Insane Valuation Case Study: Valero Energy

It is pretty easy to find ridiculously low stock valuations in today’s market, but here’s an example of the value present in the current bear market. Valero Energy (VLO) this morning reported third quarter earnings of $1.86 per share, well above estimates. The stock closed yesterday at $15 per share, which gives it a P/E ratio of 8 based solely on one quarter’s worth of earnings! Insane.

Full Disclosure: Peridot was long VLO at the time of writing, but positions may change at any time

Part of TARP Finally Ready To Go

In recent weeks there has been plenty of talk about the Treasury’s TARP initiative, but little progress on its actual implementation. On Friday we got news that PNC Financial (PNC) was the first bank to get a capital infusion from the TARP, and would use much of the cash to help fund its acquisition of troubled banking competitor National City (NCC).

I have previously written highly of PNC stock and this deal only furthers my bullish long-term view on the company. They are paying about $2 per share for a bank that traded at nearly $40 last year and fits their geographical footprint very well. PNC’s track record on successful acquisition integration is outstanding. As with the other strong banks buying weaker ones, loan losses will rise with the deals and that trend will continue for a while, but long term the buyers will only enhance their competitive positions in a marketplace that will have far fewer players overall when the dust settles.

Today we are learning about more banks raising capital through the TARP, Capital One (COF) and SunTrust (STI) among them. Don’t be surprised if Capital One makes an acquisition in coming months as well. They have indicated they are looking at potential deals and have raised money twice in recent weeks.

Hopefully the equity market can begin to gain some traction as some of these plans are not just announced, but more importantly, actually implemented.

Full Disclosure: Peridot was long shares of COF and PNC at the time of writing, but positions may change at any time

Watch the 2002, 2008 Intra-Day S&P 500 Lows

The forced selling and mass liquidations are continuing, with the pre-market futures trading limit down this morning. October has always been the most volatile month of the year, and investment fund fiscal years end a week from today (as opposed to a normal December year-end).

Don’t fool yourself into thinking the market action here is based on fundamentals, because everything we are seeing is simply irrational behavior based on forced selling. Buyers are balking because once things become irrational, there is no inherent floor to prices.

If you want to watch specific levels, the 2002 S&P 500 low was 768. The 2008 low so far was 839. The S&P 500 closed at 908 yesterday, and traded limit down (60 points) to 855 this morning. If we don’t hold those levels, another round of computerized sell programs will likely hit the market. The support there should be strong, but in this market, who knows what will happen.

Update: 10:00am — Here is a graphical representation of the last two decades:

Analysts Still Nuts With Their 2009 Earnings Projections

One of the reasons sell-side analysts on Wall Street are usually pretty bad at picking stocks is because they are reactionary, not anticipatory. Remember, the market is forward-looking, so what already happened is irrelevant.

Here we are, in a recession, and by most accounts the economy will stay bad well into 2009. And yet, the consensus estimate for 2009 S&P 500 operating earnings stood at $100.90 as of 10/14. That compares with a 2008 estimate of $75.94, which means the sell-side is projecting earnings growth next year of 33%. Absolutely nuts, right?

The problem is that analysts won’t ratchet down their numbers until the companies actually come out and give specific 2009 guidance (they wait to be spoon-fed it, rather than anticipating it ahead of time like the market does). In such an uncertain economic environment, firms are uneasy about projecting earnings for this quarter, let alone next year. As a result, we have everyone on Wall Street well aware that 2009 earnings for the S&P 500 will be nowhere near $101 (hence the market has tanked), except the analysts won’t tweak their official forecasts ahead of time.

Look, how long the bear market lasts will likely depend on how long the economy stays weak, but how far the market ultimately falls during the bear market will depend, in large part, to how far earnings fall. As you can see below, S&P 500 operating earnings peaked way back in 2006 before oil prices spiked and hurt many companies who have oil as a major input cost.

S&P 500 Operating Earnings:
2005A: $76.45
2006A: $87.72
2007A: $82.54
2008E: $75.94
2009E: $100.90

Obviously the 2009 number is crazy, but how far will earnings drop? The headwind is the recession we are facing, but with that we are seeing commodity prices come crashing down. That will help profit margins at most companies because their expenses will drop alongside their revenues.

Even if we see a recession during most of 2009, earnings might hold up better than some pessimists think. If that is the case, it should put a floor under stock prices next year, even if we hover along that floor for a while. So, the thing to watch is not whether $101 of S&P 500 earnings is doable in 2009 (it isn’t), but rather if we can manage $70 to $75, which would make some of the more dire predictions of $50 or $60 overly pessimistic.

Surprisingly, Apple Shares Jumping After Bleak Guidance

I closed out the Apple (AAPL) position in my blog model portfolio in August at more than $180 per share after a 52% gain and also trimmed my clients’ AAPL holdings at that time, but after the stock has been beaten up in the latest sell-off, searching for a re-entry point seems like a worthy endeavor.

Apple has always sandbagged guidance. The market had gotten used to it and never really punished the stock after earnings reports that handily beat quarterly earnings but issued forward quarter guidance below expectations. That all changed three months ago after Apple issued guidance that was overly conservative, even by their standards, and the stock got crushed.

Trading in the low 90’s during yesterday’s pre-earnings trading session, investors expected more of the same. Apple’s guidance had been for $8.0 billion in sales and about $1.00 of earnings. The company actually reported $7.9 billion and $1.26. Analysts were at $1.65 for the current quarter and many figured Apple would guide to $1.30 or $1.40.

Given the uncertain economic environment, coupled with last quarter’s overly conservative guidance, I figured this quarter’s guidance would be equally uninspiring and investors would get a sell-off in the stock, perhaps well into the 80’s, which in my view would be a great entry point. As a result, I did not buy any Apple shares during yesterday’s weakness.

Apple guided this quarter to between $1.06 and $1.35 last night. Compared with current consensus of $1.65, this looked perfect for my thesis. Even if Apple beats its own guidance handily, there is little chance they will actually beat $1.65, so what would prompt the stock to rise?

Well, oddly the stock is up $8 in pre-market trading this morning to about $99 per share.
I guess the numbers could have been worse. Perhaps everyone who wanted to sell Apple has already done so. Still, I would not be a buyer up 8 points in a down market today.

Personally, I think a very conservative fair value estimate on Apple stock, in today’s economy and market environment, is around $100 per share. I get there by taking 15 times net trailing operating earnings and adding in the company’s huge $24.5 billion cash hoard. If the stock gives up today’s early gains, Apple bulls should take a hard look at the stock, in my view.

Full Disclosure: Peridot was long shares of Apple at the time of writing, but positions may change at any time

Yes, Oil Demand Should Keep Growing

A few months back we had people calling for $150 and $200 oil, but now many people are saying $50 or $60 is not only possible, but likely. What a difference hedge fund liquidations and a recession can make. Is the oil bull market over, or just put on hold due to an impending global recession? My best guess is the latter.

Consider the charts below. They show crude oil consumption for this decade, with current 2009 estimates included. The first one shows oil consumption in the U.S. which isn’t very impressive and screams lower prices. After all, we represent 5% of the world’s population but consume 25% of the world’s oil.

Not so fast though. Here is a chart of oil consumption worldwide. It shows a much different picture.

Will the current recession result in a reversal of this graph? Probably not to any large degree. The line will flatten surely, and perhaps even dip slightly, but by the time that happens any global recession will be mostly over and demand growth will be set to resume alongside economic growth. Long term I still think the oil bull market remains intact until we truly start replacing large amounts of oil consumption with alternative fuels.

Airline CEOs: Hedge Your Fuel Costs Now

We have seen crude oil prices fall 50% from $150 to $75 per barrel. Aside from Southwest Airlines (LUV), my preferred air carrier for many years (for traveling, not investing), the other airlines missed the boat on hedging fuel costs and paid the price as the oil spike wiped away their profits after the last round of bankruptcies. If they were smart, they would begin hedging right now. Given the economic problems we are facing and the fear of a global economic recession, oil is on sale due to temporary factors and global demand is still growing (more on this in coming days).

Sure,oil could get even cheaper in 2009 as the economy weakens, but that would be the time to increase the hedges further as prices fall. Once the economy rebounds we will see $100 oil again and those who hedged will look very smart. Legacy carrier CEOs might not be used to being called smart, but they certainly should give it a try.

If any airline workers are reading this, pass along this advice to your bosses. Airline CEOs: start hedging your fuel costs now and increase them should oil prices continue to fall during the recession. Global oil demand is not going to start falling anytime soon, and falling gas prices today are just going to reaccelerate the demand growth that has fueled the commodity bull market.

Full Disclosure: No position in Southwest Airlines stock at the time of writing, but positions may change at any time. I do, however, have a Southwest Visa card in my wallet.

Warren Buffett Op-Ed Explains Why He Is Buying, Not Selling

Warren Buffett’s Op-Ed in the New York Times today is a must read. He echoes many of the same thoughts I offered in my quarterly letter to clients last week, but don’t take it from me, the Oracle of Omaha feels the same way.

You can read the full piece here:

Some highlights:

In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary. So… I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

I haven’t the faintest idea as to whether stocks will be higher or lower a month or a year from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “skate to where the puck is going to be, not to where it has been.”

Strong Balance Sheets Make Hunting For Value Easier

During the last bear market (2000-2002) there were dozens of situations where individual stock valuations looked down right silly. This bear market will be no different, and long term value-oriented investors can take advantage of the fact that in times like these numerous bargains can be had, but most people are too afraid to take them.

A great way to find value in the market is to use enterprise values (market values after netting out the firm’s cash on hand and debt outstanding). Investing in companies with hoards of cash in the bank allow investors to get the operating businesses on the cheap. There are many examples of this, and I often talk about net cash positions of various stocks on this blog, but let’s use former Halliburton (HAL) subsidiary KBR (KBR) to show what I am talking about. I don’t own the shares, but it fits the description perfectly.

At $15 per share, KBR stock is down 66% from its 52-week high of $44 and sports a market value of about $2.55 billion. Earnings in 2007 were $1.08 per share, and are expected to jump to $1.72 this year and $1.98 in 2009. That quick glance shows that KBR appears to be a pretty cheap stock at about 10 times trailing earnings and less than 9 times current year projections, but KBR’s balance sheet tells an even better story.

As of June 30th, KBR had cash on hand of $1.85 billion and no debt outstanding. With a market value of only $2.55 billion, KBR’s enterprise value is merely $700 million. With $11 per share of net cash in the bank, investors who buy KBR at $15 per share are getting the firm’s operating businesses for the aforementioned $700 million, or only $4 per share. This for a company that has earned $428 million in operating income in the last 12 months.

A valuation of less than 2 times cash flow is truly silly, but in markets like the one we have right now, nobody really cares because they are too busy being concerned about overnight LIBOR rates and when the Treasury is going to start buying up assets from banks. What great news for long term investors who can seize on opportunities.

Full Disclosure: No positions in the companies mentioned at the time of writing, but positions may change at any time

Redefining The Word “Plunge”

The Associated Press has done just that. The dictionary definition of plunge is “to descend abruptly or precipitously.” If you had any doubt that some in the media are making the economic situation sound as dire as possible, consider the following headline:

Retail sales plunge 1.2 percent in September
Wednesday October 15, 8:42 am ET
By Martin Crutsinger, AP Economics Writer

Honestly, given the economic challenges we face, I consider a 1.2% drop in consumer spending to be pretty impressive. Wouldn’t a 5 or 10 percent drop have been understandable? I am not arguing the economy is in good shape (we are most likely in a recession right now), but let’s choose words based on their actual definition, please.