BofA's Lewis Still Making Deals, But Now Aiming For Distressed Assets

Lots to get to this morning, so I'll be writing on several topics throughout the week, but first let me address a reader question re: BAC.

Shepherd writes:

Chad,

If the wires are correct, it looks like Lewis paid a premium to purchase Merrill Lynch. I'm curious why you hold BAC, given that he seems to have an almost emotional need to acquire things, which gets in the way of negotiating the best price for his shareholders. My guess (admittedly from afar) is that he could have done better...

Shepherd, your characterization of BofA CEO Ken Lewis and his love of acquiring things is spot on. Earlier this decade BAC has acquired companies like FleetBoston, MBNA, and U.S. Trust, and paid full prices for all of them. As a result, BAC rarely traded above 10x earnings since most of their growth was coming from acquisitions, not organic growth.

During that time Peridot clients did not hold BAC shares. It was only after the subprime crisis started to bite the big banks that I invested in BAC. There were a couple of reasons I chose BAC. First, relative to their size, BAC had less subprime exposure than their large cap bank peers. They did take writedowns, but given they are the largest bank in the nation, firms like Citigroup, UBS, and Merrill Lynch had far more exposure. On that front, BAC's losses were manageable, and they were forced to dilute shareholders far less than others via capital raises.

The second reason was that BAC is the largest bank by deposits in the country. As we have seen with the investment banks like Bear Stearns and Lehman Brothers, without deposits to fund your business, capital can dry up overnight and a freefall can result.

On the acquisition front, people have criticized the Countrywide deal, but Lewis actually bought them on the cheap. Time with tell if he gets a decent return on the investment (I suspect he will over the long term, despite short term losses), but buying distressed assets on behalf of shareholders is far better than what he used to do (pay a huge premium for assets that were already fully priced).

The Merrill Lynch deal is a similar situation. We can argue if the price he paid was fair, but at least he is buying on the cheap. That will increase the odds of a very successful deal. I'll have more on the Merrill deal in another post to examine exactly what BAC is getting for their money.

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

Ken Lewis Mulls Another Deal as Lehman Reaches Brink

As soon as Lehman Brothers (LEH) shares hit $4 today and reports came out that the company is up for sale to try and survive, only one name came to my mind as a potential buyer; Bank of America (BAC) CEO Ken Lewis. The guy loves doing deals. Who else would have bought Countrywide?

Since Peridot is long BAC, one of the two things I am worried about (the first is obviously Lehman's ugly balance sheet) is the price that Lewis might agree to pay for Lehman should a deal be reached. Lewis isn't shy about overpaying for firms he really wants, and he loves to grow by acquisition. FleetBoston, MBNA, U.S. Trust... not a bargain among them (Countrywide is still a question mark).

Now that Lehman CEO Dick Fuld has completely blown it (even after seing exactly how things played out with Bear Stearns!), BAC is likely the most probable suitor at this point, and thus I am not surprised their name is already being mentioned in press reports this evening.

Don't overpay, Ken!

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

Update Friday 9/12 9:05AM ET
Rumors today are that the U.S. government will not provide public funding to aid in a takeover of Lehman, as was the case with Bear Stearns. In that case, Bank of America should balk at buying the whole firm. I would love if they just bought a stake in Neuberger Berman, which was the kind of deal LEH was seeking several weeks ago. NB is the crown jewel of Lehman and would be a great asset for BAC to buy in order for LEH to get much needed capital.

Despite Earnings Warning, Corning Retains Strong Balance Sheet & Market Position

There are many times, particularly in bear markets like this one, when I look at a company and am quite baffled as to how investors can let a stock drift so low. Then I remind myself that Wall Street is short-term oriented and only cares about today, this week, and maybe this month. What the reality will be a year or two from now is ignored, which creates the very investment opportunities that long term, value-oriented investors like myself focus on.

I have been a long time investor in Corning (GLW), a leading provider of glass for LCD displays as well as fiber optic cable for the telecommunications industry. The company possesses strong market positions in its two core businesses, has a strong balance sheet, and could generate growth from a budding environmental products division in the years to come.

Given that GLW's main business is supplying glass for LCD displays (think flat screen televisions, computer monitors, etc), quarter to quarter financial results can vary greatly based on the supply and demand dynamics of the end markets GLW serves. That said, the company has been generating strong double digit earnings growth and has built up a net cash position of more than $5 billion, or $3 per share.

After producing several strong quarters in a row, GLW warned on its third quarter recently and as a result 2008 earnings estimates have been sliced from $1.93 to $1.82 per share. The stock, meanwhile, has cratered to around $16 per share. The only conclusion I can draw is that the adverse reaction to the earnings miss is an overreaction. Corning is surely not immune to an economic slowdown by any means, but even if the company only earns $1.70 this year, the stock trades at less than 10 times earnings and investors are getting the operating businesses for only $13 per share (given $3.30 per share in net cash on the balance sheet).

Even if growth rates slow as the global economy sputters through this business cycle, it is hard to argue that GLW shares will remain in the teens for an extended period of time, unless global demand for LCD glass really falls off a cliff and takes years to recover. While anything is possible, I still consider GLW a growth company that can grow earnings per share by 10 percent or more over the next three to five years. As a result, I am adding the stock to the Blog Model Portfolio at the close of trading today.

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

Chrome: Just Another Free Google Product

The announcement from Google (GOOG) yesterday that it has released a beta version of a new web browser called Chrome has gotten a lot of attention, but shareholders like myself aren't overly enthused. Once again it appears that Google is more about coming out with new free products than it is about its earnings or share price. I have no doubt that Chrome is a solid piece of software, but it also is yet another product from which Google will make no money.

Bullish analysts will likely point out that any product that gets Google.com in front of user eyeballs is a good thing and can only help them gain more market share. That may be true, but Google already dominates the search market. I find it hard to believe that the people who will download and use Chrome aren't already Google.com users.

In my view, a service offering such as free wi-fi supported by Google advertising would be a far better use of the company's product design efforts. It would be far more likely to add incremental revenue than a browser would (by expanding the wireless user base). Google's strategy of making an operating system irrelevant is a bold plan, but it likely won't boost Google's earnings, and therefore, its share price.

Now, I do own Google shares. When I reduced my original position a while ago, my argument was simply that Google was a one-trick pony, and although it was a strong pony, new products that actually generate revenue would be the key for Google to attain a second spurt of growth. So far, we have seen little in the way of progress on that front.

I own the stock because it is cheap (19.4 times 2009 earnings estimates), not because they are boosting their long term earnings potential with any of these free new products. For the stock to really make a huge move back to the old highs this decade, Google needs to find another way to make money other than from search advertising. I'm not convinced Chrome helps on that front.

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

Contrarian Call: 40% Drop in Boeing Shares Looks Overdone

The decline in shares of Boeing (BA) has been significant over the last year. The stock has fallen 40% from $107 to $64 as high oil prices force most domestic airlines into heavy losses. The market appears to be acting as though Boeing's only customers are domestic airlines. If that were the case, one could certainly argue near-term earnings growth would be non-existent and the stock deserves the severe haircut it has seen (BA trades at 12 times trailing earnings, 11 times 2008 estimates, and 9 times 2009 estimates).

Boeing - One Year Chart:

Investors need to keep in mind that Boeing will get 50% of its revenue from its Integrated Defense Systems (IDS) division this year, with the rest coming from commercial aircraft. The growth in the aircraft segment is coming from overseas, not the United States. With global economies growing faster than ours, much of the 95% of the world population not living in the U.S. are beginning to either fly more or fly for the first time. Countries like China, India, and the UAE are ordering more and more places from Boeing to boost their fleets. Boeing is not a one trick pony by any means.

The company has also been hit due to delays in its new 787 Dreamliner, its next generation plane. Wall Street obsesses over short term events, so a delay of a few months will hit the stock, but in reality, long term investors should feel confident that Boeing has a new product cycle coming. New planes cost more than the old ones and the 787 improves fuel efficiency dramatically, which is a great feature with high oil prices. Even with some delays with a project this big, Boeing's earnings should still accelerate after the 787 starts being delivered.

Boeing appears to be an excellent contrarian investment option after a 40% drop in stock price. There are clearly issues facing the company, but the current valuation, I believe, has factored in most of the negativity. Even if 2009 profit projections turn out to be too optimistic (current consensus is $6.93 per share), the stock looks very cheap. Even if earnings only reach $6, Boeing at $63 trades at only 10.5 times forward earnings and yields 2.5%. That is a pretty meager valuation for a company that, combined with Airbus, dominates the aircraft market and has a strong defense business in a volatile geopolitical climate.

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

With Oil Down 25%, Is The Bull Market Over?

After seeing the price of crude oil start the year around $100 per barrel, peak at nearly $150, and come nearly all of the way back, where does the oil market go from here? It is interesting to see how many people no longer think we see a range of $150 to $200 anymore. The Goldman Sachs year-end target of $149 is now considered overly bullish by most pundits. Is the bull market in oil over?

The sharpness of the recent decline lends some credence to the belief that much of the 2008 price spike was related to speculative trading activity. After all, the move from the 120's to the 140's came with nearly no new information that would lead one to think the supply/demand balance had changed materially. Daily price swings of $5+ became commonplace without significant events accompanying them. Now with oil down about 25% from its high, calls for $70 or $80 oil are easy to find.

Personally, I think it is important to note that the fundamentals of the oil bull market remain intact. Global demand is growing faster than global supply. It is true that we began to see demand destruction once crude passed $140 per barrel, but since that level was merely temporary, a price of $110 or $115 all of the sudden looks reasonable again. Should we expect gasoline demand to continue to drop at the same pace when gas drops from over $4.00 to under $3,50 per gallon? Probably not.

Even if demand growth drops in the United States and China and India see lower GDP growth levels, oil demand should still rise in coming years. Consider 2008 worldwide demand. Despite the price spike we saw this year, daily global consumption is estiamted to rise 1% to 86.3 million barrels per day. That comes on the heals of a 1% increase last year and another 1% increase forecasted for 2009.

In any bull market there are periods of sharp spikes higher and even sharper declines. Looking at the global economy, it is hard to argue that oil demand will not continue to grow. Sure, alternative energy sources can cut that growth rate noticeably, but with each and every price correction brings less pressure to really promote alternatives in a meaningful way.

A price correction moving toward $100 per barrel, without significant fundamental changes in the outlook for crude oil demand and supply and demand, makes me think triple digit oil prices are not going to become a thing of the past any time soon, for an extended period of time anyway.

From an investment perspective, leading oil producers have seen serious price per share declines, which now imply long term oil prices of far less than $100 per barrel (most are between $70 and $80 per barrel). If you think the next three to five years will see triple digit oil, as I do, then the stocks are going to prove to be excellent investments from here.

Sorry Fortune, Meredith Whitney Is Just An Average Analyst (You Even Said It Yourself!)

Remember when Henry Blodget made his $400 call on Amazon stock back in the late 1990's? He will be known forever for that call more than all the other ones he made combined. Fast forward nearly a decade and Oppenheimer banking analyst Meredith Whitney has achieved similar rock star status. The August 18th issue of Fortune Magazine has her on the cover.

Now, I like Fortune a lot. In fact, aside from an online subscription to the Wall Street Journal, my subscription to Fortune is the only periodical I actually pay for. But this Meredith Whitney hoopla is really getting old, and quite frankly, it's too much.

Like Blodget, whose $400 price target came to fruition despite the controversy surrounding it, Whitney's early warning on Citigroup (C) stock last year definitely deserves kudos. She got death threats after suggesting the banking giant would be forced to cut their dividend and raise capital. At the time it was a minority opinion, but she was right and deserves credit for a very bold and correct call.

That said, let's not get carried away. Investors and the media should not judge an analyst on a single call, but rather the entirety of their work. There are great analysts out there, but the track records of most are mediocre at best. When I have the chance to guest lecture undergraduate and MBA students, I often refer to a study that showed the stock picks of sell-side analysts, like Whitney, consistently underperform the market and do so with more volatility.

So, does Meredith Whitney deserve all the attention she has been getting lately from investors and the media (she is on CNBC all the time)? I have nothing against her, but I doubt it. She should be commended for the Citigroup call, but treating her as the "go-to" analyst on banks would only be reasonable if her track record beyond that one call was overly impressive. Unfortunately for investors, it isn't.

In the Fortune cover story, in fact, it is mentioned that according to Starmine (a company that tracks the performance of analyst recommendations against their industry peers), Whitney's stock picking ranked 1,205th out of 1,919 analysts in 2007 (the year of the Citi call). During the first half of 2008, Whitney's picks ranked 919th out of 1,917 analysts.

The only conclusion I can draw from those numbers is that Whitney is no better than an average bank analyst. In the world of sell-side research, "average" is hardly something to get excited about.

Does this mean you should completely ignore what Whitney and other analysts say? No. They put in long hours and often can provide a lot of information that is helpful in conducting stock research. Still, we should not drop everything and hang on every word whenever Whitney is on CNBC or lands on the cover story of a magazine. She just isn't going to make us rich.

Need proof? Consider her recent downgrade of Wachovia (WB). Whitney downgraded the stock on July 15th from "market perform" to "underperform." For those who prefer to translate Wall Street lingo, that means she went from a "hold" to a "sell." Good call? Umm, hardly.

Wachovia stock actually bottomed that same day at $7.80 and closed at $9.08 per share. It never traded lower than that, completely reversed course, and traded as high as $19.48 on August 1st. That is a gain of 150%, peak to trough, in just 13 trading sessions! Just imagine if you shorted Wachovia because Whitney put a sell on it!

Just as we should not judge Whitney solely on her Citigroup call, we also should not judge her solely on the terrible Wachovia downgrade. Still, since her stock picks rank her as an "average" analyst within a mediocre group of stock pickers, I can safely say the attention she is getting these days is a little over the top.

I still love Fortune and CNBC and all the other outlets going gaga over Meredith Whitney. I just think she's pretty overrated and want people to understand the facts along with the hype. People just love a good story on Wall Street and right now, she's it.

Full Disclosure: No position in Citigroup or Wachovia, long a subscription to Fortune at the time of writing

With Oil Peaked For Now, Contrarians Likely Will Turn To Refiners

There aren't many energy stocks sitting nearly 60% below their highs, but as the crude oil bull market has continued in 2008, refiners have gotten crushed. The explanation for why refiners fare poorly in the face of rapidly rising crude prices is pretty simple. Refiners buy crude oil, refine it, and resell it to users of gasoline and other refined products like jet fuel. If the price of your core cost component is soaring and end demand for your finished product is falling because of high prices curbing demand, profit margins will contract pretty aggressively.

As a result, shares of refiners such as Valero Energy (VLO) have been pummeled. After earning about $8 per share in both 2006 and 2007, profits for VLO are expected to fall 50% this year, to around $4 per share.

But what happens if crude oil stops going up so fast? Already we have seen per barrel prices top out in the 140's and trade down to the low 120's and gasoline prices nationwide are below $4 per gallon again. Frankly, the backdrop for refiners really can't get much worse that is has been so far this year. As a result, VLO shares have fallen from a high of 78 last year all the way down to the 30's.

There appears to be some value here if investors are willing to be patient and wait out a turn in refining industry fundamentals. Let's value VLO stock two different ways and see what we come up with.

1) P/E Ratio Valuation

Let's assume normalized EPS of $6 per share, up from the current run rate because conditions stand a good chance of improving, but 25% below the levels of 2006 and 2007. Use a 10 P/E and we get $60 per VLO share.

2) Asset Liquidation Valuation

Valero has sold 2 refineries since last year for about $3 billion. Those two refineries produced a total of 250,000 barrels per day. Valero now owns 16 refineries producing 3 million barrels per day. Let's assume they sold all of their refineries for the same price. That would net them $36 billion, or $66 per share.

As a result of the tremendous value that appears to be embedded in the stock, VLO is being added to the Peridot Blog Model Portfolio today. Refining margins stand a good chance of improving over time, as long as crude oil prices behave better, which would likely positively affect VLO's earnings per share, earnings multiple, and in turn, the share price.

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

U.S. Savings Rate to Increase? Thank Goodness!

In recent years much has been made about how the savings rate in this country was hovering around (or even below) zero. More and more, Americans have been living beyond their means via credit. With some banks reeling from extending credit to people they should not have, some economic pundits are predicting an increase in the domestic savings rate.

Among them, James Grant of Grant's Interest Rate Observer:

"The American consumer is no more prone to save than the American Marine is to retreat. However, with joblessness rising, house prices falling, gasoline prices orbiting and credit contracting, even America’s iron wallets must adapt. Hovering near the zero-percent marker, the savings rate has little farther to fall. It takes no great predictive courage to suggest that it may begin to rise, which we hereby do. If the savings rate returned to just half its level in 1992, it would reach 3.9% of disposable income, up from 0.6% at present. Disposable personal income is jogging along at the rate of $10.5 trillion a year. An increase in savings of 3.3 percentage points would amount to $346.5 billion of deferred spending."

How might this increased savings take shape? Most likely through high-yielding money market accounts like those offered by the likes of M&T Bank, whose M&T Bank eMoney Money Market Account currently offers 3.25% interest. Not surprisingly, large banks are advertising these types of products more and more, as mortgages go bad. It is quite a shift in focus for their marketing plans.

Not only is this good for Americans (who have not saved nearly enough, on average, to retire comfortably at a reasonable age), but it is also good for our banking system. Deposit gathering institutions will welcome the chance to grab some market share in the savings deposit business, and thereby boost their depressed earnings. Increased savings in this country would really be a win-win scenario for individuals and banking institutions alike.

Slightly Lower Gas Prices Do Not Spark Huge Increases in Consumer Spending

Oil is down a couple of bucks and retailers are on fire. Sears Holdings (SHLD) jumps $9 per share today? Remember everyone, rising gas prices did not result in plummeting retail sales and this subsequent drop does not mean Sears is all of the sudden going to see an influx of shoppers or its average ticket rise meaningfully.

These small incremental changes in the price per gallon does not materially change behavior. If national gas prices drop from the peak around $4.10 per gallon to, let's say, $3.50, how much does the average consumer save? Well, let's say you fill up once a week and have an 16 gallon tank. We are talking about less than $10 per week, or about $500 per year.

Now, I am not saying that extra $500 does not have an economic impact, because it definitely does. That said, it will not translate into incremental earnings at the retail level that would justify a 5%-10% jump in share prices of the nation's leading retailers. As much as I would love to say otherwise, Sears should not be up $9 in today's market.

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