Round Two from Round Rock: 8,800 Layoffs at Dell

Earlier this week I wrote about the push by Dell (DELL) into the retail channel as a way to boost sales and gain traction against Hewlett Packard (HPQ). On Thursday the company beat estimates for their first fiscal quarter and announced the second prong of their turnaround plan; 8,800 layoffs (10 percent of the workforce). Although Dell has perfected the very efficient direct model, evidently the company has some fat it can trim, which should help offset any margin pressure from their plan to sell lower end desktop PCs in Wal-Mart (WMT) locations starting in mid June.

Assuming the consumer experience won’t be adversely affected by the job cuts, this appears to be a good decision, from a shareholder perspective at least (some employees obviously might feel otherwise). Dell stock jumped more than $1 in after-hours trading to over $28 per share. The stock isn’t cheap enough to peak my interest, but I wanted to take a quick look and see what kind of upside investors should expect if the turnaround proves successful. The moves the company is making have a good chance to give the company some upside to currently low expectations this year and into 2008. But how much is the stock worth?

The reason I say Dell shares aren’t that cheap is based in part to where companies like HP and IBM (IBM) are trading (15x and 14x 2008 estimates, respectively). What kind of P/E should Dell get based on those comps? I would say 15 to 16 or thereabouts, but the good ol’ days of a 25 or 30 P/E for Dell seem to be over.

As far as earnings go, I decided to be pretty aggressive on this assumption, giving the company the benefit of the doubt regarding its new restructuring plan. Current forecasts call for about 2% revenue growth this year, followed by 6% in 2008. Changes at the company likely won’t produce results overnight, so a reacceleration in sales is likely to be more pronounced in 2008. Let’s assume they can grow sales 10% next year, to more than $64 billion.

Furthermore, let’s assume that Michael Dell can get the company back to peak operating and net income margins. Profits peaked at 6.4% of sales in 2005 before dropping to below 5% last year. Assuming 6.4% margins on $64.3 billion in sales for 2008, the company gets to earnings of $1.83 in 2008, well above current estimates of $1.49 per share. Assign a 16 P/E and the stock price would be above $29 per share. Even if we stretch the P/E to 18 (Dell used to trade at a premium when they were tops in the industry, so this is plausible if they regain their former glory) there is upside to $33 per share, about 16% above the current quote of $28 and change.

The bottom line: Dell stock could definitely keep rising if their turnaround efforts pay off in coming quarters, but make no mistake, this isn’t going to look like the 1990’s by any means.

Full Disclosure: No positions in any of the companies mentioned at the time of writing

Despite Harsh Words from Critics, Share Buybacks Remain a Great Way to Boost Earnings and Share Prices

You might know Herb Greenberg, an often quoted columnist for MarketWatch and a frequent guest on CNBC, as someone who focuses on telling the bearish story on the market. Although I’m about to refute one of Herb’s recent blog posts entitled “AutoZone: Sustainable Model?” regarding auto parts retailer AutoZone (AZO), I will admit that there are not enough people out there telling people what could go wrong. Wall Street is too often about selling stocks to people, and with that comes a bias toward making the bullish case for an investment, not the bearish one. Although betting against stocks stacks the odds against you, Herb makes it his duty to tell the other side of the story.

In the case of AutoZone, here is what Herb had to say about the company on May 22nd:

“Earnings per share beat estimates, yet again, thanks to buybacks. Who cares about sales missing estimates? Who cares about sales per square foot that are either down or flat year-over-year for 12 consecutive quarters? Or inventory turns at a multi-year lows? Or sliding sales per store? Or continued weak same-store sales? All that matters, in a buyback story, is earnings per share.

"The point," says one longtime skeptic, "is whether that's a sustainable business model. Anybody can do this for some finite period of time, but only the 'productivity loop' (as exemplified by Wal-Mart in its heyday and others) has proved sustainable.”

Herb does have his facts right, AutoZone has not been greatly improving their sales or inventory turns for a long time. However, when trying to judge the merit of a bearish argument, you have to ask, does any of this stuff matter? From reading Herb’s post, it is obvious that he, as well as the long-time skeptic he quotes for the piece, believe that it does matter in terms of the future for AutoZone stock.

Noticeably absent from the piece, however, are any reasons why sales, sales per square foot, inventory turns, sales per store, and same store sales do matter, or why share buybacks are bad. He simply states that a business model that focuses on buybacks, and not sales or inventory, is not sustainable. There is nothing there that explains why it isn’t sustainable. Why may that be?

If you do some digging into AutoZone’s financials over the last fifteen years, you will see that the model is sustainable. The company has been focusing on stock buybacks since 1999. This year will mark the ninth straight year that choosing buybacks over sales growth has worked for them. The argument that the model isn’t sustainable simply does not hold water because the evidence, which I will detail below, points to the contrary.

Now, why has the model worked? Why has it proved wise for AutoZone to reinvest excess cash into its own shares rather than new stores, or other projects focused on traditional retail metrics? Because buying back stock will boost AZO’s earnings more than opening a new store, or implementing new inventory management software will. And when it comes to getting your share price higher, earnings are what matters, not sales, or comp store sales, or sales per square foot, or inventory turns.

Herb writes “All that matters, in a buyback story, is earnings per share.” That is only partially correct. All that matters, in the stock market, is earnings per share. Stock prices follow earnings over the long term because owning a share of stock entitles you to a piece of the company’s earnings. Not sales, but earnings.

Let’s take a look at AutoZone in more detail. The company’s history since its IPO in 1991 tells two distinctly different stories. From 1991 through 1998, AutoZone focused on traditional retail metrics, the ones Herb and his skeptic friend believe are important when evaluating a stock's investment merit. During that time, sales compounded at a growth rate of 22 percent per year, with same store sales averaging 8 percent growth. Stock buybacks were not used, resulting in total shares outstanding rising each and every year due to option grants.

However, in 1999 AutoZone began to focus on stock buybacks, an effort that was very much an idea from a relatively unknown hedge fund manager by the name of Eddie Lampert, who had begun to amass an investment position in AutoZone stock. Lampert understood the retail sector well, and knew that industry experts loved to focus on same store sales and other metrics like that. But he also knew that such metrics had very little correlation to stock market performance, and as an investor, that is all he really cared about.

As a result of pressure from Eddie and other investors, Autozone began to implement a consistently strong buyback program. Total shares outstanding peaked in 1998, fell year-over-year in 1999, and have fallen every year since. Not surprisingly, with a new focus on share buybacks, there was less cash flow left over to improve store performance in ways that would be reflected in same store sales, sales per share foot, and inventory turn statistics. Not surprisingly, since 1999 sales have only averaged 8 percent growth per year, with same store sales compounding at a 3 percent rate. Both of those are far below the levels achieved before the buyback era began at AutoZone.

So the punch line of course lies in what happened to AutoZone stock during these two distinctly different periods. Herb Greenberg and other long-time skeptics would have you believe, without evidence to support their claims, that sales and inventory matter to Wall Street. I am writing this to prove to you that such arguments are wrong.

AutoZone’s stock ended 1991 (the year of its IPO) at $10 per share and reached $26 by the end of 1998, for an increase of about 150 percent. The buyback program reduced share count for the first time in 1999 and today the shares fetch $127 per share, an increase of about 390 percent from 1998. How could this be the case if sales growth and other metrics of retailing health were so much stronger in the earlier period?

The answer lies in the effects of the buyback program. Share count peaked in 1998 at 154 million and now sits below 70 million. So, if you bought 10% of AutoZone at the end of 1998 and held those shares until today, you would now own 22% of the company, without buying a single additional share. And although AutoZone’s sales growth has slowed in recent years, the company is still larger now than it was then, so shareholders not only have seen their ownership stake more than double, but the entire company is worth more today than it was in 1998.

Hopefully this explains why retail metrics like sales don’t really matter when it comes to share price appreciation. Earnings are all that counts, not just in a buyback story, but in any story involving the stock market. I believe Herb when he characterizes his source as a “long-time” skeptic of AutoZone. He likely has been bearish on the company ever since they decided to put buybacks ahead of sales on their priority list eight years ago. However, the skeptics have been wrong for many years and the reason is pretty simple; the buyback model has proven to be quite sustainable.

Full Disclosure: No position in AutoZone at the time of writing

AutoZone vs S&P 500 Since Market Peak in March 2000

"The Long Tail" by Chris Anderson is Worth a Read

If you ever wanted to read an interesting, in-depth explanation as to why many business ideas far exceeded expectations and became so successful (examples that come to mind include Amazon and eBay), I highly suggest you read The Long Tail by Chris Anderson, a book I just finished this weekend. The editor of Wired Magazine, Anderson explains why companies that have focused on the long tail of product demand curves, rather than only the most popular "hits" in categories such as movies, books, and music, have tapped huge levels of profitability despite far fewer units sold.

Advances in technology, the Internet in particular, have greatly enhanced our ability to distribute thousands more items than ever before. The result has been, and will continue to be, according to Anderson, a shift in customer tastes from hits to choice and selection. Niche markets, often ignored by large media companies, have become more profitable than bestsellers and companies striving to serve those markets well are thriving like few thought they ever would. The Long Tail is an excellent book for those who want to better understand how retailing is being revolutionized by technology, and which companies stand to benefit from these changes.

Wal-Mart is an Unlikely Answer to Dell's Problems

After handing off the CEO post to Kevin Rollins at Dell (DELL) for a few years, founder Michael Dell has returned to try and help his company find its way back to the top. Dell came out of nowhere in the 1990's to overtake the likes of Hewlett Packard (HPQ) and IBM (IBM) in the PC market and earned the number one spot in worldwide market share. However, customer service issues have hurt the company in recent years and a reinvigorated Hewlett Packard (thanks to the entrance of Mark Hurd) now holds the top spot.

So what is Michael Dell's master plan to get back to the top? Last week we learned that the company will begin selling several desktop models in 3,000 Wal-Mart (WMT) stores nationwide. Upon hearing the news I couldn't help but ask myself, "How is that going to help Dell solve its problems?"

After all, the company built its business perfecting the direct distribution model that Dell created in his University of Texas dorm room in the 1980's (he subsequently dropped out). Furthermore, the company focused on the higher end corporate, government, and education markets, leaving the likes of HP, Compaq, Gateway (GTW), IBM (IBM), eMachines, and Packard Bell to fight over the low-end consumer segment. That market didn't turn out to be a very lucrative one. Packard Bell no longer exists. IBM sold its PC business to Lenovo. Compaq was forced to merge with HP. A struggling Gateway bought out eMachines, but still is doing poorly.

Now we hear that Dell is entering the retail channel with what I would have to think (given Wal-Mart's customer base) is a low-end desktop computer. This decision really doesn't make a whole lot of sense to me. The company thrived by shying away from the exact area they now are going to go after. Let's not forget that Dell at first refused to offer desktop models at $300 and $400 price points, instead focusing on higher margin products. They eventually gave in and also began using Advanced Micro Devices (AMD) chips (under Rollins), something they did not do for a long time.

It has been well publicized that Dell has lost market share due to sub par customer service. The company opted to outsource their customer support in order to save money, but the result was consumers waiting on the phone for hours and upon finally getting through, not really getting helpful information. Dell should really focus on what it is that lost them market share in the first place. You can't argue that it was ignoring the low-end PC market, because Dell was number one years back when they were avoiding that segment entirely. If Dell doesn't fix their image of having poor customer support, their market share numbers aren't going to improve dramatically. Even if someone buys a Dell at Wal-Mart, a bad experience will ensure they buy HP or another brand the next time around.

All of that said, you can understand why Dell has decided to go the Wal-Mart route. If they think the key is to regain lost market share at HP's expense, then selling computers at the world's largest retailer would be a great way to boost unit volume. The only problem with that strategy is that profits won't greatly improve and as long as customer support remains lousy, new customers won't result in a high percentage of repeat business, which is really something Dell needs to maintain to sustain any sort of reemergence as the worldwide PC leader.

It seems to me Dell is focused on a short-term impact, something that can score a few points of market share. While that may be attainable, they run the risk of not really improving the overall Dell experience, either as a shareholder or as a computer user. And without that, a Dell turnaround might be very, very difficult.

Full Disclosure: No positions in any of the companies mentioned at the time of writing

Market Fails to Dismiss Double Top Scenario

About a month ago I mentioned that it was possible the market could find resistance near the old highs on the S&P 500 index and perhaps make a seven-year double top. Interestingly, yesterday marked the third straight day the market could not register a new closing high on the S&P 500 (1,527 and change).

I'm not really into short-term market predictions (You're better off just flipping a coin if you want to know what will happen in coming days), but we are setting up for a near-term top unless we can break through this level. Oddly, the all-time intra-day high is above 1,550. That must have been a wild day back in March 2000.

Here is what the last decade looks like on the SPX:

Usually a Contrarian Investor, Kerkorian Takes Aim at Bellagio, City Center Instead

In recent years billionaire investor Kirk Kerkorian and his investment company Tracinda Corp. have been focused on potential value in beaten down automobile companies like General Motors (GM) and Chrysler. However, despite a huge upward revaluation in Las Vegas properties during that time, evidently he still sees value in that area.

Monday we learned that Kerkorian is interested in acquiring the Bellagio hotel and casino as well as a new development project, City Center, which is set to open in 2009. Kerkorian is the majority owner of MGM Mirage (MGM) with a 56% stake in the gaming giant, worth about $10 billion before his intentions were made public. MGM shares rallied 10 points in after-hours trading Monday to $73 per share on the idea that Tracinda might wind up taking MGM private at some point down the line.

The announcement is interesting given Kerkorian's recent foray into domestic car companies at very depressed prices. MGM Mirage is not a cheap stock (about 12 times 2006 cash flow) but has many growth opportunities ahead, both in Vegas and abroad in Macau. Such a move indicates that he is not worried about a severe economic slowdown, which would almost certainly adversely impact the boom in Las Vegas and Macau that has been very strong during the current worldwide economic expansion. With Kerkorian still willing to buy at these levels, he must think those predicting doom and gloom on the economic front aren't likely to be vindicated anytime soon.

Full Disclosure: No position in MGM Mirage (unfortunately) or any other company mentioned at the time of writing

Until Consumer Habits Change, Energy Stocks Should Continue to Shine

It's amazing that gas prices hit $4 per gallon in Chicago and San Francisco even before the summer driving season officially started. There are several reasons why we are paying so much to fill up our gas tanks but the one that I think is most important is not talked about as much as it should be.

There is no doubt that the Iraq war is contributing to high energy prices (oil production there is below pre-war levels), as is rising demand from emerging economies like China and India. However, the habits of the U.S. consumer is the largest contributor to our country's sky-high energy use, and as a result, record-high prices. After all, what we do in this country has a profound effect on the energy market. Despite only representing 5% of the world population, we consume 25% of its oil.

The way I see it, the culprit is the rise of the sport utility vehicle in the United States. Many people who drive SUVs are quick to complain about paying $60 to $70 or more to fill up their tanks each week and accuse the oil companies of gauging prices (which is a ridiculous, baseless claim), but they are a large part of the reason gas prices are north of $3 per gallon nationally as I write this.

If you don't believe that America's love affair with SUVs is affecting gas prices, one glance at the numbers might change your mind. The statistics below are from the Environmental Protection Agency (EPA), an organization that tracks U.S. energy use very precisely. I don't think it is just a coincidence that there has been a direct correlation between SUV sales, petroleum use, and gas prices. After all, the oil markets are based on supply and demand. With worldwide supply flattening out, demand is crucial in determining price levels.

As you can see, SUV sales as a percentage of vehicle sales has more than doubled over a ten-year period. Since SUVs are far less fuel efficient than cars, they account for a large portion of the increased oil demand in the United States.

I am not a fan of heavy government involvement as far as dictating human behavior is concerned, but I would not be opposed to increasing incentives for people to ditch their SUV, as well as higher CAFE standards for fuel efficiency. If we could reverse the trend of SUV prominence, oil demand is this country would drop, and prices would follow suit.

For those who need to drive SUVs, that's fine, but they need to understand that higher gas prices might be a cost of driving a larger vehicle, and that blaming the oil companies for high prices is ignoring how the global oil market works. The biggest improvement could come from those who own SUVs without a real need for it.

Until driving habits in the U.S. change, gas prices will remain high and oil companies will continue to reap the benefits on their income statements. As long as the trend shown in the graphic above remains intact, investors should continue to hold a healthy dose of energy stocks in their portfolios.

Web Site Review: YourCreditNetwork.com

Credit card sites seem to be all the rage lately, but I guess that is not very surprising. Given how much Americans rely on credit cards for managing (or mismanaging) their personal finances, I can certainly understand why credit card information is in high demand on the Internet. There are even people who try and take advantage of the easiness of credit availability nowadays to engage in credit card arbitrage.

For those of you who use them regularly and are always looking for the best credit cards based on your individual spending habits, a site that might be worth looking at is YourCreditNetwork.com. Like the many other sites out there, YCN compiles a database of every type of credit card available. A credit card offer can be sorted by company, type of user, type of rewards, etc. Each card in the database includes detailed information about the terms of the card and even comes with an assigned rating, using a scoring system of one through five. After you find a card you are interested in, you can apply immediately using YCN’s online application.

YCN also writes a credit card blog that not only alerts readers to new cards that are introduced, but also aims to keep consumers informed about how to use credit wisely. So, if you are a credit card junkie and look to get the most out of your card, add YourCreditNetwork.com to your list of resources for the ever-increasing amount of credit card information that can be found online.

This post was sponsored by YourCreditNetwork.com

Microsoft Bid for aQuantive Signals Desperation

This stunning bid for online advertising firm aQuantive (AQNT) by Microsoft (MSFT) seems to stem from simply missing out on deals that competitors have made and feeling the need to get something, anything, done. After talks with Yahoo! (YHOO) went nowhere and Google (GOOG) bought Doubleclick for $3.1 billion, Microsoft had two options if they felt they needed to keep up with everybody else; buy aQuantive or Valueclick (VCLK).

Not only did they go with aQuantive, but they paid an astronomical price. Shares of AQNT were trading at $36 yesterday and that quote was pricing in a lot of buyout speculation already. Somehow they got Ballmer and Company to offer more than $66 per share in cash, an 85% premium. Such a bid puts Mister Softy on the hook for a cash outlay of $6 billion. In return it gets a business at 104 times trailing earnings, 86 times current year earnings, and a whopping 67 times 2008 earnings.

Is it a good move, given the price tag paid? I can't see how it could be. Based on 2006 sales figures, AQNT will represent less than 1% of Microsoft's revenue. This deal can hardly move the needle for them, in my view. Sure it will add some expertise in a field that the company is struggling with, but given that this deal is just being done to keep up with acquisitions already announced by competitors, Microsoft is just keeping pace with rivals, not gaining on them.

Buying Yahoo! would have been a better option. There aren't any comparable deals Google could have done to match a Yahoo! purchase by Microsoft, so that would have actually closed the gap. I don't think this aQuantive deal does that. And given the price they paid, I wouldn't be too happy if I was a Microsoft shareholder.

The only positive coming out of this announcement, unless you are long aQuantive shares (congrats to all of you), is an opportunity for merger arbitrage traders. AQNT is nearly $3 below the $66.50 offer price. Although no other bids are likely, the discount is more than 4% and the deal should close by year-end, so arb players can make an 8% to 9% annual return by waiting six months or so for the deal to close.

Full Disclosure: Long Google, short Yahoo!, and no positions in the other companies mentioned

Eddie Lampert Buys Citigroup Stake Over Last 12 Months

Thanks to quarterly SEC filings, we learned Tuesday that Eddie Lampert, Chairman of Sears Holdings (SHLD) and General Partner of the hedge fund ESL Investments, has been buying shares of Citigroup (C) since early 2006. At the end of the first quarter Lampert had amassed more than 15 million shares worth about $800 million. The filings show that Lampert began buying Citigroup in the first quarter of 2006 at pricesin the mid to high forties. Today shares are jumping 1.7 percent in the pre-market to more than $53 each.

The purchase makes sense given that Lampert is a value guy (Citi trades at a 10 P/E and yields 4%) and his hedge fund is big enough that large cap stocks are the only kinds of investments that he can really take a meaningful position in without buying an entire firm. I've seen various press accounts of the Citigroup purchase speculating that Lampert is planning on using his stake to put pressure on the company to make significant changes. However, those hoping for shareholder activism on ESL's part shouldn't get too excited. Although $800 million is a lot of money, Lampert now owns less than one half of one percent of Citigroup. Hardly enough to play the hedge fund activism card.

Full Disclosure: Long shares of Sears Holdings and no position in Citigroup at the time of writing

Was Senator Edwards Being Hypocritical by Working at a Hedge Fund?

I'm curious what readers think about this. After coming up short in his bid to become Vice President in 2004, Senator John Edwards worked for Fortress Investment Group (FIG) as a consultant. Given that Edwards has been focusing his political campaigning on helping solve the poverty problem in our country, is he being a hypocrite by working for a hedge fund, whose main job is helping rich people get even richer?

I'm not sure where I fall on this issue. At first blush it does seem like a questionable decision on his part. However, does the fact that he worked for Fortress really mean he is somehow abandoning the poor? Fortress is going to do what they do regardless of whether or not Edwards is there. There is no way his role at the firm had any financial benefit for Fortress clients. He might have given them a well respected politician in their corner, but he didn't boost their investment returns, so he didn't directly help the rich get richer. That is going to happen regardless.

Of course, Edwards is going to say it was, in part, a learning experience. He clearly doesn't have much financial markets knowledge. But he did admit that the money was nice too. Does someone who supposedly wants to help the poor have to purposely avoid earning a nice living because of his political platform?

It's an interesting topic. I'm curious to hear what you all think. And I know it's a political discussion, but let's keep it polite, not partisan. We can speak in terms of politicians in general, regardless of party affiliation.

Amgen Dependence on Aranesp Off-Label Use Greatly Exaggerated

I touched on the issues Amgen (AMGN) is having with Aranesp a couple months back, but I decided to take a closer look at the numbers after the latest news that an FDA panel recommended further studies and label changes for the company's anemia drug franchise. Such recommendations should not have been surprising given that a label change was already in the works (albeit less severe) and companies do follow-up studies on existing drugs all the time to measure long-term effects.

The main concern with Aranesp is that the drug is approved for patients with hemoglobin levels below 12. However, there is off-label usage going on at higher levels, and the FDA is concerned that such usage may increase cancer patients' risk of developing other health problems. Amgen stock has been crushed on these concerns, slumping from 77 to 56 per share in the last year. Is the company going to lose as much business as Wall Street seems to be pricing in? I decided to take a look.

The media and Wall Street community has been focused on the fact that Amgen's two anemia drugs, Aranesp and Epogen, represented 46% of the company's sales in 2006. If you leave the analysis at that, then dramatic changes in prescription trends for both drugs would appear quite damaging. However, if you dig further to single out the areas of concern, you learn that Aranesp sales in the United States (where the FDA and label changes will have an impact) represent less than 20% of Amgen's business. Recommendations for Epogen (which is used in dialysis patients) is not going to be known until later this year. Furthermore, off-label use is an extremely small percentage of total script volume, so even if Amgen loses all of that business, it won't be catastrophic, as the chart below shows (data courtesy of Amgen).


















The FDA panel was focused on patients with chemotherapy-induced anemia (CIA) and anemia of cancer (AoC), and especially with off-label uses in those with hemoglobin levels above the targeted range of 11-12. As you can see, only 15% of Amgen's sales in 2006 came from cancer patients taking Aranesp, and less than 3% came from off-label use.

Now, does this information warrant such a dramatic sell-off in the stock? It depends on how much business you assume Amgen is going to lose. If Aranesp revenue was going to go away all of the sudden, then yes, it would be very painful news for Amgen. But doctors are not going to stop prescribing the drug to most patients because the vast majority are using the drug safely and it is working for them.

If we make some reasonable assumptions, not allowing Wall Street's reaction to influence our thinking, we can come to a much more logical conclusion about Amgen's future. Let's assume Amgen loses all of its sales from off-label use. If the FDA issues similar recommendations for Epogen in the fall (which seems likely), that would result in a 5% hit to Amgen's annual revenue. We can further assume that some on-label scripts will be lost due to some doctors getting nervous, combined with some who have borderline high hemoglobin levels and choose to cut back just to be safe.

Even if we assume that on-label sales drop off by a substantial 25% for both drugs (which seems like a high number to me), Amgen will see an overall sales drop of 10 to 15 percent. They would likely be able to offset some of that with cost-cutting, as they indicated they will do in their last quarterly conference call. The overall effect on earnings might only be 5-10 percent. Meanwhile, the stock is down nearly 30 percent, and may even be putting in a double bottom around $55 per share.











Full Disclosure: Long shares of Amgen at time of writing

Google Stock Looks Cheap, Believe It or Not

When looking for places to invest excess cash in an overbought market it is important to not only look at your upside potential, but also how much downside there is as well. If stocks are overdue for a drop, you want to make sure you aren't buying something that has a lot of air in it that could be let out quickly in a selling frenzy.

I have been warming up to shares of Google (GOOG) more and more as of late because the stock has been dead money while the company's impressive growth continues. The result of that dichotomy has been a share price that is getting more reasonable on a valuation basis. On Thursday I began initiating Google positions in some of my accounts that had sizable cash reserves.

Long time readers may know that this will be my second bullish call on Google since the company's IPO in August 2004. Like most people I sat out the IPO after the company indicated the stock would be sold well north of $100 per share. After the first round of their auction, the actual price was reduced to $85 per share, but those who didn't bid in round one were locked out of bidding at the lower price.

After the stock began trading it became apparent to me that investors were dramatically underestimating the company's earnings power and incorrectly associating their misfortunes during the Internet bubble with Google's future. I was late to the party, but began buying Google at around $180 per share.

The stock's ascent continued and by early 2006 I had sold my entire position at prices as high as $467 per share. At the time it appeared the Street was aware of the company's earning power, resulting in a fairly valued stock. Since then I have suggested being long Google as part of a paired trade, but have not jumped back in exclusively from the long side. Let me explain why that changed on Thursday.

There is no doubt that Google has tremendous potential to expand its dominance in coming years. That said, there are no assurances that the company's foray into international markets and domestic markets outside of online search will be successful. So, in order to be willing to make a long bet on the stock, I needed to feel comfortable that my investment downside was fairly limited despite the risks the company faces. At the current price of $461 per share, I feel that is the case. As you can see from the chart below, GOOG sits at the same price it was 16 months ago.










How do I arrive at that conclusion? Some simple math really, no rocket science or anything. Current estimates for Google's earnings are $15.12 per share in 2007 (growth of 43%) followed by a 27% increase in 2008 to $19.25 per share. I decided to use what I consider to be conservative assumptions in order to do a risk/reward calculation. Very simply, what is my downside and what is my upside? If the risk-reward trade-off seems intriguing, then Google shares look attractive at $461 each.

First, what is my downside? Let's assume Google earns $15 this year ($0.12 below current estimates) and only manages 20% growth in 2008, to $18 in earnings per share ($1.25 below current estimates). Let's further assume that Google trades at a P/E of 25 next year. I think both of these assumptions are extremely conservative. A 25 P/E on $18 in earnings gets us a stock price of $450 per share. In my opinion, that is my downside over the next 12 to 18 months, less than 3 percent!

Let's compare that to the upside. Again, I'm not going to make overly aggressive assumptions here. I want the numbers to be in reach and doable, but also want to be realistic as well as conservative. For this scenario I am going to take the current consensus earnings estimate of 27% growth in 2008, to $19.25 per share and assume that the company continues to beat estimates by a modest amount. It would not be surprising at all to see 2007 EPS numbers head to toward $16.00 by year-end and 2008 numbers to actually come in closer to $20.00 per share. Further, let's assume GOOG trades at a P/E of 30.

That multiple may seem high given that the market trades at half that valuation. However, I am fairly confident Google will grow at least 20% per year over the next few years, so assuming that growth investors will be willing to pay 30 times earnings for the stock is fairly reasonable. It would be in-line with valuations given to other leading Internet companies, as well as growth stocks such as Starbucks (SBUX).

Quick math tells us that a 30 P/E on profits of $19.25 to $20.00 in 2008 implies a stock price of $577 to $600 per share. Even if we use a more conservative P/E of 25 instead, we get to $481 to $500 per share. Accordingly, the upside is as much as 30% by the end of 2008. Compare this with downside of less than 3% and you can see why I think Google stock in the low 460's is a good investment, even in an overbought market such as the one we are seeing right now.

Feel free to read through this blog's archive if you would like to review what I have written in the past about Google stock.

Full Disclosure: Long shares of Google at the time of writing


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Web Site Review - OEXoptions.com

Site Name: OEXoptions.com

Web Address: www.oexoptions.com

Topic: OEXoptions.com is a site dedicated to index options traders who specialize in online trading of the derivative for the S&P 100 index (OEX). Many people are familiar with the S&P 500. The S&P 100 is simply the largest quintile out of the S&P 500 index. The OEX is essentially the domestic market's mega-cap index.

Features: Free articles about online trading of OEX index options, FAQ, options expiration and economic calendars, OEX options chains, various levels of subscriber services geared towards varying levels of experience, 15-day free trial offer.

Summary: For those who are interested in getting started with index options trading, OEXoptions.com is a good place to boost your knowledge. The site has numerous articles aimed to help OEX traders maximize their profit potential. Topics include background information on OEX options, lessons for successful OEX trading, trading strategies, position sizing, money management, leading and lagging OEX indicators, pivot points, as well as a FAQ page. The site also offers a variety of subscription services. These include three levels of service ranging from education information on how to trade options online, all the way up to a listing of the company's current holdings. A new service called Blue Chip Options provides subscribers with daily pre-market information to get traders ready for a successful day of trading.



The site receives a rating of three out of five due to a fairly wide array of information for OEX online options traders. For those who subscribe and are able to boost their trading profits from the site's services, it would likely be quite a valuable resource. For those looking to gain enhanced technical expertise trading equity index options, and OEX options more specifically, giving the site's 15-day free trial offer a shot could prove to pay hefty dividends.

Note: Web site reviews appearing on this blog may be sponsored by the sites' respective owners. As a result, the author may have been compensated for the review.

Sub-Prime Mortgage Weakness Not Spreading to Other Credit Products

Below is an excerpt from the first quarter earnings press release of a consumer lender that serves lower end customers, including some who would be classified as sub-prime borrowers, but is not involved in the mortgage:

"Factors adversely affecting our first quarter results included lower than expected fee assessments due to lower than expected delinquencies."

No, that is not a typo. For all of those people who were expecting the sub-prime mortgage mess to spill over into other areas of credit such as credit cards and student loans, it appears the worries (and subsequent share price declines) were unfounded. Delinquencies were lower than expected!

It might seem baffling to many, but this is pretty good evidence that the sub-prime spillover effect is being greatly exaggerated, a theory I first rejected a month ago in a piece entitled Most Financials Dragged Down with Sub-Prime Lenders.

Tip: When Engaging in Insider Trading, Be Discreet!

Evidently a Hong Kong couple thought the rest of the world was asleep. Listen to what they did before their brokerage accounts were frozen, preventing them from pocketing an estimated $8.2 million. Tell me if you think their broker, Merrill Lynch (MER), might catch on that something was a bit suspicious.

In early April the couple's account was worth $1.2 million, consisting of mostly fixed income and commodity investments, along with a small position in Intel (INTC) stock. All of the sudden, they wire $10 million into their account and borrow $5 million on margin to buy 415,000 shares of Dow Jones (DJ) for an average price of $35.14 per share.

Just days later Dow Jones gets a $60 cash offer from News Corp (NWS) and the couple tries to sell all $23 million worth, netting a profit of $8 million. How on earth do people really think Merrill Lynch isn't going to notice this? Regulators often do investigations after M&A deals are announced to try and uncover illegal activity, but this case was handed to them on a silver platter.

It will be interesting to see what happens to these people. I hope they get the book thrown at them. Perhaps a copy of the insider trading laws would be a good start.

Full Disclosure: Long Intel $10 2009 LEAPs at the time of writing

Dow Winning Streak Longest in 80 Years

It has truly been a breathtaking run, with the Dow Jones Industrial Average rising in 24 of 27 sessions, the longest streak since eight decades ago in 1927. Unfortunately, Tuesday's four point drop snapped the streak. How should investors play this? Many are stuck between two prevailing ideas, either ride the momentum to ensure not missing it, or wait for a pullback and buy on the dip. The problem is, there aren't any dips. We got a 7 percent correction a couple months ago but it was so short-lived that many didn't have time to get back on the train before it left the station again.

I am sitting on an above-average amount of cash right now, due to an overbought market that I am uninterested in chasing, coupled with a seasonal inflow of deposits. Since I'm a value investor, not a momentum trader, I am content with sitting on cash and waiting for an excellent opportunity. With the broad market rallying so strongly, such a dip might only occur in select names, as opposed to a widespread sell-off that makes many stocks compelling.

Why not just get my money in when short term momentum is strong? There are far fewer bargains now than there were six months or a year ago. Although I might miss some upside in the short term, due to above-average cash positions during a long winning streak, I still believe that buying dips and not rallies will prove to be more profitable when we look back a year from now.

The result could be lagging returns in coming days and weeks, but when we get another pullback and I have the ammunition to jump at true bargains, those purchases will more than likely make up the lost ground and plenty more over the intermediate to longer term.

I'm Not Holding My Breath for a Dell-RadioShack Deal

I get a kick out of some of the ridiculous deals that are rumored on the Street. Did anyone really think Sears Holdings (SHLD) would buy Anheuser Busch (BUD)? The latest story comes to us from Business Week, speculating that Dell (DELL) could buy RadioShack (RSH) in an attempt to reinvigorate its business after Hewlett Packard (HPQ) has kicked their butt for a while now.

How does this rumor get published? There is no evidence whatsoever that Dell would even consider buying an electronics retailer. Did RadioShack shares really jump 6% Monday on this story? It's insane. Remember the Gateway Country store concept? Huge bust. That was nearly as bad as waltzing into large corporations trying to sell computers in cow boxes.

The current market environment is very conducive to spreading M&A rumors. After all, the sheer volume of deals right now is astounding. That said, don't put stock into the stories that don't really make any sense. If you are looking to sell some stock, use these temporary bumps to sell into the rumors if you don't think they have merit. A client of mine did that with BUD when merger rumors surfaced, and it proved to be the top in the stock.

I didn't sell any RSH Monday into the rally, but that is because I like the stock for other reasons, not based on a silly buyout rumor. If anyone was going to buy RSH, you'd think it would be Sears, not Dell.

Full Disclosure: Long shares of RadioShack and Sears Holdings at time of writing

Renting versus Buying a House - A Contrarian View

I'm often posed with the question, "Given that interest rates are low, why shouldn't I buy a house instead of throwing money away by renting?" In recent years, buying a home has been all the rage. With interest rates around 6% for a 30-year fixed mortgage and the housing market booming, I've been amazed at how many people who have no real need for a house (young singles) have bought one.

As someone in the investment management business, whenever I am asked my opinion about buying a house, I look at it from two perspectives. The first one ignores the financial aspect (assuming the buyer can afford the home) because if you are getting married and starting a family, there are reasons to buy a house that have little to do with return on investment or anything like that. However, for those single people out there who don't have a true need for a house of their own, I suggest looking at the possible purchase as an investment and running the numbers accordingly.

I have made many spreadsheets for people to determine if buying a house makes sense financially. In the vast majority of cases it does not, as you can usually earn a higher return investing in a bank CD (let alone the stock market) than you can on a house, even after considering the benefits (mortgage interest deduction) and the costs (insurance, maintenance, taxes). The exceptions are cases where you rent out spare bedrooms and that cash flow covers a large chunk of your mortgage-related expense.

As a result, it is baffling to me when people will choose to take money out of their high yield savings accounts, investment accounts, and even their IRA or 401(k) plans in order to fund a house purchase. The common reason given is "renting is just throwing money away." While this sounds logical (your rent check isn't going toward the purchase of any asset), you have to look at it from a return on investment point of view.

A Smart Money article published last Wednesday entitled "Why Rent? To Get Richer" outlines the case for renting very well. I suggest those of you faced with the "rent versus buy" dilemma give it a read.

Full Disclosure: No position in a house at the time of writing

Gordon Gekko Coming Back?

The movie Wall Street starring Michael Douglas as a greedy corporate raider in the 1980's is a classic and although two decades old, it appears the film will be making a comeback. According to a New York Times source, Gordon Gekko is back. Edward Pressman, the producer of the original film, has signed on to make a sequel entitled Money Never Sleeps. Other movies have tried to duplicate Wall Street's success, Boiler Room comes to mind, but none have really been able to do so. Sequels are rarely as good as the original, but this project is definitely something that has the potential to be a pretty solid film.

Microsoft and Yahoo! Have Little to Lose in Tying the Knot

There are plenty of reasons why the rumored deal that would have Microsoft (MSFT) acquiring Yahoo! (YHOO) for $50 billion is not a good idea. In general, large tech deals rarely work. The history of failures is very long; Compaq-HP, AOL-Time Warner, Symantec-Veritas to name a few. Company cultures in Silicon Valley are typically very hard to mesh. Going from evil competitor to lifelong companion doesn't happen overnight too easily. In fact, for AOL Time Warner it never worked. The two sides hated each other from the start and the result was, according to many, the biggest failed merger of all time.

Add to that Microsoft's preference against big deals and an outright merger of the two companies seems pretty unlikely. Not to mention a price of $50 billion is outrageous and would be extremely dilutive. However, given where they both are right now, I can't help but think that there would be nothing to lose. Sure, the odds are high that the deal would never bear the kind of fruit that the optimists would hope for. But that doesn't mean it is a bad idea.

From Microsoft's perspective, they are probably shocked that despite having a near monopoly on the computer desktop, they still have yet to become an integral part of the user's online experience. Windows and Office represent nearly all their profit. An inability to smoothly integrate their desktop applications and online applications is a huge failure on their part. Instead, people are using Google (GOOG) and other software to manage their online activities and search for content they need. You can certainly argue that just adding Yahoo services won't necessarily change that, but perhaps the two sides working together can be more successful at turning Internet Explorer users into money-making customers.

From the Yahoo angle, they are obviously trying hard to regain some of the market share they have lost to Google. Combining with Microsoft would give them more reach and added capability to try and regain their relevancy. The potential of a Microsoft-Yahoo! team is obviously overwhelming.

Given the history of failed tech mergers and difficulty integrating vastly competitive corporate cultures, there are certainly reasons to believe that Microsoft and Yahoo! together would be no more adept at boosting their online presence than the two firms were able to accomplish alone. That said, I have to think that they have very little to lose by giving it a try. The worst case scenario, in my mind, would be no progress. And who knows, just because something is difficult doesn't mean it is impossible.

Talks of any kind are clearly in the early stages, so it's way too early to speculate on a deal happening, despite the move in Yahoo stock today. At this point I'd put the odds of a deal at no better than 50/50 but if I were advising them, I would make sure they thought long and hard about it. If they just dismiss it as joining with the enemy, which appears to be how talks between the two sides have gone in the past, it could be a missed opportunity to eat into Google's lead.

Full Disclosure: Long Google and short Yahoo! at the time of writing

Could the Bancroft Family Reject a 67% Premium for Dow Jones?

One of the things I look for when picking stocks is high insider ownership. The logic goes that you want people running the company you own to have their interests aligned with yours. Who is more likely to act in the interests of shareholders, someone with a guaranteed salary and bonus or someone with a large stake in the company and performance-based compensation?

However, few companies do fact have high insider ownership, so finding examples that fit the bill can be difficult. If a CEO gets options that are priced below market and vest immediately, he or she will likely sell them right away and not see any meaningful ownership maintained for the long term.

In the case of media company Dow Jones (DJ), you have very high insider ownership (the Bancroft family controls 64% of the voting rights), so you might think they have shareholders' interests at heart. However, we get news that News Corp (NWS) has offered $60 per share for DJ, a premium of 67 percent, and yet reports have surfaced that the Bancrofts may be prepared to vote against the deal.

How on earth can the Bancrofts reject a $60 cash offer when their stock is trading at $36 per share? Isn't that a huge disservice to DJ shareholders? Don't they have a fiduciary responsibility to take the deal? Legally, probably not. They can vote their shares any way they want. Other shareholders should have been well aware that the family has been against a buyout for years, and should have taken that information into account when they made the choice to invest in the company.

Although the Bancrofts have every right to reject the offer, they should do the right thing for their other shareholders. They should take the company private. If you want to keep the company in your family, as it has been for more than 100 years, that's fine and very understandable. However, when you are part of a public market, you do have a responsibility to your fellow shareholders. It might be legal, but is is absolutely unfair to DJ investors if you reject a $60 offer for shares that the market says are only worth $36 each.

The "low-ball offer" defense won't work here. If you want to make financially irrational decisions, then take the firm private and run it any way you want. If you want to open the company up to outside investors, then make sure you treat your shareholders with respect. You own the stock, so it's your choice which road to go down, but it's unfair to try and have your cake and eat it too. People invest in public companies to make money. If you make it impossible for them to do so, then you shouldn't be in the public marketplace in the first place.

Full Disclosure: No position in any of the companies mentioned

Another Take on RadioShack

A client of mine passed this amusing RadioShack story along from The Onion. Skeptics appear to be plentiful, even outside the financial community.