My Aversion to Semiconductor Stocks Explained

I recently took over an existing stock portfolio for a new client and proceeded to liquidate a small cap, Taiwanese semiconductor company in favor of other tech stocks I preferred. Since the sale the stock has risen about 10% and the client emailed me wondering why I sold and what my outlook on the little company was. My answer was not as company-specific as it could have been (I knew very little about it and instead preferred to avoid small, non-U.S. chip stocks in favor of other stocks I have spent hours researching), but I did admit that I have an aversion to semiconductor stocks in general (although exceptions sometimes do present themselves).

I find the semiconductor space quite difficult to analyze and even harder to make money in as a long term investor. The industry is very cyclical, certain chips are always being replaced by a next generation product (often from a competitor), and with such high fixed costs required to manufacture chips, profit margins often rise and fall like roller coasters, making for a very volatile stock price environment. Even when you can identify solid semiconductor companies with below-average competition, in growing markets, making money on their stocks can prove quite difficult.

For example, consider flash memory manufacturer SanDisk (SNDK), a current favorite of many hedge fund managers. SNDK is a good company and with demand for flash memory soaring in recent years due to increased penetration of consumer electronics products, sales have been going through the roof. Over the last five years, in fact, SanDisk has seen its annual revenue grow more than 70% from $3.2 billion to $5.6 billion. It would be logical to assume that SNDK stock has been a great investment over that period, but you might be surprised to learn that five years ago today the shares closed at $44.50 each. Yesterday’s closing price was $44.51 per share. I know this is only one example, but chip stocks can be tough nuts to crack from an investment standpoint.

In SanDisk’s case they actually have done a great job at maintaining their strong position in the flash memory market, as opposed to many chip companies who often find themselves supplying Apple with a chip for one iPod only to see them be cut out of the next generation product in favor of a competing chip. The problem that SanDisk faces, as do most in the sector, is falling prices. If you have bought your fair share of memory cards, you know that every year prices drop. You can either buy the same amount of memory a year later for much less money, or you can spend the same and get a much larger card. There is no pricing power in the industry, which is great for consumers but not good for investors.

The problem is that huge demand and the corresponding unit growth that comes with it can often largely be eaten away by price erosion. Consider a market where prices drop 30% year-over-year for the same chip (not uncommon if you ever shop for digital camera memory cards and similar products). In order to keep your revenue in dollar terms steady, you need to grow units 43% per year. If you want to grow revenue, say 15%, over the prior year, you need to ship 64% more units! SanDisk actually has been fortunate that demand for flash memory has been so strong, as other areas within the chip space have not been nearly as robust.

So while I agree with many smart money managers who have been accumulating the stock that SanDisk is a good company that is serving a growth market, and that its stock does appear to be cheap, I do not share the same optimism about its long term prospects as an investment. It is just really hard to sustain stock price appreciation in an industry with these types of market dynamics. While there are certainly plenty of success stories within the semiconductor stock universe, I suspect for every long term stock market winner there are five or ten big losers, and I personally do not care for those kinds of odds.

Full Disclosure: No position in SNDK but positions may change at any time

Apple Stock Hitting New Highs: Where To From Here?

It has been a little over a year since I wrote that Apple Stock Can Easily Reach $450 last January, which at the time was more than $100 above where the shares were trading. Thanks to an absolutely stunning fourth quarter earnings report, Apple pierced that level late last month and closed yesterday at a new high of $464 per share. So, where to from here?

The company continues to defy expectations on the profit front, and after crushing numbers for the holiday quarter, analysts now expect $42 of earnings per share in fiscal 2012, up from just a $35 consensus figure a few weeks ago. In addition, cash continues to build on the balance sheet, reaching $98 billion at year-end, up 50% from a year ago.

An interesting thing has happened with the stock, though. As management has continued to hoard cash unnecessarily, and the company reaches a size that many believe makes it prone to a stumble in the not-too-distant future (investors expect this $100 billion a year company to grow 45% this year), the P/E ratio of the stock has tumbled. In fact, Apple now trades at a discount to the S&P 500 index on a trailing earnings basis (13x vs 14x). Looking out at 2012 profit expectations, the gap widens further as Apple’s P/E drops to about 11x. And that does not even include the $100 per share of cash Apple is sitting on.

As far as the cash goes, Apple is essentially getting no credit for it in the public market. The stock trades for about 8.7 times 2012 earnings ex-cash, which tells me that if they did pay a huge one-time special dividend ($50 per share would be my recommendation, not that anyone has come asking), the stock would likely not drop as would be the case in most similar instances (doing so would mean the discount to the market would get even larger). This is one of the reasons I am not selling Apple shares yet.

In terms of earnings, it appears that the days of Apple commanding a premium in the market are behind us. Even with a ridiculously positive earnings surprise for the fourth quarter, Apple stock popped just 6%. That compares with an earnings beat of 35% and an upward revision for 2012 profits of some 20%. Given Apple’s size, extreme bullish sentiment, and awful capital allocation practices, investors are not going to give them a rich valuation, which limits upside to a certain degree by taking multiple expansion off the table.

Given these new parameters, how can we value the darn thing? First, I will assume they do not change their cash management strategy this year (a painful thought). Since I do not see the market giving Apple more than a market multiple, I would multiply $42 in earnings for fiscal 2012 by 13 (market P/E) and that gets us to $546 per share. There are plenty of Wall Street analysts with year-end price targets that have a six in front of them, but I just do not see that happening. So, my best case guess is 17-18% upside from here, and maybe a bit more if Tim Cook eases up the company’s death grip on their cash. As a result, I am not a seller yet, even though the stock reached my $450 target price from last year.

Full Disclosure: Long shares of Apple at the time of writing, but positions may change at any time.

More on Netflix’s Valuation and How the CEO Doesn’t Own a Single Share

Netflix (NFLX) CEO Reed Hastings has certainly done a wonderful job running the company if you look at his entire body of work, despite recent slip-ups, but his handling of the stock leaves much to be desired. Buying back stock over $200 per share only to raise capital at 1/3 the price a few months later shows he is losing the pulse of his business, at least temporarily.

So exactly how much stock of his own company does Hastings own? Believe it or not, none. Hastings has been cashing out Netflix stock options to the tune of tens of millions of dollars, but he does not actually own a single share. This year alone he exercised options (strike price: $1.50) to the tune of over $1 million per week, or more than $43 million. He halted those sales in early October after the stock cratered. It should be troubling to investors that the company’s founder and CEO does not appear to have any real skin in the game here. He has just given himself millions of options at prices that essentially ensure he can continue to cash out at will as long as the stock stays above $1.50 per share, which is assured as long as the company remains in business.

All of that said, there does appear to be potential value here with the stock breaking $70 per share, providing Hastings can make the streaming business model work financially. Netflix’s enterprise value today (about $4 billion) is attractive if the company can continue to grow and make money at their $8 per month price point. Assume for a moment that Netflix can earn a net profit of $1 per subscriber per month and maintains its current base of 25 million customers. That comes out to a profit of $300 million per year. Netflix could fetch a $4 billion valuation with its existing customer base alone. Any further subscriber growth from here would be icing on the cake for investors.

I think that is the main reason why T Rowe Price, TCV, and others find the stock attractive at current prices. There are definitely sizable risks, mostly the question of whether they can continue to grow with intense competition, and even more importantly, if the company’s business model will allow it to reach something on the order of that $1 per month profit on a per-subscriber basis. Given all that we know today, Netflix is a high risk, high reward investment opportunity, but one that many people are betting on.

Full Disclosure: No position in Netflix at the time of writing, but positions may change at any time

Netflix Makes New Moves to Try and Regain Momentum

Shares of Netflix (NFLX) are getting slammed today (down $4 to $70) after announcing $400 million of financing transactions last night, consisting of $200 million in new equity at $70 per share to T Rowe Price and $200 million in convertible zero-coupon bonds to venture capital firm Technology Crossover Ventures. This move comes on the heels of the company’s recent deal to be the exclusive home to new episodes of the comedy series Arrested Development, which was canceled after a three-year run on Fox despite a cult-like following and strong critical acclaim.

Netflix may be facing headwinds after customer backlash from their recent price increase, but CEO Reed Hastings is certainly not standing still. Getting the exclusive for Arrested Development is a smart move, as it will be harder and harder for Netflix to compete strongly without original, unique content. Amazon, which offers a similar streaming service through Amazon Prime, along with Apple, which will likely launch a TV product sometime in 2012, are serious competitors to the Netflix streaming business.

While Wall Street clearly does not like these equity and bond deals, I think it is really the best possible way for them to finance the costs of deals like Arrested Development. Selling zero-coupon bonds gives Netflix 0% financing and the bonds don’t convert until 2018, which is a long time for Netflix to build up their business.

I would also point out that TCV, the investor in this bond deal, is making an interesting bet here. By taking convertible bonds that pay no interest, they are making a large bet on the direction of Netflix stock, plain and simple. TCV’s break-even point on these bonds is $86 per share, 16% above the market price when the deal was announced and more than 20% above the current quote of around $70 per share. While investors are selling off the stock today, the fact that TCV is making a pure stock bet here could be viewed as quite bullish (as would the move by T Rowe to buy new stock at $70). If Netflix was really in dire need of this cash and few investors were willing to lend it to them, you can bet that TCV or any other possible financier would be demanding a bulky interest rate.

With Netflix stock down more than 75% from its high of $300+ earlier this year, this one is surely one to watch. Of course, it is very concerning that Netflix was buying back stock in the 200’s earlier this year and now finds itself needing money and selling new stock at $70 per share. Investors likely won’t tolerate this “buying high and selling low” set of actions again down the road. The future for Netflix really depends on whether they can continue to grow the streaming business and make money on it at $8 per month. If they can, there is plenty of upside here. If not, TCV and T Rowe are going to have some losses on their hands a year or two from now.

Full Disclosure: Long Apple and no positions in Amazon or Netflix at the time of writing, but positions may change at any time

Numbers Behind Groupon’s Business Warrant Caution After First Day Pop

Daily deal leader Groupon (GRPN) is slated to go public today, selling 34.5 million shares at $20 each, which will raise $690 million in exchange for a 5.4% stake in the company. Combine a popular Internet start-up with a very low number of shares being offered (floating 5% of all shares is historically a very small IPO) and demand will far outstrip supply. We may not see a record setting first day pop, given the eleven-figure starting valuation, but the stage will be set for a solid jump at the open on Friday. And even without any first day gain, Groupon will be valued at about $12.75 billion.

As one of Groupon’s 16 million repeat customers, I was interested to dig into their IPO prospectus because I have already seen my use of Groupon decline meaningfully since I signed up to receive their daily deal emails last year. To me, Groupon has several headwinds facing their core business.

First, Groupon is dealing with many small business merchants who complain that they lose money when running a Groupon campaign. If businesses really see Groupons as a way to mint money immediately, they are mistaken about what role the deal campaign should play. A Groupon deal should be viewed as a marketing expense, not a profit center. A business should use Groupons to get prospective customers in the door. After that, just like any other marketing tool, it is the business’s job to treat them well and provide a good service, which should encourage repeat business. It will be those recurring customers that will grow your business long term and generate profits.

Generally speaking, profit margins for small businesses are hardly ever high enough to make a 50% discounted transaction profitable to the business. If you offer $50.00 Groupons for $25.00 each and only keep $12.50 per voucher (Groupon keeps the other half), the odds are slim you will make a profit initially. Unless it only costs you no more than $12.50 to offer $50.00 in goods or services, you are going to lose money. Let’s say you lose $20.00 per Groupon in this case. The real question should be, is a new customer coming through your doors worth $20 to you? The only way to answer that is to look at other marketing options you have. Do they cost more or less than $20.00 per new customer generated? If the answer is more, then Groupon is a worthwhile way to market to prospective new customers.

Along the same lines, I think Groupon will struggle once they have exhausted most of their small business merchants in any given city. As the example above shows, Groupons themselves are not money makers, which makes it less likely that a small business is going to want to run multiple campaigns. As a result, when you run out of businesses, your deal quality declines and fewer Groupons are going to sell. Groupon is probably facing these issues today, as the business is three years old and many businesses have already used the service. It is my belief that new businesses should probably strongly consider running a Groupon campaign, given that the biggest obstacle for new businesses is lack of awareness. But honestly, there are not likely enough new businesses cropping up to support strong long-term growth of Groupon’s core daily deals business. As a result, merchant growth could very well hit a wall sooner rather than later.

Groupon’s IPO prospectus provided a lot of data that investors may want to use to try and value the company. For instance, as of September 30th, Groupon had 143 million email subscribers. How many of those have ever bought a Groupon? I was pretty surprised by this number actually… the answer is 30 million. Only 20% of the people getting these emails have ever bought one, and that is a cumulative figure for the last three years! Investors trying to place a value on Groupon’s subscribers may want to forget the 143 million number, as only 30 million are generating revenue for the company.

The numbers get worse. Of those 30 million people who have bought at least one Groupon (Groupon calls them “customers” as opposed to the 143 million “subscribers”), only 16 million are repeat customers. So only about 10% of the people who get the emails have bought 2 or more Groupons since the company launched. This is hardly a metric that screams “loyal customers that generate strong repeat business,” which is what investors would want to see.

Why is this important? I think a good way to try and value Groupon (if you even want to bother) is to place a dollar value on each paying customer. After all, Groupon is not unlike a subscription service like Netflix or Sirius XM Radio, aside from the obvious fact that a paying customer of the latter two businesses are more valuable because they generate guaranteed revenue each and every month. In fact, both Netflix and Sirius get about $11.50 per month on average from their paying customers. Interestingly, Groupon earns about $11.90 in revenue for each Groupon it sells, but they are not even close to selling every customer at least one Groupon per month on a recurring basis. As a result, it is correct to conclude that investors should value a Groupon customer far below that of a Netflix or Sirius customer.

Which brings us to the stock market’s valuation of Groupon versus Netflix or Sirius. Each of Netflix’s 23 million subscribers are worth about $200 based on current stock prices. Sirius XM, with 21 million subscribers, is valued at about $600 per subscriber (considerably more than Netflix because Sirius XM has higher profit margins). How much is the market paying for each Groupon customer at the $20.00 per share IPO price? Well, $12.75 billion divided by 30 million comes out to $425 each.

It is not hard to understand why skeptics do not believe Groupon is worth nearly $13 billion today. To warrant a $425 per customer valuation, Groupon would have to sell far more Groupons to its customers than it does now, or make so much profit on each one that it negates the lower sales rate. The former scenario is unlikely to materialize as merchant growth slows. The latter could improve when the company stops spending so much money on marketing (currently more than half of net revenue is allocated there), but who knows when that will happen or how the daily deal industry landscape will evolve in the meantime over the next couple of years.

“Buyer beware” seems to definitely be warranted here.

***Update Fri 11/04/11 8:55am*** Groupon has increased the number of shares it will sell in today’s IPO to 40.25 million from 34.5 million. The figures in the above blog post have not been adjusted to account for this increased deal size.

Full Disclosure: No positions in any of the companies mentioned at the time of writing, but positions may change at any time

Sticking To Your Convictions As A Value Investor Is Hard, Just Ask Whitney Tilson About Netflix

Back in December, Whitney Tilson, a fairly well known value investor with T2 Partners, published a letter outlining a compelling bear case for Netflix (NFLX), a stock he was shorting at around $180 per share. After seeing the position go against him, Tilson was feeling pressure from his clients. After all, shorting a high-flying technology company with a cult-like following, as it is soaring in value, can be a tough psychological exercise. Tilson’s argument for betting against Netflix was clear, concise, and thorough. He boiled it down to this, in his December piece entitled Why We’re Short Netflix:

“We don’t think there are any easy answers for Netflix. It is already having to pay much more for streaming content and may soon have to pay for bandwidth usage as well, which will result in both margin compression (Netflix’s margins are currently double Amazon’s) and also increased prices to its customers, which will slow growth.

Under this scenario, Netflix will continue to be a profitable and growing company, but not nearly profitable and rapidly growing enough to justify today’s stock price, which is why we believe it will fall dramatically over the next year.”

The main bearish argument seemed reasonable at the time; customers were moving away from DVD by mail and towards streaming content. In order to secure content for their streaming library, Netflix would have to pay more than in the past, when they could just buy a DVD once and send it out to dozens of customers. But at the time subscribers were signing up at a record pace and were highly satisfied.

In February Tilson threw in the towel. The stock had continued its ascent, rising to $220. Again, Tilson went public with his changed view, writing a letter called Why We Covered Our Netflix Short. The bulls loved the fact that Tilson was admitting defeat. The stock continued soaring and hit an all-time high of $304 in July. Tilson summed up his reasoning as follows:

Our short thesis was predicated on the following stream of logic:

1) Netflix’s future depends on its streaming video business (rather than its traditional DVD-by-mail business);

2) The company’s streaming library is weak, which would lead to customer dissatisfaction and declining usage;

3) This would either cause subscriber growth to wither or force Netflix to pay large amounts to license more content, which would compress margins and profits;

4) Either of these two outcomes would crush the share price.

We are no longer convinced that #2 and #3 are true.

This was interesting because very little in the way of fundamentals had changed at that time. Tilson cited three reasons why he was doubting his earlier bearish thesis:

1) The company reported a very strong quarter that weakened key pillars of our investment thesis, especially as it relates to margins;

2) We conducted a survey, completed by more than 500 Netflix subscribers, that showed significantly higher satisfaction with and usage of Netflix’s streaming service than we anticipated (the results of our survey are posted; and 

3) Our article generated a great deal of feedback, including an open letter from Netflix’s CEO, Reed Hastings, some of which caused us to question a number of our assumptions.

In hindsight these reasons seem even more suspect than they did at the time, but it is worth pointing out the mistakes anyway so value investors can learn from each other.

First, Tilson cited that Netflix reported a strong fourth quarter. Tilson’s bearish view was never predicated on Netflix blowing the next quarter. It was the longer term trend of rising content costs, which would give Netflix two choices; maintain a weak streaming library and risk losing customers, or pay up for strong content and be forced to either raise prices (which would hurt subscriber growth and reduce profitability) or keep prices steady and lose profitability that way. The fact that Netflix reported one strong quarter really didn’t make a dent in the bearish thesis.

Second, Tilson surveyed 500 Netflix customers and found they were quite happy with the service. Again, his thesis didn’t claim that current customers were unhappy (after all, they were signing up in droves in part because streaming was free with your subscription at the time). Rather, it was about the future and how those customers would react if Netflix had to either raise prices or offer less in the way of viewing choices.

Third, and this one was perhaps the most bizarre, Tilson was evidently persuaded by Netflix’s own CEO, Reed Hastings. I find this one odd because I have never seen a CEO on TV or elsewhere who was publicly negative about their company’s prospects, regardless of how good or bad things were going at the time. In fact, many investors believe it is a huge red flag when CEOs of public companies take time to personally rebuff bearish claims from short sellers. Hastings did just that, responding to Tilson’s short case with a letter of his own that suggested that he cover his short immediately. Generally speaking, the fact that the CEO of a company you are short thinks you are wrong is not a good reason to cover your short.

And so we had a situation where Tilson’s short thesis appeared sound, albeit unresolved, but the stock price kept soaring and he was feeling heat for the position, which was losing money. Then, just a few months later, Netflix decided to raise their prices and customers canceled in droves. Tilson’s bearish thesis proved exactly correct, but he no longer had the short bet to capitalize on it.

Today in pre-market trading Netflix stock is down about 30% to $83 per share after forecasting higher than expected customer cancellations, lower than expected fourth quarter profits, and operating losses during the first half of 2012 due to higher content costs, slowing subscriber growth, and expenses for the company’s expansion into the U.K. and Ireland. Analysts were expecting Netflix to earn $6 per share in 2012 and in July investors were willing to pay 50 times that figure for the stock. Now it is unclear if Netflix will even be profitable in 2012 after forecasting losses for the first “few quarters” of next year.

This is a perfect example of why value investing is a tougher investment strategy to implement than many realize, but offers tremendous opportunity to outperform. By definition you have to take a contrarian view; either going long a stock that people don’t like, or shorting a stock that everyone loves. The bottom line is that your analysis is what is important. If you do your homework and get it right, the market will reward you. It may take more than a quarter or two, but you need to stick to your convictions unless there is extremely solid evidence that you are wrong. In this case, Tilson’s bearish thesis was never really debunked by the CEO’s defensive posture or the fact that customers were satisfied when they were getting streaming content for free. In hindsight, Tilson understood the outlook for Netflix better than the company’s own CEO. However, both are likely feeling very uneasy this morning.

Interestingly, the question now may be whether there is a point at which Netflix stock becomes too cheap and warrants consideration on the long side. I suspect the answer is yes, though probably not quite yet. If the stock keeps falling and we see $60 or $70 per share, maybe the time will be right for value investors like Tilson to go against the crowd again and buy the stock when everybody hates it.

Full Disclosure: No position in Netflix at the time of writing, but positions may change at any time

UPDATE: 3:00PM ET on 10/25

The WSJ is reporting that Tilson initiated a small long position in Netflix this morning:

Mr. Tilson tells us in an e-mail that he bought the stock this morning after it tumbled 35%:

“It’s been frustrating to see our original investment thesis validated, yet not profit from it. It certainly highlights the importance of getting the timing right and maintaining your conviction even when the market moves against you. The core of our short thesis was always Netflix’s high valuation. In light of the stock’s collapse, we now think it’s cheap and today established a small long position. We hope it gets cheaper so we can add to it.”

Dell: The Anti-Hewlett-Packard?

Following up to yesterday’s post on the outright ridiculous valuation being assigned to shares of Hewlett-Packard (HPQ) these days, it is worth playing devil’s advocate and exploring the merits of anti-H-P plays if you believe they will have a hard time convincing its customers that it finally is on the right track. Dell (DELL) should be the primary beneficiary if enterprise customers seek out new vendors, so it would be a perfect way to play the continued demise of H-P.

How does that stock look? Very, very cheap. At $14 per share, Dell fetches about 8 times earnings. But if you dig deeper the stock is even cheaper. Dell has about $10 billion of net cash on the balance sheet, which equates to $5 per share. So investors are really only paying about $9 a share for Dell’s operations, which generate north of $60 billion in annual revenue. With about $5.5 billion in trailing twelve-month EBITDA and an enterprise value of about $16.5 billion, Dell currently trades at 3 times cash flow. Heck, that is not that much more than H-P (2.5 times). Both of these stocks may make a lot of sense at current prices.

Full Disclosure: Long shares of HPQ at the time of writing but positions may change at any time

Hewlett-Packard Revisited: Lowest Tech Valuation in 20 Years

You can bet that there will be a Harvard Business School case study written about the last year in the board room at PC hardware giant Hewlett-Packard (HPQ). A little over a year ago I wrote that I thought the stock was pretty cheap after falling to $38 from a high of $55 per share. Mark Hurd, a cost-cutting guru praised by investors, had just been fired as CEO and the company later filled that position with Leo Apothekar, the former CEO of software-focused SAP, a job he held for about seven months before being ousted. At the time Wall Street was reeling from Hurd’s exit and given that H-P is the largest hardware company in the world, most everyone wondered why the Board hired Apothekar of all people. At $38 each, the stock fetched only 8.4 times earnings per share of $4.50, about as low as large tech company valuations ever get. Sure, Apothekar was unproven and hardly an inspiring hire, but unless the company’s business really was about to fall off a cliff, there appeared to be minimal downside risk given the single-digit multiple. Or so it seemed.

Here we are a year later and the H-P story has been downright bizarre. Apothekar was fired last night and replaced by former eBay CEO Meg Whitman. If you thought hiring Apothekar, a software guy, was an odd choice for the world’s leading hardware company, Whitman’s career experiences at eBay, Hasbro, Proctor and Gamble, Disney, Stride Rite, and is certainly questionable. Not surprisingly, H-P stock fetches $22 today, the lowest level since 2005 and less than five times earnings. According to an analyst that covers H-P who was on CNBC this morning, a large cap tech stock has not traded at that price in more than two decades.

From an investor’s perspective, the most interesting thing is that H-P’s business has not actually fallen apart, as the stock price would have you believe. Earnings per share for the current fiscal year will likely grow about 5% to $4.80, on flat revenue. So while large technology companies never usually trade for less than 7-8 times earnings, today Hewlett-Packard trades at 4.6 times earnings, which is simply unheard of. To me, that doesn’t make any sense unless H-P’s business crashes. And if that didn’t happen over the last year, I am not sure it is a wise bet that it will happen now. After all, Apothekar’s strategic decisions seem to be correct (focus on growing software and services, dump unprofitable tablet hardware that is bleeding hundreds of millions of dollars, etc), even when the leadership and communication to Wall Street and customers was unclear, inconsistent, and confusing.

So where do I stand on Hewlett-Packard stock now, with clients sitting on a loss over the last year? Given that the company remains a major player that is extremely profitable and trades at a valuation not seen in decades in the technology space, I am strongly considering doubling down here. There may not be many catalysts short term to get the stock higher, unless Whitman was to inject strong leadership and clear priorities quickly, but earnings would have to collapse from here to justify anything near a $22 stock price longer term. The selling pressure in recent months appears to be capitulation from investors who are fed up with the sheer incompetence of the prior board of directors, rather than significant weakness in the underlying businesses at H-P.

Assuming that management can’t get much worse going forward (seems reasonable), there is little reason to think H-P won’t fetch at least a 7-8 P/E in the intermediate term (a higher multiple is certainly possible — the stock fetched 10 times earnings under Hurd — but at this point conservative assumptions seem prudent). That would imply significant share price upside even without earnings growth (though I do think EPS growth is coming — it will be +5% this year even after all that has happened). There are just too many ways to get a higher stock price from here, even without making optimistic assumptions.

In summary, the last year has been brutal for the company and its stockholders, but at its current valuation, the stock price just doesn’t make much sense, based on what we know today.

Full Disclosure: Long shares of Hewlett-Packard at the time of writing, but positions may change at any time

Amazon: The One Overvalued Stock I Wouldn’t Mind Owning

“I know you are a value investor, but if you were forced to own one growth stock with a hugely un-Peridot-like valuation, what would it be?”

I recently was posed this question and I have to say, even though it does go against my overall philosophy when it comes to investing, it is an interesting inquiry to ponder. I would actually say Amazon (AMZN) is the one overvalued stock I would not mind owning. Now, long time readers of this blog will recall I have long warned against Amazon shares. The valuation has always baffled me and raised red flags, but for years such caution was wrong, as the stock has done extraordinarily well. So why today, at $213 per share, 50 times trailing EBITDA, and 86 times 2011 earnings would I pick Amazon as an overvalued stock that might make sense owning? Well, it doesn’t hurt that they have defied my expectations for years, and I don’t think I am the only one.

I never really thought Amazon was going to be anything more than a great online retailer of other people’s goods. And while their position in that space will only strengthen as more and more people become comfortable buying online and allocate a higher percentage of their purchases from storefronts to the web, offering low prices keeps their margins minuscule. In fact, Amazon’s operating margins in 2010 were 4.1% compared with 6.1% for Wal-Mart and 7.8% for Target. It turns out that Amazon’s retail model is not more profitable than bricks and mortar stores, probably because they still need to maintain huge warehouses across the country (fewer bricks, yes, but bricks nonetheless), which is costly, and they have to offer rock bottom prices and free shipping to entice people to buy more online. Amazon has certainly perfected this strategy, but high margin it isn’t.

The part of the story I missed, frankly, was how strong they could be in new markets that they essentially help build from scratch. The Kindle e-reader was Amazon’s first real big venture outside of just trying to beat bricks and mortar stores at their own game. They successfully created a new market and more importantly, one that has the potential to be higher margin than traditional book printing (digital books). Sure, today they don’t make much money on each e-book sold, or the Kindle device itself for that matter (publishers are still setting prices for the most part and keep most of the revenue) but Amazon has the potential to eliminate the middleman in the years ahead. They could become the publisher and help millions of regular authors publish electronically. This is not unlike what Netflix is trying to do by funding their own original tv series now that they have millions of subscribers.

Next up for Amazon is an entrance into the tablet market sometime in the fall. With such a huge library of streaming music, movies, and television shows, there is nothing stopping Amazon from being a heavyweight in digital music and streaming video. Frankly, Amazon can offer a lot more to consumers with a web-enabled Kindle or Amazon-branded tablet versus the Barnes and Noble Nook or yet another me-too Android tablet like the Motorola Xoom or Samsung Galaxy Tab.

Other than Apple, Amazon appears to be the only consumer electronics player that could offer its customers differentiated products. The margins on commoditized Android tablets will head towards zero as everyone cuts prices to the bone to try and grab market share. Amazon seems well positioned to offer more with their products. As a result, they could easily be a formidable competitor to Apple in the tablet and e-reader markets. I’m not saying they pass Apple, but they certainly can pass Samsung, Motorola, HP, and whomever else to be the clear number two player, and I feel good about that prediction even before they have launched many of the products they have in the pipeline.

So what about the stock? Why could it go higher even at its current valuation? Look, at its current market value of $96 billion, I can’t possibly make a valuation case for Amazon stock based on cash flow and earnings in the near-term. However, if you simply look at their addressable market opportunity over the next 5-10 years and compare their market value with other leading technology and retail companies, you begin to see how a bullish argument could be made longer term. Apple is worth $330B. Google $170B. Wal-Mart $185B. Facebook could fetch $100B after its IPO. If Amazon continues to innovate like they have what would stop them from being worth $125B, $150B, or even $200B in five years?

I know I have completely changed my negative tune on Amazon as a stock investment (and don’t get me wrong, as a value investor I am not going to go out and buy it), but since I was asked the question, if I had to own one seemingly grossly overvalued stock, that would be the one I would pick. Given what they have done in the last five years, coupled with what they are planning and compared with the values of other companies they compete with, $96B seems a lot more reasonable if you ignore the fact that such a figure is 50 times trailing cash flow, or 86 times this year’s profits.



Full Disclosure: No position in Amazon at the time of writing, but positions may change at any time