Is The Correction Finally Here?

Here I sit with the Dow down 130 points, oil up more than $1, and gold jumping $16 an ounce. It has been more than three years since we have had a 10% correction in the market. Is this the start of it? Nobody knows for sure, but it could be.

If you think about it, the 6% rise we have seen in less than 5 months of 2006 defies traditional investment logic. Consider the current economic environment. Interest rates are rising, commodities are soaring with gold at 26 year highs and oil at record highs. Investor sentiment is very bullish. We are a country at war. And yet, the stock market has rallied strongly.

Given that official corrections (10%+) in the market occur about once a year, you would not expect three years to have passed since the last meaningful drop, given what the country is facing and what economic indicators are showing. For some reason stocks have ignored this backdrop. It is a combination of things; strong corporate profits, balance sheets flush with cash boosting M&A and buybacks, many hope that the Fed will stop hiking rates and prevent a recession.

Whatever the reason, it is hard to argue that we are not overdue for a pullback. Our economy is unlikely to withstand all of these pressures forever. Who knows if today is a sign of more things to come in the short term, but I would not surprised if it is, and investors should be on the lookout. There is no need to panic, just be prepared.

Chesapeake Delivers Again

If you are going to invest in a natural gas company, I doubt you can do any better than shares of Chesapeake Energy (CHK). CHK has everything investors should want; a great management team, a low valuation, and strong business fundamentals.

The company did little to sway my opinion after reporting first quarter earnings last week. Net income excluding one-time items came in at $1.07 per share, well ahead of expectations. The conference call was equally impressive, but you wouldn't really know it from the share price. After jumping about 4% after the numbers came out, the stock has barely budged.

I want to point out a few things that I think investors are missing when it comes to analyzing Chesapeake. As is the case with many commodity-related companies, the day-to-day movements of the stock tends to track commodity prices (in this case, natural gas) and not company-specific fundamentals. Of course, the prices energy companies get for their production is a key component of how their financial results will turn out, but focusing simply on daily fluctuations in natural gas prices, and trading CHK shares based on that, is very misguided for long term investors (yes, it does make sense for day traders since we know that is how the stock has been trading lately).

What is interesting about Chesapeake is that they are actively engaged in a natural gas production hedging program that seeks to lock in prices for their gas well into the future, in order to ensure that they can earn returns on capital that are acceptable for shareholders. Amazingly, CHK has hedged 80% of their 2006 natural gas production at $9.45 per mmbtu. Why is this amazing? The current natural gas price is about $6.65, so CHK is getting 40% more for their gas than their competitors who have not hedged. As a result, it doesn't take a rocket scientist to figure out that not ALL natural gas stocks should track natural gas prices.

Let's take this silliness one step further. For some reason (which I cannot explain in a way that makes logical sense) Wall Street analysts exclude any gains from CHK's hedging program in their quarterly earnings estimates. The company's first quarter numbers were reported as $1.07 versus estimates of $0.98 per share. Estimates for 2006 are around $3.40 per share, putting Chesapeake's P/E under 10. But the hedges aren't even factored into these numbers!

Chesapeake made $122 million in Q1 from their hedges, which comes out to $0.29 per share. In reality, the company reported $1.36 in earnings, not the $1.07 that was reported by the press and analysts. Since this is real money that the company is generating, I can't ignore it when valuing the company. After all, investors haven't ignored the hedging program at Southwest Airlines (LUV), which is a big reason they have performed so well even with $70 oil.

Including adjustments for hedging gains, CHK could earn north of $4.50 this year (annualized Q1 hedging), which puts its adjusted P/E at around 7 rather than 10. Yup, that's right, the stock appears cheap and is actually even cheaper! 

M&A Not Slowing Down

Another "Merger Monday" is shaping up nicely today, as deals continue to pour in at record levels. Wachovia (WB) buying Golden West (GDW) for $25 billion is by far the biggest deal of the day, but perhaps the most interesting is the bidding war for Aztar (AZR), casino operator and owner of the Tropicana Casino in Las Vegas.

In March, Pinnacle Entertainment (PNK) agreed to acquire Aztar for $38 per share, more than 20% above where AZR stock was trading at the time. Late Friday, the two parties agreed to a revised price of $51 per share. It's not often that a company has to increase the price of a friendly takeover bid by 34%, but in this case, three other suitors emerged and a bidding war began.

Although Pinnacle has a signed merger agreement with Aztar at $51, it might not be done yet. Two of the bidders appear to be out of the mix, as Ameristar Casinos (ASCA) officially dropped out, and Colony Capital hasn't been heard from since their $41 bid was trumped. Columbia Entertainment, however, saw their $50 cash bid expire Friday afternoon, and could very well come over the top sometime this week.

What is all the fuss over Aztar about? The Tropicana, although fairly old in Vegas terms, sits on prime real estate on the Vegas Strip. The buyer would like to knock it down and build another brand new casino, much like the newest hot spot, Wynn Las Vegas. Vegas is hot, and as a result, Aztar's real estate appears to be worth far more than shareholders thought a couple of months ago when the stock was trading at $30 before the initial bid from Pinnacle.

Not only will it be interesting to see how the Aztar situation is resolved, but the overall theme of an immensely robust M&A market should be a focus for investors. The best way to play this, aside from speculating on which firms get bids next, is to go with the investment banks whose advisory fees are sky-high with the current deal flow.

Analysts Continue to Boggle the Mind

There are 3,400 sell-side research analysts in the United States. No matter what they do, they're not going to get too many flattering comments from me on this blog. First off, don't get me wrong, there are some good analysts out there. They are tough to find, and likely only number in the dozens, but they do exist. But for the vast majority, they baffle me. Let me explain two extremes.

First, we have Sears Holdings (SHLD), one of the largest retailers in the country with more than 3,000 stores and $50 billion in annual sales. Guess how many analysts cover SHLD? (Hint: take the "under"). The answer is 6. That compares with 23 for Target (TGT), 24 for Wal-Mart (WMT), 28 for Bed Bath & Beyond (BBBY), and 29 for Best Buy (BBY). How can this be? The sell-side is not shy about telling you that it's because Sears doesn't give guidance.

Without guidance, how can they possibly know how to project sales and earnings on a quarterly basis! It's ludicrous, really. After all, a research analyst's job is to research, analyze, and make projections. Heaven forbid should they actually be forced to do their job! So what we have on Wall Street are people who take numbers companies give out on conference calls and plug them into their own Excel spreadsheets. Not exactly quality due diligence.

But then we have the other end of the spectrum. It occurs a lot less frequently, but it does happen, as Wednesday's trading action in Cigna (CI) stock shows. Cigna shares fell $15 after reporting first quarter earnings. What happened, you ask? They missed estimates, right? Nope, they reported EPS of $2.11 on $4.1 billion in revenue. Consensus estimates were $1.89 and $4.1 billion.

Oh, well then they lowered guidance for 2006, right? Wrong again. Cigna actually raised 2006 EPS guidance from $7.25-$7.70 to $7.50-$8.00 per share. Well then why on earth did the stock drop $15? Amazingly, it was because analysts had been projecting 2006 earnings of $8.07 per share (estimates ranged from $7.50 to $9.10). Why would the average Wall Street projection be for EPS of more than $8.00 when the company 's management thinks they are going to earn less than $7.50?

As stated before, I'm all for analysts doing extra work on their own outside of conference calls and press releases from companies. However, when a stock drops $15 after the company raises their guidance for the year, something isn't right. Such a huge discrepancy between what management teams project and what analysts project should be a red flag. If the analysts are more accurate, then they are doing their job well, but such instances are rare. After all, CEO's and CFO's should certainly know more about their company than the analysts who cover them.

Now for the only really important question with respect to all of this: is Cigna a buy at $90 after the $15 drop?

Investors Punishing Legg Mason Unfairly

Shares of Baltimore-based Legg Mason (LM), a leading asset management firm, have been crushed lately and now sit more than 20 percent below their highs. At a recent quote of $111, the stock looks expensive at first glance. The company will report its fiscal fourth quarter numbers on May 10th, with consensus estimates at $4.18 in EPS for the year. How then are LM shares attractive at 26.5 times those profit expectations?

With their recently completed asset swap with Citigroup (C), Legg is now a pure play on asset management and should be able to boost margins substantially. Looking out to calendar year 2007, after the acquisitions has been fully digested and integrated, LM should be able to earn at least $7 per share. Put a reasonable 20 P/E on those profits, based on a double-digit growth rate and within the company's historical valuation range, and you have a solid 30 points of upside.

Time to Cover Express Scripts Short

Two months back I wrote that shares of Express Scripts (ESRX), a leading pharmacy benefits manager, were bloated at $93 each. A P/E of 30 for the company was simply unsustainable. Today ESRX is down nearly $10 to $74 per share after issuing an in-line earnings report. Although I would not do a complete 180 and go long quite yet, I do think it is time for ESRX shorts to be covered for a 20% gain. Where should the money go? I'm interested in taking a look at Aetna (AET), which is down more than 20% today to $36 per share.

McNealy Out at Sun Micro

Shares of Sun Microsystems (SUNW) opened up more than 4% on Tuesday after CEO Scott McNealy announced his resignation last night. There is little doubt that new blood at the helm of the once high flying tech company is a good step for the company, but is SUNW stock a good buy?

Despite a huge cash hoard, the SUNW shares have been stagnant as financial results have left much to be desired. The main thing holding back the stock has been a lack of profits. The company's cost structure is so bloated that even with billions in revenue, they aren't making a dime. The strong balance sheet, coupled with an attractive price-to-sales ratio has gotten many value investors to bite in recent years, but they have little in the way of profit to show for it.

Without profits, investors can't assign a multiple to earnings. Even if the company were able to swing earnings of 10 or 20 cents per share, the stock doesn't look cheap. A 16 or 18 P/E on even $0.25 of EPS and you get a share price lower than it is today. It is possible that a new CEO can turn the company around, but until consistent profitability is demonstrated, Sun Micro shares will be laggards.

A Healthcare Opportunity For Investors?

If you look at the fundamental outlook for the healthcare industry over the next couple of decades you can't help but be impressed. After all, the demographic shifts our country is going to see as the baby boomers retire is quite compelling. From an investment perspective, leading companies serving our aging population stand to profit tremendously.

However, the current market climate for such stocks is quite interesting; healthcare stocks are getting hammered with investor interest lackluster at best. We know big pharma is facing severe headwinds. But insurance firms are down, as are medical device companies, not to mention the brutal sell-off in biotechnology in recent weeks.

It's true that any government-led reform to the healthcare sector could be negative for these companies to a certain degree. Right now, cost containment within Medicare and Medicaid is pretty much non-existent. If policy makers took firm action to bring costs down, pricing pressures would compress profit margins for essentially all healthcare firms.

However, how likely is such broad reform? And even if it does occur, will it completely cancel out all the incremental business gained from the aging boomer generation? I think these are important questions to ask when analyzing the sector and I suspect there are some excellent values beginning to surface, and prices could certainly continue falling in the short-term as governmental involvement is always more of a concern during election years.

Companies Shunning Quarterly Guidance?

I've said here on several occasions that giving earnings guidance does two things, and neither one is beneficial to shareholders. One, it puts management's focus on short term results, not a long term strategic plan for boosting shareholder value. Two, it does Wall Street analysts' jobs for them so they can avoid having to do any real legwork on their own.

An interview on CNBC last Friday afternoon was centered around how some companies have begun to stop issuing quarterly guidance in favor of annual projections. Evidently the number of company giving guidance for three-month periods has dropped from over 60% to slightly more than 50%. I don't expect most firms to take the Sears Holdings/Google approach of not issuing guidance at all, but this is certainly a good start. A company should never be put in a position to feel compelled to ship product on the last day of a quarter just to hit their numbers, appease shareholders, and prevent a one-day stock price blowup.

One ramification of this shift is that quarterly earnings results will be more volatile. Rather than coming in right on target or a penny ahead of consensus every quarter, there will be a lot more instances of big upside surprises and large shortfalls. This will undoubtedly make share prices more volatile during earnings season, but it will also make my job as a money manager much more fun and important as more surprises require more analysis and decision making.

Fortunately, there seem to have been relatively few earnings warnings this quarter (this is a trend I began to see last quarter as compared with prior periods), so I would guess results will be pretty good when companies begin announcing their first quarter results later this month.

Sears Ups Buyback Program to $1.5B

"Sears Holdings (SHLD) announced today that its Board of Directors has approved the repurchase of up to an additional $500 million of the company's common shares. This authorization is in addition to the $30 million worth of shares that remain available for repurchase under the $1 billion share repurchase program previously announced. Since initiating that program in Sept. 2005, Sears Holdings has purchased approximately 8.0 million of the company's common shares at an average cost per share of $120.86."

That is the first paragraph of a Sears Holdings press release issued Wednesday morning. One of the most attractive aspects of owning Sears stock is the fact that as of December 31st they had $4.44 billion in cash on the balance sheet, which equates to $28 per share, or more than 20% of the company's equity value. Share repurchases are one of the main tools Eddie Lampert and Co. will use to convert store cash flow into higher earnings per share, which will subsequently create quite a lot of shareholder value.

Unlike Cisco (CSCO) and Intel (INTC), they aren't buying back stock when it is overvalued just to cover up options dilution. Rather they are buying it because it is undervalued and they have a pretty good idea that their average cost per share will be below market prices several months later.