Sleepless in Seattle

On their quarterly conference call earlier this week, Starbucks (SBUX) management indicated they envision room for 30,000 of their stores worldwide. Given that after years of rapid expansion they have yet to even reach 9,000, we can assume sleep is not something the Seattle-based premium coffee chain focuses too much on.

The stock has been on fire, having doubled in price over the last year to a recent $55 per share. Is it too late to get in? Well, it depends on your personal investment philosophy. Momentum investors love to see stocks like Starbucks defy gravity, and there is no doubt they have contributed greatly to its meteoric ascent lately. The question is, what can investors expect in the future?

I can’t recall a time Starbucks has been this richly priced. The p/e has actually risen throughout this year, despite the fact that multiples usually contract when larger companies get big enough that growth will inevitably have to slow. Fiscal 2005 earnings are expected to rise another 20% to about $1.14 per share, giving SBUX a forward p/e of 48. Much like one of their hot chocolates, the shares seem very, very rich.

Starbucks bulls can surely explain why the company deserves such a valuation. Among them, a 20% growth rate, the ability to charge $4 for something that one can buy somewhere else for $1 even though it is not four times as tasty (some may disagree), and the list goes on. The S&P 500 does trade at about two times its growth rate, so perhaps one can justify a 40 p/e for Starbucks stock. Given the company’s 30,000 store goal, it’s clear that the growth story is not going to end anytime soon.

The question remains, how long can the company maintain its 20% annual growth rate? And importantly for investors, what happens to the stock’s 48 forward p/e when growth slows to 15 percent, and then to 10 percent? That multiple clearly has little room to rise, and a significant way to fall at some point in the future. The stock’s upward move has actually accelerated over the last year or so, as momentum investors have chased the stock. This despite the fact that as the company continues to grow, it will become harder and harder to maintain its high level of growth.

If you have a sizable capital gain in Starbucks stock, perhaps it would be prudent to take some of it off the table. Here is one statistic to end with. Assume SBUX is able to maintain its 20% earnings growth rate for the next three years, through 2007, and as a result, posts 2007 earnings of $1.64 per share. If the stock trades at a 40 p/e at that time, then shares will fetch about $65 each. This would imply a return to investors of 6 percent per year between now and 2007. Hardly breathtaking, but surely a possible scenario.

Another Blown Analyst Call

The best performing equity group since President Bush won reelection last week has been the HMO sector. Stocks like United Health (UNH), Wellpoint (WLP), Anthem (ATH), and Aetna (AET) have been on fire. PacifiCare (PHS), a second-tier player and long-time Peridot holding, has also rallied, from a $34 close on election day to $44 as of yesterday. This morning, Banc of America Securities finally decided to cave and upgrade the stock from “sell” to “neutral.” The firm raised its price target on PHS shares from $25 (it’s 52-week low) to $44 (it’s current price). The report also pointed out, for those of us who are less than perceptive, that the “sell” rating had “not been a good call.”

As happens too often on Wall Street, we have another case of an analyst being completed wrong and having to throw in the towel and admit defeat. Why would anyone follow B of A’s advice on PacifiCare when they have been dead wrong on the stock for as long as the eye can see?

Google Pullback Presents Opportunity

Didn’t get any shares of the Google (GOOG) IPO? You’re not alone. Like the majority of buy side firms, Peridot avoided bidding in the Google dutch auction after the company set a high price range ($108-$135) and disclosed little information about the company’s future growth strategy. Tempered demand brought the IPO price down to $85, a much more reasonable price, but if you passed on bidding in the first round you couldn’t lower your bid when the range was lowered. The stock opened up $15 to $100 per share as some investors decided a sub-$100 price was a good bet.

In the following few months, Google stock doubled from its first day close to $200 a share. Headlines popped up everywhere that 1999 was back again, that we had learned nothing from the bubble. However, the skeptics had forgotten one important thing, Google actually makes money. The reason why stocks like Ariba, Commerce One, and theGlobe.com crashed from $100 to $1 was because their business models were flawed; they didn’t earn a dime. In 1999, analysts were justifying astronomical equity valuations by looking at revenues, not profits. Conventional wisdom back then was that with the increased use of the Internet, eventually the companies could turn sales and page hits into earnings.

For most companies, though, that never materialized and the stocks collapsed accordingly. There were, however, a select few that have survived, and not only survived, but thrived. eBay, Amazon, Yahoo, Interactive Corp, to name a few. Their market caps have risen steadily since the bubble burst for one simple reason, they are making a lot of money and still growing very quickly.

So, let’s come back to Google, which recently hit $200 before pulling back to the 160’s on concerns over its upcoming share lock-up expiration. There is one reason why those who got the Google IPO in August paid $85 and yet someone was still willing to pay $200 in November. Earnings. In the summer investors severely underestimated how much Google could earn. The initial earnings per share estimate for 2004 put out by the analysts was $1.31, giving Google a p/e of 65 at the $85 IPO price. Google’s growth rate was expected to be about 40% per year, about 10% sequentially for the foreseeable future. Understandably, many investors thought that, at best, Google’s IPO was fairly valued.

However, in October Google reported its first qaurter as a public company and it was a blowout. The analysts were wrong, and earnings estimates went through the roof. 2004 estimates now stand at $2.54, with 2005 numbers averaging $3.38 per share. If investors knew this in August, Google never would have priced at $85. Think about it. Forward EPS of $3.38, 40% growth rate, and an $85 stock price. That’s a forward p/e of 25x for 40% growth. Nobody on Wall Street would have pronounced the Google IPO overvalued if they knew it had a 2005 p/e of 25.

Recently Google has fallen from over 200 to the 160’s, mostly due to insiders who will be free to sell shares beginning in mid-November. Increased supply leads many to think Google will crash back to Earth. The question is, will a $35 or $40 decline in the stock price result in increased demand, and if so, will that demand be able to absorb the supply that will soon be hitting the market.

Nobody knows for sure, but we do know one thing. Investors so far have underestimated how much money Google can earn in the future. It wouldn’t be surprisng to me at all if after the company reports the next quarter or two, analysts once again have to raise their earnings estimates. At $165 per share, Google trades at 49x what the Street today expects them to earn next year. Given a 40+ percent growth rate and the potential for more blowout quarters to the upside, it seems that the lock-up fear has presented an opportunity to buy, not to sell.

Merck’s Value Proposition Could Prove Dangerous

Analysts and fund managers are quick to point out that recently decimated shares of pharma giant Merck (MRK) present value to investors; with an unusually high dividend ($1.52 annually for a yield of more than 5%), a below-market earnings multiple, and a stock price not seen in about a decade. Merck CEO Ray Gilmartin has remained adamant that the dividend is safe and will not be cut, despite 2005 earnings per share estimates having been slashed from $3.40 to $2.60 since the withdrawal of Vioxx.

With $2.5 billion in annual Vioxx sales now gone, investors are focused on thousands of class action lawsuits which are sure to surface shortly. Settling all claims could cost the company billions of dollars. Another blockbuster drug, Zocor, which amounts to $5 billion of Merck’s $22 billion in revenue, is set to come off patent in 2006. So, in a span of less than 2 years, Merck will have lost $7.5 billion in sales, or about a third of its business, all while attempting to defeat thousands of lawsuits from patients who have taken Vioxx for years.

It appears possible that concrete evidence will surface that could prove Merck management knew of the increased heart attack risk that Vioxx presented, but chose to keep it in close confidence. Although not a probable result, it is not out of the question that this company could be in trouble if such a scenario played out. With its base business set to deteriorate, the longevity of a large dividend payout certainly comes into question. As does the “value” presented by Merck shares with a 2005 P/E of 11, when it could prove very tough to hit the reduced EPS estimates of $2.60 per share.

Investors should not assume the 5-plus percent dividend makes the stock a safe value play, even if the CEO insists it will not be cut. Shorting the shares is costly as long as the dividend remains, as those who borrow the shares will have to pay whoever bought their shares. As a result, the best way to play a further fall in Merck shares, if you are wary of the company’s future prospects, may be owning in-the-money puts.

Do Elections Affect the Stock Market?

The last of the three presidential debates for 2004 concluded last evening. We’ve heard plenty of election coverage, so I won’t get into much of the politics here, but one question is relevant to me and my clients. Will next month’s election (or any presidential election for that matter) affect the stock market’s future returns. And if so, how?

Much of the country has concluded during President Bush’s first term that his policy of reducing taxes on income, capital gains, and dividends has helped bring investors back to the market after many portfolios were dismantled in the first three years of the new millennium. Some have worried that the market would react negatively to a Kerry victory in November due to his desire to raise taxes for those individuals earning more than $200,000 a year.

We have also heard that academics have found that the market itself performs better under Democratic Presidents, as opposed to Republican ones. Interesting contradiction, isn’t it? Rather than listen to the pundits on television, I decided to take a look at the research myself and determine which, if any, political side is better for the stock market. Stock prices are proven to follow corporate earnings over the long term, and most won’t argue that the best predicter of company profits is economic growth. Here is what I found.

There are two sets of numbers highlighted below. The first are the most commonly used economic statistics used to measure the health of the economy; GDP growth, unemployment, inflation, growth in federal spending, the budget deficit, and the national debt. These numbers came from research completed by the Bureau of Labor Statistics (BLS) and the Bureau of Economic Analysis (BEA), both non-partisan bodies that the White House and others rely on for unbiased data continually. This data is for the 40-year period from 1962 through 2001. The results are very interesting, especially if you favor the Republican political view that seeks to lower taxes and reduce government spending, as opposed to the “perceived” idea that Democrats prefer to “tax and spend.”

From 1962-2001:

GDP Growth: 3.9% (D) 2.9% (R)

Unemployment Rate: 5.1% (D) 6.8% (R)

Inflation Rate: 4.3% (D) 5.0% (R)

Growth in Federal Spending: 7.0% (D) 7.6% (R)

Growth in Federal Spending (Ex-Defense): 8.3% (D) 10.1% (R)

Yearly Budget Deficit: $36 Billion (D) $190 Billion (R)

Total Increase in the National Debt: $720 Billion (D) $3.8 Trillion (R)

(Sources: BLS & BEA)

The first point to make is that while Republicans are billed are fiscally conservative and tax reducers, over the last forty years Democratic Presidents have actually spent less and been much better balancing the U.S. budget. And while Republicans have taxed Americans less, that has not translated into better economic prosperity, as measures of inflation, GDP growth, and unemployment all have been better under Democratic leaders.

Now, that’s fine, but the real question is how this relates to stock market performance. Despite what the economic numbers above reflect, what happens to stock prices while each party is in office should be the real question. If Republicans are indeed better for the markets, then you can argue that even though favorable economic statistics sound good, they won’t really help grow your investment portfolio. Not surprisingly, though, the stock market did prefer better economic conditions, as you can see below.

Avg S&P 500 Returns: Democratic Presidents vs Republican Presidents

1926-1997: 15.1% (D) 10.7% (R)

(Source: Stock Traders Almanac)

For some, these statistics will be important when you go out and vote for our next President on November 2nd. For others, they won’t be. However, as a money manager I was curious to see if the claims made frequently in the media are actually true, so I thought I’d share my findings.