So Far, So Good on the Earnings Front

We still have a lot of reports to come, but so far second quarter profit reports have once again come in very strong. Aside from the obvious, a fairly strong economy, I think there are two key reasons why we are seeing strong corporate results.

The first is clean corporate balance sheets. Public companies are flush with cash which gives them a lot of flexibility in managing their business. Excess cash has been used for acquisitions as well as share repurchases quite heavily in recent quarters. M&A can be very accretive if done right, and buyback programs can add a penny or two to the bottom line in any given quarter.

The second reason earnings have been so strong, in my opinion, is because managements have finally figured out that the key is to under-promise and over-deliver. This is true in any business, public or private. However, in the go-go days of the late 1990’s, stocks would only rise if the firms beat numbers and raised guidance every three months. CEOs had to be overly optimistic in everything they said in order to prop up their already richly valued stocks. As a result, expectations got way out of line and eventually the bar had to be ratcheted downward.

I think today is different. The trend has been to beat numbers and issue cautious guidance. This serves to hurt share prices right after results are released, but it brings expectations down for future quarters. Then, the company beats the reduced expectations the next quarter and again issues cautious guidance. The cycle simply repeats itself over and over again. Executives have finally figured out that hyping their company’s future prospects can end badly if they fail to deliver on the lofty promises.

Readers of this blog know that I’d prefer companies shun quarterly guidance completely. However, if they insist on giving out financial projections every three months, at least most are setting the bar low enough that they can at least hit, and often even surpass, their projections.


Microsoft Questionably Entering Digital Music Biz

Microsoft (MSFT) bulls hoping that Windows Vista and a splash into the digital music industry with “Zune” branded mp3 players and music downloads will boost the company’s fortunes are set up for disappointment. Does anyone really think consumer electronic buffs are going to get excited to replace their iPod with a Zune player? Having a closed system architecture will make it even harder for Microsoft to take meaningful market share. And why are Ballmer and Co. targeting the overcrowded, low-margin digital download business?

The bigger potential boon to Microsoft’s financial results in 2007 relates to an upgrade cycle centered around Windows Vista. I can’t get too excited about the prospects for Vista either. I don’t know anyone who is running Windows XP today thinking “Man, I sure wish Microsoft would upgrade their operating system.” There just is no reason for most people to go out and buy a new system or even upgrade an existing one to Vista. All of our favorite computer tasks (email, web surfing, document management, digital music and photos, etc) work just fine on XP.

Microsoft stock is not expensive, and you will get some dividend payments here and there, but significant capital appreciation is pretty much unlikely. The company reminds me a lot of IBM, a tech giant that has been dead money for a long time, with no resurgence on the horizon.

Despite Headwinds, Consumer Discretionary Sector is a Solid Contrarian Bet

Over the last few months retailers have had a tough go of it. Even companies that continue to hit their numbers have seen their stocks fall by 30% or more. We all know the bearish arguments for the consumer discretionary sector. Higher interest rates, flat real wage growth, high gas prices, ARM’s adjusting for many home owners, etc.

While I agree these are all issues facing the U.S. consumer, I don’t think we should slash every consumer discretionary company’s stock price by a third. One must be selective, but there are companies out there that aren’t doing as poorly as their stock prices indicate, and shouldn’t later this year or next year either.

Take for instance the upper class high end consumer. Are these issues going to adversely affect them to a large degree? I’d argue that $3 gasoline and variable rate loans will squeeze the low income earners a lot more. They are the people who took out the interest-only or 3/1 ARM mortgages because it was the only way they could afford the house they wanted to buy. A tank of gas going from $30 to $50 is not going to crimp the richest 5% of America.

Moving to a company specific situation, consider the luxury goods maker Coach (COH). I started buying the stock recently at $25 and change and it’s the first time I’ve ever even considered buying shares. The stock traded at 25 or 30 times forward earnings whenever I looked at it. Even a 20% growth rate couldn’t convince me that it was a bargain at those levels.

The company has continued to hit its numbers and I expect more of the same when they report in early August. However, the stock took a dive along with the other retailers. Down from a high of $37, the stock traded at about 18 times 2006 estimates of $1.39 per share. Twenty percent growth in 2007, which I think is very doable despite the economic climate, puts the forward P/E at 15. While still a market multiple, a high end luxury goods leader like Coach looks attractive at such a price and even has $2 in net cash on the balance sheet.

I also want to mention a long time favorite, Sears Holdings (SHLD). Along similar lines, SHLD shares are down $30 from the highs set after they blew out first quarter estimates. Since the company is benefiting more from a turnaround in operational efficiencies, as opposed to shoppers banging down the doors at their stores, I expect another solid quarter when they report next month. We could very well get a post-report pop in the stock if such a scenario plays out, making the $30 correction look quite silly in hindsight.

Capital One Earnings Miss Shouldn’t Be Surprising

Capital One (COF) blew past earnings projections, reporting $2.86 versus the consensus estimate of $2.06 per share. Despite the beat, the company kept its annual guidance steady at $7.40-$7.80 for 2006. Some investors were disappointed that Q1 was so strong but the company was seemingly being conservative about the year. When asked, management expressed that they saw things being tougher and uncertain later in the year, prompting them to reiterate their guidance rather than raise it.

Fast forward to last night and investors should be not shocked that Q2 earnings came in at $1.78 per share, shy of the $2.06 estimate. Despite the company’s own guidance ($7.60), analysts were at $7.91 in EPS for the year heading into the report. The stock reacted by dropping $6 to $80 per share after last night’s report. Given what we saw and heard in Q1, the earnings miss should not be as surprising as some seem to think. The stock’s drop appears very overdone and I would suggest long term growth oriented investors pick up Capital One shares today at a sale price of $80, or 10 times earnings. Several years from now it will prove an excellent entry point, in my view.

Revisiting the Google/Yahoo Paired Trade

I’ve been experimenting with more and more paired trades in my personal accounts lately as the market overall hasn’t looked all that enticing to me over the last year or two. Yesterday I decided to take a position in the Google/Yahoo! trade that I have mentioned before on this blog.

At 42 times 2006 estimates, simply going long Google (GOOG) no longer has the risk-reward scenario that intrigues me. That said, Yahoo! (YHOO) stock at 62 times this year’s estimates looks even less compelling. There is little doubt that Google has been taking some market share from Yahoo! and many of the company’s recent quarterly reports have been lackluster as a result.

I decided to implement the long Google/short Yahoo! paired trade (at $403 and $32 per share, respectively) prior to both companies reporting their numbers this week (Google is due to release results on Thursday). YHOO’s second quarter reported last night looks unimpressive once again, but assuming that Google’s results will be equally as bad might very well be an overreaction.

I would expect that the P/E ratios of the two Internet search giants will eventually converge, which would yield a solid return from this trade. As always, opinions are welcome.

Even at Record Prices, Oil Stocks Barely Budge

If you are in the camp that oil will be heading back to $40 or $50 per barrel anytime soon, I’m afraid you are sorely mistaken. After hitting new record highs earlier in the week, crude prices are still above the previous highs set last hurricane season. Surprisingly though, energy stocks mostly sit decently below their 52-week highs.

I haven’t written about energy lately, but I am still bullish on the sector and recommend investors continue to overweight the group in their portfolios. Single digits P/E multiples coupled with attractive outlooks make the stocks very attractive, especially in a market where very few stocks have worked thus far in 2006.

Energy bears will focus on the lack of supply constraints currently in both the crude oil and natural gas markets. However, merely focusing on what the situation is right now misses the point. Barring a global recession, energy demand will continue to rise and supply will have a hard time expanding at a rate that keeps pace. Surely there will be periods of both low and high supplies, based on weather patterns and other factors, but investors should focus on the big picture. As long as annual oil demand continues to rise, and few new wells are discovered across the globe, the bull market for energy will continue.

As far as where to look for investment opportunities, I continue to focus on the producers and sellers of the actual commodity, as opposed to the equipment and drilling suppliers. Rig owners, for example, will profit based on day-rates, or the price of renting out their rigs. There is nothing stopping more rigs from being built, thereby reducing the prices the equipment companies can charge to lease them. And who knows what would happen to the fortunes of a company like Halliburton (HAL) after the Bush administration has left office.

Conversely, it is much more difficult to find new sources of oil. As a result, those exploration and production companies with the best assets will continue to thrive in a tight energy market. Leading E&P companies can be had for between 6 and 9 times earnings, quite a bargain if you ask me.


Will Earnings Help Alleviate the Geopolitical Selling?

Geopolitical concerns always spook the markets short term, but longer term investors most likely shouldn’t panic by making bold changes to their overall investment strategy. The situation overseas can change nearly overnight in some cases, and history shows that lost ground due to panic selling is often made up within several weeks or months.

After a nice rally off the June lows (around 1,225 on the S&P 500) it appears we will retest those lows, which would not be a bad thing. Rather than try and predict what will happen in the Middle East, I will instead be focusing on Q2 earnings reports. The three or four dozen companies I follow begin reporting on Monday. Recent stock price action suggests the numbers will be weak, but I am not convinced quite yet that will be the case, despite the negative reports thus far from the likes of Advanced Micro Devices, 3M, EMC, and Alcoa.

If we look back three months ago, I was pleasantly surprised by how well the companies I owned did. Stocks were mostly flat to slightly down after reporting profits in-line or above expectations. Several blowout quarters were rewarded nicely by the Street, and most importantly, there were only a handful of poor reports.

I don’t see a lot that has changed over the last few months, so my gut says that the reports won’t be as bad as stock prices are currently indicating. Of course, that doesn’t mean they will all pop to the upside if numbers are solid, but it would give me comfort in an otherwise tough market environment. In addition, there have to be at least some cases where stocks will react very well to decent reports, just because the shares were pricing in bad results.

If I am right and this earnings season turns in a fairly decent performance, hopefully the market will stabilize. Right now I have no reason to believe we are heading below the 1,200-1,225 range on the S&P 500, which is 1%-3% lower than current levels. The low end of that range represents an official 10% correction from the highs, and the high end signifies a successful retest and holding of the aforementioned June lows.

Post-IPO, Investment Banks Bash Vonage

“Many investors forget that most IPOs utterly fail to live up to their promise after they are issued. A study by Tim Loughran and Jay Ritter followed every operating company (almost 5,000) that went public between 1970 and 1990. Those who bought at the market price on the first day of trading and held the stock for 5 years reaped an average annual return of 11 percent. Those who invested in companies of the same size on the same days that the IPOs were purchased gave investors a 14 percent annual return. And these data do not include the IPO price collapse in 2001.”

[Source: “Stocks for the Long Run,” Jeremy Siegel, 2002]

The fact is often ignored, but IPOs are bad investments on the whole. The real money is made only on the hottest deals, but only an investment bank’s best clients get shares at the offering price for those stocks. With hype and exposure at a peak, the sellers can usually succeed in getting top dollar, leaving individual investors set up for below-average returns.

Vonage (VG) is one recent example. The underwriters valued the firm at $17 per share when the company went public. Now only weeks later, the same banks’ analysts have initiated coverage of the stock with neutral ratings and price targets between $9 and $11 per share. Aside from some bad publicity, nothing about the business has changed.

The Vonage example just goes to show you that, like most things where money is involved, people selling you something have inherent conflicts of interest. They are trying to maximize their cut. The only way to ensure you get a good price is to do your homework. I’d guess that at least 90% of the people who bought the Vonage IPO at $17 did no valuation analysis whatsoever.

Those that did were correct in avoiding the deal, as the current $7 share price shows. If the stock was really worth far more than $17, don’t you think they would have sold it for more than that? Retail investors need to be careful with IPOs, as history is not on their side.

Is an IPO in MySpace’s Future?

I was shocked to hear that was the most visited U.S. web site last week. I am well aware of the site’s popularity (and even have an account on the site), but still, finishing ahead of Yahoo! Mail and Google Search is pretty darn impressive. It appears that News Corporation (NWS-A) got the deal of the year when it purchased MySpace for $580 million in 2005.Should investors go out and buy News Corp stock at $19 per share? Maybe. The only problem with that idea is that NWS has a market cap of $60 billion, so MySpace still is only a small fraction of its business. How much is MySpace worth? I really don’t know, but it would not shock me in the least if it could get a $5-$10 billion market value on the public market.

If I were running News Corp, I would probably strongly consider spinning it out in an IPO to monetize the asset and boost shareholder value, especially since the site is really coming into its own right now. Will an IPO happen? I haven’t heard anyone mention the idea yet, but would not be surprised if we do soon. Meanwhile, kudos to Rupert Murdoch for such a great move.

Heading into Earnings Season

This week marks the start to earnings season. Much will be made of the possibility for yet another quarter of double digit gains in profits for the second quarter. Still, I would not expect a meaningful market rally as these reports come in, even if we do end the quarter with 11 or 12 percent growth, which I think is likely. The bulls screaming that the market is cheap at 14 times forward earnings are overly optimistic, in my view.

First of all, you can only get a P/E of 13 or 14 if you use operating earnings, which is basically the number companies report after stripping out many various items that negatively impact earnings. If you use GAAP numbers, the S&P 500 is trading at 16 times this year’s estimates, and 15 times 2007 projections. That makes the market fairly valued, based on historical context, not cheap. With double digit profit growth in 2007 unlikely, you can see why I don’t think this market will soar to new highs anytime soon.

Okay, so how do investors play this market? I would focus on stocks that have below-average valuations and with whom you have a high level of confidence that they will at least hit, if not beat, their numbers. Such a strategy gives you the potential for either multiple expansion (which the S&P 500 will not provide) or earnings per share revisions to the upside (which can lead to share price gains even if multiples stay where they are). Obviously, the double play would be to get both.

Finding names that fit this description is not an easy task, but it’s really the only way to make good money in this range-bound market environment.