The Keynote Won't Turn

Since all of us Foolish writers and analysts are also investors, we're prone to saying that investing isn't really all that difficult. Mostly, we're right in this claim. You learned the necessary math in fifth grade. Most of the required reading is freely available over the Web. And buying to hold stock in quality companies tends to be profitable, so long as you buy well and hold long enough. Heck, sometimes you even get paid for the privilege.

Sounds good, right? Of course. There's just one little problem. Investing well, you see, requires a series of judgment calls. And sometimes a stock proves so confounding that judgment calls become difficult. Take Keynote Systems (Nasdaq: KEYN  ) , for example.

Yesterday afternoon, Keynote, which tracks the Web and e-commerce performance of some 2,300 clients, reported earnings for the fourth quarter and all of fiscal 2005. There wasn't much to like. Take margins, for example. In Q4, gross margin declined a hair, while operating margin ticked upward by a couple of points. But for the full year, gross margin was down more than 4%. Operating margin was down 1.5% over the same period.

The story doesn't improve much on the bottom line, though you might not know it at first. Reported earnings were up 230% for the quarter and 59% for the year. But those figures include a $2.7 million tax benefit related to a deferred tax asset. In other words: The numbers were juiced by a one-time event. Real net income was $4.7 million for all of 2005 and $1.7 million for Q4. That's 1.1% and 29% growth, respectively.

Don't get me wrong: I think Keynote serves a useful purpose, and I think it says a lot that the company has done profitable business for 10 years. Indeed, such a track record has become an unfortunate rarity in the tech business, reserved for titans like Microsoft (Nasdaq: MSFT  ) , Motley Fool Stock Advisor pick Dell (Nasdaq: DELL  ) , and Intel (Nasdaq: INTC  ) . But that doesn't mean it's doing a good business at the moment. I mean, really, don't you know something's wrong when sales are up 27% on lower margins, resulting in flat earnings growth and a 28% decline in operating cash flow? I'd say so.

Then again, I said this wasn't an easy story. And it isn't. Keynote had $133.8 million in cash and investments and no debt as of Sept. 30. A check of the balance sheet shows the company trades for a mere 1.39 times its tangible net worth, also called book value. Another way to look at this: Ongoing operations are selling for next to nothing. That's incredibly tempting, as it's rare to see any company trade near or below its book value.

Don't fall for it. Remember: Empirical research has found low price-to-book ratios to be indicative of either an extremely cheap stock, or a business that's about to be on life support, if it isn't already. How do you know which it is? Here's a hint: Flatlining earnings and declining cash flow aren't good signs.

Let's put it even more simply: Keynote's trailing 12-month P/E ratio comes in at almost 60 times diluted earnings per share. That doesn't compare well with the industry average of 30, as reported by Yahoo! Finance. We might be able to overlook this were Keynote to use its ample cash hoard to pay a dividend. It doesn't. Sigh.

Much as I'd love to be high on a cash-rich business like this, I detest stagnating business models. That's what Keynote has today, and the stock -- appropriately, in my opinion -- reflects it.

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Fool contributorTim Beyersstill has trouble nailing a falsetto. Oh well. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. You can find out what's in his portfolio by checking Tim's Foolprofile. The Motley Fool has an ironcladdisclosure policy.


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