EFAX sounds like one of the stocks the motley fool would buy.
FOOL ON THE HILL: Valuing Hypergrowth
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This week wraps up the Hambrecht & Quist Technology Conference, still one of the most-attended conferences with the best lineup of companies each year. There was the usual parade of chief financial officers and CEOs, some presenting their stories in a contrite manner, trying to win their way back into investors' and analysts' hearts after blowing up sometime over the last 12 months. And some executives come like conquering kings telling stories of conquest on the frontier.
This year, Amazon.com (Nasdaq: AMZN) CFO Joy Kovey presented, amidst other remarks, a proposal for looking at Amazon's value, according to Jon Markman at Microsoft Investor. Kovey proposed that investors look at a company's EBITMA-generating capabilities. EBITMA, by the way, is just an adaptation of EBITDA, or interest before interest, taxes, depreciation, and amortization. In this incarnation, it is earnings before interest, taxes, marketing, and amortization. While this makes some sense, which we'll get to in a moment, it does kind of beg the question: If we're putting a multiple on operating earnings before marketing expenses, why not just project sales a number of years out, put a sensible multiple on that, and discount it to the present?
Anyway, back to Ms. Kovey's suggestion. It's an interesting one that a couple of well-regarded, or at least well-known, California investment thinkers and money managers have dealt with in their public writings. Ken Fisher, son of legendary investor Phil Fisher, took on the issue of looking at a company's price-to-sales and price-to-research ratios in his book Super Stocks. Fisher says, "Price Sales Ratios [PSR, or the market capitalization of a company divided by trailing twelve months' revenues or sales] are the most powerful single valuation methods with which I am familiar." Although one might disagree with what Fisher says about finding super stocks: "Never ever buy any stock with a PSR greater than 3. A stock selling at a PSR this high can increase rapidly, but only based on hype," since this excludes consideration of capital efficiency, profit margins, and qualitative factors, Fisher's discussion of PSRs is especially enlightening to the beginning investor who wants to start evaluating growth stocks.
Fisher and California Technology Newsletter publisher Michael Murphy also talk about price/research ratios. This valuation method essentially goes along with what Amazon's CFO proposed, which is to look at a growth company's operating earnings minus the enormous amount of funds the company has plowed back into research & development (or marketing) in order to drive the topline growth and get to the mature, highly profitable stage of corporate life. Both Murphy and Fisher add back those expenses to operating earnings, capitalize that number to get to the company's intrinsic value, and divide by the number of shares outstanding to generate a target price for that stock.
In all of these situations, these expenditures are looked at as necessary to create the growth that investors are looking for. In a static viewpoint of value, a company that cuts off all R&D spending might fall to 10 times earnings and look great to some investors, but without reinvestment, growth will likely stop. A common misperception among value investors is that without growth and without distribution of the earnings that are capitalized at such a low level by the market, there is little value.
When expenditures for marketing are necessary for creating growth, and where a company's fixed, long-lived assets are primarily intanigble, such as a brand name and reputation, capitalizing those expenses as assets to be charged off over a number of accounting cycles is a realistic way of portraying the economics the economics of that business. America Online (NYSE: AOL) had its share of detractors when it went about accounting for its economic model in this way. Cendant (NYSE: CD) is another company that has taken some lumps over the years and especially lately because it engages in what one can contend effectively to be a sensible way of accounting for its business model.
In the case of Cendant, the company needs to engage in very little investment in assets such as plant, property & equipment to generate future revenues and earnings. Its most crucial economic assets are its reputation with franchisees and its brand name and brand satisfaction with customers. That's where the spending must go to maintain and grow revenues. Rather than totally erasing these necessary expenditures from the valuation picture, one could choose to look at these things as capital expenditures. Sure, GAAP adherents will freak out. Oh, well. I'm not an accounting professor, and I'm not ruled by Ben Graham, who didn't have much to say about valuing hypergrowth situations.
The way to look at Amazon.com would be to capitalize marketing expenditures and charge them off (amortize them) over a period of time. That period of time is totally open to debate because it's very difficult to say which revenues can be attributed to which expenditures. In the case of acquisition-related intangibles, however, goodwill can be amortized on a schedule no longer than 40 years. That implies that a brand name (whether consumer brand names or trade brands) is a fungible resource on which the company feeds in creating and, equally important, retaining new accounts. While it would be aggressive to totally unrealistic to charge off Amazon.com's capitalizing marketing expenditures over 40 years, 5 years is in the ballpark, even given the fact that most look at one Internet year as five normal years (or whatever).
The first thing we look at is total marketing and sales expenditures for the company.
For fiscal years 1995, 1996, and 1997, marketing and sales expenditures were $200,000, $6,090,000 and $38,964,000 respectively. Capitalizing 1995's marketing expenditures would have resulted in yearly amortization of $40,000 over the next five years. 1996's capitalized amount would have resulted in yearly amortization of $1,218,000, and 1997's expenditures would have resulted in yearly amortization expenses of $7,793,000.
To look at what sort of valuation proposition we face, let's look at results for Q1 1998. Operating earnings as reported were negative $8,874,000. On an annualized basis, there's nothing against which we can value the company on an earnings basis. On annualized sales, it's 6.5 times sales.
Looking at adjusted earnings, we back out sales & marketing expenses and add in amortization expenses from capitalized sales & marketing. The residual amounts for each year (cutting them into quarters now because we're looking at one quarter) are $10,000, $304,500, and $1,948,200. Adding in amortization from Q1 1998, as well, we have total amortization for the quarter at $2,262,700 + $975,200 = $3,237,900.
Operating earnings then look like:
(in 000s)
Gross profit……$19,321
Prod't Devel……...6,729
Amortization…..3,237.9
G&A……………...1,963
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Operating Income..$7,422.1
Interest Expense...$2,025
Tax Provision..........1,889
Net Income...........$3,508
EPS.................... $0.145
Annualizing that (though it misses part of the point to annualize the earnings of a company growing sales in the 30%+ range sequentially), we get EPS of $0.58. That puts us at a P/E of 162.9. Not very satisfying for the value investor at the current price, but if this company were trading at the 52-week low -- a 25.8 P/E of these earnings in an exploding Internet market would be absurdly low, if all else about the company's quality were equal. In addition, that represents economic earnings on a negative base of invested capital, which is always a very powerful combination. Dell Computer (Nasdaq: DELL) could tell you about that and negative cash conversion cycles, which is the amount of days sales in inventory plus days sales in accounts receivable less days of cost of goods sold in accounts payable. (CCC = Days in Inventory + Days Sales Outstanding - Days in Payable.)
Thinking back on similar enterprises that generate huge returns on low invested capital bases, there are only a few companies that come to mind. Dell, again, is one example of that, and GEICO or Wal-Mart (NYSE: WMT) are two others. That Amazon ended its last quarter with negative invested capital and created economic profits are two tip-offs that this company deserves some leeway in the multiples that are considered "fair" in determining its intrinsic value at this time.
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