Round Two from Round Rock: 8,800 Layoffs at Dell

Earlier this week I wrote about the push by Dell (DELL) into the retail channel as a way to boost sales and gain traction against Hewlett Packard (HPQ). On Thursday the company beat estimates for their first fiscal quarter and announced the second prong of their turnaround plan; 8,800 layoffs (10 percent of the workforce). Although Dell has perfected the very efficient direct model, evidently the company has some fat it can trim, which should help offset any margin pressure from their plan to sell lower end desktop PCs in Wal-Mart (WMT) locations starting in mid June.

Assuming the consumer experience won’t be adversely affected by the job cuts, this appears to be a good decision, from a shareholder perspective at least (some employees obviously might feel otherwise). Dell stock jumped more than $1 in after-hours trading to over $28 per share. The stock isn’t cheap enough to peak my interest, but I wanted to take a quick look and see what kind of upside investors should expect if the turnaround proves successful. The moves the company is making have a good chance to give the company some upside to currently low expectations this year and into 2008. But how much is the stock worth?

The reason I say Dell shares aren’t that cheap is based in part to where companies like HP and IBM (IBM) are trading (15x and 14x 2008 estimates, respectively). What kind of P/E should Dell get based on those comps? I would say 15 to 16 or thereabouts, but the good ol’ days of a 25 or 30 P/E for Dell seem to be over.

As far as earnings go, I decided to be pretty aggressive on this assumption, giving the company the benefit of the doubt regarding its new restructuring plan. Current forecasts call for about 2% revenue growth this year, followed by 6% in 2008. Changes at the company likely won’t produce results overnight, so a re-acceleration in sales is likely to be more pronounced in 2008. Let’s assume they can grow sales 10% next year, to more than $64 billion.

Furthermore, let’s assume that Michael Dell can get the company back to peak operating and net income margins. Profits peaked at 6.4% of sales in 2005 before dropping to below 5% last year. Assuming 6.4% margins on $64.3 billion in sales for 2008, the company gets to earnings of $1.83 in 2008, well above current estimates of $1.49 per share. Assign a 16 P/E and the stock price would be above $29 per share. Even if we stretch the P/E to 18 (Dell used to trade at a premium when they were tops in the industry, so this is plausible if they regain their former glory) there is upside to $33 per share, about 16% above the current quote of $28 and change.

The bottom line: Dell stock could definitely keep rising if their turnaround efforts pay off in coming quarters, but make no mistake, this isn’t going to look like the 1990’s by any means.

Full Disclosure: No positions in any of the companies mentioned at the time of writing

Despite Harsh Words from Critics, Share Buybacks Remain a Great Way to Boost Earnings and Share Prices

You might know Herb Greenberg, an often quoted columnist for MarketWatch and a frequent guest on CNBC, as someone who focuses on telling the bearish story on the market. Although I’m about to refute one of Herb’s recent blog posts entitled “AutoZone: Sustainable Model?” regarding auto parts retailer AutoZone (AZO), I will admit that there are not enough people out there telling people what could go wrong. Wall Street is too often about selling stocks to people, and with that comes a bias toward making the bullish case for an investment, not the bearish one. Although betting against stocks stacks the odds against you, Herb makes it his duty to tell the other side of the story.

In the case of AutoZone, here is what Herb had to say about the company on May 22nd:

“Earnings per share beat estimates, yet again, thanks to buybacks. Who cares about sales missing estimates? Who cares about sales per square foot that are either down or flat year-over-year for 12 consecutive quarters? Or inventory turns at a multi-year lows? Or sliding sales per store? Or continued weak same-store sales? All that matters, in a buyback story, is earnings per share. “The point,” says one longtime skeptic, “is whether that’s a sustainable business model. Anybody can do this for some finite period of time, but only the ‘productivity loop’ (as exemplified by Wal-Mart in its heyday and others) has proved sustainable.”

Herb does have his facts right, AutoZone has not been greatly improving their sales or inventory turns for a long time. However, when trying to judge the merit of a bearish argument, you have to ask, does any of this stuff matter? From reading Herb’s post, it is obvious that he, as well as the long-time skeptic he quotes for the piece, believe that it does matter in terms of the future for AutoZone stock.

Noticeably absent from the piece, however, are any reasons why sales, sales per square foot, inventory turns, sales per store, and same store sales do matter, or why share buybacks are bad. He simply states that a business model that focuses on buybacks, and not sales or inventory, is not sustainable. There is nothing there that explains why it isn’t sustainable. Why may that be?

If you do some digging into AutoZone’s financials over the last fifteen years, you will see that the model is sustainable. The company has been focusing on stock buybacks since 1999. This year will mark the ninth straight year that choosing buybacks over sales growth has worked for them. The argument that the model isn’t sustainable simply does not hold water because the evidence, which I will detail below, points to the contrary.

Now, why has the model worked? Why has it proved wise for AutoZone to reinvest excess cash into its own shares rather than new stores, or other projects focused on traditional retail metrics? Because buying back stock will boost AZO’s earnings more than opening a new store, or implementing new inventory management software will. And when it comes to getting your share price higher, earnings are what matters, not sales, or comp store sales, or sales per square foot, or inventory turns.

Herb writes “All that matters, in a buyback story, is earnings per share.” That is only partially correct. All that matters, in the stock market, is earnings per share. Stock prices follow earnings over the long term because owning a share of stock entitles you to a piece of the company’s earnings. Not sales, but earnings.

Let’s take a look at AutoZone in more detail. The company’s history since its IPO in 1991 tells two distinctly different stories. From 1991 through 1998, AutoZone focused on traditional retail metrics, the ones Herb and his skeptic friend believe are important when evaluating a stock’s investment merit. During that time, sales compounded at a growth rate of 22 percent per year, with same store sales averaging 8 percent growth. Stock buybacks were not used, resulting in total shares outstanding rising each and every year due to option grants.

However, in 1999 AutoZone began to focus on stock buybacks, an effort that was very much an idea from a relatively unknown hedge fund manager by the name of Eddie Lampert, who had begun to amass an investment position in AutoZone stock. Lampert understood the retail sector well, and knew that industry experts loved to focus on same store sales and other metrics like that. But he also knew that such metrics had very little correlation to stock market performance, and as an investor, that is all he really cared about.

As a result of pressure from Eddie and other investors, Autozone began to implement a consistently strong buyback program. Total shares outstanding peaked in 1998, fell year-over-year in 1999, and have fallen every year since. Not surprisingly, with a new focus on share buybacks, there was less cash flow left over to improve store performance in ways that would be reflected in same store sales, sales per share foot, and inventory turn statistics. Not surprisingly, since 1999 sales have only averaged 8 percent growth per year, with same store sales compounding at a 3 percent rate. Both of those are far below the levels achieved before the buyback era began at AutoZone.

So the punch line of course lies in what happened to AutoZone stock during these two distinctly different periods. Herb Greenberg and other long-time skeptics would have you believe, without evidence to support their claims, that sales and inventory matter to Wall Street. I am writing this to prove to you that such arguments are wrong.

AutoZone’s stock ended 1991 (the year of its IPO) at $10 per share and reached $26 by the end of 1998, for an increase of about 150 percent. The buyback program reduced share count for the first time in 1999 and today the shares fetch $127 per share, an increase of about 390 percent from 1998. How could this be the case if sales growth and other metrics of retailing health were so much stronger in the earlier period?

The answer lies in the effects of the buyback program. Share count peaked in 1998 at 154 million and now sits below 70 million. So, if you bought 10% of AutoZone at the end of 1998 and held those shares until today, you would now own 22% of the company, without buying a single additional share. And although AutoZone’s sales growth has slowed in recent years, the company is still larger now than it was then, so shareholders not only have seen their ownership stake more than double, but the entire company is worth more today than it was in 1998.

Hopefully this explains why retail metrics like sales don’t really matter when it comes to share price appreciation. Earnings are all that counts, not just in a buyback story, but in any story involving the stock market. I believe Herb when he characterizes his source as a “long-time skeptic” of AutoZone. He likely has been bearish on the company ever since they decided to put buybacks ahead of sales on their priority list eight years ago. However, the skeptics have been wrong for many years and the reason is pretty simple; the buyback model has proven to be quite sustainable.

Full Disclosure: No position in AutoZone at the time of writing

AutoZone vs S&P 500 Since Market Peak in March 2000

“The Long Tail” by Chris Anderson is Worth a Read

If you ever wanted to read an interesting, in-depth explanation as to why many business ideas far exceeded expectations and became so successful (examples that come to mind include Amazon and eBay), I highly suggest you read The Long Tail by Chris Anderson, a book I just finished this weekend. The editor of Wired Magazine, Anderson explains why companies that have focused on the long tail of product demand curves, rather than only the most popular “hits” in categories such as movies, books, and music, have tapped huge levels of profitability despite far fewer units sold.

Advances in technology, the Internet in particular, have greatly enhanced our ability to distribute thousands more items than ever before. The result has been, and will continue to be, according to Anderson, a shift in customer tastes from hits to choice and selection. Niche markets, often ignored by large media companies, have become more profitable than bestsellers and companies striving to serve those markets well are thriving like few thought they ever would. The Long Tail is an excellent book for those who want to better understand how retailing is being revolutionized by technology, and which companies stand to benefit from these changes.

Wal-Mart is an Unlikely Answer to Dell’s Problems

After handing off the CEO post to Kevin Rollins at Dell (DELL) for a few years, founder Michael Dell has returned to try and help his company find its way back to the top. Dell came out of nowhere in the 1990’s to overtake the likes of Hewlett Packard (HPQ) and IBM (IBM) in the PC market and earned the number one spot in worldwide market share. However, customer service issues have hurt the company in recent years and a reinvigorated Hewlett Packard (thanks to the entrance of Mark Hurd) now holds the top spot.

So what is Michael Dell’s master plan to get back to the top? Last week we learned that the company will begin selling several desktop models in 3,000 Wal-Mart (WMT) stores nationwide. Upon hearing the news I couldn’t help but ask myself, “How is that going to help Dell solve its problems?”

After all, the company built its business perfecting the direct distribution model that Dell created in his University of Texas dorm room in the 1980’s (he subsequently dropped out). Furthermore, the company focused on the higher end corporate, government, and education markets, leaving the likes of HP, Compaq, Gateway (GTW), IBM (IBM), eMachines, and Packard Bell to fight over the low-end consumer segment. That market didn’t turn out to be a very lucrative one. Packard Bell no longer exists. IBM sold its PC business to Lenovo. Compaq was forced to merge with HP. A struggling Gateway bought out eMachines, but still is doing poorly.

Now we hear that Dell is entering the retail channel with what I would have to think (given Wal-Mart’s customer base) is a low-end desktop computer. This decision really doesn’t make a whole lot of sense to me. The company thrived by shying away from the exact area they now are going to go after. Let’s not forget that Dell at first refused to offer desktop models at $300 and $400 price points, instead focusing on higher margin products. They eventually gave in and also began using Advanced Micro Devices (AMD) chips (under Rollins), something they did not do for a long time.

It has been well publicized that Dell has lost market share due to sub par customer service. The company opted to outsource their customer support in order to save money, but the result was consumers waiting on the phone for hours and upon finally getting through, not really getting helpful information. Dell should really focus on what it is that lost them market share in the first place. You can’t argue that it was ignoring the low-end PC market, because Dell was number one years back when they were avoiding that segment entirely. If Dell doesn’t fix their image of having poor customer support, their market share numbers aren’t going to improve dramatically. Even if someone buys a Dell at Wal-Mart, a bad experience will ensure they buy HP or another brand the next time around.

All of that said, you can understand why Dell has decided to go the Wal-Mart route. If they think the key is to regain lost market share at HP’s expense, then selling computers at the world’s largest retailer would be a great way to boost unit volume. The only problem with that strategy is that profits won’t greatly improve and as long as customer support remains lousy, new customers won’t result in a high percentage of repeat business, which is really something Dell needs to maintain to sustain any sort of reemergence as the worldwide PC leader.

It seems to me Dell is focused on a short-term impact, something that can score a few points of market share. While that may be attainable, they run the risk of not really improving the overall Dell experience, either as a shareholder or as a computer user. And without that, a Dell turnaround might be very, very difficult.

Full Disclosure: No positions in any of the companies mentioned at the time of writing

Market Fails to Dismiss Double Top Scenario

About a month ago I mentioned that it was possible the market could find resistance near the old highs on the S&P 500 index and perhaps make a seven-year double top. Interestingly, yesterday marked the third straight day the market could not register a new closing high on the S&P 500 (1,527 and change).

I’m not really into short-term market predictions (You’re better off just flipping a coin if you want to know what will happen in coming days), but we are setting up for a near-term top unless we can break through this level. Oddly, the all-time intra-day high is above 1,550. That must have been a wild day back in March 2000.

Here is what the last decade looks like on the SPX:

Usually a Contrarian Investor, Kerkorian Takes Aim at Bellagio, City Center Instead

In recent years billionaire investor Kirk Kerkorian and his investment company Tracinda Corp. have been focused on potential value in beaten down automobile companies like General Motors (GM) and Chrysler. However, despite a huge upward revaluation in Las Vegas properties during that time, evidently he still sees value in that area.

Monday we learned that Kerkorian is interested in acquiring the Bellagio hotel and casino as well as a new development project, City Center, which is set to open in 2009. Kerkorian is the majority owner of MGM Mirage (MGM) with a 56% stake in the gaming giant, worth about $10 billion before his intentions were made public. MGM shares rallied 10 points in after-hours trading Monday to $73 per share on the idea that Tracinda might wind up taking MGM private at some point down the line.

The announcement is interesting given Kerkorian’s recent foray into domestic car companies at very depressed prices. MGM Mirage is not a cheap stock (about 12 times 2006 cash flow) but has many growth opportunities ahead, both in Vegas and abroad in Macau. Such a move indicates that he is not worried about a severe economic slowdown, which would almost certainly adversely impact the boom in Las Vegas and Macau that has been very strong during the current worldwide economic expansion. With Kerkorian still willing to buy at these levels, he must think those predicting doom and gloom on the economic front aren’t likely to be vindicated anytime soon.

Full Disclosure: No position in MGM Mirage (unfortunately) or any other company mentioned at the time of writing

Until Consumer Habits Change, Energy Stocks Should Continue to Shine

It’s amazing that gas prices hit $4 per gallon in Chicago and San Francisco even before the summer driving season officially started. There are several reasons why we are paying so much to fill up our gas tanks but the one that I think is most important is not talked about as much as it should be.

As you can see, SUV sales as a percentage of vehicle sales has more than doubled over a ten-year period. Since SUVs are far less fuel efficient than cars, they account for a large portion of the increased oil demand in the United States.

There is no doubt that the Iraq war is contributing to high energy prices (oil production there is below pre-war levels), as is rising demand from emerging economies like China and India. However, the habits of the U.S. consumer is the largest contributor to our country’s sky-high energy use, and as a result, record-high prices. After all, what we do in this country has a profound effect on the energy market. Despite only representing 5% of the world population, we consume 25% of its oil.

The way I see it, the culprit is the rise of the sport utility vehicle in the United States. Many people who drive SUVs are quick to complain about paying $60 to $70 or more to fill up their tanks each week and accuse the oil companies of gauging prices (which is a ridiculous, baseless claim), but they are a large part of the reason gas prices are north of $3 per gallon nationally as I write this.

If you don’t believe that America’s love affair with SUVs is affecting gas prices, one glance at the numbers might change your mind. The statistics below are from the Environmental Protection Agency (EPA), an organization that tracks U.S. energy use very precisely. I don’t think it is just a coincidence that there has been a direct correlation between SUV sales, petroleum use, and gas prices. After all, the oil markets are based on supply and demand. With worldwide supply flattening out, demand is crucial in determining price levels.

I am not a fan of heavy government involvement as far as dictating human behavior is concerned, but I would not be opposed to increasing incentives for people to ditch their SUV, as well as higher CAFE standards for fuel efficiency. If we could reverse the trend of SUV prominence, oil demand is this country would drop, and prices would follow suit.

For those who need to drive SUVs, that’s fine, but they need to understand that higher gas prices might be a cost of driving a larger vehicle, and that blaming the oil companies for high prices is ignoring how the global oil market works. The biggest improvement could come from those who own SUVs without a real need for it.

Until driving habits in the U.S. change, gas prices will remain high and oil companies will continue to reap the benefits on their income statements. As long as the trend shown in the graphic above remains intact, investors should continue to hold a healthy dose of energy stocks in their portfolios.

Microsoft Bid for aQuantive Signals Desperation

This stunning bid for online advertising firm aQuantive (AQNT) by Microsoft (MSFT) seems to stem from simply missing out on deals that competitors have made and feeling the need to get something, anything, done. After talks with Yahoo! (YHOO) went nowhere and Google (GOOG) bought Doubleclick for $3.1 billion, Microsoft had two options if they felt they needed to keep up with everybody else; buy aQuantive or Valueclick (VCLK).

Not only did they go with aQuantive, but they paid an astronomical price. Shares of AQNT were trading at $36 yesterday and that quote was pricing in a lot of buyout speculation already. Somehow they got Ballmer and Company to offer more than $66 per share in cash, an 85% premium. Such a bid puts Mister Softy on the hook for a cash outlay of $6 billion. In return it gets a business at 104 times trailing earnings, 86 times current year earnings, and a whopping 67 times 2008 earnings.

Is it a good move, given the price tag paid? I can’t see how it could be. Based on 2006 sales figures, AQNT will represent less than 1% of Microsoft’s revenue. This deal can hardly move the needle for them, in my view. Sure it will add some expertise in a field that the company is struggling with, but given that this deal is just being done to keep up with acquisitions already announced by competitors, Microsoft is just keeping pace with rivals, not gaining on them.

Buying Yahoo! would have been a better option. There aren’t any comparable deals Google could have done to match a Yahoo! purchase by Microsoft, so that would have actually closed the gap. I don’t think this aQuantive deal does that. And given the price they paid, I wouldn’t be too happy if I was a Microsoft shareholder.

The only positive coming out of this announcement, unless you are long aQuantive shares (congrats to all of you), is an opportunity for merger arbitrage traders. AQNT is nearly $3 below the $66.50 offer price. Although no other bids are likely, the discount is more than 4% and the deal should close by year-end, so arb players can make an 8% to 9% annual return by waiting six months or so for the deal to close.

Full Disclosure: Long Google, short Yahoo!, and no positions in the other companies mentioned

Eddie Lampert Buys Citigroup Stake Over Last 12 Months

Thanks to quarterly SEC filings, we learned Tuesday that Eddie Lampert, Chairman of Sears Holdings (SHLD) and General Partner of the hedge fund ESL Investments, has been buying shares of Citigroup (C) since early 2006. At the end of the first quarter Lampert had amassed more than 15 million shares worth about $800 million. The filings show that Lampert began buying Citigroup in the first quarter of 2006 at prices in the mid to high forties. Today shares are jumping 1.7 percent in the pre-market to more than $53 each.

The purchase makes sense given that Lampert is a value guy (Citi trades at a 10 P/E and yields 4%) and his hedge fund is big enough that large cap stocks are the only kinds of investments that he can really take a meaningful position in without buying an entire firm. I’ve seen various press accounts of the Citigroup purchase speculating that Lampert is planning on using his stake to put pressure on the company to make significant changes. However, those hoping for shareholder activism on ESL’s part shouldn’t get too excited. Although $800 million is a lot of money, Lampert now owns less than one half of one percent of Citigroup. Hardly enough to play the hedge fund activism card.

Full Disclosure: Long shares of Sears Holdings and no position in Citigroup at the time of writing

Was Senator Edwards Being Hypocritical by Working at a Hedge Fund?

I’m curious what readers think about this. After coming up short in his bid to become Vice President in 2004, Senator John Edwards worked for Fortress Investment Group (FIG) as a consultant. Given that Edwards has been focusing his political campaigning on helping solve the poverty problem in our country, is he being a hypocrite by working for a hedge fund, whose main job is helping rich people get even richer?

I’m not sure where I fall on this issue. At first blush it does seem like a questionable decision on his part. However, does the fact that he worked for Fortress really mean he is somehow abandoning the poor? Fortress is going to do what they do regardless of whether or not Edwards is there. There is no way his role at the firm had any financial benefit for Fortress clients. He might have given them a well respected politician in their corner, but he didn’t boost their investment returns, so he didn’t directly help the rich get richer. That is going to happen regardless.

Of course, Edwards is going to say it was, in part, a learning experience. He clearly doesn’t have much financial markets knowledge. But he did admit that the money was nice too. Does someone who supposedly wants to help the poor have to purposely avoid earning a nice living because of his political platform?

It’s an interesting topic. I’m curious to hear what you all think. And I know it’s a political discussion, but let’s keep it polite, not partisan. We can speak in terms of politicians in general, regardless of party affiliation.