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Far far away, behind the word mountains, far from the countries Vokalia and Consonantia, there live the blind texts. Separated they live in Bookmarksgrove right at the coast of the Semantics, a large language ocean. A small river named Duden flows by their place and supplies it with the necessary regelialia. It is a paradisematic country, in which roasted parts of sentences fly into your mouth.
Mobileye: the Market Opportunity
After decades of plodding along on autopilot, the automotive industry has awakened to embrace technology to advance the state of the art in driver and vehicle safety. Outside agitators led by Google, among the first to advance the idea of a driverless car, and Elon Musk of Tesla Motors, the creator of the first commercially viable electric car, have begun to pressure the automotive industry into revolutionizing vehicle manufacturing and driver safety.
At stake, for starters, is the goal to dramatically reduce the number of road traffic deaths across the globe. Remarkably, the World Health Organization appears to be the only source of reliable data on this topic. It estimates that vehicle related deaths were 1.2 million, although the most recent year for which estimates are provided is 2010. In the US alone, traffic related deaths were an estimated 33,000 in 2014.
In the last few years an emerging category of driver safety, based on software, sensors, and microprocessors has come to be called Advanced Driver Assistance Systems (ADAS). Industry definitions are not yet uniform, but the category is generally thought to contain features for blind spot detection, lane departure and lane keeping, adaptive cruise control, parking assistance, forward collision protection, traffic sign recognition, and automatic emergency braking. Most of these capabilities alert the driver to take action, while some are semiautonomous in that the ADAS system takes over control of the car in order to avoid crashing into the car ahead, or hitting a pedestrian or bicyclist.
The target market for ADAS is comprised of the 35 or so largest vehicle manufacturers who collectively account for the lion share of the nearly 90 million motor vehicles produced each year. This definition includes passenger cars, light commercial vehicles, minibuses, trucks and buses. China was the largest manufacturer of such vehicles in 2014, with just under 24 million, while the US made just under 12 million vehicles in the same period.
According to data gathered by ReportLinker.com, eight percent of new vehicles were equipped with ADAS in Europe and the US, while less than two percent of cars made in Asia have begun to deploy ADAS. On a global basis by 2019, the figure is expected to rise to 25 percent.
Market participants are utilizing a variety of technologies to create ADAS products. These include radar, lidar, as well as camera-based approaches. Each approach has its strengths and weaknesses, depending on the application. Cost is another key concern, as the car industry is notorious for relentlessly pursuing cost reduction throughout the supply chain.
Demand for ADAS is being driven by a combination of standard setting organizations, government regulators, as well as the desire on the part of global car makers to differentiate their products to meet drivers’ demand for enhanced safety and convenience. This is a key point, since most ADAS functions available on the market today are sold as options, rather than as standard features. However, this is about to change.
In an effort to achieve the highest safety standards, varying levels of ADAS will be required to be deployed, beginning in the current year. The National Highway Traffic Safety Administration (NHTSA) is on record calling for the inclusion of assisted driving technology to shift focus from crash mitigation to crash prevention. The group intends to revamp its 5 star rating system to include ADAS, though it has not yet specified which technologies will be required to achieve a newly ascribed five star rating.
Noting that 47 percent of Europe’s 26,000 road deaths in 2014 involved car collisions with pedestrians, bicyclists, and motor cycles, Euro NCAP, a European trade association that applies safety ratings to European passenger vehicles, will add a safety rating for autonomous emergency braking (AEB) beginning in 2016. The group notes that most collisions take place when drivers fail to brake, or apply the car’s braking system too late. NCAP estimates that by utilizing autonomous emergency braking (AEB) technologies one in five collisions could be avoided.
Early indications are that AEB is challenging to implement. In June of 2015, Honda’s Acura luxury car group was forced to recall 48,000 MDX and RLX SUVs produced in 2014 and 2015 due to the vehicles applying AEB when an SUV braked for no apparent reason and caused a rear-end collision. The offending SUVs were evidently using a radar, rather than a camera-based system. Toyota Motors issued a recall of 31,000 Avalon and Lexus ES sedans in November of 2015, due to a faulty AEB system. Rather than addressing the problem through a software upgrade, the issue is sufficiently serious to warrant a complete disabling of the current system to be replaced with an entirely new one at a later date.
Another factor driving demand for ADAS is the race to create the first driverless car. This has animated industry participants to a new level of competition. Just as the race to cross the Atlantic by air was initially derided as scientifically unachievable, the notion of a fully autonomous vehicle has been similarly dismissed. Recently, however, the industry is moving in fits and starts to develop and deploy the first generation of driverless cars, which some believe could begin to hit the roads as early as 2020.
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Far far away, behind the word mountains, far from the countries Vokalia and Consonantia, there live the blind texts. Separated they live in Bookmarksgrove right at the coast of the Semantics, a large language ocean. A small river named Duden flows by their place and supplies it with the necessary regelialia. It is a paradisematic country, in which roasted parts of sentences fly into your mouth.
Nintendo: Focusing on the Future
Based in Kyoto, Japan, Nintendo, loosely translated as “leave luck to him,” was founded by Fusajiro Yamauchi over 120 years ago in 1889. Nintendo’s modern era began when Hiroshi Yamauchi, a grandson of the founder, became president in 1950. Building on success in toys and games including its Ultra Machine and the Love Tester introduced in the mid-1960s, Nintendo later began to focus on home video consoles for color TVs in the mid-1970s. The company also began to develop its own games under the leadership of Shigeru Miyamoto, who remains the company’s visionary R&D chief. Under his influence, Nintendo created its most memorable and iconic characters, including Mario, Zelda, and Donkey Kong, a video game released in 1981.
In 1980, Nintendo launched the first in a series of hand-held gaming devices, and achieved critical acclaim with the introduction of the Game Boy in 1988. At the same time, the company continued to develop succeeding and successful generations of its hardware console devices, including the Nintendo Entertainment System (NES), which was launched in Japan in 1983 and in the US in 1985. NES bundled in various games, including the Super Mario Brothers, arguably Nintendo’s most iconic series, contributing to NES sales of over 60 million systems.
In 2002, after more than 50 years at the helm, Nintendo president Hiroshi Yamauchi, then aged 65, announced he would turn over the reins to 43 year-old Satoru Iwata, who had emerged from the ranks of Nintendo’s HAL Laboratory subsidiary to become the first non-family member to lead Nintendo. Two years later Nintendo introduced the Nintendo DS, its fourth major hand-held system, which featured a dual, touch screen, along with several successful game titles.
Shipped in time for the holiday season in 2006, Nintendo’s Wii became the most successful game system in the company’s history, ultimately selling over 100 million units, and catapulting the company’s stock to an all-time high of over 70,000 Yen per share on the Osaka Stock Exchange. The console featured relatively straight forward controls, including a remote control device to detect 3D movement, as well as internet connectivity, and the ability to run previous generation Nintendo games. The Nintendo Wii was the best-selling game console of its generation, decisively outselling both the Sony Playstation 3, as well as the Microsoft Xbox 360.
The Wii U, a successor to the Wii, shipped in the fall of 2012, and is generally considered to be among the more disappointing game consoles in the company’s history, inception to date selling nearly 11 million units as compared to over 100 million units for the Wii. The Wii U’s under-powered graphics, closed computer architecture, and paucity of third party game titles available at launch and afterwards, are considered to be among the leading causes of the product’s relatively mediocre performance.
Beginning in January 2014, following the announcement of a 30 percent contraction in profits during the prior nine months, Nintendo then president and CEO Satoru Iwata announced that he would take a 50 percent cut in pay, and that salaries of other key executives would be cut by 20-30 percent. In January of 2015, Nintendo announced its exit from the Brazilian games market.
In March of 2015 Nintendo began a strategic shift and announced that it would for the first time develop mobile games utilizing Nintendo characters for Apple and Android devices through an alliance with DeNA, a Japanese developer of mobile games. At the same time, Nintendo reaffirmed its commitment to dedicated gaming devices, with plans to launch a next-generation video game machine. Having staged a major turn-around in company profitability and performance, as well as a revitalization of the Nintendo brand, the company posted its first profitable fiscal year in several years for the period ended March 31, 2015.
Nintendo continues to maintain very high market share in the handheld device and game category, led by its 3DS platform which currently accounts for about 60 percent of sales and may hold as much as 80 percent of the dedicated market for hand-held gaming devices. In the last year, the company recently launched refreshes of these products in Japan, the US and in Europe, and will launch new software titles for the devices in the coming year. In addition, Nintendo is benefitting from new software titles for the Wii U platform, such as Splatoon, as well as amiibo action figure toys, based on characters from its games, which have been an important tie in to its 3DS and Wii console devices.
We see Nintendo working on three key initiatives to drive growth:
- Development of sequels and new games for the 3DS and Wii U platforms.
- Creation of a next generation “brand new” concept video game device, code-named NX;
- Mobile games for Apple and Android devices that incorporate elements of social networking as well as draw upon its extensive library of video game characters.
Over the last number of generations Nintendo has developed a remarkably creative and collegial corporate culture. For this reason, Tatsumi Kimishima, a Nintendo managing director, who was recently appointed president of the company, will play a key role. Mr. Kimishima replaces Satoru Iwata, Nintendo’s highly-respected president who passed away in July after battling an illness for several years. Iwata led the company through its greatest era of achievement during which the Wii U sold over 100 million units, and more recently developed the company’s mobile strategy.
After having been personally recruited by Nintendo’s legendary Hiroshi Yamauchi 16 years ago to become CFO of the Pokemon Company, a Nintendo affiliate, Mr. Kimishima, now age 65, went on to become president of Nintendo of America, the company’s largest division, in a relatively short time period. In addition to having been a member of the company’s board of directors prior to his appointment as president, he was also one of only a few managing directors, and recently held the position of head of human resources. Prior to joining Nintendo, he spent 27 years with Sanwa Bank, now a part of the Bank of Tokyo.
Our sense is that while Kimishima may lack the technological depth of his predecessor, and may not have the creative talent of several of Nintendo’s key leaders, his understanding of the company’s corporate culture, deep knowledge of Nintendo’s creative games and operations experience as head of Nintendo of America, gives him a unique perspective to manage the company during this crucial time in the company’s history.
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Veeva Systems: Taking the Cloud to Life Sciences
With projected calendar 2015 sales of $410 million and a market cap of roughly $3.3 billion, Veeva Systems is a leading provider of cloud software for salesforce automation, content management, and sales contact data to the global life sciences industry. Based on an exclusive software license from salesforce.com (NYSE: CRM), Veeva’s CRM software is now utilized by 17 of the top 20 largest pharmaceutical and biotech companies, including eight of the top 10. Within the top 20, only three have thus far not made the switch to Veeva: Switzerland-based Roche Holding, France-based Sanofi, and France-based Novo Nordisk, which ranks in the top 15.
Veeva has identified an annual market spend of over $5 billion in software for CRM, content management, and sales data, and so it has much running room ahead. Veeva has already captured an estimated 50 percent of the CRM market for pharma and biotech, and could very well capture as much as 60 percent of the market over the next several years, as the company continues to roll out new seats to existing customers, and sell additional CRM add-on modules.
Since Veeva is cloud-based, and features a multi-tenant architecture, the company can update the software of its entire customer base at the same time, reducing the time, aggravation, and cost associated with maintaining and updating several versions of the same software program. Veeva’s cloud-based product set stands in contrast to two of its largest competitors, Oracle (NASDAQ: ORCL), and IMS Health Holdings (NYSE: IMS), which support and maintain several software packages simultaneously, many of which have been developed for older client server computer systems, and are not hosted in the cloud. Support for these older software products detracts from keeping their cloud products up to date, which will likely lead to further market share erosion.
Veeva’s newer products for content management and sales data, respectively, accounted for less than 10 percent of sales a year ago, but now account for about 20 percent of product sales. These products carry slightly higher gross margins than the company’s CRM products, and more than double its addressable market. Veeva has additional room to sell Veeva CRM, Veeva Vault, and Veeva Network to existing and new customers, as well as to sell the new products to other segments in the life sciences market, such as medical devices, laboratory instruments, and CROs—segments with which the company conducts limited business currently.
Veeva benefits from an experienced management team, led by Peter Gassner, a former SVP of Technology at saleforce.com, and at Peoplesoft (later acquired by Oracle), where he was Chief Architect and General Manager for PeopleTools, and at IBM Silicon Valley Lab, where he participated in database research and development. Matt Wallach, co-founder and President, was formally GM of the Pharmaceuticals and Biotechnology division of Siebel Systems (later acquired by Oracle). CFO Tim Cabral has held financial management positions at Peoplesoft and other technology companies. Detailed knowledge of the specific needs of the pharma and biotech segments, gives Veeva a leg up over its competitors, many of whom have only general knowledge of the life sciences sector.
Veeva has a strong balance sheet, which features $438 million in cash and no debt, and continues to generate very solid cash flow, all the while growing the business, while running at a 30 percent operating margin in the most recent quarter.
Zynga: a Turnaround in Process
With projected revenue of $763 million in 2015, a market cap of $2.7 billion, cash and securities of $1.1 billion and no debt, Zynga (NASDAQ: ZNGA) is a pioneer in the market for interactive social video games. In less than eight years, Zynga has catapulted itself into the ranks of the world’s largest video game companies, with 100 million monthly active users, and 1.1 million monthly unique payers. Best-selling games include Farmville 2, Zynga Poker, Hit it Rich, and Words with Friends, which account for about 75 percent of sales, while the company’s other 30-plus games account for the remainder. Zynga’s products are available on a wide variety of computer platforms including PCs, laptops, smart phones and tablets, and support major commerce platforms including the Apple iTunes store, Amazon.com, Google Play, and Facebook.
Versus three years ago when it launched its IPO and Facebook’s desktop platform accounted for 90 percent of revenue, Zynga has reduced its exposure to the Facebook platform, and increased revenue generated from mobile platforms, such as iTunes, Google Play, and Amazon.com. As of the end of Q1, roughly 59 percent of sales came from mobile platforms, while 37 percent came from Facebook. With the interactive game industry undergoing a long term shift toward mobile devices, and with over 50 percent of monetized game play expected to occur on mobile devices in 2015, Zynga appears to be well positioned to harvest this shift.
Impatient with the results achieved by CEO Don Mattrick, who was hired by Zynga’s board about 18 months ago, Mark Pincus, Zynga’s founder and chairman, recently replaced Mattrick as CEO and simultaneously announced four major changes to the company’s strategy. These include: (1) a workforce reduction of 18 percent; (2) a focus on accelerating new products to market; (3) an exit from the runner and sports game categories; (4) a shift away from the company’s data centers in favor of Amazon Web services. With the changes announced by Pincus, we have a better framework for assessing the company’s progress. As a result we will focus on the pace at which Zynga:
(1) Delivers meaningful revenue from new action strategy and Match 3 games;
(2) Updates its evergreen titles, and gains share in existing product categories;
(3) Reduces its bloated cost structure relative to peers, such as King Digital and Electronic Arts;
(4) Begins to articulate a cohesive plan to achieve $2 billion in annual sales;
Despite an inglorious post-IPO history, Zynga still has a strong balance sheet, bolstered by over $1 billion in cash and no debt. The company is hovering near break-even, and even though it will be some time before Zynga demonstrates real earnings power, we believe that purchase of the stock at current levels may provide rewards to the long-term investor.
PetMed Express (NASDAQ: PETS): In Need of a House Call?
PetMed’s most recent financial results for the quarter ended March 31 were essentially in line with our revenue estimate of $50 million, as sales grew by three percent over the prior year. The company’s average order size grew by five percent over the prior year to $81, as a result of customers increasing the dosages for their pets in advance of the flea and tick season. At the same time we noted that the company added 10,000 fewer customers than during the same quarter in the prior year. And despite recording a higher percentage of sales from higher margin prescription drugs, the company’s gross margin deteriorated by 200 basis points to 33.9, due to price competition in OTC medications, a category that still accounts for an estimated 40 percent of sales.
PetMeds had recently been benefitting from a favorable trend away from OTC topical medications to prescription pills, which are easier to administer, and do not require the task of bathing a pet in an ointment that can wash off easily. In contrast to topicals, pills require a veterinarian’s prescription and are typically higher priced and carry better gross margins than OTC products. During the last fiscal year sales from prescription medication rose from 44 percent to 50 percent.
At the same time, OTC medications as a percentage of sales remained fairly constant, and until this most recent quarter, we surmise, margins had been holding up as well. However, the large number of brick and mortar and internet providers of OTC medications have evidently been cutting prices, and thus PetMeds’ margins were hurt. We do not see any reason why margins would rebound in the current or subsequent quarters.
Supplier Concentration
PetMeds offers over 3,000 skus for sale to its customers, however a “significant” percentage of sales come from just 100 skus. Moreover about 50 percent of PetMeds’ sales come from just four suppliers. At the same time, PetMeds is trying to increase its direct relationships with drug manufacturers, many of whom require PetMeds to purchase their products from distributors. These supplier dynamics are not new, yet they illustrate the challenge that PetMed faces in increasing gross margins.
The animal health business is becoming increasingly concentrated, as many of the world’s largest pharmaceutical companies are seeking to gain market share. These include Merck Animal Health, the Merial division of Sanofi, Elanco, the animal health division of Eli Lilly, which acquired Novartis Animal Health last year in the second largest acquisition in Lilly’s history. Other mega players include Zoetis, and Boehringer Ingelheim. While only a sub-set of PetMed Express’ competitors offer prescription as well as over the counter pet medications, still a large enough number do, including PetSmart, CostCo, Target, and Amazon.com. It is unlikely that PetMed will be able to develop a price or cost advantage, particularly given the clout of its supplier base.
Sales Growth Remains Elusive
Despite ongoing attempts to rekindle sales growth in the last few years, PetMeds continues to face strong competition from brick and mortar and other online sources of pet medication. Rising advertising costs throughout the industry have for whatever reason made PetMeds’ management gun-shy with respect to advertising investments to gain market share. Over the course of the last year management has reduced advertising expenses by seven percent, a decision which we believe has been detrimental to new customer growth. The company’s tight-fisted approach to advertising suggests that sales gains are likely to be minimal. We see no evidence that PetMeds is gaining market share during a period of solid consumer spending.
While the above concerns suggest that a house call very much remains in order, we also believe that the patient is by no means incapable of recovery, as PETS’ core competencies include online distribution, customer service, product knowledge, efficient inventory management, and a 2.5 million-plus pet owner customer base that have purchased at least one product in the last 24 months. We believe the company’s valuation on an EV/sales basis remains compelling at 1.2x our 2015 revenue estimate net of cash. At the same time, price competition continues to plague the company, a condition which will need to be monitored.
Au Revoir Riverbed
Yesterday morning Thoma Bravo, the Chicago-based private equity investor, in concert with its frequent partner, Teachers’ Private Capital, a department of the Ontario Teachers’ Pension Plan, announced its intent to acquire Riverbed Technology (NASDAQ: RVBD) in an all-cash deal that values RVBD at roughly $3.6 billion, or about three times projected 2015 revenue, net of RVBD’s net $43 million cash position, which includes an estimated $80 million for the sale of its cloud storage business to NetApp (NASDAQ: NTAP).
While we are disappointed to see Riverbed sell to a private equity investor, rather than a company in the software and appliance segment, we note the expertise that Thoma Bravo has developed in the business software and appliance space, which includes its recent tender offer for Detroit-based Compuware, a $2.5 billion transaction announced less than four months ago, as well as previous acquisitions of SonicWall (subsequently sold to Dell), Blue Coat Systems, and privately-held Crossbeam Solutions.
After pre-announcing a modest shortfall in revenue relative to company guidance in each of the last two quarters, Riverbed also announced that it would undertake a strategic review of its options to maximize shareholder value. That announcement was made against the backdrop of an increasingly activist shareholder, Elliot Management, which has held a near 10 percent stake in the company for more than a year. We perceive the deal to have a high probability of closing, given the all-cash nature of the transaction, its approval by Riverbed’s board, as well as Elliot Management.
Notwithstanding a rather short-lived shareholder value maximization process of less than two months, Riverbed has, in a sense, been for sale unofficially ever since Elliot Management made its first $19 per share offer, back in February. With the ability to execute its recently announced restructuring plan out of the limelight, Riverbed, under the aegis of Thoma Bravo, is well on its way to realizing its complete potential.
WebMD Health: a Precarious Prognosis
With projected 2014 revenues of $574 million and a market cap. of roughly $1.8 billion, WebMD is a leading provider of ad-driven health-related content. Online ad sales, principally to drug companies, account for 80 percent of sales. WebMD also provides private content portals to 100 companies, which account for the remaining 20 percent of sales. These portals provide information, advice, education, and services that enable employees and health plan members to evaluate healthcare benefits, treatment, and insurance options.
With the assistance of new management in the last couple of years, WebMD rekindled growth in its online business in part by reducing ad pricing and offering more flexible business terms, including ad campaigns of shorter duration, as well as targeting healthy lifestyle consumer advertisers and health insurance sponsors. As a result, WebMD’s online ad business rebounded by 11 percent in 2013, following a precipitous 18 percent decline in 2012.
In the last couple of quarters, however, online ad spending growth has begun to decline, due in part to tougher comparisons against last year’s performance, a greater emphasis on mobile advertising, for which advertisers spend less than on full-fledged PCs and tablets, which offer larger screen sizes, and the ability to gain more metrics on user behavior. Although not a single company accounted for more than 10 percent of ad sales in either 2012 or in 2013, WebMD depends on a concentrated customer base of drug companies, and an unspecified contribution from non-pharma brands in its online ad business. Recent and proposed consolidation in the global pharmaceutical business is likely to increase the company’s customer concentration.
WebMD’s private portal business, in which it provides healthcare related information to employers, employees, and health care services providers, contributed 18 percent of sales in WebMD’s Q3, and grew by 21 percent over the prior year, almost entirely due to the Blue Cross Blue Shield Association Federal Employee Program that the company launched at the beginning of 2014. The five million member program is WebMD’s largest-ever contract in this category, although the margin impact is less clear. We note that WebMD does not disclose the gross or operating margins for the private portal business, making it difficult to assess the financial impact of the transaction. Elsewhere within the business trends are not positive. WebMD had 100 private portal customers as of the end of the end of the third quarter of 2014, down from 113 in the prior year.
Key swing factors for the next 12 months include whether WebMD can (1) maintain and/or grow its share in online ad spending by the drug companies; (2) attract more consumer brands and health plan sponsors to advertise on its websites; (3) achieve margin expansion beyond current levels, while investing in new platforms and programs.