eBay Earnings Report Rattles Tech Stocks

eBay (EBAY) shareholders are feeling the effects of owning a stock with a 70 forward p/e tonight. With a equity market valuation that high, there leaves little room for error. You won’t be able to find a single person who thought eBay would miss its earnings after the bell today, and as a result the stock fell $15 in early evening trading.

The great thing about Wall Street is that if you managed to avoid having eBay in your portfolio, you can take advantage tomorrow morning when investors throw the baby out with the bath water. It always happens, even when it defies logic. All Net stocks got crushed when eBay’s earnings report came out. Yahoo! (YHOO), Overstock (OSTK), and Google (GOOG) especially. Just decimated.

Why? Because they are Internet companies. Only thing is, just because eBay feels it needs to invest in its business to maintain market dominance (which will lead to lower margins, hence, lower earnings per share), this doesn’t mean anything is wrong at Yahoo!, or Google, or Overstock.

Yahoo! barely even remembers it has an auction site, eBay won that battle long ago. Google doesn’t have auctions. Overstock said this week that it saw a huge rise in its auction listings after eBay announced its annual fee hikes (which were needed even more this year to help prop up falling profit margins). Nonetheless, all of these stocks lost 10 percent of their value just between noon and 5pm, solely due to eBay’s announcement.

The market gives investors these types of opportunities all the time. The only problem is, most investors don’t take advantage of them. They should.

Sprint-Nextel Combo Presents Arb Opportunity

Rumors were made official today as Sprint (FON) and Nextel (NXTL) announced plans for a $35 billion merger, creating a much more formidable number three player in the wireless market. With Verizon and Cingular far larger than #3 Sprint, adding Nextel’s business clients and push-to-talk technology puts the combination right on the heels of the industry’s top two giants.

Nextel had to do this deal in order to avoid spending billions to upgrade its wireless network to the latest technology. Sprint’s wireless clientele is more focused on the consumer side, so this combination will allow for Sprint-Nextel to offer push-to-talk as well as wireless Internet services to both companies’ customers. The merger should net about $12 billion in synergies, according to today’s announcement.

The proposed deal calls for Nextel shareholders (Peridot Capital is one) to receive about 1.3 shares of Sprint for each share of Nextel they hold. A small cash portion (about 50 cents per share) is also part of the transaction. As I write this, FON shares are trading at $24.55 and NXTL stands at $29.66. Nextel trades at about a 7.6 percent discount, based on the deal’s terms, presenting arbitrageurs with an attractive spread.

The deal is expected to close in the second half of 2005 and some are speculating that Verizon or another player may make a rival bid for Sprint, although this seems far from assured (I’d say less than a 50/50 chance). One last thing to keep in mind about the 7.6 percent spread on the deal; Sprint currently pays a 2% annual dividend, so those shorting the acquirer’s stock will be responsible for that payout.

Google Outlook Strong for 2005

It will be very interesting to see how Wall Street reacts when Google (GOOG) reports its fourth quarter earnings in late January. If the company exceeds estimates for the second time in as many quarters since its IPO, investors will have to decide why they are assigning Google a lower valuation than its chief competitor, Yahoo! (YHOO). Despite the fact that Google’s total sales and growth rate will likely both pass those of Yahoo! in 2005, GOOG shares trade at 51x 2005 estimates, versus 76x for YHOO. Google’s market value is also more than $5 billion less than Yahoo as I write this.

It seems that the common knock against Google (that it relies too much on paid search and is not as diversified as Yahoo!) could actually help it outgrow the competition next year and beyond. Google’s G-Mail email service is still being finalized before it will be made available to everyone (users now need a referral to sign up for an account). Other new services such as blog hosting (BlogSpot) and shopping (Froogle) are just in the beginning stages of deployment. Conversely, Yahoo! has been diversifying away from search for years (through acquisitions like HotJobs and Broadcast.com).

It is for this reason that I think Google has a better chance than Yahoo! of beating analyst sales and profit estimates going forward. They simply seem to have more avenues for growth since they have been fairly narrow in their focus on search until recently. More upside potential combined with a 2005 price-earnings ratio a full 33 percent lower than Yahoo! makes Google shares look very intriguing going into the new year.

If a long position in Google is a bit too speculative for some investors (understandable given that we are still dealing with a 51 forward p/e), a paired trade of long GOOG and short YHOO can take advantage of any closing of the valuation gap, with much less day-to-day equity price volatility.

Has Nightfall Beset Sun Microsystems?

Tech stocks have rallied nicely since the November 2nd presidential election, presenting some attractive exit points for certain stocks. Network computing giant Sun Microsystems (SUNW) appears to fall into that category. Over the last three months, SUNW shares have jumped more than 40 percent from under $4.00, hitting a high of $5.60 each this past week. Looking at the company’s current valuation, it’s difficult to make the case that the stock should continue its ascent. Wall Street analysts seem to agree. While I usually will opt not to side with the consensus view, the current ratio of buy, hold, and sell ratings stands at 3/15/6.

Despite a healthy balance sheet with more than $3.5 billion in cash (approximately $1 per share), Sun’s enterprise value-to-earnings ratio looks insanely high, mainly because the company is having trouble turning more than a slight profit on its nearly $12 billion in annual sales. For fiscal 2005 (ending in June), SUNW is expected to earn $0.06 per share or $200 million in profit. This 1.7 percent net margin gives the stock a P/E of 76x, even if we use the company’s enterprise value ($15.2 billion) instead of its entire market cap ($17.5 billion).

Even if we were to assume that Sun Micro could raise those margins substantially through cost-cutting, it is still very hard to justify the stock’s current valuation. Estimates for fiscal 2006 stand at $0.12 in earnings per share (3.4% margins on $12 billion in sales) give SUNW an enterprise value-to-earnings multiple of 38x. Assuming an overly bullish 5% margin gets you to $0.20 in EPS, but then the multiple only shrinks to 25x, which seems about as high as Wall Street could rationally justify.

All in all, investors seeing value in the $5+ share price of this former tech bellwether may well be being influenced by the share price, rather than actual “financial value.”

IBM’s Loss is Dell’s Gain

Rumors of IBM (IBM) exiting the personal computer business have been confirmed with the PC giant selling its $10 billion-a-year business to China-based Lenovo for $1.75 billion in cash and stock. Margins on PC’s are terrible, so this a clearly a good move for IBM as far as profitability is concerned. The stock has moved up on the rumors, but don’t expect IBM shares to return to their former glory. The company is so large that the bottom line effect won’t be gigantic by any means.

The PC market continues to see the number of suppliers dwindle. Compaq merged into Hewlett Packard, eMachines was bought by Gateway, and now IBM is gone as well. All of this bodes well for industry leader Dell Computer (DELL). Dell hasn’t had any trouble increasing its market share in the face of mass competition, but fewer of them surely can’t hurt. Michael Dell continues to execute flawlessly, with his company’s latest focus, printers, racking up huge sales already.

Dell stock has been on a tear ever since they reported a blowout quarter several weeks back. Even after the run, the stock doesn’t look terribly expensive. After accounting for the company’s net cash, DELL shares trade at 25 times 2005 estimates of $1.56 per share, with sales expected to rise 16 percent in the coming fiscal year. Any pullback would make Dell shares even more attractive.

Apple Shares Continue to Ride iPod Success

The momentum investors on Wall Street have gotten ahold of Apple Computer (AAPL) and they most likely won’t be letting go anytime soon. After today’s $6 jump on a very bullish analyst report, AAPL shares have tripled in the past year from under $20 to more than $60 each. We can argue whether the stock looks pricey or not (many would say it does with $1.30 in estimated earnings per share for fiscal 2005, but don’t forget the $14 in cash and lack of debt), but investors want a piece of the reinvigorated company, whose iPod MP3 player is selling like crazy, and are willing to pay up for it.

Today, the Apple analyst with Piper Jaffray raised his price target to $100, with the stock trading in the mid-fifties. Looking simply at a price-to-earnings ratio, it’s hard to justify that price, but Piper has a 2006 EPS estimate of $2.30, ahead of the current consensus of $1.60 per share. Given the iPod’s ability to boost Apple’s profit margins, that bullish forecast could very well play out. The $100 target comes from the analyst’s estimated p/e ratio on those earnings of 44x. If one is to critique this target price objective, taking issue with the 44 multiple assumption hardly seems irrational, it seems very high. Little doubt though, that profit forecasts for Apple will turn out to be too modest.

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.