Anheuser-Busch InBev Update: Nine Months Following BusinessWeek Recommendation

Back in December I was fortunate enough to be chosen by the editors to provide BusinessWeek magazine a value stock idea for their annual investment guide issue. My selection, beer giant Anheuser-Busch InBev, was controversial at the time due to the just-completed buyout of A-B by Belgium's InBev, but despite how disappointed many were with the deal (especially in St. Louis where I resided for ten years) the stock of the combined company was too cheap for me to ignore.

Nearly nine months later I figured I would publish an update to that investment idea given that many people read the BusinessWeek issue and some surely wound up purchasing the stock. Shares of Anheuser-Busch InBev (AHBIF) have more than doubled in value (+119%) since the issue hit newsstands, soaring from $21 per share to a current $46 quote.

The reasons for such a large move have turned out to be the very same arguments I made when I made the pick; the stock was deeply oversold after millions of new shares were sold to finance the A-B deal, and profit margins have increased smartly thanks to the synergies captured from the merger.

The company recently reported financial results for the first half of 2009. While revenue rose only 3% (the beer market is fairly mature in most parts of the world), normalized EBITDA rose 22% thanks to margin expansion. In fact, gross margin rose from 50% to nearly 53%, and EBITDA margins rose from under 30% to over 36%. Simply put, thus far the company has succeeded in hitting its post-merger operating goals.

The doubling of the share price has increased the equity market value of A-B InBev to $73 billion. Combined with $53 billion in net debt (much of which was borrowed to buy A-B and will be repaid in coming years with free cash flow), the stock's enterprise value sits at $126 billion, or 9.8 times current run-rate cash flow. My valuation model back in December pegged a fair value price for the company at 10 times cash flow, so the stock now appears close to fair value of ~$47 per share.

As a result, Anheuser-Busch InBev stock is no longer dirt cheap. For investors who own large positions, it may be wise to consider paring it back. I have not sold it completely for my clients because there remains decent upside over the long term as the firm's massive debt load is repaid. Every dollar of debt that is repaid (assuming constant operating cash flow) will translate into more value for equity holders.

Although the easy money has already been made, I think the stock will do fairly well longer term as the company de-levers its balance sheet and further integrates the two beer giants into one company. Translation: the stock is no longer a screaming buy, but rather a very solid hold.

Full Disclosure: Clients of Peridot Capital were long shares of AHBIF at the time of writing, but positions may change at any time

Barrick Gold Pressured To Lift Hedges Despite Elevated Gold Price

Tuesday evening we learned that gold producing giant Barrick Gold (ABX) has decided to issue $3 billion in new common equity shares in order to buy back all of its remaining gold hedges, which are currently in the red to the tune of $5.6 billion.

In the company's press release Barrick explained that investors have expressed disappointment that the company has hedged 9.5 million ounces of production below market values. Barrick claims such a fact has put pressure on its share price, and therefore seems to have concluded that lifting their hedges is good for shareholders.

The press release also included reasons why the outlook for gold was positive (as would have to be your view if you decided to lift out-of-the-money hedges), but is this really the best time to be lifting hedges? I'm skeptical about the timing of this decision and therefore am glad that I am not a shareholder in Barrick.

As you may have seen, gold prices have risen sharply in recent weeks (chart below) and now trade near $1,000 an ounce for the third time over the last couple of years. The metal never seems to stay over $1,000 for long, even in the depths of the credit crisis. Barrick has decided, seemingly based entirely on pressure from shareholders, to go 100% long on gold just as the metal is nearing its all-time high. I thought we were supposed to buy low and sell high?

Barrick is going to pay $5.6 billion to lift its hedges, which is the mark to market loss it has on the books right now. On 9.5 million ounces, that means the company is underwater by $589 per ounce and must pay that much to get out of them. That means Barrick is partially hedged at $411 per ounce with gold at $1,000.

Now, I am not saying that hedging gold at $411 per ounce makes a lot of financial sense in current times. I certainly understand that investors want to see them lift those hedges. After all, if you are long ABX stock, you clearly think gold is going to rise in price, and therefore would want to benefit if that view proves correct. Still, from a financial management perspective, Barrick is essentially buying at the top of the market.

Why not wait for gold to drop to $800 or $900 before lifting the hedges? That would be a "buy low" type of move and even buying at $900 per ounce would save the company $1 billion in cash, versus making this move right now.

The converse argument would be that gold might not trade back down to $900 or lower, but that seems unlikely. The chart above shows us that gold prices couldn't even stay above $1,000 during the worst credit crisis we have ever faced. In fact, gold traded at $700 less than twelve months ago, at $800 earlier this year, and at $900 just a few months ago.

Gold is typically seen as an inflation hedge as well as a flight to safety when fear is the paramount emotion on Wall Street. We have clearly already lived through the scariest part of this recession. In addition, inflation is unlikely to rear its head anytime soon because firms have little or no pricing power with such a weak economic situation (consumers and corporations are cutting back whenever possible, and demanding low prices, thereby rendering near to intermediate term inflation risks mute).

This $5.6 billion long bet by Barrick Gold with the metal trading at $1,000 an ounce looks like a bad idea to me and I would not be buying gold investments right now. Unfortunately, it appears that the company was forced to act by its shareholders, who likely have a biased view of exactly where gold prices are going to go from here.

If I were running Barrick Gold I would tell my shareholders, "look, we understand where you are coming from, and will look to lift the hedges when it makes sense, but not when prices are approaching all-time highs. Maybe on a pullback we will take swift action."

Time will tell whether this move pays off for Barrick's investors or not. In the meantime I believe it is a good time to be cautious on gold.

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

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

Speculative Trading Lends Credence To "Rally Losing Steam" Thesis

A disturbing recent trend has emerged in the U.S. equity market and many are pointing to it as a potential reason to worry that the massive market rally over the last six months may be running out of steam. Investment strategists are concerned that a recent rise in speculative trading activity is signaling that the market's dramatic ascent is getting a bit frothy.

This kind of trading is typically characterized by lots of smaller capitalization stocks seeing massive increases in trading volumes and dramatic price swings, often on little or no headlines warranting such trading activity. Indeed, in recent weeks we have seen a lot of wild swings in small cap biotechnology stocks as well as some financial services stocks that were previously left for dead.

For instance, shares of beleaguered insurance giant AIG (AIG) soared 27% on Thursday on six times normal volume. Rumors on internet message boards (not exactly a solid fundamental reason for a rally) which proved to be false were one of the catalysts for the dramatic move higher, which looked like a huge short squeeze.

Consider an interesting statistic cited by CNBC's Bob Pisani on the air yesterday. Trading volume on the New York Stock Exchange (NYSE) registered 6.55 billion shares on Thursday. Of that a whopping 29% (1.9 billion shares) came from just four stocks; AIG, Freddie Mac (FRE), Fannie Mae (FNM), and Citigroup (C). Overall trading volumes this summer have been fairly light anyway and the fact that such a huge percentage of the volume has been in these severely beaten down, very troubled companies should give us pause for concern.

While not nearly as exaggerated, speculative trading like this is very reminiscent of the dot com bubble in late 1999 when tiny companies would see huge volume and price spikes simply by issuing press releases announcing the launch of a web site showcasing their products.

I am not suggesting the market is in bubble territory here, even after a more than 50% rise in six months, but this kind of market action warrants a cautious stance. Irrational market action is not a healthy way for the equity market to create wealth.

Fundamental valuation analysis remains paramount for equity investors, so be sure not get sucked into highly speculative trading unless there is a strong, rational basis for such investments. Companies like AIG, Fannie, and Freddie remain severely impaired operationally and laden with debt.

As a result, potential buyers into rallies should tread carefully and be sure to do their homework.

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

Income Tax Rates Must Rise To Offset Higher Deficits? Not So Fast.

Per one's request, my latest quarterly letter to Peridot Capital clients included a section on the current macro-economic outlook for the United States. The question they wanted me to address had to do with possible hyperinflation resulting from ever-increasing budget deficits at the federal level. As with any question like that I try to completely ignore everything I have heard and instead rely on what the numbers tell me to form an opinion. Numbers don't lie, people do.

The latest set of numbers I have looked at are very interesting and so I thought they were worth sharing. The consensus viewpoint today is that higher budget deficits will ultimately lead to higher income taxes on Americans, which is likely to hurt the economy over the intermediate to longer term. Interestingly, historical data does not necessarily support his hypothesis. Let me explain.

Despite current political debates, which are more often than not rooted in falsehoods, the United States actually saw its level of federal debt peak in 1945, after World War II. Back then the federal debt to GDP ratio (the popular measure that computes total debt relative to the size of the economy that must support it) reached more than 120%. Even after a huge increase over the last decade, currently the ratio is around 80%. As a result, our federal debt could rise 50% from here and it would only match the prior 1945 peak.

Given all of that the first question I wanted to answer was "how high did income tax levels go after World War II to repay all of the debt we built up paying for the war?" After all, the debt-to-GDP ratio collapsed from 120% all the way down to below 40% before President Reagan spent all that money in the early 1980's. Surely tax rates went up to repay that debt, right?

The reality is that the top marginal income tax rate went down considerably over that 35 year period and even if Congress maintains the top rate at 39.6% (up from 35% under President Bush) the rate will still be near historic lows since the income tax was first instituted nearly 100 years ago.

Below is the actual data in graphical form. All I did was plot the top marginal income tax bracket along with the federal debt-to-GDP ratio. This makes it easy to see what was happening with tax rates as debt levels were both rising and falling over the last 70 years.

As you can see from the data, tax rates did not go up even as debt was paid off dramatically. As a result, it appears to be a flawed assumption that increased federal borrowing automatically means we will have to pay higher taxes in the future. Political junkies won't like what this data shows, but again, numbers don't lie.

Chevy Volt Could Get 230 Miles Per Gallon

This seems like the kind of thing that could get more people into GM showrooms and help them recapture lost market share, even if most consumers do not purchase the new Chevy Volt, due out in late 2010.

According to an Associated Press story today GM announced that the Chevy Volt rechargeable electric car should get 230 miles per gallon in city driving, more than four times the mileage of the current mileage leader, the Toyota Prius.From the story:

"The Volt is powered by an electric motor and a battery pack with a 40-mile range. After that, a small internal combustion engine kicks in to generate electricity for a total range of 300 miles. The battery pack can be recharged from a standard home outlet."

Despite a hefty initial price tag (expectations are ~$40,000), the car could still be cost effective. Why? According to the story, "If a person drives the Volt less than 40 miles, in theory they could go without using gasoline."

If we want to reduce our use of foreign oil in a meaningful way, this is exactly the kind of innovation that could do it. Not only will less of our money go to the Middle East region, but we will be reducing pollution and Americans will be able to keep more money in their pockets by saving on the cost of gas. Count me as very much looking forward to the launch of more electric cars in the United States.

Analyst Call on Baidu Shows Why Most Wall Street Research Calls Are Useless

There are several reasons I typically ignore Wall Street analyst calls. The most compelling is the fact that sell side recommendations over the long term have been shown to underperform the market with above average volatility. Those are lose-lose metrics for investors.

Such poor performance is largely attributable to analysts being backward looking when they make research calls, despite the fact that they are supposed to be analyzing the equity market, which is a forward looking mechanism. Too many times analysts will upgrade stocks after the firms report strong numbers and vice versa, which does nothing to add to investor returns relative to the benchmark index they are trying to beat. Successful investing requires insight into the future, not reaction to the past.

To illustrate this point, consider an upgrade from UBS analyst Wenlin Li on Monday. Li covers Baidu.com (BIDU), the internet search giant in China. Baidu reported second quarter earnings of $1.61 per share, above consensus estimates of $1.44.

Prior to the earnings report Li had a sell rating and $150 price target on Baidu, which was trading over $300 per share. That in itself appears to be a contrarian call, which would be commendable (wrong, but commendable nonetheless). After the strong report was released, despite only a small upside surprise, Li upgraded the stock to neutral and raised the price target to $380 per share, a stunning increase of 153 percent.

How does a single quarter's earnings beat of 12 percent explain a 153 percent increase in one's fair value estimate for a stock? It doesn't, not by a long shot. This is the epitome of a completely useless Wall Street research call.

To see how this analyst messed up so badly, we only need to look at the changes made to their BIDU assumptions. Li now estimates 2009 revenue at $658 million, up from $542 million, while 2010 and 2011 sales are revised upward by 33% and 38%, respectively. Gross profit as a percentage of sales estimates were also revised upward, by 60% this year, next year and 2011, and net profit was revised up by about 40% per year.

Remember, an analyst's sole job is to follow companies and estimate how much revenue they will bring in and what proportion of that will flow through to the bottom line. Without solid insight into these metrics ahead of time, analyst calls are of little use to investors, which unfortunately is the case more often than not on Wall Street.

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

Chrysler, Ford Riding Government Incentives to First Sales Gains in 2 Years

It is hard to argue with the success of the "Cash for Clunkers" automobile incentive program so far. With $1 billion already blown through, Congress is working on a $2 billion extension, despite most Republicans being against the program (probably because it was a Democratic idea, not because it is not working).

So far the average consumer is trading in their clunker for a new car that gets 9 miles per gallon more than the vehicle it replaced. The sales spike during the last week of July has led both Chrysler and Ford to report July sales gains, the first increase in 2 years for the domestic automobile industry. General Motors reported a 19% decline in sales, but still saw an enormous benefit from the program.

It remains to be seen if car sales will be sustained at higher levels, but the glass looks half full at this point. New car inventories are near all-time lows so inventory rebuilding in coming months should boost GDP pretty significantly, perhaps leading to a positive GDP print for the third quarter.

The car companies are not the only beneficiaries, however. "Cash for Clunkers" helps consumers and the country as a whole too. Higher fuel efficiency should not be understated. Consumers will save money by spending less to fill up their gas tanks, freeing up money for other things. In addition, less pollution from the new vehicles not only is safer for Americans but the environment in general as well.

Despite skepticism from many, this program does this show that smart government spending can stimulate the economy. In this case it does so in more ways than one, making the investment well worth the several billion dollars spent.

Full Disclosure: No positions in Ford or GM at the time of writing, but positions may change at any time

Recent Market Rally In Graphic Form

As we already know, the stock market moves based on how reality compares to investor expectations. The chart below, courtesy of Bespoke Investment Group, shows just how good earnings have been so far this reporting season.

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.