, Iomega has about 30% gross margin. Should we not give at least 3 times the sales, then? It looks conservative to me, since by the time revenue stabilizes like Seagate has, we are looking at probably 3 times sales becoming 1 times sales in a hurry... :) At any rate, taking 3 times the sales gives me 4.5 billion dollars. That's about 35 dollars a share.
Keep in mind that I have taken conservative variables. For example, the true profitability of annuity income from a drive probably deserves more than the factor of 2 I have used. Plus, the growth factor should push the multiple to 4 to 6. However, taking the reasonable stance, I see the stock undervalued from the fundamental view point... Good luck, everyone... :) Foolishly,
MF Chiros :)>>
I will try to justify 1.5 billion projection here. You see, the company achieved 50% quarter over quarter growth coming off of seasonally high 4th quarter 1995. Very impressive. Even more impressively, Iomega has just started ramping up Jaz. Jaz revenue contributed less than 10%. It will be much more significant in 2nd quarter. Consider that MacWeek's published monthly dollar-volume leader products for Apple products. For April, Zip SCSI(external) took the number 2 spot(same as it has been for a while). And, debuting at number 3 spot was Jaz drive. A total shocker that a product shot up that high that fast. Zip was much slower in it's product-cycle. All indications are that Jaz will contribute significantly in 2nd quarter. This leads me to believe that a conservative estimate gives us another 50% growth quarter over quarter. 333 million. Taking 30% growth for 3rd quarter(virtually in line with H&Q's old Feb. growth rate forecast), we'll get 433. Then, we get 4th quarter which is seasonally high(in 1995, Iomega went from 84 million to 149 from 3rd to 4th). However, conservatively taking another 30% growth gives us 560 million(roughly). Adding it all up, 222+333+433+560=1.55 Billion.
Now, this was before additional OEMs were announced. We now have confirmations that Acer, Packard Bell/NEC, and IBM will be including Zip in their machines. This changes the picture somewhat. The 3x valuation leading to 35 dollars per share does not take into account the possibility of Zip replacing the floppy which gives us visibility for next 2-3 years of significant growth
So, 35 dollars per share was what I saw as the fair value from just looking at the visible strength of the underlying business right now. This is where my most recent Fundamental Valuation post comes in...
<<Date: 96-05-25 11:49:46 EDT
I had in the past stated that 3x sales of 1996 is reasonable and conservative. Based on that, I had stated that 35 is supportable. Since then, we've had a series of significant announcements. We have Acer, Packard Bell, and IBM's Aptiva line. These announcements give us visibility into sales and earnings of 1997 and beyond. This necessitates a re-evaluation of Iomg fundamentally.
IDC(a leading PC industry analyst firm) has said that the first (out of 3M's product, Mitsumi/Swan vaporware, any other phantom product, and Zip) to get relationship with 3 out of top 10 PC manufacturing firms will win the race to replace the floppy. IDC then predicted 40 million drives/year in 4 years. Now, Iomg has 3 out of top 5 PC manufacturers(although IBM is not yet official, I count it as 99% probability event--IBM should've denied CRW's confirmation, otherwise). Not to mention, Micron and Acer. This means rest of PC manufacturers will fall like Dominoes... Zip has gotten to this place much, much faster than the CD-Rom did in it's product-cycle. Something to consider... This leads me to conclude that it is a 90%+ probability event that Zip will replace the floppy. (One has to laugh about Murphy's prediction to the contrary. He knows something IDC doesn't? He's shooting from the hip...)
So, what does this mean? It gives us visibility into 1997 and beyond. So, let me try to get a rough, but very conservative sales and earnings of 1997. I see 5-6 million Zip drives in 1996. I see double that as an extremely conservative position. So, 10-12 million Zip drives in 1997. I will take the tie ratio of 6 to 1 from 1997 drives. That gives us 60-72 million Zip disks. I will take 4 to 1 from 1996 drives(after-flow sales from drives sold in 1996). That gives us 20-24 million disks. This leaves us with 80-96 million Zip disks. Let me just take 85 million Zip disks. Let's take 9.99 as the retail price of Zip disks by then. That's 8 dollars whole-sale and 2 dollars cost-basis. I see 6 dollars per disk as profit then. That gives us 510 million dollars in profit from Zip disks alone. I say 10 dollars profit from Zip drives. That gives us 100-120 million dollars. Let's take 110 million.
I say 1 million Jaz drives in 1997 as an extremely conservative position. I see 70 million dollars of profit from Jaz drives. Let me take 3 to 1 tie ratio. That gives us 3 million Jaz disks. I say 40 dollars of profit from Jaz disks. That's 120 million. I see 200 million in DITTO sales. That gives us 50 million.
Adding it up, I get 510+110+70+120+50=860 million in gross profits. I subtract 240 million dollars of SGA and R&D. That leaves us with 620 million. No interest payment(since we should raise 250 million from secondary). Tax rate of 39%(although a Republican President might lower this). I subtract 241 million. That leaves 379 million. That's 2.91 of EPS.
What should be the fair P/E. Normally, I would say 15 is a fair p/e for stocks(off of comparison with the interest rate). However, Iomg will grow another 100% in 1998 since the replacement of floppy basically guarantees it. So, conservatively, I will grant p/e of 30. But, wait. :) We have not taken account of razor/razor blade thing. So, I will give p/e of 40. That leaves us with a fair valuation of IO at 116 dollars per share in 1997. Discount it by interest rate and bring it backward, we get fair valuation of IO at 108 dollars per share in 1996(roughly). Now, keep in mind that this doesn't take into account sales and earnings from new products that IO will introduce(like laptop Zip, and others). I mean 250 million dollars should go towards some productive efforts, no??? So, I think 100 dollars per share target price is conservative here from the viewpoint of p/e ratio.
Let's now take the slice from Price per Sales ratio. What will the revenue of IO be? After the OEM announcements, I take the reasonable revenue prediction to be 1.5-1.9 billion dollars for 1996. I see nearly double that for 1997. That is 3-3.8 billion dollars for 1997. What is a good p/s ratio for a company virtually guaranteed to double revenue (due to momentum to replace the floppy) with recurring earnings from disks? As I stated before, 3x is a conservative ratio. Tom Gardner likes to take 4x. I personally agree with Tom, since it's silly to give only 3x to a company about to control a facet of PC globally. No other company since MSFT has managed that ever. But, taking 3x, that gives us 9-11.4 billion dollars market cap. Divided by 130m shares, that is 70-90 dollars per share. If we take 4x, we get 12-14.4 billion dollars. That's 95-110 dollars range. About the same place as from the p/e standpoint.
It is ridiculous now to talk about 326m revenue number from 1995, and say Iomg is overvalued or that it is a story stock compared to Hershey Foods. Iomg did 222m in the first quarter of 1996 alone. Even JP Morgan predicts revenue of 1.2B for 1996. Iomg is NOT a story stock here. The valuation off of sales and earnings gives us double from here conservatively speaking. Of course, IDC can be dead wrong. But, they have been the most accurate analyst firm in the past, and will continue to be. Those guys have Ph.D's in Computer Science and get paid mucho bucks to live and breathe the PC industry. Does one trust IDC or some Wall St. newsletter publisher on what will happen to the storage industry??? You be the judge, but to make money intelligently, you listen to the experts in the industry. Even common sense sides with IDC...
Warren Buffet likes to invest in companies that can be bought for less than 50% of it's fair value. Iomg is here qualified, IMHO(in my humble opinion)... I am very comfortable with 44.5. Frankly, it's dirt-cheap bargain from where I stand, from the fundamental point of view. Of course, there are risks. Some say Zip disk may be cloned. But, Iomg has 6 patents on Zip disks pending. Some competitor may emerge. But, it's too late now (at least IDC would say so)... There may be nuclear attack on Roy. Well, we have worse things to worry about then... :) For these reasons, one may trim out of their holdings if it's overwhelming percentage of their portfolio. But, fundamentally speaking, Iomg appears very undervalued from where I stand...>>
Another way to express my thoughts is that the announced OEM deals basically get us to 1.6-1.9 Billion this year(conservatively). And that 3 Billion in revenue for 1997 is very conservative. Iomega has stated in the past that they will keep GM at 25-35%. I think this is doable since Jaz is high-margin product and will become more and more significant. However, OEM Zip drive will eat away at the margin... At any rate, 860 million dollars of gross profit is anywhere between 22-28% of my projected 1997 revenue. Seems acceptable to me... At 860 million of gross profit with annuity income coming down the pike, I evaluated the sustainable stock price to be more than double from here. This does not include the likely announcement of the laptop version of Zip drive, any other product Iomega will develop over the next 2 years, and the potential popularity of Acer's 500 dollar machine in China.
On a side note, it is significant that Iomg already has production capacity to deliver 5 million drives for 1996(according to the press release disavowing their manager saying 8 million drives for 1996). With the rash of OEM announcements, it is hard to see how they can just sit still here, not ramp up to 8 million for this year(which will be amazing). Nevertheless, I assume only 5-6 million Zip drives for 1996.
As you may well know, Iomega's Bernoulli drives were considered a marvel of engineering. It was very well designed, and it's patent on Bernoulli effect to deal with contamination of the removable drive was an impressive feat. However, Bernoulli was an engineer's product made by the engineers. In other words, it did not have the mass market. Iomega almost went bankrupt with superior engineering and bad marketing and management. Stock price went down to as low as 30 cents a share(roughly).
Then, in 1994 Kim Edwards was brought in as CEO. He took Gates Rechargeable Battery from a non-entity to number 1 spot in 4 years. Then, he was given the job to run the GE's rechargeable division. When he came to Iomega, he brought along Tim Hill. Mr. Hill was named as one of the top 10 marketers in U.S. alongside the likes of Lou Gerstner of IBM.
KE turned the company culture around. His motto was give to the consumers what they want at the price they want when they want it. He viewed storage as stuff, not fancy engineering pieces. After extensive marketing, he asked Iomega engineers to come up with sub-200 dollar device that had the qualities that the mass market deemed important. The result was Zip. Zip caught on so fast among the masses that it ended up making the number 2 spot on Vogue's magazine's Top 10 Most Desired Objects in the World List in it's December 1995 issue. I don't think any computer peripheral ever made that list, let alone a storage device. It's almost magic to make a storage device 'sexy.' Zip sells... It made backing up fun and cool thing to do. And, backing up your hard drive is probably the most important part of computing that people neglect.
While this is happening, MKE, 3M, and Compaq announced in May 1995 (over a year ago), a plan to release a floptical product later named LS-120. After a year of development efforts, we have yet to see the drive being sold. It has 40% of the speed of Zip, and is twice as expensive as an internal. Internal Zip is 99, and internal LS-120 is planned to be offered for about 200 dollars. Floptical is technology Iomega abandoned in 1994, and sold to 3M after ascertaining that it has no migration path. I hear that the head mechanism for LS-120 looks like a main-frame compared to Zip head mechanism... This is because LS-120 must have two heads, Optical and magnetic. Optical head is quite heavy, and requires stronger mechanisms... Even the most ardent skeptic of Iomega, Jim Porter, stated that LS-120 will have a tremendous difficulty getting the cost out of it's drive mechanism even at high quantities.
Syquest has been the old competition to Iomega. It announced EZ135 last May, taking Syquest stock from 12 to 19. It was actually death knell of Syquest, as it was trying to make Winchester removable technology meet the needs of mass consumers at mass prices. Can't be done... Gotta pay for the speed somehow. As expected by the Fooldom since last May, Syquest recently announced loss of 51 million dollars on revenue of 47 million last quarter. How long can they last? And, who will buy them? Even their CFO discounted that rumour. Syquest has no patents (Nomai clones every Syquest Carts). Syquest has no manufacturing capacity(they closed down their factories, and announced that they will outsource). Syquest lost their top talent in R&D. It is a difficult business. They announced Syjet 6 months ago, and we have yet to see it...
The OEMs will include a device in their machines if and only if that device will appear to add value to their product. With the 'Iomega Ready' campaign, Iomega seems to be succeeding greatly in penetrating the OEM channels. This momentum will likely increase with time going by, and 175 million dollars.
It is remarkable to note that Iomega already has 5 million/year manufacturing capacity ready. With all the OEM deals in line, the manager's slip of tongue about 8 million Zip drives may be more realistic. One does wonder why Iomega needed to raise 175 million dollars if they didn't think they will actually do more than what they already have in capacity. In fact, the internal plans(though not guaranteed) are probably much grander... With 8 million Zip drives, we're talking about revenue well over 2 Billion probably. But, let's not count on that yet... One thing is clear however. If 8 million Zip drives are sold this year, the momentum for Zip will be too large to overcome, and our stock price should be considerably higher by then(understatement of the year?)
Anyway, I hope I gave you all much food for thought... Good luck to you all...
Foolishly,
MF Chiros :) |
