IBM’s Loss is Dell’s Gain

Rumors of IBM (IBM) exiting the personal computer business have been confirmed with the PC giant selling its $10 billion-a-year business to China-based Lenovo for $1.75 billion in cash and stock. Margins on PC’s are terrible, so this a clearly a good move for IBM as far as profitability is concerned. The stock has moved up on the rumors, but don’t expect IBM shares to return to their former glory. The company is so large that the bottom line effect won’t be gigantic by any means.

The PC market continues to see the number of suppliers dwindle. Compaq merged into Hewlett Packard, eMachines was bought by Gateway, and now IBM is gone as well. All of this bodes well for industry leader Dell Computer (DELL). Dell hasn’t had any trouble increasing its market share in the face of mass competition, but fewer of them surely can’t hurt. Michael Dell continues to execute flawlessly, with his company’s latest focus, printers, racking up huge sales already.

Dell stock has been on a tear ever since they reported a blowout quarter several weeks back. Even after the run, the stock doesn’t look terribly expensive. After accounting for the company’s net cash, DELL shares trade at 25 times 2005 estimates of $1.56 per share, with sales expected to rise 16 percent in the coming fiscal year. Any pullback would make Dell shares even more attractive.

Merck Cuts 2005 Guidance (We warned you!)

Just to follow-up the piece I put out here about a month ago on embattled pharmaceutical giant Merck (MRK), here’s an update on what the company said this morning. Merck cut its 2005 earnings guidance to $2.47 per share (their range is $2.42-$2.52), citing the withdrawal of Vioxx. Consensus estimates had been for a profit of $2.57 for next year.

Last month, I suggested that 2005 estimates might prove tough to hit (analysts estimated $2.60 per share at that point). During today’s conference call, the Company failed to mention anything about setting aside reserves for Vioxx-related litigation. Merck will have to address this at some point in the new year and many believe they will have to allocate $10-$20 billion to settle claims.

The company remains adamant that it will not cut the dividend, which stands at $1.52 per share. This still seems unrealistic given the need for Merck to set aside reserves and also continue its R&D in order to replace, not only Vioxx revenue, but also Zocor when its goes off patent in 2006. Maintaining a payout ratio of 62% ($1.52/$2.47) seems like a poor use of cash flow. Once management realizes this, the dividend will be the first thing they cut.

Sirius/XM Valuations Top Clear Channel

December 7, 2004. Mark it down. Today’s the day when the combined market values of XM Satellite Radio (XMSR) and Sirius Satellite Radio (SIRI) reached $20 billion for the first time, topping that of terrestrial radio giant Clear Channel Communications (CCU), which Wall Street values at $19 billion.

Sirius and XM have about 3 million subscribers, a number expected to hit 30 million within 10 years. Investors really have no idea if that estimate will come to fruition, and if it does, how much revenue (and more importantly, profit) these companies will be generating.

What we do know, however, is what Clear Channel has that warrants a $19 billion market value. As of 12/31/03, CCU employs more than 35,000 people, owns 1,200 radio stations along with 39 television stations. They also own about 800,000 outdoor advertising billboards worldwide. CCU owns and/or operates more than 100 live entertainment venues across the globe. Cash flow, measured by EBITDA, for the last 12 months totaled $2.4 billion. Sales for 2004 should hit $9.5 billion, with net income reaching $800 million.

This comparison reminds me of the 1999-2000 bubble days when Priceline.com (PCLN) was worth more than the entire airline industry and AOL bought Time Warner.

Now, its true that 10 years from now SIRI and XMSR could prove to have been bargains at current prices. However, just be aware that today’s investors are not paying any attention to valuation (mainly because at this point we have no idea how much these companies will ultimately earn), and as a result, they are basically rolling the dice rather than investing in a business.

That said, individual investors seem to think their odds of profiting from satellite radio stocks are far better than the Powerball lottery or a craps table in Vegas. If you want to short these stocks, based on a valuation that cannot be justified, please restrain yourself. The momentum here is too strong in the short term for valuation to play a role. We’ve seen this as the stocks continue to rise in the face of multiple analyst downgrades based on valuation concerns.

Unlike the late 1990’s, the analysts are now doing their jobs correctly by warning that current prices don’t make much financial sense. So, it seems most have learned their lessons. However, as those of us who have followed the markets for many years know all too well, even when analysts are doing their jobs, investors can’t rely on their recommendations to make money. On that front, nothing has changed this time around.

Insider Selling Hit 4-Year High in November

Corporate insiders sold $6.6 billion worth of company stock in November, an increase of 187 percent from the prior month. This amount was the highest recorded in a single month since August of 2000 ($7.7 billion). For every $1 of stock purchased by insiders in November, $46.45 worth was sold. The largest group of sellers came from Charles River Labs (CRL), where 14 insiders sold nearly 800,000 shares, netting $36.7 million in the largest round of selling for that company in 5 years.

Historical evidence has shown that insider buying is a much better indication of equity valuations, when compared with insider selling. However, this statistic still indicates to me that stock prices, in general, are likely to be relatively fairly valued at this point in time. It appears that individual stock selection will be crucial in 2005, as the broad market indices aren’t likely to appreciate too much from here, given that the S&P 500 is slated to book an 8 percent earnings gain next year and the index trades at a forward P/E of 17.

One notable insider purchase was that of Washington Mutual’s CEO, who bought 50,000 shares of WM stock at $39.50, his first open market purchase ever and the largest in the company’s history.

Metris Continues Its Turnaround

Credit card issuer Metris Companies (MXT) continue to be a stellar performer in 2004. Shares of the once financially troubled firm have tripled this year from $4 to $12, greatly contributing to Peridot Capital’s success year-to-date. The stock pulled back to $10 after an analyst downgraded the stock, citing full valuation.

However, the shares have moved back toward the old highs as news of early debt repayment and refinancing of existing debts hit the wires. In addition to the strong operational turnaround orchestrated thus far, any interest expense reductions the company is able to secure, based on the improving performance of its loan portfolio, will serve as yet another catalyst for incremental earnings gains going forward.

With some analysts still bearish on the company’s future, combined with a staggering 24% of the float sold short, there are many reasons to think that Metris shares will continue their march higher in 2005. Contrary to popular belief, it’s not too late to get in, even at the current $11 price tag.

Apple Shares Continue to Ride iPod Success

The momentum investors on Wall Street have gotten ahold of Apple Computer (AAPL) and they most likely won’t be letting go anytime soon. After today’s $6 jump on a very bullish analyst report, AAPL shares have tripled in the past year from under $20 to more than $60 each. We can argue whether the stock looks pricey or not (many would say it does with $1.30 in estimated earnings per share for fiscal 2005, but don’t forget the $14 in cash and lack of debt), but investors want a piece of the reinvigorated company, whose iPod MP3 player is selling like crazy, and are willing to pay up for it.

Today, the Apple analyst with Piper Jaffray raised his price target to $100, with the stock trading in the mid-fifties. Looking simply at a price-to-earnings ratio, it’s hard to justify that price, but Piper has a 2006 EPS estimate of $2.30, ahead of the current consensus of $1.60 per share. Given the iPod’s ability to boost Apple’s profit margins, that bullish forecast could very well play out. The $100 target comes from the analyst’s estimated p/e ratio on those earnings of 44x. If one is to critique this target price objective, taking issue with the 44 multiple assumption hardly seems irrational, it seems very high. Little doubt though, that profit forecasts for Apple will turn out to be too modest.

More on Satellite Radio…

Sirius (SIRI) shares are up 20% after-hours after the company announced that Mel Karmazin, former head of Viacom, will become CEO. Increase in market cap due this development? $1 billion. Wow. Can one man really be worth that much money? Of course not, but investors are jumping on the bandwagon anyway. I just heard a projection that satellite radio will have 30 million subscribers by 2010. Once again, we can use this to try and justify a $14-$15 billion market value for SIRI and XMSR. With 30 million subs paying $10 per month, you get industry revenue of $3.6 billion. A 10% profit margin gets you net income of $360 million. So, these stocks trade at about 40 times 2010 earnings, if these assumptions prove accurate.

Investors Tuning In to Satellite Radio

The market is down today, but the satellite radio sector continues its ascent. XM Satellite (XMSR) and Sirius (SIRI) are seeing tremendous interest, mostly from retail investors looking to cash in on “the next big thing.” XM and Sirius today sport a combined market value of $13.5 billion, despite having never reported a single dollar in profit. Clearly, investors are betting on future earnings with this sector, but is there enough profit potential to justify the satellite radio market’s value at $13.5 billion today?

As usual, numbers can help us give color to the situation. While they can’t predict how the satellite market will play out over time, we can get a good idea of what the “upside” really is. According to the Department of Transportation, there are 200 million vehicles in the U.S. We’ll ignore the international markets for now, given that neither XM nor Sirius has hinted it will try and tackle those as of yet, probably for good reason. Even though prices of technology products and services tend to decline over time, we’ll assume that the $10 per month subscription fee will remain constant.

So, it’s relatively easy to determine the total market potential. If each and every car in the U.S. was equipped with a satellite radio, the industry would garner $24 billion in annual sales. Profit margins are tough to guess, especially when XM and Sirius are paying hundreds of millions of dollars to secure their content such as Howard Stern, Major League Baseball, and the National Football League. Leading radio companies such as Clear Channel and Cumulus Media net about an 8 percent margin, so we’ll use that as a guide to determine the total market’s annual profit potential: $1.9 billion.

These numbers are important because many investors who are buying these stocks today are not looking at the numbers behind the stocks, namely the extreme valuations already built into the share prices. Paying $13.5 billion today, for profit potential of $1.9 billion annually, seems excessive given that this assumption requires one to believe that every car, truck, and SUV in the country will eventually have a satellite radio. After all, only about 50% of households own computers and only 70% have cable television.

If we were to assume that in 10 years, half of all vehicles will have a satellite radio, the market will earn less than $1 billion in profit. So, investors today are paying 14x projected 2014 earnings. Clearly, a lot of people see this as a bargain. Only time will tell.

History Suggests Strong Market in 2005

If you’re a numbers person, a history buff, and an investor, you will most likely find the following numbers very bullish for the coming year on Wall Street. Now, I’ll be the first to point out that I really don’t think the numbers below will really have an effect on the stock market’s direction next year. But, they are interesting and should, at the very least, peak one’s curiosity as to whether or not it is simply a coincidence that years ending in a “5” have traditionally been great for investors.

Most of us know that the historical average for stock market returns has been about 10 percent per year. Interestingly, since the Dow Jones Industrial Average was created (1897 by Charles Dow), there has never been a year ending in the number “5” in which the Dow lost value. In fact, no such year has ever failed to beat the historical average of a 10 percent gain. In fact, these years have come and gone 10 times and the Dow has averaged a gain of 34.6 percent. I have not taken the time to investigate why this may be the case, but let’s hope the trend continues. Here are the numbers for the Dow:

1905: 38.2%

1915: 81.7%

1925: 30.0%

1935: 38.5%

1945: 26.7%

1955: 20.8%

1965: 10.9%

1975: 38.3%

1985: 27.7%

1995: 33.5%

2005: ???

10-Year Average: 34.6%

Sleepless in Seattle

On their quarterly conference call earlier this week, Starbucks (SBUX) management indicated they envision room for 30,000 of their stores worldwide. Given that after years of rapid expansion they have yet to even reach 9,000, we can assume sleep is not something the Seattle-based premium coffee chain focuses too much on.

The stock has been on fire, having doubled in price over the last year to a recent $55 per share. Is it too late to get in? Well, it depends on your personal investment philosophy. Momentum investors love to see stocks like Starbucks defy gravity, and there is no doubt they have contributed greatly to its meteoric ascent lately. The question is, what can investors expect in the future?

I can’t recall a time Starbucks has been this richly priced. The p/e has actually risen throughout this year, despite the fact that multiples usually contract when larger companies get big enough that growth will inevitably have to slow. Fiscal 2005 earnings are expected to rise another 20% to about $1.14 per share, giving SBUX a forward p/e of 48. Much like one of their hot chocolates, the shares seem very, very rich.

Starbucks bulls can surely explain why the company deserves such a valuation. Among them, a 20% growth rate, the ability to charge $4 for something that one can buy somewhere else for $1 even though it is not four times as tasty (some may disagree), and the list goes on. The S&P 500 does trade at about two times its growth rate, so perhaps one can justify a 40 p/e for Starbucks stock. Given the company’s 30,000 store goal, it’s clear that the growth story is not going to end anytime soon.

The question remains, how long can the company maintain its 20% annual growth rate? And importantly for investors, what happens to the stock’s 48 forward p/e when growth slows to 15 percent, and then to 10 percent? That multiple clearly has little room to rise, and a significant way to fall at some point in the future. The stock’s upward move has actually accelerated over the last year or so, as momentum investors have chased the stock. This despite the fact that as the company continues to grow, it will become harder and harder to maintain its high level of growth.

If you have a sizable capital gain in Starbucks stock, perhaps it would be prudent to take some of it off the table. Here is one statistic to end with. Assume SBUX is able to maintain its 20% earnings growth rate for the next three years, through 2007, and as a result, posts 2007 earnings of $1.64 per share. If the stock trades at a 40 p/e at that time, then shares will fetch about $65 each. This would imply a return to investors of 6 percent per year between now and 2007. Hardly breathtaking, but surely a possible scenario.