Introducing Smartphones Unlikely To Save GPS Hardware Firms Like Garmin

Many investors often confuse good products for good stocks. Surely the two can go hand in hand, but that is not always the case. Although they make great products, I am wary of standalone GPS hardware companies such as Garmin (GRMN). With smartphones quickly becoming multipurpose devices, including GPS, the market for standalone GPS devices is likely going to suffer from lower unit volumes and even more importantly, pricing pressure in the not-too-distant future.

There is no doubt that I envision a time five or ten years from now when all new cars come equipped with GPS in their dashboards, but the odds of price erosion not playing a role in such volume increases are slim. Companies seem to understand this likely future trend. In fact, Garmin is getting ready to launch its own smartphone to get into the GPS-enabled cell phone market. I feel comfortable predicting a Garmin phone will not be very successful.

The longer term trend will likely result in unimpressive volume growth for standalone GPS devices and large price cuts. It is very difficult to maintain profit margins at reasonably high levels when a service like GPS becomes commoditized and available through additional channels. With such market dynamics, it is reasonable to expect revenue could rise while profits actually fall, which would severely hurt the stock prices of GPS device makers like Garmin.

The stock today, fetching more than $31 per share, isn't all that expensive on an earnings basis (~12.5 times 2009 estimates), but it is the profit estimates that I would be worried about. In fact, the consensus thinks GRMN's earnings will drop 12% next year, on flat sales, so people do realize Garmin faces headwinds going forward.

The price-to-sales multiple on GRMN would worry me further if I owned the stock. Hardware firms typically have low profit margins and thus low revenue multiples (Apple is a rare exception because their brand and unique product lineup fetch higher prices), but Garmin trades with an equity market value of $6.34 billion, which is more than 2.3 times revenue of $2.7 billion. That is a high sales multiple for a hardware company.

Garmin's strong balance sheet ($1.5 billion in cash, no debt) likely contributes to the loftier-than-average valuation, but no amount of cash will be able to change the market dynamics for GPS device companies in coming years. If I owned GRMN stock I would closely monitor the situation at the very least. If I was looking to pair some shorts up with longs in the technology space, GRMN would be one to consider in terms of firms facing technological and pricing headwinds over the intermediate to longer term.

Full Disclosure: No position in GRMN at the time of writing, but positions may change at any time

Yahoo! Accepts No Cash Upfront As Microsoft Search Deal Is Finally Reached

Eighteen months ago Yahoo (YHOO) management rejected a $33 per share, $47.5 billion cash takeover offer from Microsoft (MSFT). Today the two companies have announced a search partnership that makes Microsoft's Bing the default search engine on Yahoo and gives Yahoo no cash upfront for the privilege. This story is likely one of the worst executive management screw-ups in U.S. corporate history.

Yahoo shares had traded up to $17 each on anticipation of a deal with Microsoft but are trading down sharply today after the actual terms were announced. Yahoo will receive 88% of search revenue, while Microsoft will keep 12% for providing its technology. Yahoo saves money by not having to run its own search technology.

Who wins with this deal? Both companies, but Microsoft more so. Bing instantly increases its global market share from 6% to 15% by being incorporated into Yahoo's sites. That still pales in comparison to Google's 81% global share, but there is not much more room left to conquer now. Microsoft still makes some money here, even only keeping 12% of revenue, because market share has risen by 150% overnight.

Yahoo estimates that its annual operating cash flow will rise by $275 million from this deal, but it will take two years to be fully implemented. At their current valuation, that means about $3 per share of value creation, a far cry from the $14 of value creation ($33 cash versus $19 stock price at the time) that was offered by Microsoft and subsequently rejected as "undervaluing the company."

And remember, these numbers are Yahoo estimates so they are going to be overly optimistic. A lot can change in 24 months, which is how long they think it will take to revamp these operations and integrate both companies into this new search structure.

Does this deal hurt Google (GOOG)? Not really, in my view. Do they care who has the 19% global search market share that does not flow through Google sites? Probably not, unless they really think Bing is so good that it will lure search queries away from them.

Given Microsoft's history on the web, and with search products more specifically, it is hard to fear Bing, even if it has Yahoo as a partner now. Aside from Xbox, Microsoft has had little success diversifying away from Windows based operating systems and office software products. Putting two mediocre online players together is unlikely to have a dramatic effect on the industry landscape, although it will save each some resources.

As for the stocks, Peridot Capital has small positions in all three. Microsoft appears the most attractive at current prices, as Google is approaching fair value. Yahoo is less appealing now that an outright takeover by Microsoft is less likely. They could possibly come after the rest of Yahoo at some point in the future, but owning the stock for that reason solely is not very intriguing.

Full Disclosure: Peridot Capital was long shares of GOOG, MSFT, and YHOO at the time of writing, but positions may change at any time.

Update: Smart Phone Makers Ripe for Profit Taking

Earlier this year I wrote separate pieces highlighting both Research in Motion (RIMM), maker of the Blackberry and smart phone staple, and Palm (PALM), the turnaround story trying to get their name back into the mix. In the four months or so since then both stocks have soared, nearly doubling in each case (PALM from $6 to $11 and RIMM from $44 to $78). Not surprisingly, these are instances when taking profits makes sense.

The competitive landscape for Research in Motion really hasn't changed since February. The stock move is based on two things; the overall market advance, as well as renewed optimism that Blackberries remain popular devices and profit margins will hold up nicely even in this heightened period of competition and economic challenges. RIMM has seen its P/E ratio on 2009 earnings estimates jump from a very meager 13 times to a more reasonable 20 times, which seems more appropriate to me.

In Palm's case, the stock has moved in anticipation of their new device, the Pre, set to debut June 6th. While the prospects remain bright for both the Pre and subsequent devices Palm is sure to launch in coming quarters, we often see a sell off in the stocks of tech companies heading into or right after major product releases (so called "buy the rumor, sell the news"). In order for Palm shares to make new highs above the recent peak of $14 $12 per share, the Pre launch really must go perfectly. However, as is the case with many new product launches, expectations are high and there can be hiccups along the way. Therefore, there will be opportunities for investors with big gains to take profits and put selling pressure on the stock.

In both of these cases, investors who have sizable gains and still believe in either or both of these companies longer term can have their cake and eat it too by taking some chips off the table and keeping a smaller position to profit from if their instincts are right about the future.

Full Disclosure: Peridot Capital was long shares of Palm at the time of writing, although the position has become smaller in recent weeks, and positions may change at any time

Dell Shares Look Excessively Cheap

It has been a long time since I can recall seeing a blue chip company like Dell (DELL) carry such a meager stock market valuation. It is true that Hewlett Packard (HPQ) has been stealing market share from Dell in recent years, and even overtook them as the world's leading computer maker, but investors seem to be pricing Dell stock as if they are no longer relevant in the computer hardware marketplace. Given that Dell remains number two worldwide in PC shipments, I think pronouncements of their death may be greatly exaggerated.

Just how cheap are Dell shares? Well, Dell currently has about $8.8 billion of net cash on their balance sheet, which equates to nearly half of their share price ($4.50 per share in net cash versus a stock price of $10 and change). Total cash of $5.50 per share (excluding debt) is more than 50% of their current share price. I can't name another profitable blue chip company that trades at just two times net cash.

Given the low stock price, Dell's operations must be going horribly wrong, right? Well, not really. For their latest fiscal year, which ended January 31st, Dell earned an operating profit of $3.2 billion. Subtract out income taxes and Dell's operating businesses are earning about $2.4 billion per year. This compares very favorably to their enterprise value of around $11 billion. At $10 per share, Dell stock trades at less than 5 times operating earnings. Is it a stretch to think it could fetch twice that price sometime down the road? Not in my view.

Now, something could certainly get in the way of this analysis. Excess cash is a great thing to have, but it can easily be wasted by management. Dell has been doing many smaller acquisitions in recent years to beef up its product line. If management did a large deal (using their cash war chest) and it turned out be a bad idea, shareholder value could be destroyed rather quickly.

Another risk is that they use their excess cash to beef up research and development. I say this could be a negative because the new products might not pay off. For instance, there have been rumors for months that Dell is developing a cell phone line. As a shareholder, I don't care for this idea. The cell phone market is crowded and Dell has no experience in it. If they spend hundreds of millions on something like that, and it fails, a once large cash hoard could quickly shrink without much to show for it.

Regardless, Dell stock looks very cheap to me, especially if management spends their money wisely in coming years. Finding such strong companies at discounted prices isn't always easy, but in this case Dell looks to be a bargain. Feel free to let me know what you think.

Full Disclosure: Peridot Capital was long shares of Dell at the time of writing, but positions may change at any time.

Time Warner Completes Cable Spin-Off, Sets Stage For AOL Split Next

Time Warner (TWX) has long been a media conglomerate difficult for investors to dissect. However, that may be about to change and the moves could finally extract some value for Time Warner shareholders. The company will complete its spin-off of Time Warner Cable at the end of the month, which offloads billions of debt to the cable company and frees up cash flow at TWX.

Time Warner is also making some moves at its AOL division. AOL has hired Tim Armstrong, formerly the head of U.S. sales at Google, as its new CEO. The conventional wisdom is that Time Warner will spin off AOL as well, in order to allow Armstrong to maximize profit and growth potential at the online unit.

All of this should be good news for Time Warner shareholders, whose stock has been cut in half over the last year and sits near its lows. Time Warner retains some very strong brands, including HBO. With less debt from the cable division, coupled with a $9 billion cash infusion from the spin-off and a new strong management team at AOL, investors might finally begin to look at the stock again in the intermediate term.

As a result, bargain hunters who prefer strong large cap companies might be interested in checking out TWX shares at $8 each. Not only do they sit near their lows, but they yield 3% and trade for less than 5 times trailing cash flow.

Full Disclosure: No position in TWX at the time of writing, but positions may change at any time

Research in Motion Options Scandal Is A Non-Event

Shares of Research in Motion (RIMM), maker of the popular Blackberry line of smart phones have fallen to $44 per share and the latest news is that the SEC has reached a settlement with RIM executives over an options backdating scandal. I thought options backdating was over and done with, but evidently there are still some cases that have yet to be resolved.

A lot was made at the time options backdating came to light, and the practice is certainly unethical, but it really will have no impact on the company's business. RIM shares are down 70% from their highs and now trade at only 13 times current year earnings estimates. If you think Blackberries are here to stay, the weakness this week, in part due to the options headlines, is giving investors an interesting entry point.

Full Disclosure: No position in RIMM at the time of writing, but positions may change at any time

Amazon Shares Look Expensive, Long Term Future Returns Appear Limited

In November of 2004 I wrote a piece entitled "Sleepless in Seattle" which postulated that shares of Starbucks (SBUX) were trading at such a high valuation (forward P/E of 48) that even if the company grew handsomely over the following few years, the stock's performance was likely to be unimpressive. I projected an aggressive three-year average annual earnings growth rate of 20% and a P/E of 40 by 2007. I warned investors that even if those aggressive assumptions were attained, Starbucks stock would only gain 6% per year over that three year period.

The analysis proved quite accurate. Starbucks continued to grow its profits nicely, but the stock's valuation came back down to earth. After three years had passed, Starbucks stock was actually trading 12% lower than it was when I wrote the original piece.

Today, shares of online retailer Amazon.com (AMZN) remind me of Starbucks back in 2004. Despite a cratering stock market and weak retail market, Amazon stock has been quite resilient. After a strong fourth quarter earnings report (released yesterday after the close of trading), the stock is up $7 today to $57 per share. Profits at Amazon for 2008 came in at $1.49 per share, which gives the stock a P/E of 38, which is very high, even for a strong franchise like Amazon.

I decided to do the same exercise with Amazon. I wanted to make assumptions that were both reasonable but also fairly aggressive. I decided that an average earnings growth rate of 15% over the next five years fits that mold. Projecting the P/E in January of 2014 is not easy, but given that Amazon's growth rate should slow as the company gets larger, I think a 20 P/E ratio is reasonable given where other retailers trade (less than 15x). By 2014, Amazon's growth rate should be more in-line with other retailers similar in size, so I chose 20 to be higher than average, but not in nosebleed territory like the current 38 P/E.

After some simple number crunching, we can determine that Amazon would earn $3 per share in 2013 in this scenario. Twenty times that figure gets us a share price of $60, versus today's quote of $57. Even if the company hits these assumptions, shareholders will make a total return of 5% (only 1% per year!) over the next five years. I would be willing to bet the S&P 500 index far outpaces that rate over that time.

Obviously these assumptions could prove inaccurate, but I think this exercise is helpful in illustrating how hard it is for stocks that trade at lofty valuations to generate strong returns over the long term.

There is one interesting thing about Amazon's business that I think is worth pointing out. You may recall that one of the bullish arguments for an online retailer like Amazon was that they could have a lower cost structure by eliminating the expenses associated with renting and operating large brick and mortar storefronts. Having a 100% online presence was supposed to result in higher profit margins, and therefore investors could justify paying more for Amazon's stock.

It seems that argument has not been realized. Amazon's operating margins in 2008 were 4.3%. If we look at brick and mortar retailers that are similar in business line and/or size, we find that Amazon's margins are actually lower than their offline competitors. Here is a sample list: Kohls (KSS) 9.9%, JC Penney (JCP) 7.6%, Macy's (M) 7.2%, Target (TGT) 7.8%, and Best Buy (BBY) 4.6%.

Maybe online retailers have to spend more on research and development and call center staff than offline stores do, thereby cutting into the margin advantage. Amazon also offers free shipping on orders of $25 or more, which many say they could eliminate to boost profits. Maybe so, but sales would be affected to some degree if they did that, not to mention customer loyalty.

Nonetheless, to me these statistics help make the case that a 38 P/E for Amazon is way too high. As a result, returns to Amazon shareholders over the next several years could very well be unimpressive, just as was the case with Starbucks five years ago.

Full Disclosure: Peridot Capital was long Best Buy and Target at the time of writing, but positions may change at any time

Two Suggestions for Apple's Board of Directors

As an Apple (AAPL) shareholder, the recent handling of disclosures regarding the health of CEO Steve Jobs has me upset like most other investors. For some reason, Apple's board of directors believes that a CEO facing a potentially fatal cancer is not "material" piece of news.

They didn't tell us right away when Jobs was diagnosed with pancreatic cancer several years ago, despite a five year survival rate of less than 50%, and they have refused to update us on his health. Now we have to rely on tech-related blog sources to update us and when finally forced to give more details, the Apple board said he was fine, only to announce his six month leave of absence days later.

As if this is not difficult enough for shareholders, the company is currently sitting on $28 billion of cash in the bank. Apple's cash hoard would rank it the 55th most valuable company in the S&P 500 even if it had no operations whatsoever. Why on earth is Apple keeping this much cash on its books?

They will tell you they want to keep money available to make strategic acquisitions and to weather economic downturns. Has Apple ever made a large acquisition? Did they not just announce better than expected earnings for the fourth quarter despite this severe recession? There is simply no reason for them to have $28 billion just sitting there.

I have two suggestions for Apple's board of directors. Not only will both moves boost Apple's share price, but more importantly it would simply show some desire on their part to be fair to their shareholders, the same people who pay their salaries.

1) Announce a Management Succession Plan

How hard is this, really? Apple has plenty of competent managers. All the board has to do is announce what the management hierarchy would look like if Jobs left the company for personal reasons. With that knowledge in hand, he can stay as long as he wants as far as I'm concerned! The board knows this is a crucial issue (the stock plummets each time the health issue appears troubling), but simply ignores it for some reason.

Personally, I do not believe that a Jobs-less Apple would be in trouble. The idea that he is the entire brains behind the company and its products, and not the other 35,000 employees is pretty silly. Jobs is certainly a very good CEO, but the idea that Apple lacks the talent to innovate without him seems far fetched to me.

2) Announce a Stock Buyback Plan and Repurchase 20% of the Company

At current prices they could retire 20% of the company's outstanding shares and still have $12 billion of cash in the bank (and that number would grow every quarter from there). Can anyone really make the argument that Apple needs more than $10 billion of cash? I guess if you think they are going to buy Dell for cash or something than you could, but large tech acquisitions rarely are successful and more importantly, Apple has no history of even attempting them. A large buyback would be significantly accretive to earnings per share and could get the stock rolling again after the latest Jobs-related hiccups.

Neither of these moves would hamper the future outlook for Apple whatsoever. They would simply show that the board of directors is actually doing their job; working for the shareholders of the company.

Full Disclosure: Peridot Capital was long shares of AAPL at the time of writing, but positions may change at any time

Action in Palm Stock Highlights Why Analyst Recommendations Continually Fail Investors

In recent months it would have been difficult to find a stock that Wall Street analysts were more pessimistic about than struggling smart-phone maker Palm (PALM). According to Thomson/First Call, 23 analysts follow the stock, 10 have sell ratings, and only 2 have buy ratings (the rest were neutral). In a world where brokerage firms make money by getting people to buy stocks, such negative sentiment is rare.

As a contrarian, I had actually been accumulating shares of Palm throughout 2008 in some client accounts, as hints of a possible recovery in the company's business began to appear. Most notably, the combination of a sizable equity investment from private equity firm Elevation Partners (run by Roger McNamee, a man I have great respect for) and the hiring a former research and development star from Apple (Jon Rubenstein).

In recent months Palm had explained to investors that they were revamping their software platform and with the help of Rubenstein and McNamee were set to launch a new set of innovative products in 2009. Given how short-sighted Wall Street is, Palm shares struggled as the iPhone and new Blackberry products came to market. Wall Street analysts were negative on Palm because they claimed Apple and Research in Motion were way ahead of them in terms of products and market share. The stock actually reached a low of $1.14 per share in December, down from $4.00 just a month earlier.

The reason I was interested in the stock was not because I disagreed with the analysts' assumptions (I too expect Apple and RIM to have higher market share than Palm), but rather because they were ignoring the fact that the global cell phone market is over 1.2 billion units. Palm could lag Apple and RIM and still collect 5% or 10% of the worldwide market, which would translate into tens of millions of units and perhaps several billion dollars of revenue. The idea that Palm had to beat out Apple and RIM to stay in business (some analysts are projecting Palm will file bankruptcy) seemed off the mark to me.

Sell side analysts generally recommend stocks based on what is known, not what could happen in the future. Even though the public knew a successful R&D guy from Apple was now heading up Palm and was slated to introduce a brand new operating system and product lineup in 2009, since the facts at the time were that Apple and RIM were crushing Palm, practically nobody on the Street liked the stock. At a buck or two though, Wall Street was pricing Palm shares based on the worst case scenario, so the risk-reward trade-off highly favored going long the stock, not betting against it.

Last month Elevation Partners increased their equity investment in Palm from $325 million to $425 million, obviously approving of the company's plan. Yesterday at the Consumer Electronics Show (CES) in Las Vegas Palm unveiled its new operating system and a model of the Palm Pre, the first of its next generation smart-phone products schedule to be released by Sprint in the U.S. sometime during the first half of this year. Palm stock soared 35% on Thursday and is up another 30% today to about $6, bringing its total gain since the December low of $1.14 to more than 400%.

Today analysts are more optimistic (I even saw at least one upgrade) based on the promise of the new operating system and Palm Pre product. Once again, the sell side has waited until the news is out and already priced into the stock (it's already gone from $1 to $6 in the last month) to become more optimistic on Palm's prospects. Therein lies the inherent flaw in most brokerage firm research; they base their recommendations on announcements that the market adjusts for immediately, thereby ensuring what they have to say has little or no added value by the time clients read it.

Now, you may insist that an analyst should not blindly assume that a new product being worked on will turn out to be good, so recommending Palm before knowing what the Pre phone looks like would not have been wise. I cannot argue with that, so maintaining a hold rating until seeing the new products is completely understandable if you did not want to put your neck out.

What I cannot understand is a sell rating on a company whose stock price is implying bankruptcy even though the company is getting private equity investments and you know that a highly respected former Apple exec has been leading a new R&D team for over a year. Are we supposed to act surprised that the Palm Pre looks promising? You may not have wanted to bet on it sight unseen, which is fine, but you can't say that what Palm introduced yesterday was surprising given what we already knew was happening over there.

As usual, Wall Street hated the stock at $1, $2, or $3 but likes it a lot more at $6. Now you know why I like to be a contrarian.

Full Disclosure: Peridot was long Palm shares at the time of writing but positions may change at any time

Surprisingly, Apple Shares Jumping After Bleak Guidance

I closed out the Apple (AAPL) position in my blog model portfolio in August at more than $180 per share after a 52% gain and also trimmed my clients' AAPL holdings at that time, but after the stock has been beaten up in the latest sell-off, searching for a re-entry point seems like a worthy endeavor.

Apple has always sandbagged guidance. The market had gotten used to it and never really punished the stock after earnings reports that handily beat quarterly earnings but issued forward quarter guidance below expectations. That all changed three months ago after Apple issued guidance that was overly conservative, even by their standards, and the stock got crushed.

Trading in the low 90's during yesterday's pre-earnings trading session, investors expected more of the same. Apple's guidance had been for $8.0 billion in sales and about $1.00 of earnings. The company actually reported $7.9 billion and $1.26. Analysts were at $1.65 for the current quarter and many figured Apple would guide to $1.30 or $1.40.

Given the uncertain economic environment, coupled with last quarter's overly conservative guidance, I figured this quarter's guidance would be equally uninspiring and investors would get a sell-off in the stock, perhaps well into the 80's, which in my view would be a great entry point. As a result, I did not buy any Apple shares during yesterday's weakness.

Apple guided this quarter to between $1.06 and $1.35 last night. Compared with current consensus of $1.65, this looked perfect for my thesis. Even if Apple beats its own guidance handily, there is little chance they will actually beat $1.65, so what would prompt the stock to rise?

Well, oddly the stock is up $8 in pre-market trading this morning to about $99 per share.
I guess the numbers could have been worse. Perhaps everyone who wanted to sell Apple has already done so. Still, I would not be a buyer up 8 points in a down market today.

Personally, I think a very conservative fair value estimate on Apple stock, in today's economy and market environment, is around $100 per share. I get there by taking 15 times net trailing operating earnings and adding in the company's huge $24.5 billion cash hoard. If the stock gives up today's early gains, Apple bulls should take a hard look at the stock, in my view.

Full Disclosure: Peridot was long shares of Apple at the time of writing, but positions may change at any time