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 :)
I Hope Eddie Lampert Is Mulling a Deal
What could be worse than trying to turn around Kmart and Sears? The only thing I can think of is trying to do that when the low end consumer is being squeezed from all angles and the housing market is weak. Today's earnings warnings from Home Depot (HD) and Sears (SHLD) aren't that surprising when we look at the macro view of the economy domestically, but even still, the Sears number was pretty bad and Home Depot only escaped a wrath of selling because of their enormous buyback. Sears announced a $1 billion buyback, but that is just a drop in the bucket for them (4% of shares outstanding).
Home Depot got lucky. They timed the sale of their supply business well enough that they can just use that money to buyback shares above the market price and keep their stock up even when earnings are declining. Sears has a problem, though, in that it hasn't diversified yet like everyone thought it would. The Kmart/Sears merger was supposed to be about real estate, excess cash flow, making more acquisitions, becoming the next Berkshire, etc. What happened?
Well, Eddie Lampert decided to try and fix the retail business as best he could. That's a perfectly fine idea (just look at what JC Penney has been able to do over the last five years and you'll see retail turnarounds like this do happen) but given we have the low end consumer getting squeezed and a weak housing market (which just happen to be the two core focuses for Kmart and Sears), the fact that Lampert hasn't diversified Sears Holdings yet is a problem right now.
Long term investors (myself included) likely aren't overly concerned because they know the retail weakness won't last forever, and they know Lampert has other ideas for excess cash. But, given the stock price weakness lately, he really needs to do something to get the shares moving again, a la Home Depot. So what should he do?
Quite simply, a deal, any deal. I don't mean just any deal that happens to be available (it has to make sense), but it also does not have to be an outright buyout of another company. Surely Wall Street would applaud the purchase of something at a bargain basement price, preferably outside of retail completely, but even an internal deal could boost shareholder morale.
The most logical would be a large real estate deal like many investors have been hoping for since Lampert bought Kmart out of bankruptcy and leveraged that stake to takeover Sears. Eddie hasn't sold underperforming locations as fast as many people thought he might. It is clear he wants to try things before giving up on certain locations. However, a deal to monetize some real estate would accomplish two things that would help the stock price.
First, it would show to investors that the real estate actually does have meaningful value. It has been debated exactly how much the Sears real estate is worth. Everybody has their own forecasts, but in reality, something is only worth what someone else is willing to pay. Selling stores would give investors a way to value that real estate (which is likely understated in most valuation models focused mostly on retail profits) and also show them that Lampert is willing to cut his losses on more stores.
The second thing it would do would be to help the bottom line. Selling underperforming stores not only gives you money to diversify with, but it also boosts your earnings, which are already under pressure due to the economic environment. Surely there are stores that aren't making any money, even after many have been closed. Closing those underperforming locations will help boost retail margins, which would also boost investors' perception of what the company's retail business is worth.
All in all, Sears is in the unenviable situation of trying to turn around a retailer during tough times. Since this makes it harder than usual, if they want to continue down the retail road, it is imperative for the company to make some moves to diversify away from low-end retail and housing. The only way to do that is to free up some cash, or use cash you already have on hand, and do a deal. Either sell some real estate and reallocate that money, or use the money you have now and buy something unrelated to Kmart and Sears.
If Lampert does something like that sometime this year, Sears stock can get moving again. As long as he waits it out, the odds are good that the stock is dead money for a while. I'm confident he will make the right moves, which is why I've owned the stock for years and will continue to hold it, but after Tuesday's earnings warning, I think it is important for him to do something sooner rather than later. If not, he will eventually lose some of his loyal supporters.
Full Disclosure: Long shares of Sears Holdings
Is It Time to Buy Bear Stearns?
Whenever a good company falls upon hard times that could very well just be temporary, it pays for value investors to take a look and see if Wall Street has overly punished the stock. After the hedge fund blowups at Bear Stearns (BSC) recently (they made some bad bets in the mortgage market), BSC stock has retreated more than 30 points from its highs, as the chart below shows.
Is the stock a bargain? Well, I compared it with the other big investment banking companies and I expected to see more of a discrepancy in the valuations than I found. The Big 5 (Bear along with Goldman, Lehman, Merrill, and Morgan) all trade right around 10 times forecasted earnings for 2007. As P/E multiples go, buyers of BSC aren't getting any discount compared with the likes of Goldman Sachs (GS). That didn't exactly get me excited about bottom fishing with Bear.
I also looked at a ratio called price-to-tangible book value. This measure is the same as price-to-book, but ignores intangible assets that can't be easily and quickly valued. Book value is perhaps the most important valuation metric for banks given that the vast majority of their assets are liquid financial instruments and all banks pretty much do the same things business-wise, for the most part.
On this measure Bear Stearns trades at a discount of 1.6 times net tangible assets. This compares with 3.1 times for Goldman and between 2.2 and 2.4 times for the other three major players in the industry. As you can see, investors are paying up for Goldman's superior track record and management. While Bear is cheaper, the stock would probably have to get down to 1.5 times book or less for me to really get excited about it as a contrarian play. That is not to say the discount won't narrow as the sub-prime issues subside, but 1.6 times book isn't a price that I feel like I absolutely need to jump at. It's cheap, especially relative to the other brokers, but not ridiculously cheap by any means.
Full Disclosure: No positions in any of the companies mentioned at the time of writing
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
How Should Hedge Funds and Private Equity Be Taxed?
It seems like Congress goes into attack mode anytime somebody is making a lot of money. In some cases I agree with our elected officials and in other cases their arguments make little sense if you look at the big picture. Take the oil companies for instance. We all know the industry is swimming in money. If Congress aims to repeal subsidies these firms get from the federal government, I have a hard time opposing the idea. Our country does not need to subsidize our oil companies. However, if you propose some kind of excess profits tax simply because oil prices are high, that is ridiculous. We live in a market economy and markets are cyclical. You can't tax companies during boom times just because you feel like it.
Anyway, the topic du jour is the taxation of hedge funds and private equity funds. Again, we have a group of wealthy people who are making billions and paying the same (if not less) taxes as the average worker. To figure out where I fall on issues like these, I try not to bring politics into it at all. To me, it's logic-driven reasoning that should rule the day and help form an opinion.
I haven't been following the issue that closely, but the sticking point is the fact that hedge fund and private equity fund general partners split investment profits with their limited partners. The investment managers serve as general partners and collect 20% of the profits from the investments they make, which is often taxed as long-term capital gains, at a rate of 15%. The fact that someone can make $100 million and only pay 15% in taxes is evidently upsetting a lot of people in Washington.
At first blush it might seem like the 15% tax rate makes sense. If a hedge fund has $100 million in assets and earns 10%, there is $10 million in profit to be divided up. Assuming an 80/20 split, the manager makes $2 million and the limited partners share $8 million based on their ownership percentages. Since the $10 million in profit was the result of capital gains, then it is easy to see why some feel the 15% tax is fair.
There is one difference though, that seems very important. The whole point of having a low capital gains tax rate (relative to income tax rates) is to incentivize people to invest in businesses and put their capital at risk. Such actions are the life blood of our capitalist system. In return for risking your own money by investing in other ventures that need funding, you are rewarded with a lower tax rate on any profits you earn.
The problem is, hedge fund managers aren't risking their own capital a lot of the time. They are pooling money from their investors and managing it for them. Sure, they don't earn anything unless they produce positive returns, but if they lose money, they don't lose as much, if at all, because they typically have less capital at risk, if they invest in the fund at all. This seems like the most logical reason why one would be against the 15% tax rate for hedge fund managers.
Now, it's true that most fund managers have invested some of their own money in the funds they manage. Perhaps what the tax law needs to say is, when you have your own money at risk, you can claim profits as a capital gain, but when your investors are simply sharing a portion of the profit earned on their capital, in return for your management ability, then that income should be treated as a management fee, and therefore taxed at ordinary income tax rates.
It's a tough issue for sure. I just hope the law going forward reflects reality, meaning that if you get a tax break for capital gains, it better actually be your capital that was put at risk in order to produce the gains in the first place. A fair compromise in my eyes would be to allow managers to pay 15% on the portion that is their own capital at risk, and ordinary income tax rates on fees earned on limited partner's assets that are paid out to the general partner. That way, the whole point of the 15% capital gains tax rate (reward risk taking with lower taxes) is preserved.
What do you think?
Where Does Buffalo Wild Wings Go From Here?
A reader named Hayward writes:"
Chad, how about a new update on BWLD now that it exploded to the upside."
No problem, Hayward.
Sports bar and grill chain Buffalo Wild Wings (BWLD) is a stock I have been very bullish on for a long time. Hayward is referring to my post from eight months ago entitled A Wildly Bullish Quarter for Buffalo Wild Wings. The stock has since doubled to more than $42 per share.
The investment thesis was fairly simple back in October and nothing has changed on that end. This is still a popular concept restaurant with very strong growth prospects. BWLD has more than 400 locations with a large portion of them located in Ohio, the state where it was started years ago. With a long term target of 1,000 restaurants, there is enormous expansion potential and few barriers to get there.
The stock has had a huge run as the company trounced earnings estimates, which caused me to trim the position recently as it became a large holding and traded at 30 times next year's earnings. The stock is no longer cheap, but I still believe the stock will do well in coming years as they approach a national footprint.
I would suggest investors take some profits but still hold onto some of their stock. Since the store base can still more than double from here over the next five years, the stock should beat the market over that period, even if it isn't cheap anymore at this point in time. Right now Peridot is holding an average sized position in the name, whereas in prior months it was a larger position due to P/E multiple expansion potential (which has since occurred).
I hope that helps, Hayward. If anyone would like to suggest possible topics for future blog posts, feel free to let me know by using the blog's contact link at the top of the page.
Full Disclosure: Long shares of Buffalo Wild Wings at the time of writing
With Growth Stocks Seeing Multiples Compress, Investors Should Make a Shopping List
Even though the market has done well this year, It has been interesting to see so many former high flying growth stocks come back down to earth. Over the last few years there was always a group of great companies that were growing like weeds and their share prices reflected those prospects. If I think about the premier growth companies of the last five years, names such as Starbucks (SBUX), Whole Foods Markets (WFMI), Genentech (DNA), and eBay (EBAY) come to mind but there are dozens of others as well. These stocks had traded at 40 times earnings for a long time. Momentum growth managers scooped them up, but others were wary of the high P/E multiples, and that caution proved to be correct.
Not surprisingly, these stocks have underperformed as multiple compression has taken place. I even wrote about Starbucks back in late 2004, in a post entitled Sleepless in Seattle, warning investors that even if the company continued to grow, the stock might not. The coffee giant, along with the other companies mentioned above have in fact treaded water or are hitting new lows lately. At some point, though, the stocks will look attractive. Starbucks isn't worth 40 times earnings, but maybe it is worth 20 times. Same with the other names. As former growth stars come down, investors should decide if they would like to own any of these companies, and if so, at what price. If things keep going in this direction, there might be entry points over the next year or so.
Do any of the four aforementioned companies grab my attention at current prices? After all, they now trade at between 20 and 24 times 2008 earnings projections. One jumps out at me in particular, Genentech. A 21 forward P/E seems very reasonable for a leading biotech company that can likely grow earnings 15 to 20 percent annually for the next five years. As you can see from the chart below, the stock has treaded water for two years now as the multiple compressed by more than 50%. Growth investors might want to take a look.
In general, it appears many growth stocks that were once wildly overpriced are getting more reasonable. I would suggest investors who once passed on a name or two due to valuation reexamine those companies again. Decide whether you still would like to own them or not. If so, make a shopping list complete with purchase targets and monitor them. You might find some bargains.
Full Disclosure: No positions in the companies mentioned
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