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Marrying Various Investment Themes

(Guest Commentary by Rick Konrad – May 22, 2008)

Dear Subscribers and Readers,

Before I introduce Rick Konrad's guest commentary for this month, I want to reiterate our “special alert” email that went out yesterday afternoon.  For those who haven't done so, I urge you to read the “special alert” in its entirety.  Aside from what we discussed in our email, it is also interesting to note that the A/D line of the Financial ETF, the XLF, made a new low today.  As I am writing this, the A/D line for the consumer discretionary, consumer staples, and health care ETFs are now near their mid March lows.

In our latest weekend commentary, I mentioned that we were not overly concerned with the general weakness of the NYSE CSO A/D line – given that smaller companies had tended to underperform in a general deleveraging environment – such as what occurred during the recovery off of the October 1990 lows (the NYSE A/D line did not make a new all-time high until early 1993!).  Unfortunately, the market action during the last couple of days suggest that we could be due for more weakness, given: 1) Further significant deterioration of the NYSE CSO A/D line, resulting in much weaker stock market breadth than the recovery off of the October 1990 lows, 2) A new low in the A/D line of the Financial ETF, which is very ominous given that the U.S. economy is dependent on credit creation as much as ever, and 3) Relative strength in energy and materials shares.

Point 3) needs a little explaining.  Back in the 1999 to early 2000 period, the NYSE A/D line acted horribly off of the October 1998 lows.  In essence, the price action of the S&P 500 was virtually all driven by the technology and telecom sectors.  Despite the weakness of the NYSE A/D line, the strength in the technology and telecom sectors were sufficient to drive the S&P 500 to new all-time highs.  Given that the U.S. economy is not a commodity-based economy, however, it is difficult to envision new highs in energy and materials shares driving the S&P 500 to new all-time highs anytime soon.  More importantly, wages in both sectors are still in an upward trend – signaling that margins are getting squeezed even as energy and commodity prices continue to rise (also note that some companies in the materials sector use commodities as input items, such as chemical producers).

Investing and speculating in the stock market involves calculating/estimating probabilities and evaluating potential risk/reward scenarios.  Given what we previously mentioned in our “special alert” yesterday, and given the lack of an oversold condition in the U.S. stock market, I no longer believe that the line of least resistance – at least over the next couple of months – is up.  As a result, we will look to exit our 100% long position in our DJIA Timing System over the next few days, perhaps as early as this morning.  Once we decide to do, I will send another “special alert” email in real-time informing our subscribers of this signal.  Subscribers please stay tuned.

Let us now get on with Rick Konrad's guest commentary!

For those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary.  Rick is one of our two regular guest commentators (besides Bill Rempel) and usually writes for us every third Wednesday of the month.

In this commentary, Rick will be offering his thoughts on VeriFone – a global leader in secure electronic payment solutions.  In writing about this company, Rick has “married” three of the most recent themes that he has discussed here at MarketThoughts and at Value Discipline since the beginning of this year.  Without further ado, following is a biography of Rick:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Rick Konrad on Sysco” for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


Our thoughts for Marketthoughts since the beginning of this year have focused on primarily two themes:

1) There is value in uncertainty (January 17, 2008).  The discussion centered on the value that presented in some of the consumer discretionary stocks such as Dress Barn (DBRN), Foot Locker (FL) and Bed Bath and Beyond (BBBY). These stocks are up 29.2%, 14.6%, and 16.7% respectively.

2) Finding companies in which there is a high degree of recurring revenues, (March 20, 2008). Here, we had suggested looking at MSC Industrial (MSM). It is up 26.0% since that date.

In our own Value Discipline, we also highlighted the recurring revenue theme as it pertains to selective financial services companies such as Fiserv (FISV)

Today, I would like to marry these themes in a higher risk selection, VeriFone (PAY).

VeriFone describes itself as the global leader in secure electronic payment solutions. It provides expertise, solutions and services that add value to the point of sale with merchant-operated, consumer-facing and self-service payment systems for the financial, retail, hospitality, petroleum, government and healthcare vertical markets. The company, which dates back to 1981, has designed and marketed system solutions that facilitate the long-term shift toward electronic payment transactions and away from cash and checks. Following the acquisition of Lipman Electronic Engineering Ltd (“Lipman”),in November of 2006, the company is one of the largest providers of electronic payment systems worldwide in terms of revenues, research and development spending and profitability. VeriFone, Inc. became a publicly traded company in 1990 and was acquired by Hewlett-Packard Company in 1997. Hewlett-Packard operated VeriFone, Inc. as a division until July 2001, when it sold VeriFone, Inc. to Gores Technology Group, LLC, a privately held acquisition and investment management firm, in a transaction led by its Chief Executive Officer, Douglas G. Bergeron. It resurrected as an IPO in 2005.

Electronic payment systems truly represent what Buffet describes as a toll bridge. From the company's 10-K:

“The electronic payment system serves as the interface between consumers and merchants at the point of sale and with the payment processing infrastructure. It captures critical electronic payment data, secures the data through sophisticated encryption software and algorithms and routes the data across a range of payment networks for processing, authorization and settlement. Payment networks include credit card networks, such as Visa, MasterCard and American Express, that route credit card and signature-based debit transactions, as well as electronic funds transfer, or EFT, networks, such as STAR, Interlink and NYCE, that route PIN-based debit transactions. In a typical electronic payment transaction, the electronic payment system first captures and secures consumer payment data from one of a variety of payment media, such as a credit or debit card, smart card or contactless / RFID card. Consumer payment data is then routed from the electronic payment system to the appropriate payment processor and financial institution for authorization. Finally, the electronic payment system receives the authorization to complete the transaction between the merchant and consumer.”

Essentially, the global trends that have propelled Visa (V) and MasterCard (MA) into investors' favor are also the primary trends that influence VeriFone. The company's primary competitors are Hypercom (HYC) and Ingenico S.A, a prominent French company. Following the Lipman acquisition, it is estimated that PAY has the largest market share at about 32%.

One important domestic factor is that all new point-of-sale devices must be Payment Card Industry (PCI) and PIN Entry Device (PED) certified by Visa or MasterCard as of January 1, 2008.  According to industry statistics as of December 31, 2007, nearly half of U.S. merchants were not compliant and all of those credit card reading mechanisms must be replaced by June 30, 2010.

One major issue clouds this otherwise pretty picture. In December of 2007, the company revealed that there had been some accounting inconsistencies and errors. Whereas management had indicated that it estimated gross margin to have been overstated by 400 to 500 basis points in fiscal 2007, at the time of the announcement, it is possible that more systemic accounting inconsistencies or outright fraud caused an even greater overstatement of gross margin. In a subsequent release in early April, management has indicated that there was no evidence of fraud following a forensic audit. The forensic audit revealed that there was a lack of proper control rather than malfeasance. With this behind the company, the company should be able to complete its financial reporting for 2007.

The issue was that the company had been understating Cost of Goods Sold and overstating inventory. This had been inflating gross margins and thus EBITDA and earnings. The stock was as high as $50 and is currently less than $13.

The integration of Lipman's accounting systems may be the source of the problem and a failure to provide adequate internal controls. Lipman's base in Israel only made matters worse as far as the integration issues.

U.S. recession concerns may slow the growth somewhat, but PAY derives over 60% of its revenues outside of the States.

Though restatements will reveal a much lower level of gross profit margins than previously believed, in my view, the stock is priced to absorb this disappointment.

There certainly are risks here. There are no recent reliable financial statements to “bank” on. The company mentioned a challenging revenue environment and has reduced headcount slightly. The costs of the forensic investigation and the implementation of electronic systems to replace manual accounting entry will carry some near term costs. There is a minor product recall under way as well.

Nevertheless, the overall trends of the business appear to be solid long term. The valuation of the stock in my view represents at least a 50% margin of safety over a two year period.

This is a higher risk situation than I ordinarily would publish, but the valuation is compelling. As they say in baseball, you can't steal second base with your foot on first.

Disclaimer: I, my family, and clients do not have a current position in VeriFone.

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