Wal-Mart is an Unlikely Answer to Dell's Problems

After handing off the CEO post to Kevin Rollins at Dell (DELL) for a few years, founder Michael Dell has returned to try and help his company find its way back to the top. Dell came out of nowhere in the 1990's to overtake the likes of Hewlett Packard (HPQ) and IBM (IBM) in the PC market and earned the number one spot in worldwide market share. However, customer service issues have hurt the company in recent years and a reinvigorated Hewlett Packard (thanks to the entrance of Mark Hurd) now holds the top spot.

So what is Michael Dell's master plan to get back to the top? Last week we learned that the company will begin selling several desktop models in 3,000 Wal-Mart (WMT) stores nationwide. Upon hearing the news I couldn't help but ask myself, "How is that going to help Dell solve its problems?"

After all, the company built its business perfecting the direct distribution model that Dell created in his University of Texas dorm room in the 1980's (he subsequently dropped out). Furthermore, the company focused on the higher end corporate, government, and education markets, leaving the likes of HP, Compaq, Gateway (GTW), IBM (IBM), eMachines, and Packard Bell to fight over the low-end consumer segment. That market didn't turn out to be a very lucrative one. Packard Bell no longer exists. IBM sold its PC business to Lenovo. Compaq was forced to merge with HP. A struggling Gateway bought out eMachines, but still is doing poorly.

Now we hear that Dell is entering the retail channel with what I would have to think (given Wal-Mart's customer base) is a low-end desktop computer. This decision really doesn't make a whole lot of sense to me. The company thrived by shying away from the exact area they now are going to go after. Let's not forget that Dell at first refused to offer desktop models at $300 and $400 price points, instead focusing on higher margin products. They eventually gave in and also began using Advanced Micro Devices (AMD) chips (under Rollins), something they did not do for a long time.

It has been well publicized that Dell has lost market share due to sub par customer service. The company opted to outsource their customer support in order to save money, but the result was consumers waiting on the phone for hours and upon finally getting through, not really getting helpful information. Dell should really focus on what it is that lost them market share in the first place. You can't argue that it was ignoring the low-end PC market, because Dell was number one years back when they were avoiding that segment entirely. If Dell doesn't fix their image of having poor customer support, their market share numbers aren't going to improve dramatically. Even if someone buys a Dell at Wal-Mart, a bad experience will ensure they buy HP or another brand the next time around.

All of that said, you can understand why Dell has decided to go the Wal-Mart route. If they think the key is to regain lost market share at HP's expense, then selling computers at the world's largest retailer would be a great way to boost unit volume. The only problem with that strategy is that profits won't greatly improve and as long as customer support remains lousy, new customers won't result in a high percentage of repeat business, which is really something Dell needs to maintain to sustain any sort of reemergence as the worldwide PC leader.

It seems to me Dell is focused on a short-term impact, something that can score a few points of market share. While that may be attainable, they run the risk of not really improving the overall Dell experience, either as a shareholder or as a computer user. And without that, a Dell turnaround might be very, very difficult.

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

Market Fails to Dismiss Double Top Scenario

About a month ago I mentioned that it was possible the market could find resistance near the old highs on the S&P 500 index and perhaps make a seven-year double top. Interestingly, yesterday marked the third straight day the market could not register a new closing high on the S&P 500 (1,527 and change).

I'm not really into short-term market predictions (You're better off just flipping a coin if you want to know what will happen in coming days), but we are setting up for a near-term top unless we can break through this level. Oddly, the all-time intra-day high is above 1,550. That must have been a wild day back in March 2000.

Here is what the last decade looks like on the SPX:

Usually a Contrarian Investor, Kerkorian Takes Aim at Bellagio, City Center Instead

In recent years billionaire investor Kirk Kerkorian and his investment company Tracinda Corp. have been focused on potential value in beaten down automobile companies like General Motors (GM) and Chrysler. However, despite a huge upward revaluation in Las Vegas properties during that time, evidently he still sees value in that area.

Monday we learned that Kerkorian is interested in acquiring the Bellagio hotel and casino as well as a new development project, City Center, which is set to open in 2009. Kerkorian is the majority owner of MGM Mirage (MGM) with a 56% stake in the gaming giant, worth about $10 billion before his intentions were made public. MGM shares rallied 10 points in after-hours trading Monday to $73 per share on the idea that Tracinda might wind up taking MGM private at some point down the line.

The announcement is interesting given Kerkorian's recent foray into domestic car companies at very depressed prices. MGM Mirage is not a cheap stock (about 12 times 2006 cash flow) but has many growth opportunities ahead, both in Vegas and abroad in Macau. Such a move indicates that he is not worried about a severe economic slowdown, which would almost certainly adversely impact the boom in Las Vegas and Macau that has been very strong during the current worldwide economic expansion. With Kerkorian still willing to buy at these levels, he must think those predicting doom and gloom on the economic front aren't likely to be vindicated anytime soon.

Full Disclosure: No position in MGM Mirage (unfortunately) or any other company mentioned at the time of writing

Until Consumer Habits Change, Energy Stocks Should Continue to Shine

It's amazing that gas prices hit $4 per gallon in Chicago and San Francisco even before the summer driving season officially started. There are several reasons why we are paying so much to fill up our gas tanks but the one that I think is most important is not talked about as much as it should be.

As you can see, SUV sales as a percentage of vehicle sales has more than doubled over a ten-year period. Since SUVs are far less fuel efficient than cars, they account for a large portion of the increased oil demand in the United States.

There is no doubt that the Iraq war is contributing to high energy prices (oil production there is below pre-war levels), as is rising demand from emerging economies like China and India. However, the habits of the U.S. consumer is the largest contributor to our country's sky-high energy use, and as a result, record-high prices. After all, what we do in this country has a profound effect on the energy market. Despite only representing 5% of the world population, we consume 25% of its oil.

The way I see it, the culprit is the rise of the sport utility vehicle in the United States. Many people who drive SUVs are quick to complain about paying $60 to $70 or more to fill up their tanks each week and accuse the oil companies of gauging prices (which is a ridiculous, baseless claim), but they are a large part of the reason gas prices are north of $3 per gallon nationally as I write this.

If you don't believe that America's love affair with SUVs is affecting gas prices, one glance at the numbers might change your mind. The statistics below are from the Environmental Protection Agency (EPA), an organization that tracks U.S. energy use very precisely. I don't think it is just a coincidence that there has been a direct correlation between SUV sales, petroleum use, and gas prices. After all, the oil markets are based on supply and demand. With worldwide supply flattening out, demand is crucial in determining price levels.

I am not a fan of heavy government involvement as far as dictating human behavior is concerned, but I would not be opposed to increasing incentives for people to ditch their SUV, as well as higher CAFE standards for fuel efficiency. If we could reverse the trend of SUV prominence, oil demand is this country would drop, and prices would follow suit.

For those who need to drive SUVs, that's fine, but they need to understand that higher gas prices might be a cost of driving a larger vehicle, and that blaming the oil companies for high prices is ignoring how the global oil market works. The biggest improvement could come from those who own SUVs without a real need for it.

Until driving habits in the U.S. change, gas prices will remain high and oil companies will continue to reap the benefits on their income statements. As long as the trend shown in the graphic above remains intact, investors should continue to hold a healthy dose of energy stocks in their portfolios.

Microsoft Bid for aQuantive Signals Desperation

This stunning bid for online advertising firm aQuantive (AQNT) by Microsoft (MSFT) seems to stem from simply missing out on deals that competitors have made and feeling the need to get something, anything, done. After talks with Yahoo! (YHOO) went nowhere and Google (GOOG) bought Doubleclick for $3.1 billion, Microsoft had two options if they felt they needed to keep up with everybody else; buy aQuantive or Valueclick (VCLK).

Not only did they go with aQuantive, but they paid an astronomical price. Shares of AQNT were trading at $36 yesterday and that quote was pricing in a lot of buyout speculation already. Somehow they got Ballmer and Company to offer more than $66 per share in cash, an 85% premium. Such a bid puts Mister Softy on the hook for a cash outlay of $6 billion. In return it gets a business at 104 times trailing earnings, 86 times current year earnings, and a whopping 67 times 2008 earnings.

Is it a good move, given the price tag paid? I can't see how it could be. Based on 2006 sales figures, AQNT will represent less than 1% of Microsoft's revenue. This deal can hardly move the needle for them, in my view. Sure it will add some expertise in a field that the company is struggling with, but given that this deal is just being done to keep up with acquisitions already announced by competitors, Microsoft is just keeping pace with rivals, not gaining on them.

Buying Yahoo! would have been a better option. There aren't any comparable deals Google could have done to match a Yahoo! purchase by Microsoft, so that would have actually closed the gap. I don't think this aQuantive deal does that. And given the price they paid, I wouldn't be too happy if I was a Microsoft shareholder.

The only positive coming out of this announcement, unless you are long aQuantive shares (congrats to all of you), is an opportunity for merger arbitrage traders. AQNT is nearly $3 below the $66.50 offer price. Although no other bids are likely, the discount is more than 4% and the deal should close by year-end, so arb players can make an 8% to 9% annual return by waiting six months or so for the deal to close.

Full Disclosure: Long Google, short Yahoo!, and no positions in the other companies mentioned

Eddie Lampert Buys Citigroup Stake Over Last 12 Months

Thanks to quarterly SEC filings, we learned Tuesday that Eddie Lampert, Chairman of Sears Holdings (SHLD) and General Partner of the hedge fund ESL Investments, has been buying shares of Citigroup (C) since early 2006. At the end of the first quarter Lampert had amassed more than 15 million shares worth about $800 million. The filings show that Lampert began buying Citigroup in the first quarter of 2006 at prices in the mid to high forties. Today shares are jumping 1.7 percent in the pre-market to more than $53 each.

The purchase makes sense given that Lampert is a value guy (Citi trades at a 10 P/E and yields 4%) and his hedge fund is big enough that large cap stocks are the only kinds of investments that he can really take a meaningful position in without buying an entire firm. I've seen various press accounts of the Citigroup purchase speculating that Lampert is planning on using his stake to put pressure on the company to make significant changes. However, those hoping for shareholder activism on ESL's part shouldn't get too excited. Although $800 million is a lot of money, Lampert now owns less than one half of one percent of Citigroup. Hardly enough to play the hedge fund activism card.

Full Disclosure: Long shares of Sears Holdings and no position in Citigroup at the time of writing

Was Senator Edwards Being Hypocritical by Working at a Hedge Fund?

I'm curious what readers think about this. After coming up short in his bid to become Vice President in 2004, Senator John Edwards worked for Fortress Investment Group (FIG) as a consultant. Given that Edwards has been focusing his political campaigning on helping solve the poverty problem in our country, is he being a hypocrite by working for a hedge fund, whose main job is helping rich people get even richer?

I'm not sure where I fall on this issue. At first blush it does seem like a questionable decision on his part. However, does the fact that he worked for Fortress really mean he is somehow abandoning the poor? Fortress is going to do what they do regardless of whether or not Edwards is there. There is no way his role at the firm had any financial benefit for Fortress clients. He might have given them a well respected politician in their corner, but he didn't boost their investment returns, so he didn't directly help the rich get richer. That is going to happen regardless.

Of course, Edwards is going to say it was, in part, a learning experience. He clearly doesn't have much financial markets knowledge. But he did admit that the money was nice too. Does someone who supposedly wants to help the poor have to purposely avoid earning a nice living because of his political platform?

It's an interesting topic. I'm curious to hear what you all think. And I know it's a political discussion, but let's keep it polite, not partisan. We can speak in terms of politicians in general, regardless of party affiliation.

Amgen Dependence on Aranesp Off-Label Use Greatly Exaggerated

I touched on the issues Amgen (AMGN) is having with Aranesp a couple months back, but I decided to take a closer look at the numbers after the latest news that an FDA panel recommended further studies and label changes for the company's anemia drug franchise. Such recommendations should not have been surprising given that a label change was already in the works (albeit less severe) and companies do follow-up studies on existing drugs all the time to measure long-term effects. Is the company going to lose as much business as Wall Street seems to be pricing in? I decided to take a look.

The main concern with Aranesp is that the drug is approved for patients with hemoglobin levels below 12. However, there is off-label usage going on at higher levels, and the FDA is concerned that such usage may increase cancer patients' risk of developing other health problems. Amgen stock has been crushed on these concerns.

The media and Wall Street community has been focused on the fact that Amgen's two anemia drugs, Aranesp and Epogen, represented 46% of the company's sales in 2006. If you leave the analysis at that, then dramatic changes in prescription trends for both drugs would appear quite damaging. However, if you dig further to single out the areas of concern, you learn that Aranesp sales in the United States (where the FDA and label changes will have an impact) represent less than 20% of Amgen's business. Recommendations for Epogen (which is used in dialysis patients) is not going to be known until later this year. Furthermore, off-label use is an extremely small percentage of total script volume, so even if Amgen loses all of that business, it won't be catastrophic, as the chart shows (data courtesy of Amgen).

The FDA panel was focused on patients with chemotherapy-induced anemia (CIA) and anemia of cancer (AoC), and especially with off-label uses in those with hemoglobin levels above the targeted range of 11-12. As you can see, only 15% of Amgen's sales in 2006 came from cancer patients taking Aranesp, and less than 3% came from off-label use.

Now, does this information warrant such a dramatic sell-off in the stock? It depends on how much business you assume Amgen is going to lose. If Aranesp revenue was going to go away all of the sudden, then yes, it would be very painful news for Amgen. But doctors are not going to stop prescribing the drug to most patients because the vast majority are using it as intended.

If we make some reasonable assumptions, not allowing Wall Street's reaction to influence our thinking, we can come to a much more logical conclusion about Amgen's future. Let's assume Amgen loses all of its sales from off-label use. If the FDA issues similar recommendations for Epogen in the fall (which seems likely), that would result in a 5% hit to Amgen's annual revenue. We can further assume that some on-label scripts will be lost due to some doctors getting nervous, combined with some who have borderline high hemoglobin levels and choose to cut back just to be safe.

Even if we assume that on-label sales drop off by a substantial 25% for both drugs (which seems like a high number to me), Amgen will see an overall sales drop of 10 to 15 percent. They would likely be able to offset some of that with cost-cutting, as they indicated they will do in their last quarterly conference call. The overall effect on earnings might only be 5-10 percent. Meanwhile, the stock is down nearly 30 percent, and may even be putting in a double bottom around $55 per share.

Full Disclosure: Long shares of Amgen at time of writing

Google Stock Looks Cheap, Believe It or Not

When looking for places to invest excess cash in an overbought market it is important to not only look at your upside potential, but also how much downside there is as well. If stocks are overdue for a drop, you want to make sure you aren't buying something that has a lot of air in it that could be let out quickly in a selling frenzy.

I have been warming up to shares of Google (GOOG) more and more as of late because the stock has been dead money while the company's impressive growth continues. The result of that dichotomy has been a share price that is getting more reasonable on a valuation basis. On Thursday I began initiating Google positions in some of my accounts that had sizable cash reserves.

Long time readers may know that this will be my second bullish call on Google since the company's IPO in August 2004. Like most people I sat out the IPO after the company indicated the stock would be sold well north of $100 per share. After the first round of their auction, the actual price was reduced to $85 per share, but those who didn't bid in round one were locked out of bidding at the lower price.

After the stock began trading it became apparent to me that investors were dramatically underestimating the company's earnings power and incorrectly associating their misfortunes during the Internet bubble with Google's future. I was late to the party, but began buying Google at around $180 per share.

The stock's ascent continued and by early 2006 I had sold my entire position at prices as high as $467 per share. At the time it appeared the Street was aware of the company's earning power, resulting in a fairly valued stock. Since then I have suggested being long Google as part of a paired trade, but have not jumped back in exclusively from the long side. Let me explain why that changed on Thursday.

There is no doubt that Google has tremendous potential to expand its dominance in coming years. That said, there are no assurances that the company's foray into international markets and domestic markets outside of online search will be successful. So, in order to be willing to make a long bet on the stock, I needed to feel comfortable that my investment downside was fairly limited despite the risks the company faces. At the current price of $461 per share, I feel that is the case. As you can see from the chart below, GOOG sits at the same price it was 16 months ago.

How do I arrive at that conclusion? Some simple math really, no rocket science or anything. Current estimates for Google's earnings are $15.12 per share in 2007 (growth of 43%) followed by a 27% increase in 2008 to $19.25 per share. I decided to use what I consider to be conservative assumptions in order to do a risk/reward calculation. Very simply, what is my downside and what is my upside? If the risk-reward trade-off seems intriguing, then Google shares look attractive at $461 each.

First, what is my downside? Let's assume Google earns $15 this year ($0.12 below current estimates) and only manages 20% growth in 2008, to $18 in earnings per share ($1.25 below current estimates). Let's further assume that Google trades at a P/E of 25 next year. I think both of these assumptions are extremely conservative. A 25 P/E on $18 in earnings gets us a stock price of $450 per share. In my opinion, that is my downside over the next 12 to 18 months, less than 3 percent!

Let's compare that to the upside. Again, I'm not going to make overly aggressive assumptions here. I want the numbers to be in reach and doable, but also want to be realistic as well as conservative. For this scenario I am going to take the current consensus earnings estimate of 27% growth in 2008, to $19.25 per share and assume that the company continues to beat estimates by a modest amount. It would not be surprising at all to see 2007 EPS numbers head to toward $16.00 by year-end and 2008 numbers to actually come in closer to $20.00 per share. Further, let's assume GOOG trades at a P/E of 30.

That multiple may seem high given that the market trades at half that valuation. However, I am fairly confident Google will grow at least 20% per year over the next few years, so assuming that growth investors will be willing to pay 30 times earnings for the stock is fairly reasonable. It would be in-line with valuations given to other leading Internet companies, as well as growth stocks such as Starbucks (SBUX).

Quick math tells us that a 30 P/E on profits of $19.25 to $20.00 in 2008 implies a stock price of $577 to $600 per share. Even if we use a more conservative P/E of 25 instead, we get to $481 to $500 per share. Accordingly, the upside is as much as 30% by the end of 2008. Compare this with downside of less than 3% and you can see why I think Google stock in the low 460's is a good investment, even in an overbought market such as the one we are seeing right now.

Full Disclosure: Long shares of Google at the time of writing

Sub-Prime Mortgage Weakness Not Spreading to Other Credit Products

Below is an excerpt from the first quarter earnings press release of a consumer lender that serves lower end customers, including some who would be classified as sub-prime borrowers, but is not involved in the mortgage:

"Factors adversely affecting our first quarter results included lower than expected fee assessments due to lower than expected delinquencies."

No, that is not a typo. For all of those people who were expecting the sub-prime mortgage mess to spill over into other areas of credit such as credit cards and student loans, it appears the worries (and subsequent share price declines) were unfounded. Delinquencies were lower than expected!

It might seem baffling to many, but this is pretty good evidence that the sub-prime spillover effect is being greatly exaggerated, a theory I first rejected a month ago in a piece entitled Most Financials Dragged Down with Sub-Prime Lenders.