More Tech Talk

I feel as though my recent writings are all about technology stocks. They shouldn’t be though. All of the portfolios I manage are fully diversified and none of them have more than a market weighting in TMT (tech, media, & telecom). That could be changing though, if recent events are any indication.

The reason why I am typing away about tech more often these days is simply because that’s where I’m finding value. There are still a decent amount of undervalued investment opportunities in energy and other commodity-related companies. But aside from that, I’ve been uncovering tons of ideas within the software space, as well as Internet companies.

You’re probably thinking “yeah right.” He thinks Google (GOOG) is a value at 47 times forward earnings, but that’s not really “value.” I do still like Google because it’s the fastest growing tech company around and despite rising 100% since its IPO, it still trades at a discount to eBay (EBAY) and Yahoo! (YHOO), with stronger fundamentals. The fact that the stock was up $6 today, the very day 177 million shares were free to be sold by company insiders and early investors, shows that I’m not alone in that thinking. However, let’s assume that a 47 multiple is high enough to still scare most people away. That’s perfectly understandable, even if I think that will prove to be the wrong decision.

For the first time ever, I’ve been finding Internet stocks that trade at a discount to their growth rates. That’s pretty rare in any industry, but especially in tech. Nasdaq stocks will always trade at a premium to the S&P 500, as investors look there in hopes of finding the next Microsoft (MSFT). So you can imagine what happens when Internet stocks that trade at market multiples begin to pop up on my radar screen. These companies are growing 20% to 30% percent a year, have loads of cash on their balance sheets (which is mostly being used for small acquisitions as opposed to dividends), and like many technology companies, no debt to speak of.

Let me give you a couple of examples. As always, assume that if I am saying bullish things about certain stocks that I either own them already, or am strongly considering a purchase. The first is Ask Jeeves (ASKJ: $23). Now some people will just laugh at this. Why would you want to buy Ask Jeeves? I must be kidding, right? Rather than think about who Jeeves is (which I must admit doesn’t scream “buy my stock!”) let’s look at what really matters; the numbers. ASKJ is expected to grow earnings 30% in 2005 and 20% in 2006.

Normally I would guess a stock like this would be trading at 40 or 50 times earnings and I wouldn’t even consider buying it. However, the P/E on 2005 numbers is 16.9x. That’s right, the same multiple as the S&P 500 index, only with more than twice the growth. Two things jump out a me about this company. One, it shouldn’t be trading at a market multiple. And two, if another Internet search company bought ASKJ, it would be ridiculously accretive to earnings.

The next stock is InfoSpace (INSP: $43). A very similar situation to Ask Jeeves. INSP is in paid search, as well as services for mobile phones, like ring tone downloads. Earnings are expected to jump 32% in 2005 and another 31% in 2006. The company has no debt and $9 per share in cash (which has been used for several small acquisitions in recent years and will likely continue). Strip out the cash and you get a share price of $34 and a 2005 P/E of 18.7x. Again, if someone like Yahoo! was to buy a company like this, it would add to earnings immediately, given that Yahoo! trades at over 50 times earnings.

The best explanation for why these lesser known Internet stocks are so cheap compared with the likes of giants Google and Yahoo! is that they are second tier players. Many growth investors simply go with the biggest company in the area they want to invest in. However, smaller firms like ASKJ and INSP have proved that there is room for them too and they continue to grow handsomely under the radar.

I really think eventually Wall Street will realize this and give them a higher market value. They may still trade at a discount to the industry bellwethers, but a 25 or 3o P/E seems attainable as soon as the Street realizes how cheap these stocks are and that these companies can survive. I wouldn’t be surpruised if other companies realize this first, and scoop them up before they are in higher demand.

The Internet Bubble Revisited

As we approach the five year anniversary of the end of the greatest bull market ever, it still confounds us how crazy valuations actually were back in March of 2000. Metrics were being created on the fly by analysts to justify price targets since traditional price-to-earnings and price-to-book ratios could not be determined without profits or tangible assets. Page views actually seemed like the perfect means to value shares of Yahoo (YHOO) to many people. After all, the company was an Internet portal, not an online store or auction site.

I was not immune to this either, of course. I recall a favorite metric of mine at the time was to look at relative price-to-sales ratios. If you had three companies in the same market, but one traded at 12x sales and the other two traded at 20x, you could pretty much assume that if you bought the cheaper one some analyst would come along and point out the “mis-pricing” and before you knew it your stock was fetching 20x as well.

I bring this up, not to blast buyers of Sirius at $9, Taser a $30, or Travelzoo at $100, but instead to point out that some of these profitless companies actually did survive. Most have changed business models (or businesses for that matter) several times since 2000, and very few have the same management teams in place. Those former Internet entrepreneurs have long since cashed in their stock options and left the spotlight.

An example of the aforementioned transformation is Ariba (ARBA). Now, Ariba has a special place in my heart. I never owned the stock, but I went to college with the daughter of one of the company’s earliest employees. My discovery that my dorm room neighbor’s dad had worked for and knew the company’s co-founder and former CEO, Keith Krach, actually was the launching pad for our friendship.

How is this important, other than to rekindle my college memories and remind me that I haven’t talked to that very friend in a couple of years? Well, it appears even though I missed out on the stock’s tremendous run in 1999 and 2000, I may be getting a second chance to make money on the shares of the business-to-business software company. After hitting a high of more than $1,140 per share (split adjusted) five years ago, the stock currently trades at $8, down some 99.3 percent.

With $130 million in cash, no debt, and $360 million in sales expected in fiscal 2005 (ending September 30th), the stock looks very cheap. Ariba just completed the acquisition of Free Markets (another former Internet high-flier) and is in fact growing again. Net of cash, investors today are paying about $6.25 per share and 1.1x revenue for $0.35 in earnings per share in 2005 and $0.56 in 2006. If the company can indeed hit its numbers, there is little chance the stock will continue to trade at 11 times projected 2006 profits.

Breakin’ Up Is Hard To Do

It is always interesting to watch a stock price jump 10 percent on news that the company’s CEO has resigned. Although the headlines will use the word “resign” it is clear that Hewlett Packard (HPQ) chief executive Carly Fiorina was forced out after she orchestrated a horrendous Compaq acquisition.

Maybe now Hewlett will do what they should have done long ago; spin off their crown jewel printing business. Rather than focus on higher margin products (such as plastic containers of ink that sell for $30), Fiorina opted to add scale by gobbling up Compaq, forming (at the time) the largest personal computer maker in the world. The only problem was that with razor thin margins, tech companies were trying to flee that business, and for good reason.

Fiorina thought she could get bigger, take market share, and make money selling computers through various channels such as retail outlets and large tech distributors. As she would find out later, there was a reason why no other company had been able to accomplish that feat. Dell (DELL) continued to take market share as players in the PC market diminished. Gateway bought eMachines, IBM sold its PC biz to Lenovo, Packard Bell disappeared.

So, what should HP focus on now? How about the printer business? Hewlett’s printing division accounted for 90 percent of HPQ’s operating income in fiscal 2004. Using Lexmark (LXK) as a guide, the unit as a stand-alone company would be worth two-thirds of HPQ’s current market value, despite only representing a third of total sales. With shareholder value unlocked, the new CEO would focus on the rest of the company’s operations and hopefully find a way to be a profitable number two player behind Dell in personal computers, servers, and storage.

It won’t be easy, but with Carly gone, the transformation that should have been attempted years ago can finally get started, if the board chooses to go in that direction.

Google Delivers

Updating last week’s piece on Google (GOOG), it appears the bullish stance was the correct one. The company blew away Q4 profit estimates last night, and the stock opened up $23 a share as 2005 EPS numbers will be revised from $3.40 to $4.00. Worries about the Valentine’s Day lock-up combined with some investors lightening up positions after today’s huge move could very well cause GOOG to give back some of the gain short-term. However, don’t think that a 200 handle on Google is far-fetched.

In another wonderful analyst call, the Internet analyst for Jefferies & Co. raised his rating from hold to buy this morning, at $215 a share. Hardly a helpful call, given that the same guy pulled his buy rating last year when the stock was $135. I guess $135 didn’t warrant an investment, but a $215 price tag does.

Oddly enough, Jefferies’ 2005 and 2006 EPS estimates are of some value to investors, as they try to determine fair value for GOOG shares. His 2005 EPS number goes to $3.99, with 2006 upped to $5.40 per share. His price objective of $230 sounds about right to me. I’m using a 60x multiple on $4 EPS, to get to a $240 price target. Any near-term weakness for the rest of the month will allow investors to get in before we get there.

Tech Bargains Can Be Had… Finally

Peridot Capital has been underweight technology stocks for a while. The highly cyclical sector traded at a premium for years, even after the bubble burst, and investors expecting decades of consistent double-digit earnings growth were, and still are, in dreamland. The Nasdaq as a whole still looks expensive, but for the first time in a long time, tech stock bargains have been popping up lately.

The timing isn’t clear to me, as we haven’t had a dramatic correction. The Nasdaq rose nearly 9 percent in 2004, and even though 2005 has been weak thus far, most stocks haven’t seen eBay-like haircuts. It’s becoming easier to find tech leaders trading at or below market valuations nonetheless.

For example, Cisco (CSCO) looks cheap. After buying the networking giant in 1994, I haven’t wanted to put new money into the stock in years. However, at $18 a share the stock looks like a conservative, fairly low risk tech value. After subtracting $7 billion in cash, Cisco trades at about 18 times calendar 2005 earnings. When was the last time that happened? Juniper (JNPR) might have better business fundamentals right now, but you’ll pay at least twice as much for such growth.

Another attractive candidate for purchase is Symantec (SYMC). The stock was crushed after it announced plans to acquire Veritas (VRTS). Both companies have stunning balance sheets and are leaders in their spaces. Investors should question how two companies that sell completely different product lines will be integrated, but the combination at 20x earnings could prove a good value if the deal meshes better than some people think.

Tech isn’t a place to jump in with both feet. That said, large cap leaders used to trade at a premium but now seem to have lost their luster. P/E’s of 17-20 for the industry’s dominant players now seem fair, fair enough to at least have a market weighting and not feel nervous about significant downside risk.

Google Weakness Unwarranted

After hitting an all-time high of $205 just weeks ago, shares of Internet search giant Google (GOOG) have slid 30 points amid the eBay (EBAY) earnings miss and fears of an impending lockup expiration for pre-IPO holders of the stock. Let’s analyze these two events.

First, eBay’s disappointing fourth quarter report and 2005 outlook. eBay is seeing growth slow down considerably. They are being forced to invest heavily in the business, domestically and even moreso abroad, to keep up the growth Wall Street has come to expect from the company. This has no direct negative effect on Google. In fact, since eBay is a large customer of Google’s, higher capital expenditures at eBay could only help Google, not the other way around.

Second, the expansion of Google’s lockup period that goes into effect on Valentine’s Day. Sure, more supply does little to help a company’s publicly traded shares, but one must look at the demand side of the equation, not just the supply side. There is plenty of demand for GOOG stock, as evidenced by its run to over $200 per share in the midst of the initial lockup expiration late last year.

The good news for Google shareholders is that the company reports its fourth quarter results on February 1st, before the lockup expires and about when investors looking to get out ahead of such an event would sell. Given the results we’ve seen from Yahoo (YHOO) and InfoSpace (INSP), the odds are very good that Google’s results will blow the consensus out of the water. Numbers for 2005 will be ratcheted upward and euphoria over Google’s financials will surely overcome any new supply of shares from the company’s early investors.

With the stock at $177, down from $205 recently, shares of Google look ripe for the picking this week, ahead of the earnings release. The catalysts are there for a strong push back to new highs in the coming weeks.

eBay Earnings Report Rattles Tech Stocks

eBay (EBAY) shareholders are feeling the effects of owning a stock with a 70 forward p/e tonight. With a equity market valuation that high, there leaves little room for error. You won’t be able to find a single person who thought eBay would miss its earnings after the bell today, and as a result the stock fell $15 in early evening trading.

The great thing about Wall Street is that if you managed to avoid having eBay in your portfolio, you can take advantage tomorrow morning when investors throw the baby out with the bath water. It always happens, even when it defies logic. All Net stocks got crushed when eBay’s earnings report came out. Yahoo! (YHOO), Overstock (OSTK), and Google (GOOG) especially. Just decimated.

Why? Because they are Internet companies. Only thing is, just because eBay feels it needs to invest in its business to maintain market dominance (which will lead to lower margins, hence, lower earnings per share), this doesn’t mean anything is wrong at Yahoo!, or Google, or Overstock.

Yahoo! barely even remembers it has an auction site, eBay won that battle long ago. Google doesn’t have auctions. Overstock said this week that it saw a huge rise in its auction listings after eBay announced its annual fee hikes (which were needed even more this year to help prop up falling profit margins). Nonetheless, all of these stocks lost 10 percent of their value just between noon and 5pm, solely due to eBay’s announcement.

The market gives investors these types of opportunities all the time. The only problem is, most investors don’t take advantage of them. They should.

Sprint-Nextel Combo Presents Arb Opportunity

Rumors were made official today as Sprint (FON) and Nextel (NXTL) announced plans for a $35 billion merger, creating a much more formidable number three player in the wireless market. With Verizon and Cingular far larger than #3 Sprint, adding Nextel’s business clients and push-to-talk technology puts the combination right on the heels of the industry’s top two giants.

Nextel had to do this deal in order to avoid spending billions to upgrade its wireless network to the latest technology. Sprint’s wireless clientele is more focused on the consumer side, so this combination will allow for Sprint-Nextel to offer push-to-talk as well as wireless Internet services to both companies’ customers. The merger should net about $12 billion in synergies, according to today’s announcement.

The proposed deal calls for Nextel shareholders (Peridot Capital is one) to receive about 1.3 shares of Sprint for each share of Nextel they hold. A small cash portion (about 50 cents per share) is also part of the transaction. As I write this, FON shares are trading at $24.55 and NXTL stands at $29.66. Nextel trades at about a 7.6 percent discount, based on the deal’s terms, presenting arbitrageurs with an attractive spread.

The deal is expected to close in the second half of 2005 and some are speculating that Verizon or another player may make a rival bid for Sprint, although this seems far from assured (I’d say less than a 50/50 chance). One last thing to keep in mind about the 7.6 percent spread on the deal; Sprint currently pays a 2% annual dividend, so those shorting the acquirer’s stock will be responsible for that payout.

Google Outlook Strong for 2005

It will be very interesting to see how Wall Street reacts when Google (GOOG) reports its fourth quarter earnings in late January. If the company exceeds estimates for the second time in as many quarters since its IPO, investors will have to decide why they are assigning Google a lower valuation than its chief competitor, Yahoo! (YHOO). Despite the fact that Google’s total sales and growth rate will likely both pass those of Yahoo! in 2005, GOOG shares trade at 51x 2005 estimates, versus 76x for YHOO. Google’s market value is also more than $5 billion less than Yahoo as I write this.

It seems that the common knock against Google (that it relies too much on paid search and is not as diversified as Yahoo!) could actually help it outgrow the competition next year and beyond. Google’s G-Mail email service is still being finalized before it will be made available to everyone (users now need a referral to sign up for an account). Other new services such as blog hosting (BlogSpot) and shopping (Froogle) are just in the beginning stages of deployment. Conversely, Yahoo! has been diversifying away from search for years (through acquisitions like HotJobs and Broadcast.com).

It is for this reason that I think Google has a better chance than Yahoo! of beating analyst sales and profit estimates going forward. They simply seem to have more avenues for growth since they have been fairly narrow in their focus on search until recently. More upside potential combined with a 2005 price-earnings ratio a full 33 percent lower than Yahoo! makes Google shares look very intriguing going into the new year.

If a long position in Google is a bit too speculative for some investors (understandable given that we are still dealing with a 51 forward p/e), a paired trade of long GOOG and short YHOO can take advantage of any closing of the valuation gap, with much less day-to-day equity price volatility.

Has Nightfall Beset Sun Microsystems?

Tech stocks have rallied nicely since the November 2nd presidential election, presenting some attractive exit points for certain stocks. Network computing giant Sun Microsystems (SUNW) appears to fall into that category. Over the last three months, SUNW shares have jumped more than 40 percent from under $4.00, hitting a high of $5.60 each this past week. Looking at the company’s current valuation, it’s difficult to make the case that the stock should continue its ascent. Wall Street analysts seem to agree. While I usually will opt not to side with the consensus view, the current ratio of buy, hold, and sell ratings stands at 3/15/6.

Despite a healthy balance sheet with more than $3.5 billion in cash (approximately $1 per share), Sun’s enterprise value-to-earnings ratio looks insanely high, mainly because the company is having trouble turning more than a slight profit on its nearly $12 billion in annual sales. For fiscal 2005 (ending in June), SUNW is expected to earn $0.06 per share or $200 million in profit. This 1.7 percent net margin gives the stock a P/E of 76x, even if we use the company’s enterprise value ($15.2 billion) instead of its entire market cap ($17.5 billion).

Even if we were to assume that Sun Micro could raise those margins substantially through cost-cutting, it is still very hard to justify the stock’s current valuation. Estimates for fiscal 2006 stand at $0.12 in earnings per share (3.4% margins on $12 billion in sales) give SUNW an enterprise value-to-earnings multiple of 38x. Assuming an overly bullish 5% margin gets you to $0.20 in EPS, but then the multiple only shrinks to 25x, which seems about as high as Wall Street could rationally justify.

All in all, investors seeing value in the $5+ share price of this former tech bellwether may well be being influenced by the share price, rather than actual “financial value.”