Business Week Reads This Blog Too

In the current issue of Business Week, dated 4/28, an article about Citigroup (C) mentioned my conservative $22 break-up value for Citigroup in an article entitled “Where Pandit Is Taking Citi.”

Although the piece failed to put the $22 number in context (it was the lowest of three projected scenarios I made – conservative, moderate, and aggressive), a special thanks to Business Week for reading this blog as part of their research.

If you would like to read the article online, I have included a link above. Links to my three Citi posts are below:

Citigroup Break-Up Analysis:
Part 1, Part 2, and Part 3

Full Disclosure: Neither a position in Citigroup, nor a subscription to Business Week, at the time of writing

Housing Price Stabilization Nowhere In Sight

March 2008 existing home inventory data was released this week and for about nine months now we have seen inventories hover around a ten month supply, as shown by my updated chart below.

Without declining inventories (prompted by sellers reducing their prices to more reasonable levels) we will not see stabilization in housing prices or improved loan performance in the banking sector. So for anyone looking for housing market improvement anytime soon, it looks pretty bleak on a national level. After all, basic economics tells us that when supply far exceeds demand, prices fall.

Merck’s First Quarter Report Substantiates View of Vytorin Overreaction

Back in February I wrote that Vytorin worries looked overdone and concluded that Merck (MRK) shares especially looked attractive. Since then the stock has dropped further (MRK is down 32% year-to-date as shown by the chart below), but yesterday’s earnings report from the company leaves my prior view unchanged.

Merck reported first quarter earnings of $0.89 per share, three cents above estimates. They also reiterated their 2008 profit view of $3.33 per share. So, MRK shares have lost a third of their value this year but Vytorin losses are not expected to meaningfully impact their earnings. Such a dichotomy makes me even more confident of my previous assertions.

Merck has lowered its 2008 projections for its share of income from the cholesterol joint venture which sells both Vytorin and Zetia by $700 million to account for the negative ENHANCE study results. While it may be too early in the year to know exactly if such a cut is enough, the fact that a $700 million hit leaves earnings guidance unchanged shows that Merck is not overly dependent on these two products.

In fact, being conservative and using the company’s low end of guidance for the joint venture, these two drugs will only represent 9% of Merck’s 2008 sales. Given they can adjust their cost structure (staff, marketing, manufacturing capacity, etc) quickly to reflect lower revenue expectations, it is not difficult to see how $700 million can have only a modest impact on overall profitability.

Merck shares today fetch $39 each, down from $57 at the outset of the year. The stock trades at less than 12 times this year’s expected earnings and yields about 4%. Yesterday’s report did nothing to sway my view from back in February. The MRK sell off still appears overdone.

Full Disclosure: Long shares of Merck at the time of writing

Two Big Reasons Why The Google Bears Were Wrong This Quarter

I am getting ready to hop onto a conference call here in a few minutes but Google (GOOG) shares are soaring 60 points in after-hours trading tonight after the company beat estimates on both the top and bottom lines, so I figured I would weigh in briefly. Bears on the stock have been insisting that the weak domestic economy was going to severely impact Google’s results, but this view ignored two very important points.

First, Google’s core market (online advertising) is not completely dependent on the economy. If the online ad market was mature already, then the bears would have been right. However, online advertising is still growing very quickly as a percentage of the overall advertising market. As a result, lower overall ad spending can actually occur simultaneously with growing online advertising, which is what Google is benefiting from. When you are taking market share, as Google is, those gains can offset much of the decline in corporate discretionary spending.

Second, Google gets 51% of its revenue from overseas. This helps them two ways; exposure to growing international markets, coupled with currency gains due to the weak dollar. In fact, we just saw great first quarter numbers from IBM (IBM), due in part to their very strong presence overseas.

Now, I am not saying Google is completely immune to a slowdown in the United States, that would be naive. However, when you get half of your sales outside the United States and you are taking market share domestically as well, the impact from a weak U.S. economy is not as dramatic as many would have you believe. And this is not only a Google phenomenon, it is a factor behind many of the strong earnings reports we have seen so far this quarter. Investors should keep these things in mind.

Full Disclosure: Long shares of Google at the time of writing

UPDATE: Friday 4/18 8:30AM

From Reuters:

“Jefferies & Co upgraded Google(GOOG) to “buy” from “hold,” saying the Internet leadershowed impressive improvements in converting Web searchers intoadvertising viewers and delivered stellar quarterly results, defying economic headwinds.”

Typical Wall Street analyst move… completely worthless upgrade with Google opening up $80 per share. Thanks, Jefferies!


Despite Writedowns and Loan Losses, Core Banking Businesses Remain Very Profitable

Since earnings season gets underway in full force this week, the headlines are going to look bad for the financial services industry as loan losses and asset writedowns lead to severe first quarter losses. However, investors need to focus on where these losses are coming from and how the core banking business is holding up during this mess.

I bring this up because the media would have you believe that the banking business is broken and loan defaults by consumers on their mortgages, credit cards, car loans, and student loans are crippling the banks. Interestingly, that is simply not the case.

Consider the first quarter earnings report from Wachovia (WB) issued this morning. The company reported revenue of $7.9 billion and a loss of more than $300 million, or $0.20 per share. That sounds bad, and it is, but digging deeper into the company’s income statement reveals that more than 90% of WB’s business remains extremely profitable, as you can see from the numbers below.

Why is this important? Because these three segments represent 93% of Wachovia’s business and all three are very profitable even in today’s economy. Now, should you simply ignore the losses from asset backed securities and leveraged loans? Of course not. Those losses are real and are resulting in capital infusions, equity dilution, and dividend cuts that are melting away shareholder value.

That said, the banking operations are here to stay whereas record levels of structured product issuance and leveraged loans are not. For those investors who are willing to take a long term view, these large banks are going to make a lot of money from their core businesses going forward, and investors need to take this into account when trying to value financial stocks. Wall Street will not ignore these short term losses in coming days, weeks, and even months, and they shouldn’t, but two or three years from now the core business segments highlighted above will be the driving force behind bank earnings, and as a result, bank share prices.

Full Disclosure: I do not have a position in Wachovia. I simply used their numbers as an example since they just reported this morning, before all of the other banks. Given that Wachovia purchased Golden West Financial and AG Edwards at the peak of the market, there are likely better investment opportunities in the banking sector, taking both fundamentals and senior management teams into consideration. That said, Wachovia’s numbers are relevant because most banks have similar profit margins in their core banking businesses.

Blockbuster Bid for Circuit City Makes Little Sense

The Wachovia (WB) news is garnering all the headlines today, but an interesting story is developing in the retail space; Blockbuster (BBI) is making a bid for Circuit City (CC) and taking the offer directly to shareholders after CC ignored the video rental giant’s repeated attempts to negotiate a deal.

A couple of different reasons come to mind as to why this deal is a bad idea. First, we have too many retailers in this country, which is why so many of them are marginally profitable, if profitable at all. The credit bubble we have experienced in recent years has led to more retail stores than can be supported in a typical economic environment. These excesses can only be corrected by bad retailers going away.

We have already started to see bankruptcies in the retail space (Sharper Image, Bombay, etc), which is a good thing. Blockbuster and Circuit City have thousands of poor performing locations. The solution to make these companies more stable financially is to shrink them, not keep them open. However, a merger proposal is a clear sign that Blockbuster thinks the synergies from a deal (if there are any, which is debatable) would slow the progress of their eventual demise, which is doubtful.

Secondly, why should we have any confidence that Blockbuster and Circuit City would do any better together than apart? There is no evidence that either retailer has any idea what they are doing. As a result, there can be little confidence from shareholders that either party would be successful in combining the two firms and seeing any benefit from such a move.

All in all, it is certainly a positive development that Blockbuster feels it needs to do something to improve its competitive position, but a deal with Circuit City likely isn’t a very viable solution.

Full Disclosure: No positions in the companies mentioned

Yahoo to Outsource Ads to Google for Two Week Trial Run

So much for Steve Ballmer’s attempt to get a Yahoo (YHOO), Microsoft (MSFT) deal done more quickly by making threats. Now it looks like Yahoo is really serious about fighting back (or they’re just pissed).

This afternoon we learned that Yahoo is going to use search advertising technology from Google (GOOG) on its own site for a two week test period. The goal of this trial, of course, is to see if Google’s system can boost Yahoo’s advertising revenue substantially. If it can then Yahoo certainly has some ammunition left as it tries to argue that Microsoft’s current bid actually undervalues the company.

It is pretty fascinating that in a few short years we have the old search leader (Yahoo) outsourcing its search advertising to the very upstart that took over the top spot (Google). What makes this even more interesting is that some are speculating that if the Google test is successful, Yahoo could choose to merge with AOL, not Microsoft.

Why would that make sense? Well, AOL looks a lot more like Yahoo than Microsoft does, so merging those two companies could yield sizable synergies and help them both slow their path down the road to irrelevancy. Time Warner (TWX) would also benefit not only by unlocking the value of its AOL unit, but also strengthening it by combining with Yahoo.

Google also wins under this scenario. They potentially could take over all of Yahoo’s search advertising, which clearly would be a positive growth driver. Google already manages AOL’s search advertising and owns 5% of AOL, so a Yahoo-AOL deal strengthens that investment too.

The lone loser here would be Microsoft, in their eyes anyway. Wall Street would likely cheer and send Microsoft shares higher. Remember, MSFT shares were in the mid thirties before the Yahoo bid and dropped to the high twenties on news of the hostile offer. The other option, of course, would be for Ballmer to raise his bid to try and squash an AOL deal.

Whether you own shares in these companies or not, if you are interested in how the Internet landscape is going to shift, this saga is pretty darn interesting. Stay tuned.

Full Disclosure: Long shares of GOOG, MSFT, and YHOO at the time of writing

Now rumors are that News Corp (NWS) could team with MSFT in a higher bid. Here is my question: Why did it take an unsolicited bid from MSFT for these Internet companies to actually start discussing bold moves to boost profits and shareholder value? These companies were perfectly fine making no progress competitively but now they all of the sudden have a “reason” to get creative and make some positive changes? Better late than never I guess, but these companies don’t need buyout fights to do something bold. Standing still against upstart companies (like Google was five years ago) is essentially moving backwards.

Motorola Valuation – Part 2

Last I month I asked the question “Are Motorola Shares a Bargain at Nine Bucks?” To help answer that I decided to do rough valuations for each of the company’s major business segments (mobile devices and networking/mobility). Carl Icahn has been involved with Motorola (in fact he won two board seats from the company this week) and has been calling for the firm to spin off its cell phone business, which they have agreed to do sometime next year. Hence, my desire to value each segment separately.

I came up with an ~$8 value estimate for the non cell phone division (Motorola Valuation – Part 1). With Motorola trading at $9 and change right now, the market is essentially saying the cell phone business is worth next to nothing. Below are my estimates for that segment. My main assumption is a 5% operating margin (half of the 2004-2006 average due to more intense competition nowadays) and relatively steady sales from here on out. As always, I try to be realistic, and this is by no means an extremely optimistic projection.

As you can see, the cell phone segment might not be worth anywhere near what it would have fetched between 2004 and 2006, but it does appears Wall Street is too pessimistic about Motorola. Investors are getting the business for less than $2 per share (according to my numbers), which should prove conservative if the new CEO for the phone business can get it back into the black as early as next year.

If you add my two segment valuations together, you get a per share value of $11.50 for Motorola, which is about 20% above current levels. I can understand Carl Icahn’s interest, although he clearly was too early on this one, getting in at much higher levels.

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

Microsoft, Yahoo Deal Hopefully on Fast Track

I can’t blame Microsoft (MSFT) for getting a little impatient with the top brass over at Yahoo (YHOO). Now that Microsoft has set a three-week deadline for making some progress (in a letter sent out this weekend), hopefully this whole thing will be concluded shortly.

For some reason, Yahoo seems to think they have leverage here. Their stock was in the teens, their business was deteriorating, they got a $31 per share buyout offer, and yet they are still quacking that MSFT should raise their offer. With no competing bids? Why would Steve Ballmer do that?

Yahoo should be thrilled that Microsoft is so keen on doing a deal. Deals with 60% premiums aren’t really open for renegotiation when there are no other interested parties, and this fact will force Yahoo’s hand.

Yahoo should simply come to the table and tell Microsoft that they’ll agree to sell, but that they will take no less than $31 per share in real economic value (MSFT is offering half stock, so the actual price is below $31 right now). Either MSFT offers 100% cash or they increase the share exchange ratio to ensure Yahoo shareholders actually get $31, not $28 or $29. Come on everyone, let’s get this done already.

Full Disclosure: Long both MSFT and YHOO at the time of writing