Pape's Pick: A Keynote Idea

06/09/2006 12:00 am EST


Gordon Pape

Editor and Publisher, The Income Investor and the Internet Wealth Builder

Despite market jitters, Gordon Pape remains bullish. He says, "Selective, fundamentally-undervalued stock offer excellent long-term opportunities for the patient investor." Here, he and analyst Irwin Michael offer a new buy recommendation, a "key" play in the tech sector.

"Once commodity prices consolidate, we will see a recovery of prices and another attempt at new highs. Overall, we remain relatively optimistic with respect to the North American economy. We expect creeping inflation to be contained, rising interest rates to plateau, and corporate profit results to remain healthy. We continue to believe that common shares are the last major asset class to participate in the mid-2000 decade asset price run-up.

"In fact, a natural artifact of the commodity mania has been the mispricing of previously hot sectors and stocks. Certain technology companies, previously high-fliers, have returned to levels where long-term value investors can find attractive entry points. We believe that once share prices return to levels supported by the fundamentals, investors should take positions. We have found such a pick in Keynote Systems (KEYN NASDAQ), this month's new stock selection.

"Keynote is a California-based leading provider of measurement and monitoring systems for e-ecommerce Web sites with a market share of about 80%. Its customers range from small Web-based companies to large Fortune 500 companies such as Amazon, American Express, Cisco, Dell, eBay, and Microsoft. The company is headed by Umang Gupta, a well-known Silicon Valley visionary and entrepreneur. Incidentally, Gupta is one of Keynote's largest shareholders owning approximately 1.8 million shares or 10% of the company.

"Keynote went public in September 1999 at $14 a share and didn't look back. Five months later it did a secondary offering at $105. The shares rose to an incredible $163.75 in March 2000 before succumbing to the bursting technology bubble. By December 2000, Keynote shares had given back all they had gained and eventually fell below the original IPO price. For the last five years, Keynote's stock has been virtually flat in comparison to its amazing rise and fall in 1999-2000.

"During this time, however, the company has quietly improved its product and service offerings and managed to remain the dominant monitoring company in the industry. It is also interesting to note that Keynote has partially used the money it raised at $105 a share to repurchase shares at a fraction of the cost. Since 2000, Keynote's share base has declined from 23 million to just under 19 million today.

"We do not usually purchase shares in technology companies because they are often too expensive on a book or net asset value basis. However, when we discovered that Keynote was trading below its tangible book value of $10.43, we felt it warranted further investigation. After doing our homework, we found that Keynote was in fact an ABC-type stock. With a market capitalization of close to $200 million, Keynote was debt-free with cash in the bank of $137 million.

"It also owns its headquarters in San Mateo, California. The building, which was purchased for $85 million in 2000, had been subsequently written down in 2002 to just $35 million. While we don't know for sure what the building is worth today, we feel confident that its value has appreciated since 2002. When we added the cash and real estate together, we found that it accounted for nearly the entire market capitalization of the company. In effect, we were getting the remaining technology business for next to nothing. With sales of over $50 million in 2005, comparable peer analysis indicated the remaining business could conservatively be valued at two times sales, or over $5 a share.

"Today, CEO Umang Gupta is focusing on expanding Keynote's service offerings and increasing its customer base. With the company's large war chest of cash, he is also on the prowl for opportunistic acquisitions. In April, Keynote announced the acquisition of SIGOS, a German-based company and leading supplier of mobile data network testing systems, for approximately $30 million. The acquisition is expected to be accretive to earnings by next year and introduces Keynote to some large European telecom customers such as Vodafone and T-Mobile.

"But with its share price continuing to trade at such low valuations, the hunter could become the hunted. Given its large cash position, hidden real estate, and dominant market position, we think Keynote might just end up being sold to a larger industry player. If it was to be purchased, we think an acquirer would have to pay a premium price to where the stock is currently trading. Buy at current levels."

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