S&P 500 Index Reaches 1,500 Again: A Multi-Decade Triple Top

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If you are thinking we have seen this level on the S&P 500 index before, you are absolutely correct. As you can see, the last 16 years or so has been a roller coaster ride, with three separate bull runs to around these levels, and the prior two have ended badly thanks to bubbles bursting (dot-coms in 2000-2001, housing in 2008-2009). So do you want the good news first or the bad news?

The bad news is pretty evident from the chart. We have reached a triple top and U.S. stocks have now risen 125% from their lows made in March 2009. That is a huge move in just the last four years. It warrants being cautious in the short term, as the market does feel overbought here.

The good news is actually pretty good though. At the March 2000 peak of the dot-com bubble, the S&P 500 reached 1,553 and the index components earned $56 in profits. P/E ratio: 28 (the highest ever recorded). Students of market history should have realized that stocks were dramatically overvalued. (Author’s note: As a college sophomore at the time, I was less than well-versed in market history, so it was the beginning of my history lesson, and a very good one at that).

At the 2007 peak of the housing bubble, the S&P 500 once again pierced the 1,500 level, topping out at 1,576. Earnings for the index hit $88, giving the market a P/E ratio of 18. That is still a high valuation, but rather than being unprecedented, the market was simply at the top end of its historical valuation range. Dangerous, yes, but not unheard of.

You can see where I am going with this. Today the S&P 500 sits at 1,502 and 2012 earnings are likely to come in around $100. That P/E ratio (15) is only slightly above the long-term median of 14. So the U.S. stock market is not materially overvalued as it was in both 2000 (by a large margin) and in 2007 (by a smaller margin). Now, that does not mean we cannot see stock prices fall meaningfully from these levels. After all, P/E ratios aren’t everything (despite the dot-com bubble being far more dramatic in terms of overvaluation, the market actually fell more after the 2007 peak because the economic shock was larger), but U.S. corporations are now earning enough in profits to justify the S&P 500 trading at 1,500, especially compared with the two prior peaks on this long-term chart.

My takeaway: it makes sense to be cautious, but not alarmed.

The Most Entertaining CNBC Segment Ever: Ackman vs Icahn

Yeah, I don’t think they like each other. It’s rare that two hedge fund titans are on the opposite side of such a controversial trade (Herbalife HLF) and in this case the result is an on-air feud. If you have any interest or follow Ackman, Icahn, Herbalife, and/or activist hedge funds, you might find this as entertaining as I, and many others in the industry, did on Friday when this altercation unfolded live on CNBC.

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CNBC: Ackman vs Icahn 01/25/13 (27 min 39 sec)

Wow: Apple’s Round Trip Back Below $450 Brings Trailing P/E Down To 7x

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That kind of looks like a mountain landscape I would see from higher elevations out here in Oregon, but instead it is a 1-year chart of Apple (AAPL) stock. After Tuesday’s solid but uninspiring fourth quarter earnings report, Apple’s quick fall from perceived market darling to “just another large cap tech stock that is being passed by on the innovation front” has reached a crescendo. The magnitude of the drop from the September high of $705 now sits at -37%. Instead of $800 price objectives, some are suggesting $300 may be more fitting. How times have changed in just four months.

Apple earned $44 per share last year, giving the stock (at the current $445 quote) a trailing P/E of 10x. Free cash flow in 2012 was $47 billion, giving the stock a 9x free cash flow multiple. The P/E is actually lower if you use free cash flow instead of reported earnings. That hardly ever happens and shows you just how cheap the shares are right now. And don’t forget the $137 billion ($145 per share) of cash that Apple has in the bank). Subtract out the cash position and investors are getting Apple’s operations for just $300 per share ($285 billion). That equates to a trailing P/E of 6.8x and 6.1x times last year’s free cash flow.

How do those numbers compare to others? The P/E is lower than Microsoft, Intel, Cisco, IBM, and Oracle. The free cash flow multiple is unheard of. Try finding any other company that trades at 6x free cash flow, in any industry!

Now, I did write about a month ago that I thought Apple stock was cheap at $525 (“Apple Shares Now Nearly As Cheap As Microsoft: Which Would You Rather Have?”) so it should come as no surprise that I think it’s super cheap at $445. The point is, even if you think both their growth and margins have peaked, it is not easy to justify the stock being at $445 or $300 net of cash. The business would have to decline meaningfully from here for that to make sense.

Sure, it’s not impossible, but is that the most likely outcome? Is it likely that Apple’s share of the tablet market declines meaningfully? Is it likely that their share of the smartphone market declines meaningfully? Remember, those end markets are growing, so just maintaining current market share results in Apple’s business growing, not declining from here. Is it likely that they never come out with any new products? A television? A lower cost tablet for the education market to replace expensive, heavy textbooks? A streaming radio competitor to Pandora? Something else that has not yet been rumored already (those three have)?

Yes, it is possible that nothing positive happens for Apple from here on out. That they have peaked and will graduate to “old tech” like Gateway, Dell, HP, Intel, or Microsoft. But that is what the stock is priced for right now. To me, that does not seem like the most likely outcome. And if some things start to get better, or if Apple’s 80,000 employees use their $137 billion of excess cash to create something new and great again, then the current stock price might look a little silly.

There is a difference between growth rates and profit margins peaking and massive deterioration in sales and profits. The stock has broken down technically, emotions are running high, analysts are slashing their price targets, and there are no catalysts to turn things around in the short term. But all of that could change fairly quickly. And given how cheap the stock is and how much money the company continues to print each day in its stores and on its web site, I just don’t think fair value on Apple is a 7 trailing P/E multiple.

But we will just have to wait and see. I am willing to wait this out and will likely selectively add to client positions in the stock.

Full Disclosure: Long shares of Apple, but positions may change at any time.

Netflix Stock Repricing Overdone

Netflix (NFLX) stock is soaring this morning, up 36% ($37) to $140 per share in pre-market trading. The company’s fourth quarter financial results were above expectations, but at first glance do not appear to warrant a 36% stock price increase. Revenue rose 7.9% year-over-year, leading to a very small quarterly profit of 13 cents per share.

Investors are enthusiastic about Netflix’s addition of 2.05 million domestic streaming customers (up 8.2% versus the prior quarter), but that figure is a bit misleading as actual paid customers rose by just 1.67 million (+7.0%). Obviously, lots of free trial memberships are given out at the holidays, but how many of them convert to paying customers is a big question mark.

It was also a good sign to see operating earnings from the domestic streaming segment rise to $109 million in Q4, versus just $52 million a year ago. The DVD mail segment earned $128 million domestically for the quarter, which just goes to show you how much more profitable those subscribers are. The DVD mail business earned more money, despite having just 8.05 million paid subs, versus 25.5 million paid streaming subs.

Netflix continues to see subscriber losses in its most profitable segment and gains in a streaming business that has very high operating costs. Just how valuable a streaming customer actually is will remain an important issue for investors. Based on the stock’s rise this morning, you would think streaming customers mint money for the company. Conversely, Netflix reported segment profits of $4.25 per paid subscriber during the fourth quarter. That comes out to less than $1.50 per month in profit from the $8.00 per month in revenue they generate.

Back in August, with the stock floundering in the mid 50’s, I wrote an article on Seeking Alpha entitled “Netflix Is Finally Cheap.” I did not buy the stock, which in hindsight was a mistake since the analysis was correct. With the stock around $140 as I write this post, I can not justify an equity valuation of $8.25 billion for the company, so if you have played this stock correctly lately, you might want to strongly consider lightening up on your long position into today’s strength.

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

Dell LBO: A Logical Move That Others Might Mimic

Investors have been speculating for a couple of years now that Michael Dell could eventually take his computer company private, after leaving the option on the table in multiple press interviews. His large stake as founder and CEO (about 15% of the company) coupled with his transformation plan and lack of respect on Wall Street (for the stock, not himself) all make a leveraged buyout seem logical. With news that a deal is being negotiated and could be finalized shortly in the $13-$14 per share range, I think the deal makes a lot of sense and others might take Dell’s lead and follow suit.

All of the ingredients required for a successful LBO are there in Dell’s case. The stock is so unloved on Wall Street that even after a premium is attached to the shares (which were hovering around $10 before news of the deal discussions leaked) the company can be had for a very attractive price. The company generates about $4 billion of cash flow annually, with $3.5 billion or so left over after capital expenditures. With a market value of around $23 billion, which excludes $6 billion of net cash on the balance sheet, Dell and his group would be paying about 4 times EBITDA.

Bears on the stock will be quick to point out that Dell still gets the majority of its revenue from desktop and laptop computer sales and that business is in decline thanks to the emergence of powerful smartphones and tablets. Indeed, that is why the stock has been pressured lately and accounts for the meager enterprise value assigned by the public market, but it also ignores the transformation plan that Dell and his team have slowly been implementing. While PC deterioration is offsetting the financial benefits of the company’s move into the corporate world of servers, storage, security, and services right now, over time that side of the business (which is both Dell’s current focus and future) will overtake the PC side and allow the company to continue to book strong profits. Once PCs dwindle to 20-25% of the business over the next several years, Dell can re-IPO and the LBO investors can cash out big time. At that time, Dell will look more like IBM than HP.

So why might other companies seen as “old tech” go down a similar route as Dell? First, it makes it a lot easier after someone else does it first, as it gives credibility to the idea. Companies heavy into PC-related businesses are not going to get respect from Wall Street going forward. Dell’s pre-deal P/E ratio of 6x proves that. After a while, the frustration mounts and staying public loses its luster. Hewlett Packard is likely going through a similar thought process right now, even though they are far behind Dell in orchestrating a solid transitional game plan. Even PC-related software companies like Symantec are being painted with the same brush and could explore the idea of going private. Anti-virus software is simply seen as yesterday’s technology and lacking growth potential.

All in all, this Dell LBO idea makes a lot of sense on multiple fronts, and while other companies might not have as many strong cards to play to make a deal like this work, I bet a finalized Dell deal prompts a lot of discussions in board of directors’ meetings across the industry in coming months.

Full Disclosure: Long SYMC at the time of writing, but positions may change at any time