Is Priceline's Stock Valuation Out of Whack with Reality?

Rob Cox of Reuters Breakingviews was on CNBC this morning sharing his view that the stock of online travel company Priceline.com (PCLN) appears to be dramatically overvalued with a $30 billion equity valuation (even after today's drop, it's actually more like $35 billion). Rob concluded that Priceline probably should not be worth more than all of the airlines combined, plus a few hotel companies. While such a valuation may seem excessive to many, not just Rob, it fails to consider the most important thing that dictates company valuations; cash flow. In this area, Priceline is crushing airlines and hotel companies.

As an avid Priceline user, and someone who has made a lot of money on the stock in the past (it is no longer cheap enough for me to own), I think it is important to understand why Priceline is trading at a $35 billion valuation, and why investors are willing to pay such a price. While I do not think the stock is undervalued at current prices, I do not believe it is dramatically overvalued either, given the immense profitability of the company's business model.

At first glance, Priceline's $35 billion valuation, at a rather rich eight times trailing revenue, may seem excessive. However, the company is expected to grow revenue by nearly 30% this year, and earnings by 35%, giving the shares a P/E ratio of just 23 on 2012 profit projections. Relative to its growth rate, this valuation is not out of line.

The really impressive aspect of Priceline's business is its margins. Priceline booked a 32% operating margin last year, versus just 4% for Southwest, probably the best-run domestic airline. With margins that are running 700% higher than the most efficient air carrier, perhaps it is easier to see how Priceline could be worth more than the entire airline industry.

Going one step further, I believe investors really love Priceline's business because of the free cash flow it generates. Because Priceline operates a very scalable web site, very little in the way of capital expenditures are required to support more reservations and bids being placed by customers. Over the last three years, in fact, free cash flow at Priceline has grown from $500 million (2009) to $1.3 billion (2011). At 27 times free cash flow, Priceline stock is not cheap, but given its 35% earnings growth rate, it is not the overvalued bubble-type tech stock some might believe.

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

Tread Carefully, Apparently Another Mini Internet Bubble Is Here

The good news is that we are nowhere near 1999 levels in terms of Internet company hype and excessive valuations. The bad news is that we are seeing the same types of froth, just to a lesser degree, that we saw back then. More than a decade ago we were wondering how Yahoo (YHOO) was worth more than Disney (DIS) and the market eventually corrected that inefficiency (today's values: Disney $76B, Yahoo $18B). Today we see online gaming company Zynga (ZNGA) worth $8 billion ($1 billion in annual revenue) compared with a value of $5 billion for Electronic Arts (EA) ($4 billion in annual revenue). Monster Worldwide (MWW) has $1 billion in sales and a $1 billion equity valuation, versus LinkedIn (LNKD) which has similar revenue and a $10 billion market value. These figures are lopsided in percentage terms, but at least these Internet stocks aren't worth more than the country's bluest of blue chips.

Facebook's $1 billion deal this week to buy Instagram, a mobile photo service with no revenue, shines a light on another phenomenon that we saw during the last bubble; huge changes in valuations one day to the next without any change in business fundamentals. In the 1990's a company could issue a press release announcing they were going to launch a web site and the stock would pop 50 or 100 percent. The Facebook deal is not astonishing as much for its price tag as it is for the fact that just last week Instagram raised $50 million in venture capital money at a valuation of $500 million. In a few days, Instagram's value doubled to $1 billion without it doing anything on the business side to warrant that price. Can you imagine how giddy the VC folks who made that deal must be? It's almost unbelievable.

To put the $1 billion price in perspective, consider than Instagram has 30 million registered users who pay nothing. Facebook is paying more than $30 per user for the company. Facebook itself has about 850 million users and netted $3 billion in revenue from them last year. At the forthcoming IPO valuation of $100 billion, Facebook is being valued at just over $100 per user. Should three Instagram users be worth the same as one Facebook user? It's hard to see how. Now, I understand that Facebook is paying a premium to buy the company outright, so these per-user numbers are skewed by that fact, but still, it's the general trend of the numbers that seems unsettling.

Overall, the U.S. stock market has more than doubled from its 2009 low. The IPO market has been on fire lately and these Internet stock valuations certainly are pointing to the strong possibility that we have a mini bubble yet again. While I would never predict we will see a repeat of 1999, I do think market participants need to tread carefully with these new companies. The current environment might indicate that at least a certain part of the equity market is overheating.

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

My Aversion to Semiconductor Stocks Explained

I recently took over an existing stock portfolio for a new client and proceeded to liquidate a small cap, Taiwanese semiconductor company in favor of other tech stocks I preferred. Since the sale the stock has risen about 10% and the client emailed me wondering why I sold and what my outlook on the little company was. My answer was not as company-specific as it could have been (I knew very little about it and instead preferred to avoid small, non-U.S. chip stocks in favor of other stocks I have spent hours researching), but I did admit that I have an aversion to semiconductor stocks in general (although exceptions sometimes do present themselves).

I find the semiconductor space quite difficult to analyze and even harder to make money in as a long term investor. The industry is very cyclical, certain chips are always being replaced by a next generation product (often from a competitor), and with such high fixed costs required to manufacture chips, profit margins often rise and fall like roller coasters, making for a very volatile stock price environment. Even when you can identify solid semiconductor companies with below-average competition, in growing markets, making money on their stocks can prove quite difficult.

For example, consider flash memory manufacturer SanDisk (SNDK), a current favorite of many hedge fund managers. SNDK is a good company and with demand for flash memory soaring in recent years due to increased penetration of consumer electronics products, sales have been going through the roof. Over the last five years, in fact, SanDisk has seen its annual revenue grow more than 70% from $3.2 billion to $5.6 billion. It would be logical to assume that SNDK stock has been a great investment over that period, but you might be surprised to learn that five years ago today the shares closed at $44.50 each. Yesterday's closing price was $44.51 per share. I know this is only one example, but chip stocks can be tough nuts to crack from an investment standpoint.

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In SanDisk's case they actually have done a great job at maintaining their strong position in the flash memory market, as opposed to many chip companies who often find themselves supplying Apple with a chip for one iPod only to see them be cut out of the next generation product in favor of a competing chip. The problem that SanDisk faces, as do most in the sector, is falling prices. If you have bought your fair share of memory cards, you know that every year prices drop. You can either buy the same amount of memory a year later for much less money, or you can spend the same and get a much larger card. There is no pricing power in the industry, which is great for consumers but not good for investors.

The problem is that huge demand and the corresponding unit growth that comes with it can often largely be eaten away by price erosion. Consider a market where prices drop 30% year-over-year for the same chip (not uncommon if you ever shop for digital camera memory cards and similar products). In order to keep your revenue in dollar terms steady, you need to grow units 43% per year. If you want to grow revenue, say 15%, over the prior year, you need to ship 64% more units! SanDisk actually has been fortunate that demand for flash memory has been so strong, as other areas within the chip space have not been nearly as robust.

So while I agree with many smart money managers who have been accumulating the stock that SanDisk is a good company that is serving a growth market, and that its stock does appear to be cheap, I do not share the same optimism about its long term prospects as an investment. It is just really hard to sustain stock price appreciation in an industry with these types of market dynamics. While there are certainly plenty of success stories within the semiconductor stock universe, I suspect for every long term stock market winner there are five or ten big losers, and I personally do not care for those kinds of odds.

Full Disclosure: No position in SNDK but positions may change at any time

As U.S. Stock Market Rises, Growth Stock Premium Widens Over Blue Chips

With the S&P 500 piercing through the 1,400 level for the first time since the recession, it is getting harder for value investors to find bargains. Consumer-oriented growth stocks, in particular, have seen their share prices and valuations soar during the current bull market. Restaurants like Chipotle Mexican Grill (CMG) and Panera Bread (PNRA) as well as clothing companies like Lululemon (LULU) and UnderArmour (UA) have become market darlings, with P/E ratios stretching into the 30's, 40's and even 50's. Bargain seekers need to dig deeper to find attractive stocks if they want to avoid paying 2-3 times market multiples for their stocks.

An interesting dichotomy has arisen in the beverage space, which to me is a great illustration of how the bull market has played out in recent months. A blue chip beverage company like Dr Pepper Snapple Group (DPS) has lagged in the recent market rally, whereas the smaller, faster growing Monster Beverage Corp (MNST) has soared. In fact, despite being three times the size of Monster in terms of sales, Dr Pepper Snapple is actually valued at more than $2 billion less on the public market. Below is an interesting comparison of the two companies and their stocks.

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Now, given that MNST is a smaller company and as a result is growing faster, I would not argue it should not trade at a premium to DPS, but this much of a premium seems a bit out of whack. If I was investing in a set of brands, I would choose DPS in a heartbeat. And the fact that I could get three times the revenue for a cheaper price would be icing on the cake.

In this current market, I suspect MNST shares are overvalued and DPS is undervalued. The energy drink market is growing faster and is more of an exciting growth story for investors, whereas the DPS brands, while prolific, only grow at the rate of GDP globally. As I try to find bargains in an overbought (my personal view) stock market, I am gravitating towards stocks like DPS. Not only do they look fairly inexpensive on a valuation and brand equity basis, but the value is even more apparent when they are compared with some of today's hottest consumer companies.

Full Disclosure: Long DPS and no positions in CMG, MNST, LULU, PNRA, or UA at the time of writing, but positions may change at any time

The Sears Holdings Dismantling Begins... Years Too Late

It is February 23rd and shares of Sears Holdings (SHLD) have already risen 100% this year, after a more than 20% jump today to nearly $64 per share. Such gains seem irrational, given how poorly the retailer's business has been, but keep in mind that the stock opened 2011 about 10 points above where it currently trades, so you had to be quite nimble (and daring) to capitalize on the recent surge.

Today's stock strength is due to the fact that the company seems finally ready to start splitting itself up, as it believes (probably correctly) that the sum of its parts are worth more than the whole. Sears will spin off its Hometown, Outlet, and Hardware stores (about 1,250 of the company's 4,000 stores) via a rights offering to existing shareholders. This comes on the heals of the recently completed spin off of the Orchard Supply Hardware (OSH) division. Sears Holdings expects to reap $400-$500 million from the separation, which equates to about 7 times annual EBITDA of ~$75 million.

Splitting up the company is the right call, and should have been done many years ago when the retailer was far more profitable. Annual cash flow at SHLD peaked in 2006 above $3 billion and has collapsed, coming in at just $277 million in 2011. Interestingly, however, Sears has been spinning out its small and less desirable assets. Orchard Supply, now public, is a small cap stock, as will be the specialty store business later this year. The company's crown jewels (Kenmore, Craftsman, Die Hard, Lands End) remain deeply hidden within the parent company, making it very hard for investors to figure out their intrinsic value.

In fact, Sears also announced today the sale of 11 stores for $270 million to a large mall operator (General Growth Properties). Selling just 11 of its full line Sears stores will bring in more than half as much cash as a complete spin off of their 1,250 unit specialty store business. It is a nice way of padding their balance sheet and alleviating concerns about a cash crunch and a possible bankruptcy (those rumors are completely baseless by the way), but it doesn't really create all that much in the way of shareholder value.

The biggest problem Sears Holdings faces is that even with its crown jewels, the operating businesses are barely profitable (cash flow margins came in at less than 1% in 2011). Many of their stores are worth more to a strategic buyer like GGP ($24 million each) than they are on the public market inside SHLD. Before today's stock jump the company had $5.5 billion of store inventory that was fully paid for. The equity value of the entire company was also $5.5 billion. Similarly, Lands End and Kenmore would both likely garner multi-billion dollar valuations as standalone companies, but aren't inside SHLD. By spinning out the specialty business (32% of the store base and 27% of cash flow) for just $450 million, you can easily see that SHLD is worth more busted up than it is as a retailer.

Which brings us to the problem for investors with the stock now well north of $60 per share (a $9 billion enterprise value). As long as SHLD management is content doing smaller breakup transactions to pad the balance sheet, and not large ones to truly show Wall Street how much their brands and real estate could be worth on a standalone basis, it is hard to see how a pure play retailer with less than $300 million in annual EBITDA is worth $9 billion as an operating conglomerate. Management would argue that they will be able to improve profit margins by retooling the company's retail strategy, but we are talking about Sears and Kmart here. That argument holds no water. Those stores are dying a slow death plain and simple.

The bottom line from my perspective is that with bankruptcy talk in the media and this stock at $30 (as was the case a few months ago) it is a very cheap stock. With only small moves being consummated to create value and those cash crunch rumors off the table, $64 per share is a tough sell for would-be buyers of the stock. The right number is probably somewhere in between as long as SHLD continues to focus most of its attention on improving the retail operations. If and when the focus becomes monetizing their various brands and real estate assets no matter what path that leads them on, then investors can start to get serious about the stock as an investment.

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

Apple Stock Hitting New Highs: Where To From Here?

It has been a little over a year since I wrote that Apple Stock Can Easily Reach $450 last January, which at the time was more than $100 above where the shares were trading. Thanks to an absolutely stunning fourth quarter earnings report, Apple pierced that level late last month and closed yesterday at a new high of $464 per share. So, where to from here?

The company continues to defy expectations on the profit front, and after crushing numbers for the holiday quarter, analysts now expect $42 of earnings per share in fiscal 2012, up from just a $35 consensus figure a few weeks ago. In addition, cash continues to build on the balance sheet, reaching $98 billion at year-end, up 50% from a year ago.

An interesting thing has happened with the stock, though. As management has continued to hoard cash unnecessarily, and the company reaches a size that many believe makes it prone to a stumble in the not-too-distant future (investors expect this $100 billion a year company to grow 45% this year), the P/E ratio of the stock has tumbled. In fact, Apple now trades at a discount to the S&P 500 index on a trailing earnings basis (13x vs 14x). Looking out at 2012 profit expectations, the gap widens further as Apple's P/E drops to about 11x. And that does not even include the $100 per share of cash Apple is sitting on.

As far as the cash goes, Apple is essentially getting no credit for it in the public market. The stock trades for about 8.7 times 2012 earnings ex-cash, which tells me that if they did pay a huge one-time special dividend ($50 per share would be my recommendation, not that anyone has come asking), the stock would likely not drop as would be the case in most similar instances (doing so would mean the discount to the market would get even larger). This is one of the reasons I am not selling Apple shares yet.

In terms of earnings, it appears that the days of Apple commanding a premium in the market are behind us. Even with a ridiculously positive earnings surprise for the fourth quarter, Apple stock popped just 6%. That compares with an earnings beat of 35% and an upward revision for 2012 profits of some 20%. Given Apple's size, extreme bullish sentiment, and awful capital allocation practices, investors are not going to give them a rich valuation, which limits upside to a certain degree by taking multiple expansion off the table.

Given these new parameters, how can we value the darn thing? First, I will assume they do not change their cash management strategy this year (a painful thought). Since I do not see the market giving Apple more than a market multiple, I would multiply $42 in earnings for fiscal 2012 by 13 (market P/E) and that gets us to $546 per share. There are plenty of Wall Street analysts with year-end price targets that have a six in front of them, but I just do not see that happening. So, my best case guess is 17-18% upside from here, and maybe a bit more if Tim Cook eases up the company's death grip on their cash. As a result, I am not a seller yet, even though the stock reached my $450 target price from last year.

Full Disclosure: Long shares of Apple at the time of writing, but positions may change at any time.

The Obama Bull Market Continues

Below are some pretty surprising statistics, regardless of which political party you side with. With today's stock market rally, thanks to another strong employment report, the S&P 500 index has now risen more than 20% per year since President Obama moved into the Oval Office, besting even Bill Clinton's best term as Commander in Chief. This could certainly play a role in the 2012 campaign, but it is also important to note that although the U.S. unemployment rate has fallen from a peak of 10.0% down to 8.3%, it is a still above the 7.3% level from January 2009, the month Obama took office.

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JCPenney: Great New Ads, Overbought Stock

Shares of department store retailer JCPenney (JCP) have been on a tear this month (up 20% year-to-date, from $35 to $42) after the company unveiled a new advertising campaign (love it!) and shared with investors the details of its new retail strategy. I recently wrote that the stock made sense, at the right price, given the potential for Ron Johnson to start working his magic. That price never really materialized and now that the stock has jumped into the 40's, it looks too expensive.

How can we value the shares given that business has not been great and the new CEO could really turn things around? It is not an easy task, but since Johnson turned Target into a hip retailer more than a decade ago, that seems like a good place to start. Let's assume Johnson can get JCP's margins all the way up to those of Target. That is a hefty assumption (and one that even if accomplished will likely take years, not months or quarters) but using optimistic projections can really help investors figure out what the upside could be. In 2010 Target earned 11% cash flow margins, versus just 7% at JCP, so Johnson clearly has some room to boost JCP's profitability. However, that upside is largely negated by an expensive stock price after a 20% gain so far in 2012. JCP shares trade at 8 times trailing cash flow, versus just 7 times for Target.

Target currently fetches an enterprise value-to-revenue ratio of 0.75 times. If we assume JCP can match TGT's profit margins (again, a very optimistic assumption) they too would fetch the same price. We can use EV-to-sales here because with the same level of profitability, sales and earnings multiples are interchangeable. Giving JCP a 0.75 EV-to-sales multiple puts the equity value at about $10.75 billion (excluding $2 billion in net debt), versus $9 billion today. The stock price at that level would be right around $50 per share.

So if Ron Johnson can turn JCP into a profit machine like Target, and we assume the stocks trade at similar valuations to reflect their strong businesses, JCP stock could rise another 20% or so, from $42 to $50 per share. It could be worse, of course, but with those numbers it is hardly an overwhelming attractive investment at current prices. That gain would be several years away, and assume Ron Johnson can live up to the hype he earned at Target and Apple, even though JCP is clearly in a more challenging competitive position.

As a result, I am steering clear of the soaring stock even though the TV commercials are great and the odds are good that Johnson will greatly improve the store experience over time.

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

Despite Cyclical Headwinds, Goldman Sachs Stock Is Still Too Cheap

Shares of Goldman Sachs (GS) are rising modestly this morning, to about $98 each, after the investment banking giant beat earnings estimates for the fourth quarter. Earnings for 2011 came in at $7.46 per share, down about 50% versus last year, as the business has been struggling through a cyclical industry downturn. Still, the company made a $4 billion profit, bought back about 8% of its shares outstanding, and grew book value by 1% in 2011. And yet, the stock is trading about 20% below tangible book value of $120 per share.

I have been making this argument for a while, and holding the stock has not been fun while it has been treading water far below tangible book, but even with a cyclical industry like investment banking, GS stock should not be at these levels. It is really hard to see how the company would face a scenario where book value dropped 20% from here (which is essentially what investors are fearing when the stock trades at $98). If the sub-prime mortgage meltdown barely hit book value at Goldman, I don't see the European debt crisis doing far more damage. And even if the industry does not turn around as quickly as it has in past cycles, book value will likely go sideways or slightly higher, as we saw in 2011.

For investors to justify the idea that large, well-positioned, and profitable financial institutions should be trading far below tangible book value per share (and GS is far from the only one), one of two scenarios would need to play out. First, the companies would have to have huge unrealized losses already sitting on their books, which when realized would crush book value and wipe out the discount on the shares. Unlikely. Second, the business model would have to break down long term, rendering the firms unprofitable, which would result in a slow degradation of book value (again, narrowing the valuation gap to the downside). Again, unlikely.

Profit margins will likely drop permanently due to the Volcker Rule (no prop trading), but they should stay in positive territory (Goldman's ROE in 2011 was 6%). That should result in lower price-to-book valuations for these banks versus prior cycles, but not below one. As a result, I think GS and their strong peers should trade for at least tangible book value, which means about 25% upside from here.

Full Disclosure: Long Goldman Sachs at the time of writing, but positions may change at any time