The Internet Bubble Revisited

As we approach the five year anniversary of the end of the greatest bull market ever, it still confounds us how crazy valuations actually were back in March of 2000. Metrics were being created on the fly by analysts to justify price targets since traditional price-to-earnings and price-to-book ratios could not be determined without profits or tangible assets. Page views actually seemed like the perfect means to value shares of Yahoo (YHOO) to many people. After all, the company was an Internet portal, not an online store or auction site.

I was not immune to this either, of course. I recall a favorite metric of mine at the time was to look at relative price-to-sales ratios. If you had three companies in the same market, but one traded at 12x sales and the other two traded at 20x, you could pretty much assume that if you bought the cheaper one some analyst would come along and point out the “mis-pricing” and before you knew it your stock was fetching 20x as well.

I bring this up, not to blast buyers of Sirius at $9, Taser a $30, or Travelzoo at $100, but instead to point out that some of these profitless companies actually did survive. Most have changed business models (or businesses for that matter) several times since 2000, and very few have the same management teams in place. Those former Internet entrepreneurs have long since cashed in their stock options and left the spotlight.

An example of the aforementioned transformation is Ariba (ARBA). Now, Ariba has a special place in my heart. I never owned the stock, but I went to college with the daughter of one of the company’s earliest employees. My discovery that my dorm room neighbor’s dad had worked for and knew the company’s co-founder and former CEO, Keith Krach, actually was the launching pad for our friendship.

How is this important, other than to rekindle my college memories and remind me that I haven’t talked to that very friend in a couple of years? Well, it appears even though I missed out on the stock’s tremendous run in 1999 and 2000, I may be getting a second chance to make money on the shares of the business-to-business software company. After hitting a high of more than $1,140 per share (split adjusted) five years ago, the stock currently trades at $8, down some 99.3 percent.

With $130 million in cash, no debt, and $360 million in sales expected in fiscal 2005 (ending September 30th), the stock looks very cheap. Ariba just completed the acquisition of Free Markets (another former Internet high-flier) and is in fact growing again. Net of cash, investors today are paying about $6.25 per share and 1.1x revenue for $0.35 in earnings per share in 2005 and $0.56 in 2006. If the company can indeed hit its numbers, there is little chance the stock will continue to trade at 11 times projected 2006 profits.

Krispy Kreme Bankrupt?

While I haven’t been short Krispy Kreme (KKD) stock over the last year, I wish I had been. The shares have fallen from $40 each to $7 today, an all-time low. Having ignored this stock since the IPO due to a terribly high valuation and a personal preference for the product at Dunkin Donuts, I finally decided to do some due diligence this week after hearing whispers of the company’s ultimate demise.

As a contrarian, whenever I hear rumors of possible bankruptcy, I take notice. Often times people spread bankruptcy rumors when they are short a particular stock, regardless of whether the risk is really there or not. One of my best trades in recent years was picking up shares of then-troubled Nextel (NXTL) in 2002 when the stock was pricing in tremendous bankruptcy risk due to a mountain of debt.

After carefully examining the company’s finances, investors would have realized that although debt levels were too high, the company’s wireless business was so strong that cash flow from operations would be able to cover the firm’s interest expense. The Nextel story is about to be closed, as Sprint (FON) has agreed to buy the company for about $30 per share. Not bad for a stock that bottomed out at $2 per share less than three years ago.

Back to Krispy Kreme. As you may have read in recent months, KKD has had poor accounting practices in the past, resulting in a CEO resignation recently. Evidently, the company has used the repurchase of stores from franchise owners to boost financial results. In the midst of a full accounting review, the company missed its deadline to file financial statements for the last quarter, due in late January.

Normally this wouldn’t be that big of a deal. The company’s new management is on track to clean up the books, file financial statements, and move on to turnaround the company’s business. However, KKD has a $150 million credit facility that freezes should the company miss a regulatory filing deadline, which it did. Given the internal accounting probes, numerous legal issues, and restructuring going on right now, KKD needs some additional cash to weather the storm and continue to fund operations. But since their credit facility is frozen, they can’t borrow any money until they file.

As a result, newly appointed CEO Steven Cooper is scrambling to cut costs in order to ensure they don’t run out of money before they can tap their credit. KKD’s creditors have extended a deadline for the financials until late March, so current cash must last for six more weeks, assuming the March deadline can be made. To help, the company has sold its corporate jet (why did they have one to begin with?) for $30 million and announced plans to lay off 25% of its workforce at the company’s corporate headquarters.

The interesting thing about this whole story is the talk of possible bankruptcy. KKD is hardly overly leveraged. They have about $120 million in total debt, but the interest rate is less than 3 percent. Operations generate positive free cash flow and the company’s tangible net assets are more than $250 million. Sales at KKD’s 435 stores nationwide are $700 million annually. Interest expense ran $1.4 million last quarter, hardly dramatic.

While I still have some DD to do today on KKD shares, it appears that the largest issue with the company is not its debt load, but rather the ability of their accountants to file accurate financial statements. The company’s operations can adequately fund the debt after these legal and regulatory issues have been resolved. Of course, there is always a chance that things could get worse and they would not hit their deadlines. However, it seems unlikely that the creditors would choose to force KKD into default when the operations seem not only salvageable, but also potentially extremely valuable.

As for trading this situation, it depends on which side of the fence you fall on. I haven’t made a conclusion yet, and don’t know if I will opt to put on a trade or not, but you really have two choices that make sense. If you think bankruptcy is a real option, then short the common stock and buy some calls to hedge your position. If you think they’ll survive, buy the common along with some puts to protect you, should they happen to file Chapter 11.


Breakin’ Up Is Hard To Do

It is always interesting to watch a stock price jump 10 percent on news that the company’s CEO has resigned. Although the headlines will use the word “resign” it is clear that Hewlett Packard (HPQ) chief executive Carly Fiorina was forced out after she orchestrated a horrendous Compaq acquisition.

Maybe now Hewlett will do what they should have done long ago; spin off their crown jewel printing business. Rather than focus on higher margin products (such as plastic containers of ink that sell for $30), Fiorina opted to add scale by gobbling up Compaq, forming (at the time) the largest personal computer maker in the world. The only problem was that with razor thin margins, tech companies were trying to flee that business, and for good reason.

Fiorina thought she could get bigger, take market share, and make money selling computers through various channels such as retail outlets and large tech distributors. As she would find out later, there was a reason why no other company had been able to accomplish that feat. Dell (DELL) continued to take market share as players in the PC market diminished. Gateway bought eMachines, IBM sold its PC biz to Lenovo, Packard Bell disappeared.

So, what should HP focus on now? How about the printer business? Hewlett’s printing division accounted for 90 percent of HPQ’s operating income in fiscal 2004. Using Lexmark (LXK) as a guide, the unit as a stand-alone company would be worth two-thirds of HPQ’s current market value, despite only representing a third of total sales. With shareholder value unlocked, the new CEO would focus on the rest of the company’s operations and hopefully find a way to be a profitable number two player behind Dell in personal computers, servers, and storage.

It won’t be easy, but with Carly gone, the transformation that should have been attempted years ago can finally get started, if the board chooses to go in that direction.

Google Delivers

Updating last week’s piece on Google (GOOG), it appears the bullish stance was the correct one. The company blew away Q4 profit estimates last night, and the stock opened up $23 a share as 2005 EPS numbers will be revised from $3.40 to $4.00. Worries about the Valentine’s Day lock-up combined with some investors lightening up positions after today’s huge move could very well cause GOOG to give back some of the gain short-term. However, don’t think that a 200 handle on Google is far-fetched.

In another wonderful analyst call, the Internet analyst for Jefferies & Co. raised his rating from hold to buy this morning, at $215 a share. Hardly a helpful call, given that the same guy pulled his buy rating last year when the stock was $135. I guess $135 didn’t warrant an investment, but a $215 price tag does.

Oddly enough, Jefferies’ 2005 and 2006 EPS estimates are of some value to investors, as they try to determine fair value for GOOG shares. His 2005 EPS number goes to $3.99, with 2006 upped to $5.40 per share. His price objective of $230 sounds about right to me. I’m using a 60x multiple on $4 EPS, to get to a $240 price target. Any near-term weakness for the rest of the month will allow investors to get in before we get there.

When Do You Buy Pfizer?

A one-year chart of Pfizer (PFE) looks more like a black diamond slope in Vail than a stock price graph. The stock has fallen almost 40 percent over the last 12 months. Now, at$24 per share, you hear a lot of recommendations to buy PFE. The 3.1 percent dividend yield is very attractive, combined with a 2005 p/e ratio of less than 12.

After holding off in the low 30’s and high 20’s, Pfizer shares at today’s prices don’t have too much downside if you want to try and catch a falling knife. A Celebrex withdrawal would prompt significant selling, but aside from that, most of the bad news has been priced in.

The issue really is growth. Money managers on CNBC will exclaim that Pfizer hasn’t traded at 11 or 12 times earnings in years, with historical p/e ratios ranging from 17 to 30 times over the last decade. The problem is, Pfizer was growing nicely back then, at a 15 percent annual rate. Those days appear to be over as mergers have created a company with more than $52 billion in sales. At this point, a new blockbuster drug (defined as $1 billion in annual sales) contributes less than 2 percent to Pfizer’s total sales.

As a result, sales are expected to be essentially flat. The current 2006 revenue estimate for Pfizer is less than 2 percent higher than the company’s actual 2004 sales. While 11 or 12 times eanrings may be too modest a valuation, the days of 17-30 multiples on the major drug companies are over in my opinion.

Tech Bargains Can Be Had… Finally

Peridot Capital has been underweight technology stocks for a while. The highly cyclical sector traded at a premium for years, even after the bubble burst, and investors expecting decades of consistent double-digit earnings growth were, and still are, in dreamland. The Nasdaq as a whole still looks expensive, but for the first time in a long time, tech stock bargains have been popping up lately.

The timing isn’t clear to me, as we haven’t had a dramatic correction. The Nasdaq rose nearly 9 percent in 2004, and even though 2005 has been weak thus far, most stocks haven’t seen eBay-like haircuts. It’s becoming easier to find tech leaders trading at or below market valuations nonetheless.

For example, Cisco (CSCO) looks cheap. After buying the networking giant in 1994, I haven’t wanted to put new money into the stock in years. However, at $18 a share the stock looks like a conservative, fairly low risk tech value. After subtracting $7 billion in cash, Cisco trades at about 18 times calendar 2005 earnings. When was the last time that happened? Juniper (JNPR) might have better business fundamentals right now, but you’ll pay at least twice as much for such growth.

Another attractive candidate for purchase is Symantec (SYMC). The stock was crushed after it announced plans to acquire Veritas (VRTS). Both companies have stunning balance sheets and are leaders in their spaces. Investors should question how two companies that sell completely different product lines will be integrated, but the combination at 20x earnings could prove a good value if the deal meshes better than some people think.

Tech isn’t a place to jump in with both feet. That said, large cap leaders used to trade at a premium but now seem to have lost their luster. P/E’s of 17-20 for the industry’s dominant players now seem fair, fair enough to at least have a market weighting and not feel nervous about significant downside risk.

P&G Purchase of Gillette Continues Merger Mania

The Oracle of Omaha has to be very happy today. His holding company, Berkshire Hathaway, owns a 9 percent stake in Gillette (G), a stock that rose $6 today on word that consumer products giant Procter and Gamble (PG) will buy the company for about $11 billion in stock.

Fortunately for Mr. Buffett, he is on the receiving end of this deal. While he is publicly raving about the prospects for the combined P&G/Gillette, it is fairly obvious that this is not the kind of purchase Buffett himself would ever make. Procter is paying a whopping 28 times forward earnings for Gillette. With P&G shares fetching about 20 times earnings, this merger is extremely dilutive. Analysts estimate earnings per share will drop 15 to 30 cents in the upcoming fiscal year, as much as a 10 percent dilutive effect.

Company executives will clearly try and mask the dilution by praising its plan to buy back billions of dollars in stock, but that doesn’t change the fact that P&G paid 28 times for a mature, slow growth, cash cow business. Sure there will be some synergies, but like with most deals, they will be overstated from the outset. It will be very interesting to see how well P&G stock does for Buffett and Co. over the next 5 or 10 years. I suspect despite all of the rave reviews presented today, actual stock price appreciation long term won’t be all that impressive, given current valuations.

Market Struggles Out Of The Gate In ’05

It looks like the stock market may fall in each of the first four weeks of the new year, a feat not accomplished in many years. January is supposed to be a seasonally strong time for stock prices, as pension fund and retirement account contributions flood the trading floors. Not so this year. It looks like the huge rally we saw in November and December has run out of steam. Take this morning for example. Blowout earnings from Microsoft (MSFT) and the announcement of yet another promising merger; Gillette (G) to be bought by Proctor and Gamble (PG), and yet the market can’t trade up.

Perhaps it’s the Iraqi election that is holding us back. If Sunday goes well, maybe the market will rally strong next week. If not, the many optimists who predicted a 10 percent market gain in 2005 may very well be disappointed. We definitely need some kind of catalyst soon, as the short term action looks bleak.

Despite a poor outlook for the broad indexes, don’t think you can’t make money if you know where to look. This truly is, to use a terrible cliche, a “stock picker’s market.” Oil prices are near $50 a barrel. Energy stocks like Suncor (SU) are still cheap. There are many financial stocks that carry p/e’s under 15 and pay nice dividends. Small caps still fly under the radar most of the time, providing below-market valuations but above-average growth prospects.

And always use overreactions after an earnings report to your advantage. Verisign (VRSN) fell 15% after hitting its Q4 targets and slightly raising its guidance. Wall Street wanted more upside to the numbers and slammed the shares, but that was wrong. Now you can pick up the stock for $25 a share, giving it a p/e of 25 with a 30 percent projected growth rate for 2005.

Google Weakness Unwarranted

After hitting an all-time high of $205 just weeks ago, shares of Internet search giant Google (GOOG) have slid 30 points amid the eBay (EBAY) earnings miss and fears of an impending lockup expiration for pre-IPO holders of the stock. Let’s analyze these two events.

First, eBay’s disappointing fourth quarter report and 2005 outlook. eBay is seeing growth slow down considerably. They are being forced to invest heavily in the business, domestically and even moreso abroad, to keep up the growth Wall Street has come to expect from the company. This has no direct negative effect on Google. In fact, since eBay is a large customer of Google’s, higher capital expenditures at eBay could only help Google, not the other way around.

Second, the expansion of Google’s lockup period that goes into effect on Valentine’s Day. Sure, more supply does little to help a company’s publicly traded shares, but one must look at the demand side of the equation, not just the supply side. There is plenty of demand for GOOG stock, as evidenced by its run to over $200 per share in the midst of the initial lockup expiration late last year.

The good news for Google shareholders is that the company reports its fourth quarter results on February 1st, before the lockup expires and about when investors looking to get out ahead of such an event would sell. Given the results we’ve seen from Yahoo (YHOO) and InfoSpace (INSP), the odds are very good that Google’s results will blow the consensus out of the water. Numbers for 2005 will be ratcheted upward and euphoria over Google’s financials will surely overcome any new supply of shares from the company’s early investors.

With the stock at $177, down from $205 recently, shares of Google look ripe for the picking this week, ahead of the earnings release. The catalysts are there for a strong push back to new highs in the coming weeks.

Capital One Shares Crushed After 4Q Report

After blowing earnings estimates out of the water for the first three quarters of 2004, Capital One (COF) fell short last week when it reported fourth quarter profit below the consensus estimate. Shares of COF were slammed, falling 5% after the announcement. The stock also saw analyst downgrades after the earnings miss, much to the delight of shareholders, I’m sure.

The earnings miss was mostly attributable to higher than expected marketing expenses and more money set aside as loan reserves. While Wall Street seems to see this combo of unexpected news as a warning sign, that conclusion makes little sense. While seen as a financial services firm, Capital One is just as much a consumer marketing company. The better job it does of marketing to the public, the more loans it can make, and the more money it pockets.

Unless the advertising dollars were failing to provide an adequate ROI, Capital One’s $511 million in marketing spend for Q4 (which was more than Citigroup and JPMorganChase) will allow it to continue its rapid growth, hardly a bad sign. Higher loan reserves don’t indicate more difficulty in collecting debts, as some are quick to conclude. Rather, more loans outstanding require higher reserves, even when the default rates on such loans remain the same or even decline.

In the mid seventies, COF shares trade at 11 times 2005 earnings. Not bad for a company that has grown earnings per share 20 percent annually since its IPO.