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Monday, February 20, 2006

Keynote Systems (KEYN) quick look

This is just a quick look at KEYN, so I could easily miss something.
yahoo sec
19 million shares on Feb 10, 2006. 6 million stock options outstanding on Dec 31, 2005.

Assets are current-short-term investments, cash, PP&E, goodwill. Very low liabilities, almost all equity. Extremely liquid. Hardly any change from prior year.

Revenues are flat from prior year.
Operating margin is only 1.5% (based on their table). Prior year was even worse at 1.1%. Operating income is dwarfed by interest income from all that cash!
Net margin is more than twice operating margin (even worse in prior year).
Earned 3 cents per diluted share.
3 month cash flow from ops is much higher than net income due to stock based compensation (which is still an expense seen by the shareholder via dilution), AP, deferred tax assets, and depreciation. Capex is about half of depreciation.

They acquired a business for $2.5 million. They shifted $20 million between different short-term investments. Stock options were exercised and less stock was repurchased.

There's an IPO allocation related lawsuit outstanding.

I read this investor presentation pointed out by Kevin at MarketMoneyLetter and I wasn't impressed. It just seems like the area where they do business is a real slugfest and not conducive to long term big earnings. It looks surprisingly like LiveWorld. They even hit a wall at about the same time as LiveWorld. While you could argue that the jury is still out on LiveWorld, that itself is a good reason not to invest in it. That's more like speculation. I have nothing against having something which may or may not pan out, but only when it's part of an otherwise valid investment. Even if the net cash was equal to the market cap, I'd be hesitant to invest because the underlying business itself isn't clearly solid. I passed on Liquid Audio around the same time as I invested in ValueClick because, unlike ValueClick, they weren't going to be a reasonably good business on their own. Both were selling for significantly less than their net cash.

Looking back at KEYN's 10-K, They had $38 million in revenues in 2003 and $48 million in expenses. They probably strived very hard for profitability and in 2004 revenues grew to $42 million while expenses were slashed to $40 million. In 2005, revenues increased again to $54 million but expenses climbed to $52 million. Either the business doesn't scale well, or they manage to find ways to burn any extra earnings that happen to occur. The profitable part of their business is buying and selling short term investments, but are they really doing well at that? They're getting interest income of roughly $2 million per year while sitting on roughly $130 million in cash and short term investments. That's only a 1.5% return.

This is a great example of Warren Buffett's "sitting on a savings account" type of business. All those millions of stock options are being propped up by passive-rate levels of returns on shareholder cash with no dividends. The employees can essentially do nothing while the cash builds up from plain old savings account rates of return.

Here's an alternative: hand me $130 million and I'll use it to buy 1-year retail bank CDs and get a much higher return while I stand outside the bank doing performance art for change from passersby while drawing hundreds of thousands of dollars in salary. Overall, you'll be better off. I won't even give myself those 6 million stock options.

Anyway, since these guys don't make any money with their razor thin margins (and thankfully they aren't losing money... right now), I figure the business is worth the net cash (plus short term investments) on the balance sheet, which is $128 million. That works out to about $4.72 per fully diluted share. Since the stock is selling for $11.73, I think I'll pass.

was that too harsh?

UPDATE 3/26/06: I've been informed that I missed some things (like I said above, it's a quick look, so I could easily miss something). In the 10-K from 2002, they bought a 188K sq ft building in San Mateo, California.
We purchased the building from our lessor on September 30, 2002, before the expiration of the synthetic lease arrangement in 2005.
And there's this as well:
After we entered into the lease in July 2000, real estate market conditions worsened, including a significant increase in available space for lease and significant declines in corresponding lease rates for commercial property. Accordingly, a loss on termination of this lease was recognized in connection with the purchase of the building. The loss was calculated by comparing the purchase price of the building to its fair value. To determine the fair value of the building, we had an independent real estate appraisal conducted, which indicated that the fair value of the property was approximately $25.0 million. The calculated loss of approximately $60.7 million was recorded in the fourth quarter of fiscal 2002. The $60.7 million loss on termination was adjusted for the reversal of the remaining excess facility charge accrual and costs associated with the acquisition of the building, resulting in a net charge to the consolidated statements of operations of approximately $52.0 million.
It doesn't give me a warm-fuzzy feeling when management makes an $85 million decision in July 2000 and then ends up with a $60.7 million overall loss two years later. But they're not in the real estate business, I suppose. And I'm told rather firmly that this building might be worth $40-43 million today, which would place it as worth perhaps $17 million more than the stated value on the books.

So let's be generous and add $22 million to the valuation of the business bringing it up to $150 million. Using 25 million fully diluted shares, that would put the value at $6 per share. I suppose you would then add the value of the business on top of that, which is probably worth more than zero, despite my own views.

It was kind of KEYN to amend their stock option plan to require shareholder approval before lowering the exercise price of outstanding options. How nice of them.

Ok, so now let's look at KEYN's operations apart from their savings account-like earnings. They generated $211K in the last 3 months of 2005. Now is there anything in the cash flow statement that would lead me to believe that free cash flow from operations is any more than this? Well, we should add back in the $796K of stock-based compensation if we're going to assume a totally diluted share count (i.e. total number of shares they'll probably have when I sell the stock... but even that is underestimated the share count because someone else needs to buy the stock and will want to view their own totally diluted share count). Since capex is about $350K less than depreciation, can we assume that this represents permanent free cash flow? Probably not, but we'll do it anyway. So then we would assume about $1.3 million per three months of free cash flow. We'll assume about 21 cents of free cash flow per share, making the business worth about $3.15

So then the stock would be worth $6 plus $3.15, which is $9.15. Since the stock is selling for over $10, I think I'll still pass.

NOTE: It's entirely possible for there to be something that I don't see or can't see which makes the company more valuable. Your own estimate of the value may differ because of that.

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