Stocks That Almost Made The Cut: September 2006

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September 6, 2006 | S.T.A.M.T.C | | Author Asif

As most SINLetter subscribers already know, the stocks that almost made the cut were RealNetworks (RNWK), IMAX Corporation (IMAX) and Western Digital (WDC). In fact because Real Networks did not make the cut, Teva Pharmaceutical (TEVA) was the only featured stock in the September 2006 edition of the investment newsletter. I wonder how subscribers felt about that.

There was a lot I liked about RealNetworks and also wrote about it in my very first blog entry. As I mentioned in that blog entry as part of a lawsuit settlement, Microsoft (MSFT) paid Real $460 million in cash and $301 million in marketing credits. To promote its Rhapsody music service that allows you to listen to over 2 million songs for a monthly subscription fee, RealNetworks not only relies on these marketing credits but also an expensive rebate program. Consumers could almost get certain Sandisk Sansa MP3 players for free thanks to this $80 rebate.

When I recently visited Circuit City (CC) to pick another Sandisk Sansa, I noticed that Real was no longer offering those rebates. At the same time I noticed the newer versions of the Sandisk Sansa MP3 players like the 2GB e250, the 4GB e260 and the 6 GB e270. These players not only have the “cool factor” that made the Apple iPods so popular but they also cost less and work with subscription services like Rhapsody To Go and Yahoo Music Unlimited To Go. It comes as no surprise to me that these Sansa players were rated excellent by CNET.

I feel that these new Sansa players are going to do very well, helping drive up sales at both SanDisk (SNDK) and RealNetworks (RNWK). I am also a Rhapsody subscriber and absolutely love it. I did jump ship for a couple of months to give Yahoo Music Unlimited a test drive but did not like it at all and barely used it during those months. These three things convinced me revisit RealNetworks as a potential investment almost 9 months after I posted my previous blog entry about it. According to the latest quarterly results, the number of paid subscribers reached 1.625 million in the second quarter of 2006, a 41% jump from last year.

So why did I back away from featuring RealNetworks at the last minute? While looking through the numbers for the last two quarters, it became very clear that Real was profitable primarily because of payments from the Microsoft settlement. After removing the effects of the Microsoft settlement, operating expenses increased 11.17% to $64.7 million in the second quarter. Once the payments from Microsoft stop three quarters from now, Real is likely to revert back to a loss unless they cut their operating expenses a lot or have a huge surge in sales.

The stock slid 8.52% in the last two days based on an analyst downgrade and I am glad I chose not to feature RealNetworks for the reasons discussed above.

I chose not to feature Western Digital (WDC) even though I like its valuation because I felt that there might be a better point of entry in the future. It looks like my wish may be granted sooner than expected as the stock fell 7.47% on Wednesday after Komag (KOMG), a company that makes hard disk platters used by almost all the major hard disk makers, cut its sales forecast due to slowing demand. Komag fell $4.93 or 13.6%, while Seagate Technology (STX) fell 8.14% in sympathy. Revisiting this sector in about three months before the release of Microsoft’s next operating system called Windows Vista in early 2007 may be a good idea. However I feel that more than Vista, it is the massive server farms that are being erected by companies like Google (GOOG), Yahoo (YHOO) and Microsoft (MSFT) that will continue to drive demand for hard drives in addition to their use in consumer devices like cell phones and iPods.

Sometimes the best thing to do is nothing at all.

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