Investors who closely follow Capital One Financial (COF) shouldn’t be very surprised to hear that the company has agreed this weekend to buy New Orleans-based Hibernia Corporation (HIB), a bank with over $22 billion in assets, for $5.3 billion in cash and stock. The writing for a deal like this has been on the wall for a while. Capital One, which focuses on marketing directly to customers, is seeking to boost its reach by acquiring a regional bank, opening up new avenues for growth.
From an investing standpoint, it makes little sense to bet against Capital One based on this acquisition. The company is run brilliantly, having increased earnings per share at least 20 percent every year since its IPO in 1994. Wall Street will likely sell off COF shares tomorrow, given the company is paying a 24% premium and many will likely question the decision for a direct marketing lender to spend over $5 billion for a bank with branches in Louisiana and Texas.
In such a case, investors who have missed out on Capital One’s magnificent track record thus far should consider stepping up to the plate and buying the stock on any merger-related weakness. The stock trades at only 11 times 2005 earnings, and that valuation will only get more compelling should the stock get hit tomorrow. And who knows, an analyst downgrade or two might spark enough of a sell-off that existing shareholders, such as myself, should consider adding to their positions.
After months of baffling investment strategists and economists, long-term interest rates have finally begun to rise. The 10-year bond rate has risen from under 4.00% to nearly 4.40% in a heartbeat. Prospective home buyers are finding their rates rising, putting pressure on them to lock in a low rate as soon as possible.
There is little doubt that higher rates will hurt the housing market. The homebuilding stocks haven’t been hit much yet, but it’s certainly dangerous to own them for the rest of the year, if this rate trend continues. If you believe rates will continue to move higher, the housing stocks could make for an attractive short (especially with the S&P 500 setting up for a potential triple top).
If you want further evidence to question the sustainability of the homebuilding sector’s tremendous run on Wall Street, below is a piece written this week by a very competent hedge fund manager:
“According to the National Association of Realtors, who should know, second homes accounted for 36% of U.S. home purchases last year, up from more than 16% in 2003. That 36% breaks down thusly: 25% of homes were bought for investment; 13% bought as vacation homes.
Think about that for a second. More than a third of all homes bought last year were bought for either speculative purposes or as vacation homes.
This doesn’t square at all with the mantra of the home building companies and their fans, which is that the U.S. has a perennial housing shortage caused by job creation, immigration and the deep-seated hunger for home ownership.It has nothing to do, they assure investors, with the recent 4% 10 year treasury yield.
It has nothing to do with adjustable rate mortgages or “IO” loans–interest only loans–in which the only thing the homeowner pays is the interest, leaving the principle for later (which to the buyer means “when I flip the thing for a big profit”).
And it has absolutely nothing to do with speculative buying, according to home builders including–and I’ve heard them all say it–Toll Brothers, Pulte, Lennar, KB and Hovnanian.
But now we know the facts: home purchases were inflated a full 20% (the jump from 16% in 2003 to 36% in 2004) by boomers snapping up spec housing and vacation homes around the country. That’s a bubble.
And not for nothing, it seems the average single-family home financed by Fannie Mae or Freddie Mac shot up almost 12% last year, the highest rate since 1979. For those who remember that far back, 1979 ushered in a couple of pretty ugly years in the housing market.”
In less than two weeks, shares of Tibco Software (TIBX) have been decimated, falling from $11.88 on February 18th to $7.00 this morning. Rumors have been swirling that weakness in Europe would lead to a profit shortfall in Q1 2005. Sure enough, TIBX issued a press release last night saying that first quarter sales and earnings per share would likely come in at $100 -$102 million and 4-5 cents, versus prior guidance of $116-$120 million and 8 cents.
Tibco shares had been one of the few bright spots in the software sector in 2004. The shares soared from under $6.00 last August to hit a high of $13.50 in December. Not surprisingly, with such enthusiasm for the company heading into 2005, this quarter’s miss has caught investors by surprise. Most have chosen to sell.
Wall Street too often focuses on the short-term, and can punish companies (especially those of the small cap technology variety) in extreme ways after an earnings warning. While the Q1 hiccup is undesirable, have the company’s fundamentals gotten so bad that it warrants a $13.50 stock getting cut nearly in half over the course of a couple months? Not in my opinion. There is a ton of stock for sale today. Take advantage of it.
A few years back, Prudential Securities got out of the investment banking business. It was widely expected that without the typical conflicts of interest that other diversified investment companies faced, Pru’s research department would be less biased, and therefore produce more valuable recommendations for their clients.
So much for valuable research. Prudential lifted its view on the energy sector to overweight today, and slapped a buy rating on shares of ExxonMobil (it was rated neutral before). Evidently their energy analysts see something fundamentally favorable to the big oil stocks, as of this morning. I’m sure Pru’s clients are thrilled with such a timely call.
The Dow staged a late day rally today, closing up 75 points to 10,750, despite the fact that oil prices have once again cracked through $50 per barrel. Many would expect that with oil at $51.39, stock prices would have suffered. After a 170-point Dow drop on Tuesday (oil soared more than $2 that day, to over $50), we have recouped most of those gains already without a pullback in the oil market.
From this, we see that the relationship between oil and stock prices can get pretty interesting. Many economists hate to see increasing energy prices, fearing it will cripple any moderate economic growth we do have in this country. They see higher gas prices at the pump as an indirect tax on consumers, curbing their disposable income. Since the consumer represents two-thirds of the U.S. economy, stock prices generally falter when gas prices head higher.
While I won’t argue there is some connection, I have long thought that the impact higher energy prices have is somewhat exaggerated. After all, if the average consumer fills up his or her 15 gallon tank once a week, a 25 cent increase in the per-gallon price of gas costs that person about $195 per year extra. Hardly insignificant, but not enough to cripple an economy by any means, in my opinion.
Another interesting thing is how energy prices are affecting corporate earnings. While many will make the case that high gas prices will hurt the profit of consumer-related companies, earnings estimates have actually risen since the beginning of the year, even though oil prices have gone up as well. Growth in earnings for the S&P 500 was initially expected to be in the 7 to 8 percent range in 2005. Estimates have creeped up to between 9 and 10 percent already in the first two months of the new year. This has mostly been driven by the energy sector, whose profits are through the roof, and show no signs of slowing down.
As a result of higher profit estimates and a stock market that is down 1% thus far in 2005, the forward P/E on the S&P 500 has fallen to 16.2 or so. With the 10-year bond only yielding 4.29%, investors probably feel pretty comfortable buying stocks at these prices. The risk of course, is that energy prices fall meaningfully from here. The stock market might react postively to that initially, but don’t forget that such a move will lower corporate profit estimates, leaving stocks relatively more expensive than they are now.
If I was running a public company, I would not give investors and analysts any type of precise financial guidance. Giving such sales and profit estimates stems from the implementation of Regulation FD, which required companies to divulge all meaningful information to the public, not just Wall Street analysts and boards of directors. No longer faced with having the luxury of “guiding” analysts to how a particular quarter was tracking, companies began issuing financial guidance in their press releases for everyone to see and interpret.
Unfortunately, earnings guidance plays right into the hands of those who focus too much on short-term financial performance, as opposed to building long-term shareholder value. CEO’s should not make business decisions in order to ensure they can make their numbers every quarter, but instead because it is in the best interest of the company and its shareholders long-term.
Making sound decisions that succeed in hitting both short-term and long-term goals is not always possible. Sometimes corporate managers have to make short-term sacrifices to ensure long-term stability and growth. Examples of these actions might be a dilutive acquisition, or price cutting to prevent a key customer from bolting to a competitor. Price discounts and dilutive deals will cause many companies to miss a quarter or two, but investors will be much better off five years later.
The fact remains that Wall Street focuses too much on quarter-to-quarter financial results. Investors see this every day when companies miss their EPS numbers by a penny or two and their stock drops 10, 20, or 30 percent in a single day. As a result, CEO’s begin to manage their business just to make sure they hit their numbers.
Taser (TASR) shipped out a $1 million order on December 31, 2004 to ensure they hit Q4 profit estimates. Pharmaceutical companies convinced wholesalers to take delivery of more product than they needed (a tactic called “channel stuffing”) so sales would be on target. According to court records, former WorldCom CEO Bernie Ebbers agreed to cook his company’s books because they needed to “hit their numbers to keep the stock price up.”
Finding companies that manage their businesses based on strategic plans, and not their public financial guidance, will do a much better job over the long term, and that’s something investors should look out for.
Martha Stewart Living Omnimedia (MSO) is trading at $35 a share, giving the company a market value of $1.75 billion. Short sellers covering and momentum players have contributed to this stock’s meteroic rise from $8 within the last 12 months. At today’s price the stock trades at 194 times 2006 earnings. Now, I’ll be the first to tell you I don’t really trust those estimates. I don’t think anyone really knows how much MSO will earn next year. There are just too many uncertainties to come up with an estimate that one should feel confident with.
What we can do is take a look back and see how this company did when business was great. Here are the historical sales numbers for Martha Stewart’s company. The 2004-2006 numbers are current estimates. MSO reports its full year 2004 numbers next week (Edit–2004 sales came in at $187 million – as reported on 2/23).
1997: $133 million
1998: $180 million
1999: $232 million
2000: $286 million
2001: $296 million
2002: $295 million
2003: $246 million
2004: $187 million
2005: $176 million
2006: $219 million
As you can see, this company has never had $300 million in annual revenue. The highest net profit margin the company has ever earned is 7.5 percent. This stock trades at 6 times peak sales! That translates into 80 times peak earnings! How long will it take MSO to get back to peak sales and profit margins? No way to know for sure, but it won’t be anytime soon.
Granted, this stock has not traded on financial metrics for a long time. It has been event driven recently; the jail sentence, the Mark Burnett “Apprentice” show, etc. Interesting side note — Burnett got 2.5 million options when he agreed to make the show. When he exercises them it will dilute the company’s owners by a whopping 5%, as there are about 50 million shares outstanding right now.
Eventually, this stock will once again trade based on how much money it can make. Judging from history, it looks like that might be bad news for shareholders.
I’ve decided to cover my short position in Tivo (TIVO) a little earlier than expected. The stock was trading at $12 per share last year when it became fairly obvious that cable giants like Comcast (CMCSA) were not going to partner with Tivo, but rather build proprietary DVR technology into their own digital set-top boxes. This development left little room for Tivo to differentiate itself enough to outdual the cable companies in providing a soon-to-be standard feature.
With the premise that Tivo’s fundamentals were going to be in steady decline, and profitability was years off (if ever in the cards), covering the short wasn’t something I was really considering. However, with today’s announcement of Tivo’s 3 millionth subscriber, I once again found myself looking at the stock’s valuation. After a precipitous drop from $12 to $3 and change, the time has come to take my profits off the table.
The financials are still pretty ugly. Sales for 2005 are expected to be just under $200 million, with a net loss of approximately $25 million. Tivo has boosted marketing expenses recently as it realized that its partnership with DirecTV will become less and less valuable over time. As a result, it wouldn’t surprise me if sales come in ahead of expectations this year, but losses are higher than anticipated.
The losses are less of a concern given that Tivo has little debt and a sizeable cash position. Further funding may be required later on, depending on how well increased marketing spend boosts sales and its impact on margins, but for right now the company is okay financially.
With the stock up 5% on the subscriber figures, the market cap is about $300 million, or about $100 per subscriber. This valuation seems to be very reasonable to me, and I have a tough time making the case it should be lower than that. As a result, today I am moving on to bigger and better opportunities.
I rarely put much emphasis on technical analysis of individual stocks. Reading charts can work, but only in the absence of material new information. Without meaningful newsflow, technical indicators will often hold up because everybody is looking at the same thing and traders will act similarly, thereby allowing the technical analysis to become a self-fulfilling prophecy.
However, as soon as the company reports earnings, receives an analyst upgrade, or announces a merger (among dozens of other possible catalysts), chart reading goes out the window in favor of a necessary revaluation of the company’s shares based on new revelations.
With indexes, however, technical analysis has a bit more merit. Many hedge funds trade the indexes as a whole, as well as individual stocks. Newsflow for an entire index, the S&P 500 for example, doesn’t occur. The S&P doesn’t report earnings. Wall Street research departments don’t have analysts covering indexes. As a result, the double top that formed recently on the S&P 500 could be concerning.
Traders focused on indexes could very well use that formation as a reason to sell, and not only their index ETF’s and futures, but their stock holdings as well (based not on company fundamentals but rather index technicals). Despite a nice move higher in February, the market is still down for the year, as January’s drop has yet to be fully recouped.
If we can’t break the overhead resistance in the 1,212-1,213 area on the S&P, the recent rally might not continue very much longer. Interestingly, the market opened the year at 1,212, which turned out to be the high for this week before we headed south once again.
Google (GOOG) shares are up another $3 this morning after rising nearly $6 yesterday, the first day every share of the Internet search company was available for sale. It appears that demand for the shares is more than adequate to soak up a little extra supply (little because any shares that will be sold by company insiders will be unloaded in a slow and orderly fashion, as opposed to all at once).
What lies ahead for Google in the short to intermediate term? How about inclusion in the S&P 500? With a market cap of more than $50 billion, Google would find itself in the top quintile of companies in the index (based on market cap) upon its addition. With so many mergers and acquisitions being announced recently (AT&T and Gillette are two examples of S&P companies that will need to be replaced), it is only a matter of time before index funds will have to gobble up Google shares.
The largest S&P 500 fund, Vanguard Index 500, had $106.6 billion in assets as of 12/31/04. If Google was added to the S&P today, that fund alone would need to purchase more than $500 million in stock, about 1% of the company’s total outstanding shares. As a result, the announcement of Google’s inclusion in the S&P 500 will only serve to further buoy the stock price, and help to absorb the recently increased float.