GuruFocus Premium Membership

Serving Intelligent Investors since 2004. Only 96 cents a day.

Free Trial

Free 7-day Trial
All Articles and Columns »

A Stamp of Approval for Stamps.com

July 06, 2014 | About:

Don’t you just love to go places and stand in long lines that never seem to move? It seems the best place to find those long, stationary lines are consistently government run facilities. I believe the main reason for that is that in a private business, customers have the option of going someplace else if they don’t care for the level of service offered by one provider. There are always multiple choices available for the same product and those businesses that don’t satisfy customers don’t survive. In the case of most government functions, there is only one provider and we just have to take what we get.

Standing in line at the Post Office on Saturday mornings when I need to buy stamps is one of my least enjoyable activities. I don’t know and don’t really care why the line seems to move at a snail’s pace; I simply know that it does. Standing in those lines listening to the vocal complaints from the other customers lets me know in no uncertain terms that I am not alone in my frustration. Surely, in the land of everything we want, anytime we want it, there must be a better way.

Where There Is A Profit To Be Made, A Way Will Be Found

One of the great things about capitalism is that private entrepreneurs have a great profit incentive to identify things people don’t like to do and sell them options that allow them to avoid doing those things. When those entrepreneurs can find a way to eliminate something that not only people do not like doing but something that almost everyone must accomplish somehow, great opportunities exist for creating exceptional profits.

When those conditions come together and find themselves combined in a business trading at very reasonable valuations…………..well, the time to act is upon us. I believe that opportunity exists today in Stamps.com (STMP). Stamps.com is exactly what its name suggests. They sell postage over the Internet and save their customers from the inconvenience of standing in line at the Post Office to buy stamps. So, we have here a business that fills two very important aspects for businesses I believe make the best investments. It provides a product or service that is necessary for most people to have, in this case postage, and it eliminates something people do not like to do, in this case, standing in long, slow-moving lines. These propositions are sufficient to garner my attention.

However, an interesting business idea that fills a need should not be enough to justify the allocation of investors’ capital. The business must have a current valuation that provides a reasonable expectation for exceptional upside potential with limited downside risk.

What Is The Risk With Stamps.com

The first concern of any investor allocating capital to any opportunity should be a careful assessment of the downside risk. The first rule of becoming a successful investor is to avoid losses. While it would be excessively arrogant as an analyst to believe I could ever know or predict every possible thing that could go wrong with a given business, careful due diligence and analysis can minimize the prospects of negative outcomes.

The 52-week price range for the shares is $27.18, seen on May 1, 2014 after the company missed expectations for quarterly earnings, to $48.57 in November of 2013. Since that May low, the share price has recovered to $34.77. The earnings miss against analysts’ expectations that crushed the shares on May 1st was the only earnings miss the company has experienced in the last five quarters. That particular shortfall was 6.38% below the average estimates of the analysts covering the stock. However, over the previous 4 quarters, the company had beaten earnings expectations by anywhere from 20.45% to 48.48%. The business was a high-flyer and was price as such at its high in November. At that time, there was too much risk, now, the stock would have to rise 42% just to reach its previous high. The fall in the share price has greatly reduced the risk for new investors and has brought the valuation of the business down to a very reasonable level for such a quality company.

The company maintains an exceptionally clean balance sheet as well. At the end of this year’s first quarter, the balance sheet showed cash and short-term investments of $90.3 million and receivables of $11 million. The total liabilities of the business were listed as only $17.8 million. This is obviously a business on a very firm financial footing.

What Is The Upside Potential Of This Business?

There are two effective ways to estimate fair value of a business. An analyst can evaluate the fundamentals based on a comparison to the overall prospects for the business itself or a comparison of the current market value compared to other companies in the same industry classification. In regard to the latter, Stamps.com is just plain cheap, as indicated by the table below.

Metric

5-yr. Avg. Return on Equity

5-yr Avg. Return on Assets

5-yr. Avg. Return on Capital

Price to Cash Flow

Current P/E Multiple

Stamps.com

24.7%

21.2%

24.7%

13.83

17.65

Industry

20.27%

10.98%

16.67%

23.81

55

Based on the numbers shown in the table, Stamps.com ranges from on par with its overall industry (software and applications) to just plain cheap in terms of its price to cash flow, return on capital and return on assets figures. Even where the number is close on average return on equity, the company is trading at a 20% discount to its industry.

The analysts’ consensus for earnings growth over the next 5 years for Stamps.com projects them to expand at an annual pace of 20% compared to an expectation of 19.8% for the overall industry. Based upon this number the business should carry a similar valuation to the overall industry.

Assigning a valuation to Stamps.com based on the industry average 5-year return on equity would require a share price approximately 20% above the current market value. A valuation equal to the industry average price to cash flow would result in a 72% increase in the share price. My estimate of the current fair value of this business is 16 times free cash flow due to the niche they fill in the market of providing a product most of us need through a far more convenient delivery system than standing in line at the Post Office. This valuation would provide for a 15.7% increase from the current share price just to reach my estimate of fair value. It should then be reasonable to expect the share price to continue rising in direct relationship to the annual earnings growth rate. If the analysts’ estimates for forward earnings growth are off by 25%, that would result in an annual earnings growth rate of 15% and would imply a similar expectation for the return investors could expect from the share price increases that would follow. This is an exceptional return from a low-risk investment.

Final Thoughts And Actionable Ideas

Passive investors who are simply seeking an attractive long-term stream of capital appreciation can simply buy the shares at the current price with a reasonable expectation for 15% annualized returns of the next 3-5 years with less risk than the overall market. The reduced risk, in my opinion, is based upon the superior balance sheet strength of this business.

For those deep value investors who insist on discounts for everything, they might be interested in selling the $30 strike price puts options with an August 16, 2014 expiration for a premium of $0.60/share. For each option contract sold, the seller will be obligated, but not entitled, to purchase 100 shares of the stock at $30/share at any time between now and August 16th. The $0.60/share premium collected for the sale of these options represents an immediate return of 2% on the $30 exercise price and the exercise price of the contract represents a discount of 13.7% to the current market price. Should the shares not be assigned at expiration, the seller of the contracts would have an annualized return on the capital required to execute the purchase of shares equal to 17.38% over the 42-day life of the contract. Should the shares be assigned at the expiration of this contract, the option seller will have a cost basis of only $29.40 in the shares which represents a discount to the current value of 15.7%. Sometimes, it really can pay to be cheap.

For those investors who really want to enter a position at the current price but would like a bit of an incentive to do so, can create what I call a synthetic dividend by purchasing the stock and simultaneously selling the $40 strike price August 16, 2014 expiration date call options for $0.60. Each call option covers 100 shares of the stock so investors would sell one call option for each 100 shares purchased. This transaction would produce an immediate “dividend” of 1.72% on the $34.77 current stock price for an annualized return of 14.94%. If the share price is below $40 on August 16th, the option seller will simply keep the premium collected and still retain ownership of the shares.

Should the shares of Stamps.com be trading above $40 on August 16th when the options expire, the shares would be called away and the option seller would keep the $0.60 premium collected for selling them plus add another $5.23 in short-term capital gains, for a total profit of $5.83/share or 16.7% over 42 days. This scenario would result in an annualized rate of return equal to 145.7%.

About the author:

Ken McGaha
Ken McGaha has been managing his own investment portfolios for over 20 years. On July 20, 2012 he launched the Self-Made Millionaire Tracking Portfolio with a portion of his capital as an aid to teach younger members of his extended family how he built his own investment portfolios and maintains them today.

Ken's Self-Made Millionaire website now has subscribers in at least 13 countries and the Self-Made Millionaire Tracking Portfolio has delivered a 28.36% annualized rate of return on capital between July 20, 2012 and June 21, 2014.

In late December of 2013, Ken added the Maggie's Money Mountain Tracking Portfolio to his website to show young investors with limited capital how he would invest and trade an account with $4,500 in order to grow it at a compounded rate of 12% annually. From December 30, 2013 through June 21, 2014, this account has produced an actual return of 26.05%.

Visit Ken McGaha's Website


Rating: 0.0/5 (0 votes)

Comments

Please leave your comment:


Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK
Email Hide