Brilliant Brokerage Call of the Day

A few years back, Prudential Securities got out of the investment banking business. It was widely expected that without the typical conflicts of interest that other diversified investment companies faced, Pru’s research department would be less biased, and therefore produce more valuable recommendations for their clients.

So much for valuable research. Prudential lifted its view on the energy sector to overweight today, and slapped a buy rating on shares of ExxonMobil (it was rated neutral before). Evidently their energy analysts see something fundamentally favorable to the big oil stocks, as of this morning. I’m sure Pru’s clients are thrilled with such a timely call.

Oil Volatility Continues to Drive Stock Prices

The Dow staged a late day rally today, closing up 75 points to 10,750, despite the fact that oil prices have once again cracked through $50 per barrel. Many would expect that with oil at $51.39, stock prices would have suffered. After a 170-point Dow drop on Tuesday (oil soared more than $2 that day, to over $50), we have recouped most of those gains already without a pullback in the oil market.

From this, we see that the relationship between oil and stock prices can get pretty interesting. Many economists hate to see increasing energy prices, fearing it will cripple any moderate economic growth we do have in this country. They see higher gas prices at the pump as an indirect tax on consumers, curbing their disposable income. Since the consumer represents two-thirds of the U.S. economy, stock prices generally falter when gas prices head higher.

While I won’t argue there is some connection, I have long thought that the impact higher energy prices have is somewhat exaggerated. After all, if the average consumer fills up his or her 15 gallon tank once a week, a 25 cent increase in the per-gallon price of gas costs that person about $195 per year extra. Hardly insignificant, but not enough to cripple an economy by any means, in my opinion.

Another interesting thing is how energy prices are affecting corporate earnings. While many will make the case that high gas prices will hurt the profit of consumer-related companies, earnings estimates have actually risen since the beginning of the year, even though oil prices have gone up as well. Growth in earnings for the S&P 500 was initially expected to be in the 7 to 8 percent range in 2005. Estimates have creeped up to between 9 and 10 percent already in the first two months of the new year. This has mostly been driven by the energy sector, whose profits are through the roof, and show no signs of slowing down.

As a result of higher profit estimates and a stock market that is down 1% thus far in 2005, the forward P/E on the S&P 500 has fallen to 16.2 or so. With the 10-year bond only yielding 4.29%, investors probably feel pretty comfortable buying stocks at these prices. The risk of course, is that energy prices fall meaningfully from here. The stock market might react postively to that initially, but don’t forget that such a move will lower corporate profit estimates, leaving stocks relatively more expensive than they are now.

Why Do Companies Give Guidance?

If I was running a public company, I would not give investors and analysts any type of precise financial guidance. Giving such sales and profit estimates stems from the implementation of Regulation FD, which required companies to divulge all meaningful information to the public, not just Wall Street analysts and boards of directors. No longer faced with having the luxury of “guiding” analysts to how a particular quarter was tracking, companies began issuing financial guidance in their press releases for everyone to see and interpret.

Unfortunately, earnings guidance plays right into the hands of those who focus too much on short-term financial performance, as opposed to building long-term shareholder value. CEO’s should not make business decisions in order to ensure they can make their numbers every quarter, but instead because it is in the best interest of the company and its shareholders long-term.

Making sound decisions that succeed in hitting both short-term and long-term goals is not always possible. Sometimes corporate managers have to make short-term sacrifices to ensure long-term stability and growth. Examples of these actions might be a dilutive acquisition, or price cutting to prevent a key customer from bolting to a competitor. Price discounts and dilutive deals will cause many companies to miss a quarter or two, but investors will be much better off five years later.

The fact remains that Wall Street focuses too much on quarter-to-quarter financial results. Investors see this every day when companies miss their EPS numbers by a penny or two and their stock drops 10, 20, or 30 percent in a single day. As a result, CEO’s begin to manage their business just to make sure they hit their numbers.

Taser (TASR) shipped out a $1 million order on December 31, 2004 to ensure they hit Q4 profit estimates. Pharmaceutical companies convinced wholesalers to take delivery of more product than they needed (a tactic called “channel stuffing”) so sales would be on target. According to court records, former WorldCom CEO Bernie Ebbers agreed to cook his company’s books because they needed to “hit their numbers to keep the stock price up.”

Finding companies that manage their businesses based on strategic plans, and not their public financial guidance, will do a much better job over the long term, and that’s something investors should look out for.

Is Martha Stewart Worth $1.75 Billion?

Martha Stewart Living Omnimedia (MSO) is trading at $35 a share, giving the company a market value of $1.75 billion. Short sellers covering and momentum players have contributed to this stock’s meteroic rise from $8 within the last 12 months. At today’s price the stock trades at 194 times 2006 earnings. Now, I’ll be the first to tell you I don’t really trust those estimates. I don’t think anyone really knows how much MSO will earn next year. There are just too many uncertainties to come up with an estimate that one should feel confident with.

What we can do is take a look back and see how this company did when business was great. Here are the historical sales numbers for Martha Stewart’s company. The 2004-2006 numbers are current estimates. MSO reports its full year 2004 numbers next week (Edit–2004 sales came in at $187 million – as reported on 2/23).

1997: $133 million
1998: $180 million
1999: $232 million
2000: $286 million
2001: $296 million
2002: $295 million
2003: $246 million

2004: $187 million
2005: $176 million
2006: $219 million

As you can see, this company has never had $300 million in annual revenue. The highest net profit margin the company has ever earned is 7.5 percent. This stock trades at 6 times peak sales! That translates into 80 times peak earnings! How long will it take MSO to get back to peak sales and profit margins? No way to know for sure, but it won’t be anytime soon.

Granted, this stock has not traded on financial metrics for a long time. It has been event driven recently; the jail sentence, the Mark Burnett “Apprentice” show, etc. Interesting side note — Burnett got 2.5 million options when he agreed to make the show. When he exercises them it will dilute the company’s owners by a whopping 5%, as there are about 50 million shares outstanding right now.

Eventually, this stock will once again trade based on how much money it can make. Judging from history, it looks like that might be bad news for shareholders.

Covering the Tivo Short

I’ve decided to cover my short position in Tivo (TIVO) a little earlier than expected. The stock was trading at $12 per share last year when it became fairly obvious that cable giants like Comcast (CMCSA) were not going to partner with Tivo, but rather build proprietary DVR technology into their own digital set-top boxes. This development left little room for Tivo to differentiate itself enough to outdual the cable companies in providing a soon-to-be standard feature.

With the premise that Tivo’s fundamentals were going to be in steady decline, and profitability was years off (if ever in the cards), covering the short wasn’t something I was really considering. However, with today’s announcement of Tivo’s 3 millionth subscriber, I once again found myself looking at the stock’s valuation. After a precipitous drop from $12 to $3 and change, the time has come to take my profits off the table.

The financials are still pretty ugly. Sales for 2005 are expected to be just under $200 million, with a net loss of approximately $25 million. Tivo has boosted marketing expenses recently as it realized that its partnership with DirecTV will become less and less valuable over time. As a result, it wouldn’t surprise me if sales come in ahead of expectations this year, but losses are higher than anticipated.

The losses are less of a concern given that Tivo has little debt and a sizeable cash position. Further funding may be required later on, depending on how well increased marketing spend boosts sales and its impact on margins, but for right now the company is okay financially.

With the stock up 5% on the subscriber figures, the market cap is about $300 million, or about $100 per subscriber. This valuation seems to be very reasonable to me, and I have a tough time making the case it should be lower than that. As a result, today I am moving on to bigger and better opportunities.

A Double Top on the S&P 500?

I rarely put much emphasis on technical analysis of individual stocks. Reading charts can work, but only in the absence of material new information. Without meaningful newsflow, technical indicators will often hold up because everybody is looking at the same thing and traders will act similarly, thereby allowing the technical analysis to become a self-fulfilling prophecy.

However, as soon as the company reports earnings, receives an analyst upgrade, or announces a merger (among dozens of other possible catalysts), chart reading goes out the window in favor of a necessary revaluation of the company’s shares based on new revelations.

With indexes, however, technical analysis has a bit more merit. Many hedge funds trade the indexes as a whole, as well as individual stocks. Newsflow for an entire index, the S&P 500 for example, doesn’t occur. The S&P doesn’t report earnings. Wall Street research departments don’t have analysts covering indexes. As a result, the double top that formed recently on the S&P 500 could be concerning.

Traders focused on indexes could very well use that formation as a reason to sell, and not only their index ETF’s and futures, but their stock holdings as well (based not on company fundamentals but rather index technicals). Despite a nice move higher in February, the market is still down for the year, as January’s drop has yet to be fully recouped.

If we can’t break the overhead resistance in the 1,212-1,213 area on the S&P, the recent rally might not continue very much longer. Interestingly, the market opened the year at 1,212, which turned out to be the high for this week before we headed south once again.

So Much for the Google Lock-Up Expiration

Google (GOOG) shares are up another $3 this morning after rising nearly $6 yesterday, the first day every share of the Internet search company was available for sale. It appears that demand for the shares is more than adequate to soak up a little extra supply (little because any shares that will be sold by company insiders will be unloaded in a slow and orderly fashion, as opposed to all at once).

What lies ahead for Google in the short to intermediate term? How about inclusion in the S&P 500? With a market cap of more than $50 billion, Google would find itself in the top quintile of companies in the index (based on market cap) upon its addition. With so many mergers and acquisitions being announced recently (AT&T and Gillette are two examples of S&P companies that will need to be replaced), it is only a matter of time before index funds will have to gobble up Google shares.

The largest S&P 500 fund, Vanguard Index 500, had $106.6 billion in assets as of 12/31/04. If Google was added to the S&P today, that fund alone would need to purchase more than $500 million in stock, about 1% of the company’s total outstanding shares. As a result, the announcement of Google’s inclusion in the S&P 500 will only serve to further buoy the stock price, and help to absorb the recently increased float.

More Tech Talk

I feel as though my recent writings are all about technology stocks. They shouldn’t be though. All of the portfolios I manage are fully diversified and none of them have more than a market weighting in TMT (tech, media, & telecom). That could be changing though, if recent events are any indication.

The reason why I am typing away about tech more often these days is simply because that’s where I’m finding value. There are still a decent amount of undervalued investment opportunities in energy and other commodity-related companies. But aside from that, I’ve been uncovering tons of ideas within the software space, as well as Internet companies.

You’re probably thinking “yeah right.” He thinks Google (GOOG) is a value at 47 times forward earnings, but that’s not really “value.” I do still like Google because it’s the fastest growing tech company around and despite rising 100% since its IPO, it still trades at a discount to eBay (EBAY) and Yahoo! (YHOO), with stronger fundamentals. The fact that the stock was up $6 today, the very day 177 million shares were free to be sold by company insiders and early investors, shows that I’m not alone in that thinking. However, let’s assume that a 47 multiple is high enough to still scare most people away. That’s perfectly understandable, even if I think that will prove to be the wrong decision.

For the first time ever, I’ve been finding Internet stocks that trade at a discount to their growth rates. That’s pretty rare in any industry, but especially in tech. Nasdaq stocks will always trade at a premium to the S&P 500, as investors look there in hopes of finding the next Microsoft (MSFT). So you can imagine what happens when Internet stocks that trade at market multiples begin to pop up on my radar screen. These companies are growing 20% to 30% percent a year, have loads of cash on their balance sheets (which is mostly being used for small acquisitions as opposed to dividends), and like many technology companies, no debt to speak of.

Let me give you a couple of examples. As always, assume that if I am saying bullish things about certain stocks that I either own them already, or am strongly considering a purchase. The first is Ask Jeeves (ASKJ: $23). Now some people will just laugh at this. Why would you want to buy Ask Jeeves? I must be kidding, right? Rather than think about who Jeeves is (which I must admit doesn’t scream “buy my stock!”) let’s look at what really matters; the numbers. ASKJ is expected to grow earnings 30% in 2005 and 20% in 2006.

Normally I would guess a stock like this would be trading at 40 or 50 times earnings and I wouldn’t even consider buying it. However, the P/E on 2005 numbers is 16.9x. That’s right, the same multiple as the S&P 500 index, only with more than twice the growth. Two things jump out a me about this company. One, it shouldn’t be trading at a market multiple. And two, if another Internet search company bought ASKJ, it would be ridiculously accretive to earnings.

The next stock is InfoSpace (INSP: $43). A very similar situation to Ask Jeeves. INSP is in paid search, as well as services for mobile phones, like ring tone downloads. Earnings are expected to jump 32% in 2005 and another 31% in 2006. The company has no debt and $9 per share in cash (which has been used for several small acquisitions in recent years and will likely continue). Strip out the cash and you get a share price of $34 and a 2005 P/E of 18.7x. Again, if someone like Yahoo! was to buy a company like this, it would add to earnings immediately, given that Yahoo! trades at over 50 times earnings.

The best explanation for why these lesser known Internet stocks are so cheap compared with the likes of giants Google and Yahoo! is that they are second tier players. Many growth investors simply go with the biggest company in the area they want to invest in. However, smaller firms like ASKJ and INSP have proved that there is room for them too and they continue to grow handsomely under the radar.

I really think eventually Wall Street will realize this and give them a higher market value. They may still trade at a discount to the industry bellwethers, but a 25 or 3o P/E seems attainable as soon as the Street realizes how cheap these stocks are and that these companies can survive. I wouldn’t be surpruised if other companies realize this first, and scoop them up before they are in higher demand.

Examining Changes to the Dow 30 Components

Every few years investors hear of impending changes to the Dow Jones Average, the broad index of 30 industrial stocks created by Charles Dow in 1897, widely used as a stock market barometer. For the majority of the 20th century, changes to the index’s components were rare. Only when one of the 30 stocks was acquired by another company would they be replaced, and the new addition would usually be in the same industry as its predecessor.

However, with the bull market of the 1990’s, Dow Jones & Company (DJ), the publisher of the index, began changing the group of 30 stocks even without any news of a merger. With stock prices rising at a rapid pace, cheerleaders for stock ownership were everywhere. Dow Jones & Company figured it could boost stock prices even more by replacing underperforming companies with better ones.

Rather than saying they wanted to boost the Dow’s performance, those who orchestrated the changes justified such actions be claiming that the new index “better represented the country’s ever-changing economy.” Basically, even though we still filled up our cars’ gas tanks at Chevron stations and wrote on paper made by International Paper, these companies really weren’t good gauges of the so-called “new economy.” With the advent of the digital camera, somehow Kodak no longer deserved to be in the Dow, despite billions of dollars in annual sales and owner of one of the country’s more prominent brands.

Were these changes really necessary? I was never a big fan of them. Companies go through ups and downs. Businesses are cyclical. When oil prices are low, companies like Chevron won’t make very much money and their stock prices won’t perform very well. Does that mean we should boot them from the Dow? Probably not. Nonetheless, since 1999 exactly 7 of the Dow’s 30 stocks have been replaced due to economical irrelevency (read “bad stock performance”).

Not being a big proponent of bandwagons as far as stocks are concerned, I am truly excited to have discovered yet another contrarian indicator for stocks. Think about it. Dow Jones boots a poorly performing stock and adds an elite name to the index. Isn’t this the perfect contrarian indicator for someone who loves buying out-of-favor stocks? After all, if you get booted from the Dow, your company must really be down in the dumps. And if you are the lucky company to be named a replacement, you really must have done well lately.

So, the next time a change is made to the Dow Jones Industrial Average, I will be trading on the news. I’ll short the stock that gets added and pair that trade with the purchase of the company that got the axe. Will this strategy work, you ask? Well, let’s take a closer look at how the aforementioned 7 alterations since 1999 have fared after the changes took effect.

On November 1, 1999, four stocks were removed from the Dow; Chevron (CVX), Goodyear Tire (GT), Sears (S), and Union Carbide (UK). Not surprisingly, they were replaced by some bull market high-fliers; Home Depot (HD), Intel (INTC), Microsoft (MSFT), and SBC Communications (SBC).

Less than five years later, in April 2004, more changes were announced. This time 3 companies were replaced. American International Group (AIG), Pfizer (PFE), Verizon (VZ) took over for AT&T (T), Eastman Kodak (EK), and International Paper (IP).

Dow Jones & Company, as well as most investors, were probably thrilled with the decision to replace these “old economy” stocks with newer, faster growing market darlings. The great news (if you’re looking for contrarian investment opportunities) is that the performances of the two groups of stocks has been quite a dichotomy, just not in the way many would have expected.

Of the 7 stocks deleted from the Dow since 1999, 3 of them were either acquired or are in the process of being acquired (Dow Chemical bought Union Carbide, Sears is going to be bought by Kmart, and AT&T is going to be purchased by fellow Dow member SBC Communications). All told, on average, the seven deleted stocks have risen by a staggering 227% since their removal. That equates to a return of more than 32% each.

While those returns are impressive, they won’t make for much of a contrarian investment strategy unless the ones that replaced them gained less than 32% on average. Amazingly, the 7 stocks added to the Dow haven’t gone up at all. In fact, they’ve lost a combined 155% since they were added to the index, for a loss of 22% each. Only one of the seven has risen in price (Verizon) and its shares are up a meager 2%.

Hopefully more changes to the Dow are coming, for contrarian investors’ sake anyway.

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.