Seagate Adopts Baffling Policy on Financial Guidance

I am sitting here listening to the second quarter conference call hosted by Seagate Technology (STX), the world's leading provider of hard disk drives for the consumer electronics industry, and I just had to write a post with the audio going in the background. Seagate CEO Bill Watkins has just announced that his company is changing their policy on company guidance.

I have written on this blog before that financial guidance is very overrated. Many companies have abandoned giving guidance completely (kudos to them) and others have at least stopped giving quarterly projections. So, I was expecting STX to either cease quarterly guidance and give only annual projections, or to halt guidance completely. Wrong on both counts!

Seagate will now give only quarterly guidance. Are they kidding? The whole point of stopping quarterly guidance is to focus management on the long term and not put them in a situation where they might take actions just to hit a number in the short term. Now they are embracing three-month projections?

I understand them not wanting to give out annual projections. The disk drive business is very hard to predict, as it is largely a commoditized market. Supply and demand, and therefore pricing, is tough to gauge over long periods of time. Essentially, STX management is saying they have no idea what they will earn in fiscal 2008 (which began on July 1st).

If you are going to ditch giving guidance, then stop giving guidance! It seems very strange that they say they are focused on the long term, but yet are still going to predict sales and profits every three months. They should have just stopped guidance altogether.

Full Disclosure: Some Peridot clients have positions in STX, but those positions are under review

How Relevant is Dow 14,000?

The move from Dow 12,000 to Dow 14,000 has been pretty stunning. How relevant is that index though? We can argue that it is heavily weighted towards mega cap stocks, and that is true, but so is the S&P 500 since it is market cap weighted. Some of you may not be aware of this, but the Dow Jones Industrial Average is not market cap weighted. Instead, it is share price weighted.

This serves to make its moves pretty much irrelevant in terms of gauging the market's overall health. A one dollar move in Boeing (BA) has the same effect as a one dollar move in Microsoft (MSFT), even though Boeing trades over $100 per share and MSFT shares sell for $30 each.

What is the end result of this pricing method for the Dow? Boeing has more than 3 times as much influence as Microsoft does, and the same pattern holds for any other Dow component. In fact, materials and industrials account for a whopping 35% of the Dow Jones Industrial Average due to their high share prices (which may not be shocking given the name of the index).

Those two groups have been leading the market higher, so it is not surprising that the Dow has been soaring. On the other hand, financial services firms have been lagging this year, but they only account for 14% of the Dow, more than 30% less than their weight in the S&P 500. Dow 14,000 is a nice round number, but it really doesn't tell us a lot about the market as a whole, only certain sectors that dominate its composition.

Should We Invest in Unethical Companies?

I had a telephone conversation last week with a new client and one of the questions he had for me was, "Do you invest in unethical companies?" He was speaking about Wal-Mart (WMT) specifically, it turns out, but there are a lot of investors who avoid buying shares in companies with which they disapprove of their products, their way of doing business, or both. Common examples include stocks with ties to alcohol, tobacco, firearms, casinos, Mideast oil, etc. It was a good question and one that I don't think I've addressed on this blog before, so I figured I would give my perspective.

Before I get into an explanation, the answer to this question is yes, I will buy shares in the likes of Anheuser Busch (BUD), Altria (MO), Halliburton (HAL), Wal-Mart, and MGM Grand (MGM) if I think the stocks are good investments. This assumes of course that the client is okay with this. If a client does not want to own certain stocks, I have no problem following their request.

The issue here, in most cases, is whether or not you want to support companies like this if you disagree (insert a stronger word here if you prefer) with what they stand for. Many people equate buying stock to supporting a company. The reality though, is that Wal-Mart does not benefit in any way if I were to buy 100 shares of their stock. That action simply results in one of their current investors transferring their shares to me, in return for cash. Wal-Mart does not benefit monetarily from that transaction. After an initial sale of common shares, the money changing hands is between individuals, so the company is out of the picture.

I have no problem ceasing support for companies I don't like. However, if I wanted to stop supporting Wal-Mart, for example, I would simply choose to never again set foot in one of their stores. No longer shopping there is adversely affecting their business. Not investing in their stock is not having the same effect. Since my job is to make money for clients, I will generally invest in the stocks that I feel can accomplish that goal, regardless of whether or not I like the underlying firms or not.

This reasoning of course assumes that you are not buying shares in an IPO or a new offering of stock through which the firm is directly receiving the proceeds from the sale. In those cases, not buying the stock does have an impact on them, even though there will always be someone else willing to invest even if you're not. Still, it's the principle that is important.

Full Disclosure: No positions in the companies mentioned at the time of writing, but not for the reasons discussed above :)

For a 40% Premium, How Could Hilton Say "No" To Blackstone?

Rumors of a large private equity deal in the lodging industry had been running rampant recently and late Tuesday we learned that Blackstone Group (BX) plans to acquire Hilton Hotels (HLT) for $18.5 billion plus the assumption of debt. Hilton shareholders should be elated, as they are getting a 40% premium for their shares.

The M&A boom we are seeing right now is clearly propelling the market higher. Firms like Blackstone have billions of dollars to put to work and they can't raise more money until what they have now gets spent. As a result, you see prices like this being paid for Hilton. For a 40% premium, they had to say "yes" to Blackstone. If the offer was 20%, maybe they pass, but not 40%.

And this is a big reason why the market has been so good lately. Private equity firms need to spend their cash hoards and aren't afraid to overbid if it means getting a deal done. The companies getting bought out jump, helping the market. The stocks considered next in line for a bid get a pop on the rumors and speculation, and short sellers have to scramble to cover any positions that could possibly get a bid. You can't afford to risk being short a name like Hilton before a Blackstone bid comes along.

Liquidity will dry up at some point, deal flow will lighten up, and market returns might be subdued, but there is really no way to know when exactly that will happen. It is clear the private equity firms themselves think we are in the late innings, or else we would not have seen Blackstone go public and KKR file for an IPO just a few hours ago. Until the game is over though, there is plenty of liquidity to keep stock prices fairly high.

Investors should simply focus on values in the marketplace. Maybe one of your companies gets a bid, maybe not, but it would be wise to make sure you are comfortable with your investments even if they remain independent. Unless you think you are the ultimate market timer, I would avoid the private equity IPO market, including Blackstone, KKR, as well as the others that will surely follow suit as long as the new issue market can support them.

Full Disclosure: No positions in the companies mentioned at the time of writing

Sam Zell Called a Top, Will Steve Schwarzman Do the Same with Blackstone?

What does this Blackstone Group (BX) IPO mean? That seems to be a question that everyone is trying to answer. There is no doubt that monumental events, such as Blackstone Group becoming the first private equity firm to go against its own culture and issue stock to the public, deserve to be analyzed on Wall Street. That does not mean this IPO has to mark the end of something, whether it be the boom in private equity led leveraged buyouts, mergers and acquisitions, or even the overall equity market. Still, there is evidence that sometimes these game-changing events can signal something.

Consider an example. Earlier this year Sam Zell, a brilliant contrarian investor and businessman, sold his crown jewel, commercial real estate giant Equity Office Properties (EOP). The sale of EOP signaled to many that Zell thought the price he could get was so large that he had to cash out given the huge bull market for commercial real estate. There would be no other reason for Zell to sell after all these years. It appeared that the market forced his hand and he quickly moved on to Tribune (TRB), a company at the opposite end of the exuberance spectrum.

What is amazing is how well Zell timed his exit from EOP. As you can see from the chart below, the iShares U.S. Real Estate Fund (IYR), an exchange traded fund serving as a benchmark for publicly traded REITs, peaked on February 2, 2007. The index has fallen sharply (17 percent) in the five months since. Now get this, shareholders of EOP voted to approve the sale of the company on that very same day, February 2nd. And who bought EOP in a deal valued at more than $39 billion including assumed debt? Steve Schwarzman's Blackstone Group.

Things like that (it's not the first time this has happened) are exactly why people are trying to figure out what to gleam, if anything, from the Blackstone IPO. From my perspective, I think it says something about the global boom in M&A activity, but not necessarily the broad equity market. I think the market on the whole is tied to the economy more than anything else, of which private equity is tiny sliver. More likely, Blackstone decided to go public because they thought their firm would receive a peak valuation right now, both because PE firms are in high demand and because profit levels are through the roof due to immense deal volumes.

As we have seen in recent weeks, even a small increase in interest rates can startle investors. As soon as borrowing costs go up, it becomes much harder to issue debt to buy equity, which is exactly the mechanism that is fueling most of this private equity boom. It doesn't matter if a 5.5% or 6.0% ten year bond rate is still pretty low in historical terms. It's not 4.5% and therefore deals will be harder to complete. Fewer deals mean less money for the likes of Blackstone.

It will be interesting to monitor how the M&A market unfolds in the near to intermediate term. Worldwide M&A deal volume in 2006 rose 38 percent to $3.8 trillion, shattering the previous record of $3.4 trillion set in 2000. The first quarter showed year-over-year growth, so 2007 is on pace for another record. It would not be surprising, especially given the eerie coincidence of the aforementioned sale of Equity Office Properties, if we are near the peak in M&A. If that is the case, it will be yet another reason why people are so quick to postulate what something like a Blackstone IPO really means for investors.

Full Disclosure: No positions in the companies mentioned

Playing the Changes to the S&P 500

We just learned that three former highflyers are being removed from the S&P 500 index to accommodate the addition of three spin-offs from Morgan Stanley (MS) and Tyco (TYC). These changes reminded me of an article I wrote back in 2005 about the contrarian way to play these types of index modifications.

What essentially happens is that poor performing stocks are the ones that get removed from the index, in favor of better performing ones, or as is the case now, spin-offs from member companies. Contrarian investors, not surprisingly, would take the view that the very fact that a stock is being removed from an index due to poor performance would be an excellent contrarian indicator.

The piece I wrote two years ago, Examining Changes to the Dow 30 Components, focused on the Dow because that index often is changed arbitrarily even when no stock get bought out and needs to be replaced. In the case of the recently announced changes, it is simply bigger firms replacing smaller ones. Still, the three beaten down tech stocks could very well represent contrarian long ideas. If you would like to take a closer look, the trio includes ADC Telecom (ADCT) at $19.14, PMC Sierra (PMCS) at $8.14, and Sanmina (SANM) trading at $3.41 per share.

Full Disclosure: No positions in the companies mentioned

Stock Buybacks versus Dividends

There was an article written by Jennifer Openshaw last week on TheStreet.com entitled Three Reasons to Prefer Dividends Over Buybacks. A lot of people agree with that opinion, namely that dividends are cash in your pocket, which is preferable to a stock buyback. However, I'm not so sure I personally prefer a dividend payment. Let me explain why by playing devil's advocate for the three reasons cited in Jennifer's article.

1) "Dividends are taxed at a rate not exceeding 15% while a capital gain may be taxed at ordinary rates if the stock is sold within a year. And if you wait more than a year, who knows what the tax law will be? So the dividend, at least for now, locks in the lower rate."

I can think of a few different scenarios and only one of them results in the dividend being the better alternative from a tax perspective. If you own the stock in a retirement plan, tax rates are irrelevant. If we are talking about a taxable account, a dividend payment triggers a taxable event, meaning you pay the 15% tax on the dividend payment in the year you receive it, regardless of whether you sold the stock or not. Buybacks don't trigger taxes.

The argument that the tax law could change in the future, therefore you should lock in a low rate, is a poor one. Typically when capital gains rates change, they are not retroactive. If you bought a stock in 2005 and the long term capital gains tax rate goes up in 2010, you don't get stuck paying the higher rate when you sell the stock when the law was different.

In my view, the only time dividends are more beneficial from a tax perspective is when you hold a stock in a taxable account and you sell it in less than 12 months. I would argue this occurs less often than not. Most traders don't rely on dividend paying stocks. Long term investors are more likely to have high levels of dividend income. Also, many investors have the bulk of their investments in tax-sheltered accounts.

2) "You can't cash in on an announcement. there is no guarantee that the buyback will happen."

I think this argument is weaker than the first one. The article is supposedly comparing dividends to stock buybacks, not dividends to stock buyback announcements. Obviously, given the choice between a dividend payment and a buyback announcement that doesn't happen, you would take the dividend. If you are going to compare dividends and buybacks, I think you have to simply assume you are comparing a $1 paid out to shareholders with a $1 used to repurchase shares.

A lot of buyback opponents will throw out the argument that some buybacks are announced and never implemented, but the vast majority of buybacks are actually completed, not just announced and then thrown under the rug. If you are debating which use of cash is better, I think you need to assume the announced dividends get paid and the announced buybacks are implemented.

3) "A buyback accomplishes nothing if the company is granting just as many shares on the back end for options."

This one is simply untrue. Assume you have two companies, all else equal, except one issues 1 million options per year without a buyback program and the other company issues the same 1 million options per year but also buys back 1 million shares in the open market with available free cash flow. Did the second company accomplish anything? Absolutely!

Stock buybacks are accretive to earnings per share, regardless of whether or not the company issues options or not, simply because buying back stock is better than not buying back stock. A company's earnings per share will always be higher if they buy back stock compared to if they don't. How many options the company issues to employees, if any, makes no difference. Of course, the higher the repurchased share to issued options ratio, the better off investors will be.

For the most part, I don't think the reasons to prefer dividends cited in this particular article are very compelling. If you are seeking income from your stock portfolio, clearly you would prefer dividends. Other than that, I think share buybacks in many cases are just as good as dividends. In fact, if you are a long term investor in a taxable account, I would prefer a buyback because it postpones the payment of taxes. Anytime you can postpone paying someone something, especially the federal government, the time value of money is working in your favor.

So which do you prefer? A dollar of a company's free cash flow paid out to you or used to increase your ownership percentage of the company?

Nobody is Right All of the Time

To me, the above statement is pretty obvious. Today a reader left an anonymous comment on my latest post about Google (GOOG) that said the following:

"Yeah, GOOG is up some 13% or so, about the same as KFT is up since you bashed it a couple of months ago saying it was not a good buy. .... Trust me, you will actually gain more credibility with your readers if you admit your mistakes."

I decided to expand on this issue in a separate post, in addition to my answer to the reader.

First, I think the reader's characterization of the Kraft (KFT) post is a bit unfair (you can read it here: Kraft Shares Still Not Overly Attractive, Even After Altria Spin-Off Selling Pressure). I didn't "bash" Kraft stock. The shares dropped from $32 to $30 as investors were set to sell the small pieces they received from the Altria (MO) spin-off. Given the drop was likely to be temporary in nature, I decided to take a look and see if the pullback presented a buying opportunity.

I concluded that the stock didn't appear to have much value even after the $2 drop. It traded at 18 times forward earnings and was only growing in the low to mid single digits. That type of valuation failed to persuade me to suggest readers take a look at it as a potential purchase. In the two months since that article, Kraft stock has made up the two points it lost and had added two more, taking it to the current price of $34 per share.

The reader is correct in pointing out that I did not write another post alerting everyone that Kraft went up four points. And perhaps there are more people out there that would have preferred that I had done that. However, I'm not sure that the conclusion one should reach from that is that I refuse to admit when I am wrong. I can't think of a time when I tried to deny being wrong. If you read the post about Kraft when it was $30 and now see the stock at $34, you are well aware that it went up. Just because a stock doesn't interest me, it doesn't mean it won't go up.

The reason I didn't go out of my way to point out the rally in Kraft shares is pretty simple; nothing changed. The stock still trades at 18 times forward earnings. Nothing is fundamentally different at the company and nothing has changed my opinion on the stock. I still don't think it is a good value, based on valuation and growth prospects, and I would not be surprised if it continues to trail the market.

As far as Google goes, I tend to write more about stocks I recommend than those I don't. When I recommend stocks on this blog, some people do wind up buying them after reading my views and doing their own due diligence. Since I know that those people are curious about when my opinions change (they email me and ask), I will often write updates when things change. Google shares rallied more than fifty points in a very short amount of time. I thought it was relevant to let people know that I was not selling, despite the quick move, and how much further I thought it could climb.

By no means does this mean I am unwilling to admit mistakes. If I was, there would be little reason for me to run a blog. My opinions are out there for everyone to see, over 400 posts since I started. I have been wrong a lot and every one of those posts is still sitting in the site's archives. In the last six months alone I thought Amazon (AMZN) was overvalued in the high thirties, Express Scripts (ESRX) was close to fairly valued in the mid eighties, and liked Amgen (AMGN) at 16 times earnings. Amazon has doubled, Express jumped twenty percent, and Amgen is down to 13 times earnings.

I'm pretty sure the vast majority of my readers understand that writing this blog is the last thing I would do if I wanted to hide the track record of my investment opinions. But since not everyone seems to realize that, I figured I would address the issue. If anyone has any suggestions on how to make the blog better, please let me know. I'm always interested to hear what readers have to say.

Full Disclosure: Long Amgen and Google at the time of writing

Prudential Shuts Down Research Department

One of the themes I have written about on this blog is the worthlessness of most sell side equity research. Most firms use their research departments to push stocks they have underwritten, and most investors understand that and discount their opinions as a result. Prudential (PRU) didn't believe in that model, and they were right. They decided a while back to put their equity research group out on its own, not joined at the hip with investment banking. I'm sure the thinking was that their research will carry more weight since it is unbiased, and therefore will be a valuable product.

We learned Wednesday that Prudential has shut down its equity research, sales and trading business known as Prudential Equity Group. This move speaks much more loudly than my comments ever could regarding the value (or lack thereof) of analyst research. If the product was valuable, people would buy it and it would make a profit. The fact that sell side research is given away for free to clients should tell you just how valuable it is.

I really do think it is that simple. The last study I read showed that analyst recommendations not only trailed the returns of the S&P 500 index, but did so with more volatility. Hardly a ringing endorsement. Expect other research departments to be shut down now that someone got the ball rolling by being the first.

Full Disclosure: No position in PRU at the time of writing