This company is profitable, has a proven business model and one of its founders is a Nobel laureate. Financial Engines (FNGN) priced its IPO at $12 per share in March of this year and currently trades about 11% above its IPO price at $13.42. The company has a disruptive yet proven business model where it uses technology to offer portfolio management services and investment advice. Given the importance of asset allocation to portfolio returns as discussed in our October 2008 newsletter, William Sharpe, Professor of Finance, Emeritus at Stanford University and winner of the 1990 Noble Prize in Economics decided to start Financial Engines in 1996 and use technology to offer sophisticated investment advice to individuals regardless of their wealth or investment experience.

While the average client balance for the top 100 traditional Registered Investment Advisors (RIAs) is over $1 million, the average size of a portfolio managed by Financial Engines is $72,000. In fact 43% of the portfolios managed by the company have less than $20,000 in them. Despite the low average portfolio size, Financial Engines has almost $30 billion in assets under management (AUM) as of the first quarter of 2010. Their technology based solution and partnerships with several large employers to offer advice to 401K participants has helped the company scale AUM effectively from $6 billion in 2006 to $30 billion now. The company has partnerships with 115 of the Fortune 500 companies and has signed up over 360 employers in total.

Growth:

The company has a three pronged growth strategy:

1. Grow Assets Under Contract (AUC), which are currently $289 billion, by signing on more employers, organic growth through ongoing contributions by existing 401K participants, market appreciation, net new hires by employers and a shift towards automatically enrolling employees in 401K plans.

2. Grow Assets Under Management (AUM) by increasing enrollment by 401K participants from employers under contract who have not signed on yet.

3. Entering new markets by going beyond 401Ks and into IRA.

Q1 2010 Results:

Revenue in the first quarter of 2010 increased 40% year-over-year to $24.3 million. Net income increased to $1.6 million in Q1 2010 when compared to a loss of $0.7 million in Q1 2009. Non-GAAP Adjusted EBITDA for Q1 2010 increased 130% year-over-year to $5.3 million. However due to a one-time $5.5 million stock dividend, net loss attributable to shareholders  was $3.9 million or 25 cents a share.

Valuation:

Financial Engines expects to post revenue of $105 to $110 million in 2010 and adjusted EBITDA of $24 to $26 million. Using the mid-point of their EBITDA range and the current enterprise value of $448 million, I get a EV/EBITDA value of 18. The EV/Revenue ratio works out to 4.17. The company expects long-term EPS growth of 25 to 40% at operating margins of 15 to 20%.

Running a 10 year DCF model using a 10% discount rate, 20% earnings growth for 10 years and a 2% terminal rate, I get a current value of $23.54 for the stock. If you are a growth investor, Financial Engines should definitely be on your watch list and may provide a less risky alternative to Tesla Motors.

Related Reading:

Original S-1 Filing

William Sharpe and the Capital Asset Pricing Model (CAPM)

Investor Presentation – June 2010

The video game industry can certainly use any boost it can get from these new innovations mid way through the console refreshment cycle. While May video game software sales numbers are yet to be released, April was a dismal month with sales falling 22% year-over-year. If there is any company in this industry that can use a shot in the arm, it is Electronic Arts (ERTS). Once the largest game company, Electronic Arts with its aging franchises like The Sims and Need For Speed has been displaced from its perch by Activision Blizzard (ATVI) both in terms of revenue and market cap. Bobby Kotick, the CEO of Activision Blizzard, who was once a developer for Electronic Arts, achieved his goal of “pushing Electronic Arts aside and becoming No. 1 in the industry” in the words of Josh Resnick, a former director of production for Activision according to this outstanding LA Times article Activision’s modern warfare. For a slightly kinder profile of Mr. Kotick, check out this Kotaku article titled A Delightful Chat With The Most Hated Man in Video Games.

With Activision Blizzard the largest position in the SINLetter model portfolio and my personal portfolio I have been asked from time to time about my thoughts on Electronic Arts as a potential turnaround play or an acquisition candidate. On the surface it does appear that Electronic Arts has a lower valuation than Activision Blizzard with EA selling for less than 1.5 times sales and has a market cap of $5.2 billion while Activision trades at over 3 times annual sales and has a $14.35 billion market cap. However when you compare the two companies on every other metric including strength of the balance sheet, margins, growth rate and cash flow, Activision emerges as the clear choice. During the conference call announcing fourth quarter 2009 and full year results, Activision’s CFO and now COO Thomas Tippl remarked “we generated a record $1.2 billion of operating cash flow, which is more than ten times ahead of our next best competitor.”

One of the driving forces for the high margins and cash flow at Activision has been the contribution of the Blizzard unit and specifically the high margin subscription business from World of Warcraft (WoW). Is it conceivable that Electronic Arts may someday create a Massively Multiplayer Online Role Playing Game (MMORPG) that could challenge WoW’s dominance? Could Electronic Arts have a hit in its pipeline that could rival the success of Call of Duty: Modern Warfare 2? To answer these questions and to look into the potential of Electronic Arts as a turnaround play, I asked contributing author Jackie Judge to explore Electronic Art’s pipeline of upcoming games. Given below are some of her thoughts.

2010 bodes well for EA Games. The year was kicked off with the release of the highly anticipated Mass Effect 2 – developed by Bioware, and published by EA Games  – a game that sold over two million copies within a week of its release, and holds near perfect scores from game reviewers, according to Metacritic, close to 100 for both the PC and consoles. Following closely in the successful wake of Mass Effect 2 are several highly anticipated games being released later this year.

1. One of these projects is Project Redlime by Starbreeze Studios that promises a “reinvention of the classic action/strategy game Syndicate”. Project Redlime was recently chosen, as evident through a March press release given by Starbreeze Studios’ CEO Johan Kristiansson, to continue onward in development over another game in development with EA, one based on the ever-popular Jason Bourne franchise.

The Bourne license was last used in Robert Ludlum’s The Bourne Conspiracy, which received solid reviews in 2008. However, following Activision’s merger with Vivendi that same year, the Ludlum family reacquired the rights to make games based on Robert Ludlum’s novels, eventually shopping them out to EA in February 2009. According to the LA Times, EA will remain in partnership with the Ludlum estate, though no games based on the authors work are currently in development. An EA spokesperson reportedly told the newspaper that, “EA and the Ludlum Estate are still discussing making a game based on the Bourne franchise.”

Electronic Arts' Medal of Honor

2. Another highly anticipated game from EA Games this year includes a remake of the highly successful Medal of Honor game, originally released in 1999 by DreamWorks Interactive for the Playstation, and so popular it spawned an entire series. This first person shooter will launch on October 12, 2010 in North America, and will veer away from the original settings to a modern day Afghanistan one, and will emphasize a greater sense of realism; to achieve this, EA consulted with the United States Military on real issues faced overseas, like raiding terrorist hideouts, hostage situations, undercover operations and more.

Harry Potter Videogame

3. EA has partnered with Warner Bros. Interactive Entertainment to develop two Harry Potter and the Deathly Hallows games to coincide with the equally anticipated final movies in the much-loved series. The first part will be released on all major gaming platforms alongside, purportedly, the release of the first half of the movie this autumn of 2010. When fans leave the theatres in droves this autumn, giggly from the scent of butterbeer and pumping adrenaline from throes of wand casting, this game could await them at home, to continue the story.

4. Another highly anticipated game from EA called Crysis 2 is expected to release in the fourth quarter (November 2010 by some accounts). The sequel to the original PC only title will now be available for PC, XBOX 360 and Playstation 3 and could very well surpass sales of the original, which sold more than 1 million copies.

5. Star Wars: The Old Republic built by Bioware in association withe Lucas Arts could be EA’s answer to World of Warcraft. Slated for release in 2011 and built around a strong franchise, this massively multiplayer game is expected to hit 2 million subscribers according to some analysts.

With EA’s foray into the social gaming through their acquisition of Playfish for $300 million, an interesting pipeline of products, new innovations on the console/controller front, the potential of a successful MMORPG in 2011 and $2 billion in cash/investments on its balance sheet, EA is certainly worth a second look. However given current market conditions and the fact that I already have exposure to the industry in my portfolio through Activision Blizzard  and Glu Mobile (GLUU), I prefer keeping EA on my watch list for now.

Related Posts:

Ten Reasons I am Buying Activision Blizzard

Thoughts on Activision Blizzard’s Q4 Results

Activision Blizzard: A New MMORPG and Subscription Model for Starcraft II

The Apple App Store Ecosystem and Glu Mobile – Part 1

The Apple App Store Ecosystem and Glu Mobile – Part 2

Sell/Buy Ratio:

The insider Sell/Buy ratio is calculated by dividing the total insider sales in a given week by total insider buying in that week. The adjusted ratio for last week was 30.11. In other words, insiders sold more than 30 times as much stock as they purchased. This is significantly higher than the 9.41 ratio from the week prior but still well below the high of 68 in the last week of April. We are calculating an adjusted ratio by removing transactions by funds and trying as best as possible only to retain information about insiders and 10% owners who are not funds.

I also removed two sets of transactions, one on the buy side and one on the sell side that were significantly skewing the ratio last week. The transaction on the buy side I removed was the purchase of 15.59 million shares of Lions Gate Entertainment (LGF) by famous investor Carl Icahn through his tender offer of $7/share. Mr. Icahn spent $109.15 million acquiring these shares and bumping up his total stake in Lions Gate to 32%. The transaction on the sell side I removed was the sale of 19.63 million shares of Ulta Salon (ULTA) through an offering by its CEO and other directors that generated $419.39 million. One could argue that while Mr. Icahn is neither a founder of Lions Gate nor part of the management team, taking out that buy transaction makes sense but the sale by the insiders of Ulta Salon should be retained. Not removing the Ulta transaction bumps the ratio up to 48.52.

Notable Insider Buys Last Week:

1. Saul Centers (BFS) $41.89

Chairman and CEO Francis Saul II once again acquired 94,306 shares of this shopping and office REIT paying $3.975 million at an average purchase price of $41.96. Over the last 13 weeks he has purchased over $23 million of Saul Centers stock.

Key Statistics:

2. DuPont Fabros Technology (DFT) $26.40

Director Mark Amin acquired 84,332 shares of this Washington DC based data center REIT paying $2.16 million at a purchase price of $25.65. Even with a recent 50% increase in the dividend, the dividend yield is now just 1.9% and not very attractive for a REIT.

Key Statistics:

3. MRV Communications (MRVC.PK) $1.41

Director Charles Gillman acquired 1,308,722 shares of this telecommunications equipment provider paying $1.82 million at a purchase price of $1.39 per share. Director Kenneth Shubin Stein also acquired 100,000 shares paying $129,430 at a purchase price of $1.29. Dr. Kenneth Shubin Stein, MD, CFA also happens to be the founder of the deep-value fund Spencer Capital Management and teaches as an adjunct professor at the Columbia University Graduate School of Business. Charles Gillman is Senior Managing Member at value oriented hedge fund Boston Avenue Capital.

Key Statistics:

4. Quidel (QDEL) $12.35

A number of insiders including the CEO, CFO and three directors acquired 130,525 shares of this San Diego based diagnostic testing solutions company  paying $1.4 million at an average purchase price of $10.75 (transactions range from $10.61 to $11.25).

Key Statistics:

5. NCI Building Systems (NCS) $9.85

A number of insiders including the CEO, CFO and two directors acquired 102,630 shares of this construction metal products company paying $883,720 at an average purchase price of $8.61 (transactions range from $8.56 to 9.39). CEO Norman Chambers acquired a bulk of these shares purchasing 95,516 shares and increasing his holdings by 39%.

Key Statistics:

Another insider purchase worth noting is the purchase of 43,260 shares of Hornbeck Offshore Services (HOS) by father-son team Larry Hornbeck and Todd Hornbeck. HOS is a 1,300 employee Louisiana based company that provides transportation and logistics services to the offshore drilling industry through offshore supply vessels, tugs and barges. Larry, the original founder of the business is now a director and son Todd is currently President and CEO.

Larry purchased 22,500 shares at an average price of $14.36 and Todd purchased 20,760 shares at an average price of $14.40. The stock closed Friday at $14.98, up 4.46%. According to this Barron’s article, less than 25% of the company’s offshore contract coverage in the second half of the year is for drilling in the Gulf of Mexico and just 6% in 2011. Five of its 55 vessels were also involved in relief efforts. The company  has filed a lawsuit against the federal government seeking to nullify the six month ban on deep water drilling in the Gulf of Mexico. The stock is off 39% from its April 30 high of $24.47 following the BP oil disaster.

Notable Insider Sales Last Week:

1. The Home Depot (HD) $31.94

Director David Batchelder sold 4.08 million shares of this home improvement retailer company generating $131.2 million at an average selling price of $32.17

Key Statistics:

2. Mercadolibre (MELI) $59.23

Director Anton Levy sold 700,956 shares of this Argentinian e-commerce and payments provider generating $40.67 million at an average selling price of $58.03. CFO Kazah Hernan sold 20,000 shares generating $1.2 million at a selling price of $59.06 and Senior VP of Payments Gimenez Osvaldo sold 5,000 shares generating $290,750 at a selling price of $58.15.

Key Statistics:

3. Fidelity National Information Services (FIS) $27.48

Executive Chairman William Foley II sold 750,000 shares of FIS generating $20.75 million at an average selling price of $27.67. This transaction reduced his holdings by 29%.

Key Statistics:

4. Plains All American Pipeline (PAA) $58.47

Director Gary Petersen sold 328,200 shares or 98% of his holdings of this oil and natural gas pipeline company generating $19.15 million at an average selling price of $58.35.

Key Statistics:

5. United Natural Foods (FIS) $32.79

Several Directors and a regional President sold 231,805 shares of this natural and organic food company generating $7.65 million. Transaction prices ranged from $32.53 to $33.65.

Key Statistics:

Voluntary Disclosure: I own shares of Lions Gate Entertainment (LGF) and Quidel (QDEL).

In a market that appears directionless and bounces from day to day, reviewing insider transactions for opportunities could turn up some gems in the rough. I have personally seen many small and micro cap companies that had strong insider buying near the March 2009 lows go on to become 10 baggers.

Insiders may sell for a number of reasons including the purchase of a new home, paying for education or in some instances simply to diversify their holdings. The selling may not necessarily imply that they view the near term prospects of their company negatively. On the other hand, insider buying often implies better prospects for the company in the future or a stock that in the insider’s opinion is undervalued.

Sell/Buy Ratio:

The insider Sell/Buy ratio is calculated by dividing the total insider sales in a given week by total insider buying in that week. The adjusted ratio for last week was 9.41. In other words, insiders sold more than 9 times as much stock as they purchased. While this might seem large, the Sell/Buy ratio that we calculated for the last several weeks since we started collecting this data has been much higher and was an astounding 68 in the last week of April. The last week of April is when the market began its recent correction as you can see from the chart of the S&P 500 index below. We are calculating an adjusted ratio by removing all funds and trying as best as possible only to retain information about insiders and 10% owners who are not funds.

Given below is the list of 5 notable insider buys and 5 notable insider sales last week. I have also included a few key metrics below the name of the company. Certain industries have their preferred metrics such as sales store sales for retailers, funds from operations (FFO) for REITs and revenue per available room (RevPAR) for hotels that provide a better basis for comparison but the simple valuation metrics like Price/Earnings, Price/Sales and Enterprise Value/EBITDA included below should provide a good starting point for analyzing the majority of stocks.

Notable Insider Buys Last Week:

1. Legg Mason (LM) $32.37

Billionaire Director Nelson Peltz acquired 1 million shares of the asset management company paying $30.4 million and bumping up his holdings by 10% to 11.08 million shares. Average acquisition price $30.4.

Key Statistics:

2. Saul Centers (BFS) $41.84

CEO Francis Saul II acquired 130,800 shares of this office and shopping center REIT paying $5.1 million at an average purchase price of $38.97.

Key Statistics:

3. MF Global Holdings (MF) $6.99

New CEO and Chairman of the Board Jon Corzine acquired 352,100 shares of this financial company paying $2.499 million at a purchase price of $7.1. Directors and other senior management also acquired an additional $692,250 of stock last week.

Key Statistics:

4. A. H. Belo Corporation (AHC) $6.75

Chairman, President and CEO Robert Decherd acquired 234,249 shares of this newspaper and publishing company paying $1.67 million at a purchase price $7.13.

Key Statistics:

5. SunPower (SPWRA) $13.40

Director Thurman Rodgers acquired 100,000 shares of this solar company paying $1.04 million at a purchase price of $10.36. SunPower’s CFO also acquired 5,000 shares for $50,443 at a purchase price of $10.09.

Key Statistics:

What is interesting about this group of companies is that with the exception of Saul Centers, all of them are trading below book value. Please note that the book value number on Yahoo Finance includes intangibles and goodwill. It is worth mentioning that besides the $5.1 million purchase last week, Francis Saul has been purchasing stock of Saul Centers on the open market since mid-March and has acquired nearly $20 million of stock over the last 12 weeks.

Another company that stood out is Center Bancorp (CNBC), the parent company of New Jersey based Union Central National Bank. Besides its eye catching stock symbol what made this company stand out was a number of purchases by its directors that totaled $817,176. Center Bancorp  had considered raising capital through a common stock offering but scrapped plans earlier this month.

Director Joseph Hyde III at the microcap biopharmaceutical company GTx (GTXI) acquired $865,535 of its stock for an average purchase price of $2.59. His total open market purchases since early May have amounted to $2.42 million. Given that the market cap of GTx is under $105 million, maybe Mr. Hyde knows something we don’t.

I also noticed a number of insider purchases by the CEO and directors of SINLetter Special Reports Portfolio holding Employers Holdings (EIG). While the total transaction amount last week was less than $65,000, insiders have purchased $284,350 in stock since late May and it was good to see some insider buying in this undervalued insurance company.

Notable Insider Sales Last Week:
1. Nu Skin Enterprises (NUS) $26.77

Chairman Blake Roney sold 4 million Class A shares for $25.65, generating $102.6 million from the sale. Two additional directors also sold an additional 57,000 Class A shares at the same price. All three sellers are founders of the company and the offering was handled by JP Morgan and Deutsche Bank.

Key Statistics:

2. Tutor Perini Corporation (TPC) $17.20

Chairman & CEO Ronald Tutor sold 600,000 shares of this construction services company generating $10 million at a selling price of $16.68.

Key Statistics:

3. Estee Lauder (EL) $57.86

Chairman Emeritus Leonard Lauder sold 150,000 shares of this cosmetic giant over the last two weeks generating $8.53 million at an average selling price of $56.88. Chairman of Clinique Labs LLC, Ronald Lauder, sold 125,000 shares two weeks ago generating $7.42 million at a selling price of $59.36.

Key Statistics:

4. Salesforce.com (CRM) $96.64

Salesforce.com probably shows up on every insider selling screen because founder, CEO and Chairman Marc Benioff has been consistently selling shares as far back as I can remember. He currently seems to be on a 10,000 shares a day sales plan and has sold $52.22 million worth of stock since mid-March. However the reason Salesforce.com made the list does not have to do with Marc Benioff’s sales but instead a $3.94 million sale last week by EVP Parker Harris where he sold 42,873 share at a price of $91.95. The stock hit a new 52 week high last Friday and has a very rich valuation despite the fact that they have to defer both revenue and expenses due to the subscription nature of their product.

Key Statistics:

5. BJ’s Wholesale Club (BJ) $38.49

Director Herbert Zarkin sold 152,606 shares of this warehouse retailer generating $5.76 million at a selling price of $37.74. BJ’s CFO Frank Forward also sold nearly $1 million of its stock by selling 25,000 shares for $38.5. The CFO reduced his stake in the company by 26% through this sale.

Key Statistics:

Voluntary Disclosure: I hold Employers Holdings (EIG) both in my personal portfolio and in the SINLetter Special Reports portfolio.

“The iPhone numbers nearly match the Christmas sales numbers. You have to ask whether Christmas has come again for Apple in March.”

Apple reported net income of $3.1 billion, up 90% from Q2 2009 and revenue increased 49% year-over-year to $13.5 billion. Earnings per share came in at $3.33. Gross margin was 41.7%, 270 basis points above Apple’s guidance. Gross margin for the current quarter is however expected to fall to 36% with 25% of the drop attributed to the introduction of the iPad.

Consensus analyst expectations for the quarter were earnings of $2.43 per share and these expectations had already been revised higher multiple times over the last three months. IDC had expected Mac sales to increase 24% when compared to Apple’s 33% year-over-year increase to 2.96 million units. Industry research firm Gartner was on the money expecting Mac sales to increase 34% year-over-year. Based on Gartner estimates, Apple is the fifth largest PC vendor in the United States with 8% market share.

Going into this quarter Apple has strong tailwinds in the form of the iPad, a new line of MacBook Pro laptops that was released just this week (it sucks that my four month old MacBook Pro is already outdated) and a new version of the iPhone that is widely expected to launch in June. In the words of Apple COO Timothy Cook regarding the iPad, “We will see where this thing goes but it has shocked us the level of demand at least initially”. Considering their experience with iPhone demand over the last three years, one would hardly expect Apple to be caught off guard by the demand for iPad, which we discussed in the article The iPad Revolution: Naysayers are Missing the Big Picture last week. The comment by Mr. Cook combined with Apple’s decision to delay the international launch of the iPad clearly indicates strong sales of the product.

A breakdown of the results by product line is given below. Once I compiled this information from their conference call transcripts, it was interesting to see that the average selling price of the iPhone dropped to $600 from $620 in the first quarter but is up from $579 in Q2 2009. Also worth noting is that while iPod units have dropped year-over-year, revenue was up 12% due to a higher mix of the more expensive iPod Touch. iPhone revenue mentioned below does not include revenue from accessories and carrier payments.

Apple earned $7/share in the first half of fiscal 2010. Analyst expectations for the year were $12.06/share based on Q2 coming in at $2.45. Using the higher Q2 actual EPS of $3.33 and leaving the consensus analyst expectations unchanged for the second half of the year, we still get an EPS of $12.94 for fiscal 2010. Based on yesterday’s closing price of $244.59, we get a forward P/E of 18.89.

The company has nearly $23.155 billion in cash and short-term investments on its balance sheet, which works out to about $25 per share. Given the strength of its balance sheet, high growth and a slate of new products, the stock probably still has a lot of room to run.

Voluntary Disclosure: No position in Apple.

Research In Motion (RIMM) took the lions share of the smartphone market with its Blackberry line of smartphones by getting email right and building durable phones that did not crash. However even though I was a power Blackberry user, as soon as the iPhone released, I knew this was the convergence device I had been waiting for. While the Blackberries models circa 2007 like the 8700 and the Curve could do email well, the selection of apps was limited, the process of getting an external app cumbersome and the Blackberry browser felt like something from the stone age after trying out Safari on the iPhone. Research In Motion has been playing catch up since the release of the iPhone.

Amazon’s Kindle device is going to experience a similar fate following the release of the iPad. When considering gift ideas for my nephew whom I was going to meet after nearly 8 years, I strongly considered getting him a Kindle given his passion for reading but ended up picking up an iPad instead. The iPad is a convergence device that successfully combines the best of an E-book reader and a Netbook. Not only can you access books on the iPad through the iBooks application, an app called Free Books given you access to over 23,000 free books. The FreeBooks app itself costs $1.99 for the iPhone and iPod Touch but is free for the iPad.

Apple sold 300,000 iPads on the day it was released. This was well below analyst estimates that had touted sales as high as 600,000 to 700,000. As you can read from the article titled “Apple Analyst Pulled 700,000-iPads-Sold Number Out Of His Ass”, those analyst estimates were little more than conjecture. You are not alone if you find it ironic that Wall Street’s disgraced internet poster boy Henry Blodget is taking a shot at another analyst.

The Monday following the release of the iPad, I was surprised to see Michael Bigger of Bigger Capital short the stock of Apple. I respect Michael’s investing acumen given his decision to pick up Amazon.com (AMZN) following the 2001-2003 recession and more recently footwear company Crocs (CROX) after most people had given up on the company for dead. He has the rare ability to not only go against the crowd but also has the patience to hold on to his investments for years. His approach brings the words of the great speculator Jesse Livermore to mind. In the book Reminiscences of a Stock Operator by Edwin Lefèvre, Jesse is quoted as saying

“It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I’ve known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine–that is, they made no real money out of it. Men who can both be right and sit tight are uncommon.”

Michael’s coverage of Crocs was published in the March 2010 edition of SINLetter and the stock is up more than 45% since that newsletter was published. I can see why Michael and a number of other people would dismiss the iPad as a fad but I felt that he was missing the bigger picture here (yes Michael, this is a pun on the name of your investment firm). The similarly priced iPhone sold 270,000 units when it was first released but eventually went on to sell more than 25 million units in 2009 (3.8 million in fiscal Q2, 5.2 million in fiscal Q3, 7.4 million in fiscal Q4, 8.7 million in fiscal Q1 2010) and now has every smartphone company from Palm (PALM) to Research in Motion playing catch up. After testing the water shorting Apple, Michael decided the momentum was too strong and covered his short position in Apple for a small profit.

The Apple sales associate who helped me with my iPad purchase used an iPod Touch to accept my credit card payment right on the floor of the Apple store without requiring a visit to a long checkout lane. You can currently use the iPhone and the iPad to unlock your car and start it remotely using the Viper SmartStart app should you desire a warm and toasty car on those chilly winter mornings. I can easily fathom someone developing an app that would allow restaurants to accept orders using iPads from tables and displaying these orders on a large screen for the chef along with the timestamp of the order. With over 3,000 apps specifically designed for the iPad and the ability to use a majority of the 180,000 iPhone apps, the number of ways you could use this device is almost limitless. Zynga’s word game Scramble 2, which is actually an iPhone app and not a native iPad app was fun to play on the iPad even after I expanded the app to make it fit the iPad screen. According to tech review site Engadget, “To say Apple is about to put a major dent in Kindleworld is an understatement. The iBooks app is one of the most beautiful and thoughtful uses of the iPad screen real estate on the device.”

Amazon.com’s Kindle reader is available in 130 countries and Amazon sells 6 Kindle books for every 10 physical books sold. Despite this first mover advantage, the iPad is a clear and present danger to Amazon’s Kindle device. Amazon would do well to take a page out of Google’s Android book and focus its attention towards using the Kindle software as a delivery device for its customers irrespective of the actual hardware used. When the editor of Wired magazine Chris Anderson released his book Free: How Today’s Smartest Businesses Profit by Giving Something for Nothing on the Kindle for the grand price of $0 (the hardcover version cost more than $20 at the time of release), I decided to give the Kindle app for the iPhone a whirl and read nearly a third of the book on my iPhone. An iPad version of the Kindle app was released on April 7, less than a week after the iPad’s April 3, 2010 launch.

Amazon is a very well run company with their G&A expenses falling 25 basis points to 14.5% in Q4 2009 even as revenue grew 42% to $9.52 billion. Return on invested capital (ROIC) was an eye-popping 66%. In the fourth quarter of 2009, third party sellers accounted for 28% of overall worldwide revenue for the company. Amazon simply acts as a middle man for this revenue stream and it is highly profitable for the company. Amazon Prime, a service that offers 2 day free shipping for an annual subscription fee, is reaching maturity in international markets. As an Amazon Prime customer I can see how it could help enhance international growth in the months to come. However if your investment thesis regarding Amazon depends of Kindle fueled growth, this might be a good time to reassess that thesis. The iPad is going to change the landscape for every E-reader in the market including Kindle, Barnes & Noble’s nook and Sony’s Reader just like its little brother the iPhone did a couple of years ago.

On an unrelated note, I wrote most of this blog entry on a Virgin America (@virginamerica) flight from Washington DC to San Francisco. This was my first time flying Virgin America and the experience was as good as some of the best international airlines I have flown like Singapore Airlines and Emirates. In flight Wi-Fi and a personal entertainment console that can be used to watch movies, play games, order food and drinks by adding them to a shopping cart, listen to music by creating a custom playlist with artists ranging from Moby to Bob Dylan and even the ability to chat with others on the plane made the hours melt away. An upgrade to Main Cabin Select allowed me to check in bags, watch on demand movies and order as much food, snacks or drinks as I wanted without paying a dime more. The only thing that was not included was Wi-Fi, which was an additional $10 charge from a third party provider. I would highly recommend checking Virgin America out for domestic flights even if they cost a few dollars more than incumbents like United Airlines (UAUA) and keeping an eye out for an upgrade to Main Cabin Select (I only had to pay about $40 more).

The app store by Apple (AAPL) has been immensely successful since its launch on July 10, 2008 and has been the subject of countless media articles like this Dec 2009 New York Times article gushing about how it has helped certain developers become millionaires overnight. One billion apps were downloaded from the app store by April 23, 2009 and it was just 5 months later that Apple announced on September 28, 2009 that downloads had topped more than 2 billion. It took the app store just over 3 months to hit 3 billion downloads by January 5, 2010.

Everyone from mom and pop development shops to current SINLetter portfolio holding Activision Blizzard (ATVI) want in on this gold rush. Just like the California Gold Rush in the mid nineteenth century, it is often the people selling the tools that may end up becoming rich after the easy gold had been mined by early arrivals. This article is about those developers and companies that have tried to capture some of the app store magic only to find their apps disappear in a vast ocean of more than 160,000 apps.

One of the first iPhone games we reviewed on our sister site AppStruck shortly after its launch in May 2009 was a game with stunning graphics called Glyder published by a company called Glu Mobile (GLUU) that is listed on the Nasdaq stock exchange. There are just a handful of public game companies and when I found Glu, I decided to kick its tires to see if it was an investment worth considering especially given its focus on building games for the iPhone and the iPod touch. But before we get into the specifics of Glu, I figured it might be a good idea to get a reading on the market size.

Size of the App Store Ecosystem:

One of the first things a venture capitalist wants to know when you enter a room with your business plan is the size of the market and what portion of that market you expect to capture. The perception of the sheer size of the App Store ecosystem is one of the reasons start-ups like ngmoco have managed to raise $40 million from venture capital funds over the last two years. In stark contrast, Glu, which targets the exact same market, has a market cap of just $25.7 million.

The size of the App Store ecosystem has been a subject of lot of discussion and probably even Apple does not have the answer to it because the ecosystem not only includes the sales of apps through the App Store but also in app purchases of virtual goods and advertising revenue. Mining through the database of apps we built on AppStruck, I found that over 24% of the nearly 160,000 apps in the app store were free and 42% of them were priced at $0.99. Given below is the price distribution for 95% of the apps in the app store.

While having lunch in San Francisco with Jeff Scott, the founder of the leading iPhone app review site 148Apps.com and the Best App Ever Awards, we started discussing the size of the app store and he told me that roughly 70% of the people who land on his website are looking for free apps. GIGaom pegs the number of free downloads to 75% of all downloads based on data obtained by mobile analytics firm Flurry. Using the more conservative 75% number and assuming that downloads for the year 2010 are likely to hit 6 billion, it means that 1.5 billion downloads are for paid apps.

Based on the price distribution from the AppStruck app database, the weighted average price works out to $2.41 per app. The number should probably be lower because more 99 cent apps are likely to be downloaded than apps priced at $99.99. Taking a conservative approach, I am going to put the average price at $2. This means that the Apple app store is likely to generate $3 billion in revenue in 2010 on the low end and $3.61 billion on the high end of the range. Since developers get paid 70% of revenue, we have a potential market size of $2.1 to $2.53 billion available for developers.

AdMob, a mobile advertising company acquired by Google last November for $750 million, was approaching $100 million in gross revenue from advertising. Once you add revenue generated from virtual goods and advertising, the app store ecosystem could begin to approach $3 billion.

Part 2  of this blog entry will cover some of the challenges and opportunities that Glu Mobile faces in this rapidly evolving app store ecosystem.

I had personally experienced a stalling issue with a new 2000 Toyota Camry that would manifest itself only when I exited a freeway and was stopped at a red light without manually turning the cruise control off. The dealer could not figure out why this was happening and the problem went away after a few months. In contrast I had very good luck with two Fords and still sometimes regret trading in my reliable 35th anniversary Mustang for an IS 350. Both these incidents occurred during a period of time when Toyota enjoyed the unblemished status of being one of the safest car companies and went on to surpass General Motors as the largest car company in the world. With two cars made by Toyota parked in my driveway (the IS 350 is affected by the recall), I have to say that over the years I have been satisfied with the quality and reliability of these cars.

Stalling of a car especially in the middle of a freeway could be dangerous but there is little that can unnerve drivers more than an accelerator pedal that gets stuck or brakes that do not do their job when needed. The situation Toyota faces right now has a number of parallels with the sudden acceleration related issues that Audi ran into in the mid 80s. The company issued a number of recalls and sales suffered as a result of the media attention the case received. It later came to light that there were really no problems with sudden acceleration and that most of the reports related to sudden acceleration had to do with human error. However the damage to Audi was already done and it took Volkswagen’s luxury brand a number of years to recover from this negative publicity. Given Toyota’s global reach and product lines, the impact of these recalls will probably not be felt as deeply at Toyota as they were at Audi.

These recalls and the associated media circus will impact Toyota in a number of ways including,

1. The direct cost of the recalls, which is estimated to range anywhere from $1.1 billion (Toyota’s estimate) to as much as $4 billion (analyst estimates).
2. The intangible impact on Toyota’s brand, which until now was synonymous with quality.
3. Loss of sales estimated at close to $1 billion by the company.
4. The impact on the brand potentially leading to pricing and hence margin pressure in the near term.
5. Defending against individual and class action lawsuits.

Valuation:

Toyota has shed more than $33 billion of its market cap since these recalls began but to ascertain if Toyota looks attractive at these levels, I am comparing several financial and valuation metrics of Toyota versus competitors like Honda and Ford in the tables below. With the acquisition of Jaguar and Land Rover from Ford, India based Tata Motors (TTM) has also become a global player and I have included this SINLetter favorite in the comparison as well.

These car companies are complex entities with operations in many countries and a number of product lines, so simple valuation metrics may not give us the complete picture but they provide a starting point for further analysis.

When you look at some of these valuation metrics, at first glance Ford actually looks more attractive than its peers with a trailing P/E of just 13.7 and a P/S of 0.33. However these numbers mask the fact that Ford’s profits in 2009 were primarily driven by Ford Credit and the automotive division lost money last year. The $132 billion in debt on Ford’s balance sheet is also as a result of Ford Credit and automotive debt at the end of 2009 was “just” $34.3 billion. Ford does expect its automotive division to post a profit in 2010 after excluding special items.

Toyota’s stock is currently trading at very close to book value at a price of $73.90, off 19.48% from its January 19th high of $91.78. In contrast, at the height of the financial crisis, the stock hit a low of $57.68 on March 9, 2009 and fell well below book value. There remains a distinct possibility that Toyota shares still have a ways to fall especially in light of the fact that they don’t exactly look cheap when compared to peers like Ford and Tata Motors. According to some estimates Toyota is losing $500 million in sales each month right now.

Given that the nearly one year old market rally appears to be sputtering and attractive investments are still available in the small cap sector, I would personally hold off on investing in Toyota at this juncture.

Growth for Verizon and AT&T is being driven primarily by wireless and service bundles that include TV, phone, internet service and cell phone even as they are losing wireline business. The focus of this post is the valuation comparison tables at the bottom but I have briefly touched upon the two factors that are driving growth at these companies.

FiOS or U-verse?

Verizon had planned on investing $18 billion by 2010 to build out its fiber optic network and launch the FiOS service. I still recall the stock dropping back in 2006 when that news came out but the carrier had no choice to invest or be left behind. FiOS is generating $1.4 billion in quarterly revenue right now with Average Revenue Per User (ARPU) of $137/month when compared to standard consumer ARPU of $75/month. Using the quarterly revenue and monthly ARPU number provided, Verizon had approximately 3.41 million FiOS subscribers by the end of the third quarter of 2009. They expect to add a million new FiOS subscribers a year. Even if Verizon ends 2010 with 5 million FiOS subscribers, this would still be well below the 7 million subscribers estimated by the company back in 2006 when they started investing in FiOS. The investment in FiOS will be “substantially” complete by the end of 2010.

AT&T’s equivalent service called U-verse is tracking well behind Verizon with 2 million subscribers as of December 9, 2009 but is growing at a much faster clip. Revenue from U-verse is expected to top $2 billion in 2010 and customers who purchase these services are less likely to leave AT&T, thereby reducing churn. Looking at the bundles offered by Verizon and AT&T, it looks like Verizon’s $99.99 bundle offers more bang for the buck especially when you take into account the FiOS internet service (up to 15 Mbps downloads and 5 Mbps uploads) when compared to the $132 triple play bundle offered by AT&T with their Pro internet service (3 Mbps downloads) and U200 TV service.

iPhone or Droid?

Over the last decade, I have used mobile phone service from 5 different carriers starting with Voicestream Wireless (acquired by T-mobile) in 1999 to my current iPhone with AT&T. My worst experience was with Sprint and AT&T comes a close second in terms of connectivity issues. If I had the ability to transfer my iPhone from AT&T to another carrier like Verizon, I most likely would. When a journalist from AOL reached out to me a few weeks ago about AT&T’s service in the San Francisco bay area, I told him that my calls often drop especially while driving along highway 101 on the stretch just north of the San Francisco airport. A friend of mine who lives in the City runs into two dead zones during a short 10 minute commute to work. The question is not if AT&T will lose its iPhone exclusivity but when.

Verizon on the other hand is often mentioned as the carrier with the best network but every time I looked at the phone offerings from Verizon I used to come away unimpressed. The much anticipated release of the Motorola Droid running Google’s Android operating system sparked new interest in Verizon a few weeks ago. When having lunch with a friend earlier this week, he showed me his new Motorola Droid phone that he purchased after returning an iPhone. He told me that while there were certain things the Droid better than the iPhone, while the iPhone was like having a beautiful and charming person by your side, the Droid was the equivalent of a being in the company of a robot. I briefly tried the Droid and was not impressed. In contrast as you can see from this very detailed comparison of the iPhone vs. the Droid posted on our sister site AppStruck.com, a lot of iPhone users have found the Droid to be a worthy rival if not an iPhone killer.

Valuation:

AT&T activated 3.2 million iPhones just in the third quarter of 2009 and if you look at AT&T’s wireless ARPU for post-paid customers, the phone has been very beneficial to AT&T bottom line despite the data usage issues that the top 3% of iPhone users are creating for AT&T. Churn rates for iPhone users are also lower.

If you were to only consider the numbers in the tables below, one could easily make the case of investing in AT&T over Verizon after considering its wireless ARPU, profit margins, leveraged free cash flow and dividend yield. However when you look at churn, the balance sheet, valuation (EV/Operating Cash Flow or EV/Revenue) and management effectiveness metrics such as ROA or ROE, Verizon appears to be the better alternative. Finally throwing in the risk of AT&T losing its iPhone exclusivity and the early ramp of FiOS, I would personally pick Verizon over AT&T. Interestingly legendary hedge fund manager George Soros decided to buy both AT&T and Verizon for his portfolio but picked up a larger stake in Verizon.

Operating Metrics

Financial Metrics

Valuation Metrics

In case you did not follow Satyam’s saga at the time, here is a timeline of the events that transpired:

• Dec 16, 2008: Satyam announces a plan to acquire Maytas Properties and Maytas Infrastructure, companies run by the sons of Satyam founder and chairman Ramalinga Raju that are completely unrelated to Satyam’s core software business. Angry investors react by punishing the American Depository Receipts (ADRs) on the NYSE with a 55% loss. The company scraps its acquisition plans in the face of investor backlash and announces the board is instead going to consider a stock buyback program.
• Dec 23, 2008: The stock drops 13.55% on the Bombay Stock Exchange on rumors that its founder and chairman Ramalinga Raju has resigned from the board. On the same day the World Bank confirms that Satyam was barred from doing all business with the bank for an eight month period last February following allegations of data theft.
• Jan 7, 2009: Satyam’s founder admits to falsifying accounts stating that the $1.04 billion in assets that the company listed on its balance sheet did not exist and that revenue was 20% lower than reported.
• Jan 10, 2009:Founder Ramalinga Raju is arrested and sent to prison awaiting trial.
• Jan 12, 2009: The stock plunges to $1.46 on the NYSE having closed the previous Friday at $9.35 per share. The stock is now down 95% from its 2008 high of $29.10 set less than 8 months ago on May 30, 2008.
• Apr 2009: Tech Mahindra eventually acquires a 43% stake in Satyam. Tech Mahindra is a subsidiary of Indian automobile company Mahindra & Mahindra, one of Tata Motors (TTM) key competitors and the company that battled Tata Motors to acquire Jaguar and Land Rover from Ford Motor (F).
• Jun 11, 2009: Satyam’s new chairman Kiran Karnik announces that the near-term revenue outlook was not great and that the company was under severe stress. The stock rises 10% for a third day in a row after results show that the company was still profitable. The NYSE listed ADRs open at $5.20 and hit an intraday high of $5.49 before closing the day at $4.30. The stock slides the rest of the month to end June at $3.11.
• Nov 13, 2009: Indian infrastructure firm Larsen & Toubro that held a 6.9% stake in the new entity, sold a third of its position for Rs 112.5 ($2.42, based on an exchange rate of $1 = Rs 46.5)
• Dec 3, 2009: JP Morgan (India) upgrades the stock from neutral to overweight with a price target of Rs 140 ($3.02 based on an exchange rate of $1 = Rs 46.31). JP Morgan analysts expect revenue to decline 36% in Fiscal 2010 (ended March 31, 2010), increase 18% in 2011 and 19% in 2012.
• Dec 9, 2009: Satyam settles a more than $1 billion patent dispute lawsuit with U.K based Upaid Systems for $70 million. The settlement gives Satyam a royalty-free license of Upaid’s patents. $265 million in lawsuits from 37 companies remain unresolved.

What is the stock actually worth?

Regarding JP Morgan’s forecast, since the Satyam ADRs represent two shares each, the equivalent price target for the US listed ADRs is $6.04, representing a 9.6% upside from the current price of $5.51. The litigation risk that Satyam continues to face combined with a tarnished image and lack of visibility should ideally support a valuation that is at a steep discount of at least 50% to its peers. The last time Satyam reported revenue under US GAAP was back in October 2008 when they reported revenue of $652.2 million. If revenue was indeed inflated 20%, let us assume actual revenue was $543.5 that quarter. Revenue most likely declined after the scandal broke out and at the time Tech Mahindra acquired a stake in Satyam, full year revenue was expected to be $1.3 billion. If Satyam does post $1.3 billion in revenue for fiscal 2010 ending in March 2010, based on its current market cap of $1.86 billion, the stock is trading at 1.43 sales.

With competitors like Wipro (WIT) and Cognizant (CTSH) trading at 5.63 and 4.38 times sales respectively, Satyam is indeed trading at a steep discount to its peers when you look at revenue. However Satyam’s operating margins were 3% when the scandal broke out while Wipro and Cognizant sport operating margins of 17.91% and 18.99% respectively. Unless Tech Mahindra can improve Satyam’s operating margins, which it most likely will, the steep discount appears to be justified. Assuming Satyam does post revenue of $1.3 billion, manages to improve its operating margins to Cognizant’s level, and we apply a 50% discount to Cognizant’s 4.38 times sales valuation, I get a market cap of $2.85 billion for Satyam, representing 53% upside for the stock from current levels provided you are willing you live with the risks, don’t mind the lack of visibility and are hopeful that these assumptions will bear out.

With the Indian economy expected to grow by 7 to 8% for the current fiscal year that ends in March 31, 2009 and a world bank real GDP growth forecast of 8% in 2010 and 8.5% in 2011, India is certainly a favored investment theme. Despite the fundamental reasons for buying into India and the cost cutting in developed countries that has fueled the rise of Indian software companies like Infosys, Wipro and Satyam, the industry does face a number of headwinds in the form of a weak dollar, rising salaries and increased competition from companies like IBM that have developed large operations in India. So along with company specific risk, you also have currency risk and industry risk to consider.

Overall it appears that Satyam might be worth considering as a highly speculative investment that may do well should conditions at the company improve in 2010 and beyond. If JP Morgan’s revenue forecasts for 2011 and 2012 bear out, the stock is a bargain at current levels.

Model Portfolio Update: I am going to close our position in mattress fabric and furniture upholstery maker Culp Inc (CFI) and book gains of approximately 93% in the SINLetter model portfolio. The stock has performed well beyond my expectations since I wrote about it in the November 2009 investment newsletter and taking profits at this point would be prudent. The closing price tomorrow (Jan 13, 2010) will be used as the selling price.