Martha’s Apprentice Starts Slow

Viewership for the premiere of “The Apprentice – Martha Stewart” was below expectations, at 7 million, and shares of Stewart’s company, MSO, have dropped 30% in the last two weeks to under $25 per share. After missing the first episode, I tuned in tonight to see how the show compared to Trump’s version, and also to see David, a contestant who recently graduated from my alma mater.

After an hour, David survived the second week and it was easy to see why ratings have not been very good. Martha just isn’t the draw that Donald Trump is. She’s boring to watch, and her background voiceovers sound like a bad actress reading from a cue card, not someone who draws a lot of attention and interest on television. It takes more than just a successful entrepreneur to draw viewers in prime time. Just ask Mark Cuban after his show, The Benefactor, completely bombed.

Ad pages in Martha’s magazine might be up nicely year-over-year, but Martha Stewart Living Omnimedia stock remains overvalued at 5 times sales.

Despite Cash Hoards, Companies Aren’t Paying Out

With cash reserves of U.S. public companies sitting at all-time record highs, investors might think dividend payments would be booming as well. Combined with the relatively new 15% dividend income tax rate, investors should be reaping the rewards of record cash payouts. However, the average S&P 500 company is paying less than 2% annually out to its shareholders.

Why does the average large cap stock pay out less than 2% in dividends? Well as we’ve seen this year, M&A activity has been red hot. Corporate profit margins are at cycle highs, so further cost savings have to be squeezed out via merger synergies. So far in 2005, deals have been running rampant on Wall Street. One need just look at the recent earnings report from Goldman Sachs (GS) to see evidence of that.

In addition to mergers and acquisitions, the rise of stock option compensation over the last two decades certainly accounts for the reduction in dividend yields. In order to minimize the equity dilution from option issuances, companies need to instate massive share repurchase programs. The money to do so comes straight from free cash flow that would otherwise be widely available for cash payouts to shareholders.

Throughout history, stock market returns have come from the combination of equity price appreciation and dividend payments. Yields that have averaged about 4 percent historically, along with 6 percent annual growth in earnings, explains the 10 percent average annual return from equities since the 1800’s.

With 2% dividends and peak margins upon us, it’s no wonder that some suspect future stock market returns, say during the next decade or so, will fail to hit the magic 10 percent mark. Even if somehow peak margins can be sustained, which is unlikely, investors are only looking at 8 percent annual returns from stock indices in the near to intermediate term. While that kind of performance pales in comparison to the great bull market of 1982-1999, it will still mark the highest return of any asset class, so abandoning the stock market because of it makes little sense.

Different Year, Same Old Story

It was postulated here earlier in the year that 2005 could very well turn out a lot like 1994, the last time the Fed went on autopilot and raised interest rates consistently for an extended period of time. The result was a flat-to-down market that ended up a mere 1% for the year (only after a substantial rally late in the year). As some of us expected, 2005 has indeed played out the markets tend to do when the Fed is increasing the cost of money.

To see exactly how similar it has been I decided to construct a year-to-date chart of the S&P 500 and compare it to the same nine-month period in 1994. Below you will find both charts, 1994 first, followed by 2005.

Fossil: Back from the Dead?

There are certain companies that seem to have a huge profit miss and a resulting stock price catastrophe every so often. Fossil (FOSL) is a perfect example. This company is used to seeing its equity get crushed every few quarters. Investors who are willing to pounce can get a terrific price and wait for a rebound to sell for a nice profit.

Fossil, a leading maker of watches, once again has seen its stock drop from a 52-week high of $32 all the way down to below $20 per share, for a haircut of about 40 percent. Estimates for 2006 earnings are nearing $1.50 and the company has almost $2 per share in net cash on its balance sheet. The result is an enterprise value-to-earnings ratio of only 12x for a company that is growing double digits.

This most likely isn’t a stock that investors should buy today and hold for 3 to 5 years, given its history of putting together a few good quarters and then giving back the gains. Nonetheless, buying at these levels should give investors some upside as the company delivers on reduced expectations. When should FOSL be sold? I think a rebound of 25 percent is in the cards, so Fossil could see at least $25 per share in the next 6 to 9 months.

The Math Behind a Bullish Call on Sears

With the stock of Sears Holdings (SHLD) down 25 percent from its high, concerns are mounting, good news goes unnoticed, and sentiment has waned. Why then am I still bullish? Why is this the third time I’ve mentioned SHLD this month? Don’t worry, in the days and weeks ahead I will try to move on from talk of Google, Sears, and the airlines and explore some new companies.

Let me throw some numbers out there that show why I feel SHLD shares at $120 are a steal. After this, I’ll try and stop talking about it so much. Current estimates for 2006 call for Sears to earn $7.88 per share on $56 billion in sales. This equates to a 2.3% net profit margin. I happen to think this margin projection is too low. The way I see it, the best two comparables for Sears are J.C. Penney (JCP) and Federated (FD). After all, the Sears model is moving toward Sears and the newly created Sears Essentials stores, which very much will be traditional department stores.

Now, let’s look at consensus estimates for JCP and FD. For next year, JCP is expected to earn $4 on $19.5 billion in sales, with FD slated to make more than $5 per share on $16.6 billion. Both of these estimates come out to a 5 percent net margin. Call me optimistic, but I think the turnaround at Sears should net margins very close to JCP and FD. There is no reason to think a solid management team cannot attain department-store-like margins.

It is possible that Kmart was so screwed up that it is beyond repair, at least to get to the same level of profitability as these other stores. For sake of being conservative, I’m going to assume SHLD can get to a 3% profit margin by the end of 2006. Since the Sears model is going to be to sacrifice sales in order to boost profits, I’m going to combine my 3% margin estimate with $55 billion in annual sales, one billion dollars less than analysts currently expect. All of the sudden, SHLD is earning $1.65 billion per year, which makes for an easy calculation with 165 million shares outstanding; that’s $10 per share in earnings.

At $120 per share, the stock is only 12 times these profit estimates. And remember, this model does not include the $900 million cash Sears will get from Sears Canada, the $500 stock buyback program recently announced, or any real estate sales of any kind. There is a lot of upside here, and while it is by no means assured, given the recent negative sentiment and a 25 percent drop in the share price, SHLD looks very attractive. Just imagine if SHLD can ever get to a 5 percent margin, that would get us to nearly $17 per share in EPS. Put a market P/E on that and you get a stock price of $250.

The Future of AOL

Rumors are swirling about what Time Warner (TWX) will do with AOL. CEO Dick Parsons has stood firm that they want to keep AOL as part of the company and transition it to an advertising model from a subscription model, given that AOL’s more than 20 million members have been leaving, and will continue to do so for obvious reasons.

Today, with the Google (GOOG) secondary offering complete (and it went well by the way, with the stock trading above the $295 offering price) the market is trying to figure out which of the rumors could come to fruition. Will Google buy AOL? Will Microsoft (MSFT) buy at least a stake in it and combine AOL with MSN? Reports indicate that at the very least, all of these major online players have had discussions.

While I don’t really have any insights into what will happen, I can tell you that the media and Wall Street will almost certainly badmouth any company that partners with AOL. For years investors have basically ignored AOL as a long-term viable part of Time Warner. Analysts often say that Wall Street is valuing it at zero when trying to explain TWX’s stalled out stock price.

However, there are things to consider here. Not only would any type of deal benefit Time Warner, assuming investors are assigning no value to AOL right now, it might not be a bad deal for Google, Microsoft, or anyone else. For the first six months of 2005, AOL had revenue of $4.23 billion. Some may be surprised how profitable this business is for TWX. Adjusted operating income (before amortization and depreciation) was $1.09 billion. Clearly, AOL is worth something and that something is in the billions.

AOL has to change business models. Home users of the Internet no longer need AOL as their gateway. Advertising at AOL has an uphill battle as Google and Yahoo (YHOO) continue to gain market share. With the help of a leading Internet force, AOL could very well become even more valuable, and investors are already underestimating the value of Time Warner’s America Online unit today.

Sears Buyback & Bear Stearns Incompetence

After recommending investors buy Northwest Airlines (NWAC) stock at $5.00 less than a month ago, today Bear Streans downgraded the stock to a sell, after yesterday’s bankruptcy rumors sent the stock down as much as 60 percent to $1.57 per share. Amazingly (well, maybe not given this analyst’s track record) NWAC stock is up 25 percent today as some investors bet Northwest will temporarily avoid filing Chapter 11 this week by using that possiblity to reach an agreement with its mechanics on wage consessions. It would be hilarious if Bear’s sell call marked the bottom in NWAC and the stock actually rose significantly after news of a deal. At that point, Bear would probably upgrade the stock just in time for the company to file bankruptcy.

Although the stock isn’t really reacting to the news, Sears Holdings (SHLD) today announced a $500 million stock repurchase plan. This represents 2.3% of the company’s total shares outstanding. These are the kinds of things SHLD management will do to enhance shareholder value through the use of its free cash flow. They will not use the money to mimic other retailers that open new stores. Rather they will try and increase the profitability of existing stores and use that money to boost the stock price.

More Northwest Craziness

This is a first for me; an analyst upgrades a stock to sell.

Standard & Poor’s Equity Research upgraded Northwest Airlines to “sell” from “strong sell” but cut the price target. “With the shares off sharply today amid market talk about possible bankruptcy, we think the current share price more adequately discounts the risks of bankruptcy we foresee,” S&P Equity Research said. Investors should sell shares of Northwest, “which we do believe is likely to file for bankruptcy, but our upgrade reflects possibilities for the share price,” the research firm said. S&P Equity Research said shares could see upside if Northwest denied bankruptcy talk, reached agreement with striking mechanics, or if there are further oil price declines or “meaningful progress” with other unions. The firm cut Northwest’s 12-month target price to $1.50, from $3.

So, let me get this straight. They think NWAC will go bankrupt, and their 12-month price target is $1.50 per share? Has a bankrupt airline ever given equity holders anything when they come out? And what is the difference between a sell and a strong sell? Do you use a market order if you want to sell strongly, versus a limit order if you just want to sell?

Oops…

Thursday August 18th: Bear Stearns upgrades Northwest Airlines (NWAC) to “buy” causing the stock to soar 10% to $5.48 per share.

Tuesday August 16th: Morgan Stanley upgrades Northwest Airlines (NWAC) to “buy” and sets a $9 target price. The stock jumps from $4.17 to $4.65 per share.