Bank of America/MBNA Deal Boosts Capital One

Credit card companies have been hot acquisition targets lately. The sale of Providian (PVN) sparked speculation that more deals would follow as independent card companies aren’t very plentiful. Today’s announcement that Bank of America (BAC) will buy MBNA (KRB) for $35 billion only furthers that thesis.

MBNA is getting a very nice premium, with the purchase price of $27 being about 30% above the stock’s $21 closing price yesterday. B of A is paying 13.5x MBNA’s 2005 EPS estimate of $2.00 per share. Such a price has resulted in a repricing of other credit card firms in the market. Longtime Peridot favorite Capital One (COF) is rallying $5 per share (7%) today. With Providian and MBNA now out of play, COF is the last remaining large credit card company without a merger partner.

The 13.5x multiple for KRB implies that COF shares remain undervalued. Capital One should earn $7 this year, making a implied buyout value of $95 per share, versus its $74 closing price yesterday (shares are up to $79 this morning). While the speculation today will be that COF will be next in line to get a bid, I seriously doubt they are interested in selling. Nonetheless, the stock remains both undervalued and a Peridot core holding even as they remain independent.

Google vs Time Warner

It seems CNBC has fallen in love with a market value comparison between Google (GOOG) and Time Warner (TWX). Their anchors are asking every single person they can find how one can justify GOOG being valued at $86 billion while TWX sports an $80 billion market cap. The way they have been wording it makes it seem like any sane human being should think that statistic is completely insane. After all, TWX will have $44 billion in annual sales this year, whereas Google will book less than $4 billion in revenue.

Let’s break this comparison down to see how silly it is. Since when are stocks valued based on their sales? Healthcare services firm Express Scripts (ESRX) is worth $3.7 billion with expected sales in 2005 to hit $16 billion. Another healthcare company, Lincare Holdings (LNCR) is going to book $1.2 billion in revenue this year but it’s worth $4.3 billion. ESRX has 13 times as much revenue, but is worth 15% less in the market. Are these two companies being misvalued on Wall Street too?

The formula for a stock’s price is pretty simple:

Stock Price = (Earnings per Share) x (Price/Earnings Multiple)

Nowhere in this formula will you find anything about sales. Companies are valued on their earnings. That’s one half of the equation. The other half is the multiple. The multiples investors are willing to pay are determined by growth potential. More growth… higher P/E, and vice versa.

Now let’s take a look at Google and Time Warner again. Time Warner has billions in debt. Google doesn’t. Time Warner’s enterprise value of $93 billion is far greater than its market cap of $80 billion. Google, on the other hand, has a ton of cash giving it an enterpise value of $82 billion, or $11 billion less than TWX.

Now let’s look at earnings. It’s true that Google’s 2006 P/E is 46x whereas Time Warner’s is 19x. If we use enterprise value instead of market cap, we get 44x for GOOG versus 22x for TWX. How can we justify a P/E for Google twice that of Time Warner? Well, in 2006 Google is expected to grow its business by 41%. Time Warner’s growth? A paltry 5%.

The question investors are asking themselves is this. Would I rather pay 44x for 41% growth or 22x for 5% growth? The answer has been obvious, as Google shares have soared from $85 to $308 since August. Conversely, Time Warner stock has been dead money. Interestingly, I think TWX is a very attractive investment down here at $16 per share.

Google Prints $300

After a run earlier this month failed at $299 and change, Google shares finally hit $300 today, closing at $304 per share. This level has been the one I’ve been waiting for to lighten up on my Google position. While I am still bullish on the company, I think it is careless to not cash in a little bit of stock.

The $300 level equates to 45 times 2006 earnings estimates. This multiple seems fair given Google’s growth prospects and the ability of the current consensus EPS number to move over $7 as 2005 plays out. That said, it is a very high multiple. Only companies that are in a truly unique position are going to fetch such a price.

I continue to want exposure to the name in coming months. However, the time has come to ring the register. As a value-oriented guy, Google shares no longer present the “value” they did at $170 each. That said, I do not think they are overvalued given what we know today. If we get to 50x forward earnings, it might be time to sell off another chunk of stock.

It should be interesting to see how the future plays out, or more specifically, how high earnings projections can go. That will determine how long this rally continues.

The Roth 401(k) is Coming

While I’m surprised we have not heard more about them, I suspect that as 2005 comes to a close individuals will hear a lot more about the Roth 401(k) plan, set to be instated in 2006. The Roth IRA has truly been a boon for investors, allowing them to contribute as much as $4,000 per year in after-tax dollars to an account where profits are tax-free at age 59 1/2. Investment principal can even be withdrawn early tax-free with no penalty.

As great as this deal is for investors, the Roth IRA’s glaring limitations (namely annual contribution limits and income limits that don’t allow the wealthy to participate) do provide some discontent. However, beginning in 2006 employers will have the option of offering their workers a Roth 401(k) plan, which can take the place of an employee’s traditional 401(k) retirement account.

The Roth 401(k) will have similar contribution limits to a regular 401(k), $15,000 per year in 2006, which far surpasses the Roth IRA limits. As with regular 401(k) plans, there will not be income limits with the new plan. Contributions will be treated just like a Roth IRA, meaning after-tax dollars are used (as opposed to the current plan that uses pre-tax dollars) and withdrawals after age 59 1/2 are tax-free.

For those with extra income who are looking to invest for their retirement in a tax-efficient way, the Roth 401(k) could be the single best way to accomplish that feat starting next year. That assumes of course that your employer will choose to offer it as an option, as it will be strictly a voluntary offering.

The Epitomy of a Contrarian Stock Market Bet

1) I am the most heavily shorted stock on the New York Stock Exchange with over 240 million shares sold short as of May 2005, equal to 45% of my float.

2) I am the cheapest stock in terms of price-to-book ratio in the S&P 500 index, trading at less than 50% of my tangible asset value.

3) My share price was once as high as $58 in 2001, but since then my stock has dropped by 95 percent.

4) Wall Street analysts dislike my stock immensely and many have a “sell” rating on it.

5) I am in the midst of a restructuring focused on selling assets and paying down and/or refinancing debt.

6) I am Peridot Capital’s most recent purchase.


Google Mulls New Online Payment System

A reader first postulated this idea to me on this site a while back. What if Google (GOOG) came out with its own online payment system to rival PayPal? Given eBay’s lack of success in trying to topple the market leader years back (eBay created Billpay, only to later fold it and purchase PayPal for $1.3 billion three years ago), I was doubtful as to the merits of such a strategy and how it fit in with Google’s overall focus on search applications.

However, The Wall Street Journal is reporting that Google plans to launch its own online payment system later this year. I still believe, given PayPal’s overwhelming lead and seemless integration with eBay, it will be difficult for Google to make significant inroads in the business. But you still have to think about the possible ramifications.

There is one way Google could really put the heat on PayPal, in my opinion. As eBay has seen its domestic listing growth slow, they have responded by raising prices both on their auctions and for online payments. This has infuriated many sellers and caused them to look elsewhere in many cases. In fact, eBay saw month-over-month declines in total listings earlier this year, which many attribute to their fee hikes.

If Google decided to meaningfully undercut PayPal on price (PayPal currently takes 2.9% of debit and credit card payments received, plus a transaction fee), eBay would have to react with price cuts of its own, or risk losing meaningful market share. How vulnerable is eBay to such an event? Well, in the first quarter of 2005 PayPal accounted for 23% of eBay’s revenue.

As a Google shareholder, I am hoping they can make a dent in eBay’s business. If they can, eBay’s stock, which currently fetches 38 times 2006 earnings, may be ripe for selling. For 42 times 2006 earnings investors can own GOOG shares instead, and enjoy a higher growth rate, more EPS upside surprise potential, and fewer competitive pressures.

Morgan Stanley Initiates SHLD with a Sell

This morning’s initiation of coverage on Sears Holdings (SHLD) by Morgan Stanley could prove to be one of the worst analyst calls of the year. I can understand people who doubt the viability of combining Sears and Kmart in order to turn the franchises around. As an analyst though, I would suggest those bears simply stick a neutral rating on the stock and highlight the risks that go along with banking on this combination.

Slapping a sell on this stock, even at $150 per share, is a very risky proposition and could make the retail group at Morgan look like idiots if certain things go right. The basic premise for the sell rating is that Morgan feels Sears Holdings can not be fixed. That’s a fair view, but I think you should at least give them a chance before pronouncing the company dead. The merger just closed and they haven’t even had a chance to implement their strategy yet. Those plans are just beginning and could take until 2006 to bear fruit.

There are many catalysts that could send this stock higher over that time. There will be real estate sales. After all, there are Kmart and Sears locations next to each other throughout the country. Retailers like Costco (COST) are struggling to find new store lots and when they do, it takes several years to get permission to build on them. That’s how extra off-mall real estate becomes valuable.

Sears Holdings also hasn’t announced anything about Sears Canada or some of their other divisions that don’t fit in with the main strategy. What will happen with Lands End or Orchard? They have $1.6 billion in cash and a lot of debt outstanding that can be retired early. All of these catalysts are unrelated to reinvigorating the core brand, but matter very much to the value of the business, and the share price.

Sticking your neck out and recommending purchase is a gutsy call (but one I’m willing to make), especially when the stock is up 10-fold since emerging from bankruptcy. However, I think putting the rare sell rating on this stock will prove one of the worst analyst calls of 2005 when we look back on this years from now.

Market Holds Up Despite Oil Spike

All year we’ve heard numerous pundits citing high oil prices as a main reason for the market’s year-to-date losses. However, after seeing oil spike from the mid $40’s per barrel up to nearly $57, along with a stock market that is holding up very well, we can see that oil has not been the primary driver of stock prices, up or down.

Instead, it’s all about interest rates. Speculation of the Fed stopping at 3.5% Fed Funds, coupled with tame inflation data recently, has more than made up for higher energy prices in the minds of investors. This is not to say oil prices are completely irrelevent, but rather to imply that if the market gets everything else it is looking for, $60 oil most likely will not hold back equity prices in a meaningful way.

So, where are interest rates headed? You may have noticed that in a relatively short period of time the consensus view has shifted from “Greenspan always overdoes it and will take rates too high which will slow the economy” to the current view that “Inflation is low and Greenspan doesn’t want to overdo it again so he’ll stop after 1 or 2 more hikes, taking Fed Funds to 3.25% or 3.5%.”

The consensus on the 10-year bond has also shifted from “It’s just a matter of time before we see 5%” to “We could stay under 4% for a very long time.” Bill Gross of PIMCO has even said publicly that he sees the 10-year going to 3% in the next couple of years.

While I certainly think we could see the rate hikes come to a halt at 3.25% or 3.5%, and would welcome such a development from an investor standpoint, I’m not as convinced as most are that this will occur. I still think there is a good chance we’ll get to 4% Fed Funds, with the 10-year bond around 4.5%.

If this happens, the market will have to once again adjust expectations and we could give back some of the recent gains. I have been playing this thesis by trimming some equities during this run-up, along with shorting the 10-year bond under 4%.

For Sale: Brokers, Asking: 10x Earnings

Goldman Sachs (GS), Morgan Stanley (MWD), Merrill Lynch (MER), Lehman Brothers (LEH), and Bear Stearns (BSC). They all trade at 10 times earnings. At first glance this may seem too cheap, and they very well might be, but let’s take a look at why you can buy a share of Goldman Sachs at 10x when it used to trade at a premium to the market and sport a P/E of 18 or more.

In case you haven’t noticed, we’ve been in a bear market since March of 2000, more than five years. The major investment banks have had to alter their business models. Some of the old ways of making money don’t really exist anymore; taking Internet companies public, or generating $100 per trade retail commissions. The public has soured on stocks. Those that haven’t can trade their own accounts for $7 per trade. The IPO market isn’t lively at all. Today, M&A is really the only way the investment banks are making money from their traditional businesses.

So what are these companies doing to cash in? After all, the profits at the Goldmans and Lehmans of the world have been pretty robust. John Mack, former CEO of both Morgan Stanley and CS First Boston, summed it up pretty well in a recent interview:

“The profitability at investment banking firms has moved to the trading desk. A lot of people say that certain firms are nothing, really, but hedge funds.”

Mack is exactly right. Proprietary trading has fueled much of the growth in earnings for the investment banks. A booming fixed income market has helped Bear and Lehman greatly, and Goldman and Merrill are seeing a nice pickup in M&A activity in 2005, but trading is where the extra juice has come from.

This can explain why the group once sold for 15 times and Goldman once fetched 20 times, but now the multiples are all around 10. They are basically hedge funds, making risky bets. If they are right, cha-ching. If not, bad news. Just look at how many firms got hurt when Kirk Kerkorian’s company made a bid for General Motors. Traders were short the common stock and long the bonds as a hedge. The common went up after Tracinda’s $31 offer and the bonds went down after GM debt was downgraded to junk status.

Sure the people trading for these firms are extremely smart, and they’ll do pretty well for the most part. However, investors aren’t going to be willing to pay premium valuations for companies that are relying on trading profits for a large chunk of their earnings. As far as business models go, its one of the riskier ones out there. The more risk you carry, the less someone is going to pay for a chunk of the business.