Defense Stocks Continue Dropping

Shares of the country's leading defense companies have been fairly weak in recent weeks as worries of budget cuts in the U.S. defense budget have surfaced. It's true that the Pentagon has actually asked the government to not fund certain projects that it deems unneeded. However, not all defense companies will see a reduction in spending growth.

Most of the cuts will likely center around missile defense systems and certain models of fighter jets. Other areas of the defense sector, such as homeland security, intelligence, and surveillance equipment based on new technologies, should continue to thrive.

One of the leaders in this area is L3 Communications (LLL). Along with the rest of the sector, LLL shares have dropped in recent months, and now trade under $74 per share, about $11 below their 52-week high.

L3 is trading at a market multiple of 15 times earnings, despite above-average growth for the defense industry. CEO Frank Lanza continues to make small, strategic acquisitions to fill out the company's new product offerings, and the L3's solid performance should be able to weather any small cuts in less important areas of the U.S. defense budget.

Is U.S. Airways the Next Kmart?

Well, judging from the stock price action lately, you can see some correlation. Kmart stock began a rapid ascent after emerging from Chapter 11 bankruptcy (it has risen 700% in fact). Similarly, U.S. Airways (LCC) recently completed a merger with America West and new equity began trading in late September at around $20 per share.

Here we are only six weeks later and the stock is breaking through $30, for a move of 50 percent. Is this the start of a bigger move a la Kmart? Let's not get ahead of ourselves. It is true that the airline's cost structure has been greatly improved and debt has been wiped away by the courts, but we are still talking about an airline here, with oil at $60 a barrel.

With other airlines also emerging from bankruptcy court, LCC is not alone is having a new, leaner, and meaner business. However, these companies still can't make money with energy prices this high, and the competition will hardly let up with carriers able to revamp and go at it all over again.

Monitoring future financial results out of LCC (they just reported Q3 today) may prove a valuable use investors' time, as it's quite possible the new U.S. Airways will turn out to be nothing like the new Kmart.

Toyota Continues to Close In on Big 3

October market share numbers for the domestic automobile industry tell the whole story. For years the Big 3 (GM, Ford, and Chrysler) have commanded the majority of sales in the United States. Once as high as 70%, their combined market share has been falling fairly precipitously in recent years, hitting 55% last month.

More interestingly, however, is the fact that Toyota Motor (TM) is closing in on Chrysler's number three position in terms of market share. Not only should they surpass Chrysler soon, but Ford's number two position is also in jeopardy, as seen by the six top sellers:

GM 22%

Ford 17%

Chrysler 16%

Toyota 15%

Honda 10%

Nissan 7%

Investors, after seeing these numbers, will probably want to rush out and buy shares of Toyota Motor (TM). However, does increasing share in the U.S. thanks to superb quality, value, and fuel efficiency, translate into a winning stock price?

As you can see from this chart, TM shares have been on fire recently but still trail the highs set in 2000. After more than doubling in the last two years, investors might want to wait for a pullback before adding TM shares. Although business is good and Toyota is taking share, the car business is still a tough one, and the stock today is pricing in a lot of good news.

Much like Southwest Airlines (LUV) and JetBlue (JBLU), the best companies in extremely competitive industries don't always shine as much as some might think.

It's Decision Time for General Motors

It has been widely reported that General Motors (GM) is considering selling a huge stake in its financing division, GMAC, in an attempt to sure up its finances. With net income of $2.5 billion expected this year, GMAC is worth somewhere in the $30 billion range, so a majority stake would yield the leading domestic automaker a substantial sum of $15 billion.

What's interesting is GM's current value. At $28 per share, Wall Street is valuing the entire company at $16 billion. In essence, GM's car business has an implied value of negative $14 billion. GMAC itself, therefore, is worth nearly $60 per share.

Maybe GM should try and sell a stake in its auto division, not GMAC. Such a move would substantiate a positive dollar value for the car business, and maybe get the stock price up. If GM could ever sell cars and trucks for a profit consistently, you can see why value investors like Kirk Kerkorian think the upside is tremendous.

Selling GMAC, though, could backfire if the $15 billion generated slowly disappears. Right now GMAC is the life support for GM. Perhaps that's something they should hold on to in its entirety.

The Energy Debacle

The following numbers were pulled from the October 2005 report from the Energy Information Administration:

Total worldwide oil demand:
2004 - 82.5 million barrels per day
2005 - 83.7 million barrels per day
2006 - 85.6 million barrels per day

Total worldwide oil supply:
2004 - 83.0 million barrels per day
2005 - 84.3 million barrels per day
2006 - 85.5 million barrels per day

As readers of this blog are aware, I think buyers of energy stocks are current prices will be handsomely rewarded. Most are down 20% or more this month alone. ConocoPhilips (COP) has forward P/E of 6.4x. Occidental (OXY) is 7x. Plains (PXP) is 8x.

It is true that dramatic commodity price erosion from here would put these estimates in jeopardy, and therefore make these P/E's irrelevent. However, when I see numbers like the ones from the EIA, along with $60 oil and $13 natural gas today, I tend to think the reaction right now on Wall Street is out of line. We'll just have to wait and see.

OXY Purchase of VPI Implies Energy Undervaluation

Late yesterday we learned that Occidental Petroleum (OXY) is buying Vintage Petroleum (VPI) for $20 cash plus 0.42 OXY shares. This represents a huge premium (33%) over yesterday's closing price and 12.5 times VPI's 2006 estimate of $4.13 per share. This deal very much backs up my contention yesterday that energy multiples are too low.

Take Plains Exploration (PXP) for example, and their 2006 consensus expectation of $4.44 in EPS. If investors put the same 12.5 multiple on PXP that OXY was willing to pay for Vintage, you get an implied buyout value of $55 per share for Plains, about 50% higher than its current share price.

Energy Selling Overdone

With the XLU down 15% from its high, you'd think energy prices were tanking. Instead we have $63 crude oil and $13 natural gas. While a warm winter would bring natural gas prices down considerably from here, earnings estimates for energy companies right now are probably based on no more than $50 oil and $7 natural gas, nowhere near where we are now.

Stocks like Chesapeake (CHK), Suncor (SU), and Plains (PXP) are trading at 8-10 times 2006 earnings. Plains is getting crushed today, in fact, on news of charges it will be taking from its hedging positions. However, that will be money well spent since it assured they could get high prices for their product in 2006.

Unless energy prices plummet from here, current earnings numbers will prove conservative. The volatility is hard to stomach, but these stocks are too cheap to ignore if you don't have your 10% position in energy yet.

Sears Buyback & Bear Stearns Incompetence

After recommending investors buy Northwest Airlines (NWAC) stock at $5.00 less than a month ago, today Bear Stearns downgraded the stock to a sell, after yesterday's bankruptcy rumors sent the stock down as much as 60 percent to $1.57 per share. Amazingly (well, maybe not given this analyst's track record) NWAC stock is up 25 percent today as some investors bet Northwest will temporarily avoid filing Chapter 11 this week by using that possibility to reach an agreement with its mechanics on wage concessions. It would be hilarious if Bear's sell call marked the bottom in NWAC and the stock actually rose significantly after news of a deal. At that point, Bear would probably upgrade the stock just in time for the company to file bankruptcy.

Although the stock isn't really reacting to the news, Sears Holdings (SHLD) today announced a $500 million stock repurchase plan. This represents 2.3% of the company's total shares outstanding. These are the kinds of things SHLD management will do to enhance shareholder value through the use of its free cash flow. They will not use the money to mimic other retailers that open new stores. Rather they will try and increase the profitability of existing stores and use that money to boost the stock price.

More Northwest Craziness

This is a first for me; an analyst upgrades a stock to sell.

Standard & Poor's Equity Research upgraded Northwest Airlines to "sell" from "strong sell" but cut the price target. "With the shares off sharply today amid market talk about possible bankruptcy, we think the current share price more adequately discounts the risks of bankruptcy we foresee," S&P Equity Research said. Investors should sell shares of Northwest, "which we do believe is likely to file for bankruptcy, but our upgrade reflects possibilities for the share price," the research firm said. S&P Equity Research said shares could see upside if Northwest denied bankruptcy talk, reached agreement with striking mechanics, or if there are further oil price declines or "meaningful progress" with other unions. The firm cut Northwest's 12-month target price to $1.50, from $3.

So, let me get this straight. They think NWAC will go bankrupt, and their 12-month price target is $1.50 per share? Has a bankrupt airline ever given equity holders anything when they come out? And what is the difference between a sell and a strong sell? Do you use a market order if you want to sell strongly, versus a limit order if you just want to sell?

Oops...

Thursday August 18th: Bear Stearns upgrades Northwest Airlines (NWAC) to "buy" causing the stock to soar 10% to $5.48 per share.

Tuesday August 16th: Morgan Stanley upgrades Northwest Airlines (NWAC) to "buy" and sets a $9 target price. The stock jumps from $4.17 to $4.65 per share.