Even with Palm, Hewlett Packard Faces Uphill Battle in Consumer Electronics

After it was made public that smart-phone maker Palm (PALM) had put itself up for sale, most every rumored suitor was an Asian hardware firm such as HTC or Lenovo. The logic was that Palm had a strong set of assets that would be a good fit for a foreign company looking to make a splash in the U.S. phone market without having to build the business from scratch. When Hewlett Packard (HPQ) surprised the Street this week with an agreement to buy Palm for about $1 billion, some praised the deal while others expressed their doubts. To me, it makes sense that HP would buy Palm as a way to more quickly enter the market for mobile devices, but I really doubt that we will look back two or three years from now and say buying Palm really paid off for HP.

There is no doubt that HP is getting a large patent portfolio, a strong team of engineers, and a proprietary operating system in Palm webOS, and it is reasonable to assume that HP did not have other ways to acquire such assets for less than the price it is paying for Palm. However, the question really is whether HP can gain traction in an already crowded market for smart-phones and tablet PCs. Large hardware makers always seem eager to compete with the market leaders when new hot products come about but I do not think there is room for everyone.

Dell, for instance, is another computer maker that is developing both a cell phone and a tablet PC. HP is widely known to be developing a tablet and now with Palm it will be able to easily enter the cell phone market as well. Owning the operating system will make these products easier to control and produce than they were for HP before the deal (having to use Microsoft’s mobile operating system in their products raises HP’s costs due to licensing fees and gives them less flexibility in the design of the product), but companies like HP and Dell still face the challenge of bringing to market a product that people want more than a Blackberry, iPhone, or iPad.

The track record of large computer-focused firms trying to invade leading innovators’ turf is poor. Both HP and Dell have been trying for a long time to break into other consumer electronics but really have not been successful. Many companies were convinced that they could grab a chunk of the MP3 player market, even with Apple’s iPod as the best in class product, but companies like SanDisk (with their Sansa players) failed to gain much ground. Why would this trend change this time around? Do we really think a tablet PC from HP or Dell will be better than the iPad and therefore really hurt Apple? Can Barnes and Noble or Sony really take a bite out of the e-book reader market by dethroning the iPad or the Kindle?

It is highly unlikely that companies, no matter how large, can come along later with a me-too product and succeed. As a result, while we all can understand why HP buying Palm for $1 billion makes sense if their goal is to go after these markets, it is a lot harder to have confidence that such an endeavor will prove even remotely successful. For only $1 billion, which is mere pennies for a company as large as HP, they probably do not think it is a large risk to take. And they are probably right, on that front at least.

Full Disclosure: No position in HP or Palm at the time of writing, but positions may change at any time

Thomas Weisel Buyout Only Helps Bullish Case for Goldman Sachs Stock

Yesterday Stifel Financial (SF) agreed to acquire investment banking competitor Thomas Weisel Partners (TWPG) for about $7.60 per share in stock, a premium of about 70% for shareholders. This deal got my attention because I have written positively about Goldman Sachs (GS) lately and this deal reinforces my view on the undervalued nature of the investment banking sector. As is the case with houses, stock values are largely determined based on what are known as “comps” or comparable sales. You see how much your neighbors’ houses have sold for and use that as a yardstick for valuing your own house, or in this case, your own company.

One of my arguments for liking Goldman Sachs stock is that investment and commercial banks typically fetch between 2 and 3 times book value. The former figure is often used with gross book values, with the latter coming more into play when firms look at net tangible book values. In the 150’s, Goldman Sachs shares are trading at around 1.25 times book value, which to me seems like a very attractive price given their strong global franchise.

Anyway, back to the Stifel/Thomas Weisel deal. Stifel is paying $7.60 per share in stock, which equates to about 1.85 times book value and 2.1 times net tangible assets. Given the economic and political climate, it was not surprising to see this deal get priced at the lower end of the historical range, but I was still very happy to see that the range remained relevant in a deal that actually got done in 2010.

I think it is hard to argue that Thomas Weisel Partners, a small specialized investment banking firm, should fetch more than the leading global franchises such as Goldman Sachs or Morgan Stanley (MS). As a result, both of those large cap investment banks look attractive at today’s prices. To reach a price-to-book ratio of 1.85, Goldman Sachs shares would need to rise about 50% from current levels. Morgan Stanley is even cheaper and would need to rise by more than 60% to reach that valuation level. All in all, yesterday’s Thomas Weisel buyout offer only strengthens my bullish convictions on Goldman and it appears that Morgan Stanley fits the same mold as well.

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

Current Bull Market Now More Than 400 Days Without 10% Correction

For several months I have been holding elevated cash levels (above 10%) in most client accounts, due to the fact that the stock market appears overbought and has gone a very long time without a standard 10% correction. In fact, we have now gone more than a year without a 10% drop which is a long time historically. I decided to look at the data to see exactly how overbought this market is relative to other bull markets.

It turns out that the current streak of more than 400 days without a correction represents only the 14th time this has happened since 1928. Of those instances, the current bull market (up more than 80% from the March 2009 intra-day lows) places fourth on the list. The three stronger bull market streaks (1953-1955, 1990-1996, and 2003-2007) ranged from +97% to +131%.

Depending on your time frame, the current streak could be either alarming or unimportant. One could argue that the fourth longest streak in 82 years indicates near term problems on the way, but one could also conclude that the last streak of this length was only a few short years ago, so maybe it is becoming more and more common.

I prefer to look at the longest set of data we have, which is why I continue to hold above-average cash levels. The fewer data points you consider, the less reliable the data will actually be. This can explain a lot of things in various topics, including why there is such a heated debate about global warming right now. If you look at the last 5 years you might conclude that global warming is no longer happening. Conversely if you look at the temperature trends over the last 100 years, it is pretty obvious that global warming is occurring.

Looking at historical stock market data tells me that the current bull market is near the top of the list historically, but of course that does not mean stocks are going to fall anytime soon. Just three years ago the S&P 500 went 4 years without a 10% correction. Today it has only been a little more than 1 year. As a result, I prefer to hold extra cash to use should the correction come, but still have most of my clients’ capital invested in attractively-priced stocks.

Update: Goldman Sachs Indicates ACA Management Was Largest Long Investor in ABACUS

That was quite an interesting press release issued by Goldman Sachs (GS) after the closing bell tonight. All day today investors concluded from the details of the SEC’s fraud charges that Goldman worked with Paulson and Co. to weaken the composition of the ABACUS transaction in some fashion, perhaps in an effort to boost the odds that Paulson would profit from taking the short side of the trade. The SEC seemed to indicate, judging by the fact that it charged the Goldman employee in charge of the deal for lying, that someone from Goldman told ACA Management that Paulson was actually making a $200 million long investment in ABACUS. Goldman’s latest press release seems to tell a much different story. The side that makes their case the best could potentially make the other side look a bit foolish here.

What did Goldman claim tonight? First, they state that their firm lost $90 million on the transaction, as it had a net long position that soured when the CDO went bust. Next, Goldman denies that their employee ever told ACA that Paulson was taking a long position in ABACUS. That directly contradicts the SEC’s claim that ACA was told Paulson was going to be long alongside them, which if true, would seem to imply that ACA was fooled into thinking that collaborating with Paulson while structuring the CDO would not be problematic for them.

Another Goldman claim in the release seems to be the most important, in my view, if it is accurate. Goldman says that the single largest long investor in ABACUS was, believe it or not, ACA Management (with an investment of $951 million). If ACA truly was the largest long investor in the CDO, they had every incentive to structure the deal correctly (and Goldman is quick to point this out). In such a scenario, why would ACA ever allow Goldman and/or Paulson to hand-select mortgage securities for the CDO that might jeopardize their investment?

Now, it will take a lot of time to determine whether Goldman’s defense is true or not. However, their press release seems to make a bit more sense. If ACA was the firm that selected the portfolio, and also was the largest long investor in the CDO, the ABACUS deal goes from looking like a huge conflict of interest (as it did earlier today) to having interests aligned quite nicely. If you were the largest investor in a deal, it makes sense that you would want to be the firm that got to approve the mortgage securities that were included in it.

Did ACA consult with Paulson and Co. as well as other firms while structuring the deal? The Goldman press release essentially admits this to be true. Should those discussions have been disclosed in the CDO’s marketing materials? Maybe. But as long as ACA had the final say, it really does not seem to be a big deal.

After all, would it be considered fraud if a Wall Street analyst recommended clients buy stock in Company XYZ, but before doing so consulted numerous sources, including Company XYZ’s CEO? Would that single discussion with the CEO need to be disclosed in the analyst report in order to assure that investors knew that one of the analyst’s sources for the research was biased in their assessment of the company’s prospects? Of course not.

Like I said, we cannot take Goldman at face value at this point, just as we cannot take the SEC at their word either. After all, the SEC recently brought insider trading charges against high-profile Dallas Mavericks owner and high-tech entrepreneur Mark Cuban — and lost. If most of what Goldman has said in this latest press release can be proven, it looks like the SEC’s case this time around might not be a slam dunk either.

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

SEC: Goldman Sachs May Have Crossed the Line from Conflicted Investment Banker to Fraudulent Communicator

It always disappoints me when the financial media cannot wrap their hands around certain business stories. Here I am today watching the CNBC coverage of the SEC’s fraud charge on Goldman Sachs (GS) and the network has half a dozen reporters and anchors all talking at the same time and confusing what exactly was happening, even though they played the SEC’s conference call live on the air and it was pretty clear what was being alleging.

At any rate, let me review what exactly the SEC claims Goldman Sachs and its Vice President Fabrice Tourre did that was fraudulent in this particular case. The SEC is charging both the firm and the employee in charge at the time with omitting and misstating important disclosures related to the structuring and issuance of a CDO called ABACUS which was backed by sub-prime residential mortgage securities.

One of Goldman Sach’s most prominent hedge fund clients, Paulson and Co, actually helped create the CDO by deciding which mortgage-backed securities were to be included in ABACUS. In addition, Paulson and Co took a short position in ABACUS after it was issued, meaning that it helped structure a CDO that it planned on shorting.

Many on CNBC are incorrectly reporting that this clear conflict of interest is what the SEC is targeting in its complaint. In fact, Paulson and Co. is not being charged at all. Not only that, having a hedge fund help structure a CDO in and of itself does not violate any securities laws. Neither would it be illegal for that same hedge fund to short the CDO after it was created and sold to the public. While this is yet another situation where Goldman Sachs appears to be engaging in transactions that are filled with conflicts of interest with their various sets of customers, these conflicts are not illegal. Rather, they simply beg the question whether Goldman will lose customers due to the perceived conflicts.

All of that said, what exactly is the SEC’s charge related to? It turns out that in the marketing and disclosure materials prepared for potential investors in ABACUS by Goldman Sachs, it was claimed that ACA Management LLC, an independent third party expert in mortgage-backed securities, was hired to select which mortgages were packaged into the CDO. There were no disclosures made to investors that the hedge fund Paulson and Co. was also involved in selecting the securities.

Now you may be wondering why on earth ACA Management would agree to let a hedge fund assist them in structuring ABACUS, given that they are supposed to be an independent third party taking on such a job.  The SEC hints it may have the answer. They are charging that the lead Goldman Sachs employee on this deal told ACA that Paulson and Co. was going to invest $200 million in ABACUS, which would likely calm any fears they had about the interests of ACA and Paulson and Co. being aligned while they collaborated on the creation of ABACUS. Fabrice Tourre, the Goldman VP in charge of the deal, seems to have both omitted disclosures related to Paulson’s involvement, as well as misrepresented to ACA what Paulson’s investment objectives were once ABACUS was issued.

The key point here is that the SEC is charging Goldman Sachs with fraud related to the disclosures made (and not made) relating to the creation and issuance of ABACUS. Therefore, the obvious conflicts of interest here by themselves would not have been illegal had Goldman adequately disclosed to investors the true facts behind the creation of ABACUS.

Now, how does this news alter my opinion of the stock, if at all? Goldman Sachs shares opened today at $185 and are now trading down 15% ($25) to around $160 each. You may recall I wrote a bullish piece on Goldman Sachs back in March explaining why I was accumulating the stock in the 150’s. Until today that investment had proved very timely and given that even with today’s drop, the stock is still above my purchase price, I am not likely going to be doing any heavy bargain hunting at current levels.

If the shares fall back to around the 150 level or even lower as more people react to the SEC’s charges, it is quite possible that I would get more of my clients involved with the stock and/or add to existing positions for those who are already long. While I do not expect there to be much of a negative financial impact on the firm from these charges (Goldman’s fees related to ABACUS were only $15 million), it is reasonable to expect that customers of the firm will have even more questions about conflicts of interest surrounding Goldman’s dealings, including the possibility that other employees are lying about deals they are putting together personally.

Goldman surely has its hands full trying to alleviate these concerns with clients, but they can likely argue that this was an isolated incident involving a rogue employee and minimize the customer fallout from these allegations (as long as this proves to be an isolated incident rather than a pervasive problem at the firm). Given the stock’s valuation based on book value and earnings, I still believe it represents a solid long-term value for investors interested in owning part of the most dominant investment banking firm in the world.

Full Disclosure: Peridot Capital was long Goldman Sachs at the time of writing, but positions may change at any time. And yes, you can be assured that there are no material omissions or misstatements in this disclosure.

Homebuilder Stock Favorites with Data

This week I have taken a closer look at the valuation metrics for a dozen large publicly traded home building companies with a goal of identifying attractive investment opportunities to play the likelihood of a rebound in new housing starts over the next few years. As a value investor, I looked mainly at valuation data rather than fundamentals for each individual company. For the most part these stocks trade together as a group, so I am trying to find ones I think could outperform the sector based on a lower entry point price relative to the rest. The fundamental backdrop (i.e. housing market conditions) are likely going to impact them all in a similar fashion.

Below you will find a summary of the 12 stocks I looked at. I created my own screening criteria to weed out smaller companies, those with above-average debt levels, as well as those that, for some reason or another, have a valuation metric that is meaningfully above the rest of the group.

The four stocks highlighted in yellow are the ones that fit my criteria and therefore are the companies I am going to focus on for this investment thesis. The black boxes indicate a data point that eliminated a certain company from contention. Not all of the black boxes indicate bad metrics. In fact, they include market values below $1 billion (which itself is not a negative) as well as one outlier metric that actually indicates company strength (NVR trades at a premium to the group on a price to book basis because it has the strongest balance sheet). This does not mean NVR is a bad investment, but I eliminated it because I am not getting enough value in the market because investors have already identified NVR as being in a strong financial position. I did eliminate stocks with a high proportion of debt relative to cash and investment holdings, so that was a negative metric that I used.

As you can see, I have identified four home building stocks that appear to have strong valuations relative to the group as a whole. Among these companies there is not much valuation differential, so other factors may play into how I would go about choosing one to invest in for the longer term. As with most of my potential investment candidates, these housing stocks are contrarian ideas. The housing starts data is unlikely to rebound in the short term, so investors looking to play this potential improvement should take a multi-year view of the investment thesis.

Full Disclosure: Peridot Capital had no position in the common stocks of any home builders at the time of writing. However, clients of the firm do currently own positions in the debt securities of Pulte Homes, although positions may change at any time

More Housing Start Data from Hovnanian

After reading my housing starts post from yesterday, Hovnanian Enterprises (HOV) CEO Ara Hovnanian was kind enough to have his investor relations department send over some additional information on trends and demand for U.S. housing starts. Of course, we need to keep in mind that Hovnanian is a home builder, so they have a dog in this fight, but their data certainly jives with the other figures I have seen. Here are some of the more interesting data points included in their materials as it relates to what I wrote yesterday.

  • Average U.S. housing starts since 1971 have been 1.6 million per year
  • Demographers estimate new home demand of 1.7-1.9 million units per year going forward
  • Prior cycles all showed housing start troughs of at least 1 million units per year (1975, 1982, 1991), compared with about half that level in 2009, indicating an over-correction during this current housing cycle
  • Housing starts per capita have hit the 7th lowest level on record, with the prior six lows occurring during World War I, World War II, and the Great Depression

Now, one of the reasons we are likely seeing this “over-correction” in housing starts is due to the credit crisis and the huge number of foreclosed properties coming onto the market. Foreclosure filings are running at about 300,000 per month right now, which equates to more than 3.5 million foreclosed properties per year. As long as foreclosures are at such a high level, in my view, it is probably unlikely that housing starts could rebound to a more historically normal level. However, as the economy continues to improve and unemployment slowly drops, foreclosures will decline as well. At that point, there appears to be nothing in the demographic data that suggests that housing starts should not rebound to a level of at least 1.5 million annually over time, which is nearly three times greater than today’s annual run rate.

Later this week I will post some information on the dozen or so large publicly traded homebuilding companies I have taken a look at and will highlight a few that I think represent excellent ways to play an eventual rebound in residential housing starts.

Full Disclosure: No position in Hovnanian Enterprises at the time of writing, but positions may change at any time

Is a Boom in U.S. Homebuilding Coming?

Crazy headline, right? At first I thought the same thing. After all, with nearly 10% unemployment and a flood of foreclosed properties hitting the market, why would anybody need to dramatically boost new home construction anytime soon? Last week I saw a statistic from a former Goldman Sachs economist that estimated new home demand in the United States (from the combination of new household formation and the replacement of old homes) of approximately 1.5-1.6 million units per year. Given that the U.S. population is around 300 million, this figure does not really stand out as being unreasonable, and it is in-line with other forecasts I have seen.

In the short term, current inventory combined with foreclosures, weak loan demand from the recession, and tighter credit standards all contribute to the fact that new housing starts in the U.S. today are near record low levels, coming in at an annualized rate of around 500,000 per year. At some point, however, it does seem likely to me that housing starts would have to begin to trend upward toward that 1.5 million figure, which is three times the current annual run rate.

Before you dismiss this potential need for new homes as being years and years away, consider the graph below showing annual U.S. housing starts from 1991 through 2009.

ushousingstarts1991-2009
You can easily see the effects of the housing bubble (from the early 2000’s through the 2005 peak of more than 2 million units), which resulted in home construction far outstripping demand (by 400,000-500,000 units if you use the 1.5-1.6 million base demand estimate). However, we also see if we ignore the bubble period that housing starts of 1.5-1.6 million per year would simply put us back to the level housing starts were in the mid 1990’s, when the U.S. population was much lower than today.

Despite the foreclosure glut we have in many states nowadays, this chart makes me think that the current housing start rate of 500,000 or so per year really is not sustainable for any prolonged period of time. Such a thesis would lead one to consider analysing the leading homebuilding companies to try and find some attractive long term investment opportunities. Accordingly, I will share some data and thoughts on specific companies with you once I conclude my work on the leading publicly traded U.S. homebuilders. Do you have any favorites, or do you think this investment thesis is unattractive?