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2008-February-Archive

Update on Coverage

February 29, 2008  |  4:45 PM

The Ockham Research coverage universe, which includes nearly 3000 stocks, is chock full of attractively valued stocks right now. Earlier this month we reached over 90% buy recommendations, which is the most bullish we have been since we very nearly called the bottom after the internet bubble burst in 2002. Of course, at the time we did not know that we were at the bottom, but valuations were at levels that made it more likely that the market would rebound rather than continue its slide. Back then, the stock market had dropped very rapidly and while we were becoming bullish, many pundits remained decidedly bearish. Co-founder of Ockham Research, Marsh Douthat, used to say that “logic and reason are never embarrassing in hindsight” when he pondered market action. He meant that one cannot know the future but it is surely better for an investor to implement a consistent and logical guiding methodology rather than allowing emotion, fear and greed to dictate one’s responses.
The number of buys based on Ockham’s ratings methodology may have diminished quite a bit from the peak earlier this year, but we still have about 45% of our universe rated a buy, and that was before today’s stock plunge. Valuations are back within the band of what we consider to be “normal” levels historically, which entails that stocks are at a price-to-peak earnings ratio of between 12 and 15x. In the spring and summer of last year, we warned repeatedly that that the market’s price-to-peak earnings ratio, which was hovering at around 18x, was neither justifiable nor sustainable. The market was overbought and that condition was prolonged by speculative buying. Currently, while the market may not be at an absolute bottom for this cycle, there are plenty of stocks that have fallen out of favor and represent excellent long term buying opportunities for patient and disciplined investors. 
From a valuation standpoint, a few large cap stocks that we recommend are: Amgen (AMGN), BB&T (BBT), Cisco (CSCO), Dell (DELL), Home Depot (HD), and Eli Lilly (LLY).

 

Applause for Paulson

February 28, 2008  |  12:10 PM

Treasury Secretary Henry Paulson today stood strong against rising calls for a taxpayer bailout for the struggling housing industry. Paulson rejects the notion that the only way out of the housing mess is for government to engineer a giant bailout using taxpayer money. In an interview yesterday, Paulson said that a bailout would more likely rescue reckless lenders, investors, and speculators than be of any real assistance to the stated targets of such a plan—struggling homeowners who cannot afford the rising mortgage rates they now face. Paulson and the Bush Administration are in favor of encouraging mortgage lenders to voluntarily ease up on borrowers that are current in their payments but probably will not remain so as their rates adjust upward. At Ockham, we always appreciate fiscal solutions which are grounded in free market principles rather than those based on Keynesian interventionism.
Data released earlier this week demonstrates that the housing market is worsening, as the fourth quarter 2007 S&P/Case-Shiller national home-price index fell 8.9% from a year earlier. This represents the biggest such decline in 20 years. Furthermore, mortgages guaranteed by Fannie Mae and Freddie Mac declined in number by 0.3% last year, the first year over year drop in 16 years according to the Office of Federal Housing Enterprise and Oversight. Paulson himself estimates that last year some 1.5 million Americans were foreclosed on and he expects that number to climb to 2 million in 2008, whereas a normal rate would be about 650,000 homes a year. 
Armed with such bleak data in an election year, numerous politicians are anxious to put their name on a bill that will save homeowners. However, is that what is best for either the economy or said homeowners? Barack Obama would like to set aside $10 billion to help homeowners avoid foreclosure and to assist first time home buyers. Hillary Clinton would put a 90-day moratorium on foreclosures and also freeze rates on adjustable rate mortgages for 5 years. These proposals are not sound economic policy but rather an attempt to pander and glean votes and they will not be able to reverse market forces. Paulson referred to plans such as these and those being considered in the House of Representatives: "I'm seeing a series of ideas suggested involving major government intervention in the housing market, and these things are usually presented or sold as a way of helping homeowners stay in their homes. Then when you look at them more carefully what they really amount to is a bailout for financial institutions or Wall Street.” In sharp contrast to the bi-partisan support afforded the recently-passed economic stimulus package, debate over a homeowner bailout plan presages a fiercely partisan battle in Washington.
Paulson is correct to trust in the efficiency of the free market to work through this crisis. Housing slumps are not a unique economic circumstance. When prices drop, buyers are incentivized to in enter the marketplace and the situation self-corrects until it reaches equilibrium again. Government intervention, no matter how well-intended, only interferes with market forces and results in complications and distortions which often have unintended consequences—typically worsening and prolonging the correction. That explains why some of the greatest economic minds in the country—Bernanke and Paulson for instance—believe that any government intervention should involve the original lenders and be targeted to a specific class of intended beneficiaries, the well meaning homeowners current in their debt but at risk going forward. Financial markets do not always go up and, in situations such as these, the best fiscal policy is to “first, do no harm”.
URS Shares Plunge on Weak Forecast

February 27, 2008  |  4:10 PM

URS Corporation (URS) is an engineering and design services company which derives a fair amount of its business from U.S. Government contracts. These contracts are mainly for systems engineering, but also for construction operations and project management. Already in 2008 URS has won bids on contracts to head up nuclear waste remediation and flight training projects. In late 2007, URS completed the acquisition of The Washington Group (TWG) for $3.1 billion. OSHA has just reaffirmed its alliance with TWG, especially in nuclear waste cleanup projects. URS‘s business backlog soared to $18.71 billion which is more than four times greater than the prior year backlog. However, after releasing results from fiscal 2007 the stock has tumbled nearly 20% as future forecasts call for moderating growth.
The results for 2007 were essentially in line with estimates, but based on the flurry of activity surrounding the company many investors had hoped that URS would have outperformed. The company raised profits by 17% over the year before, but the tepid prognosis for the coming year triggered a sell-off in the stock.  The company’s revenue projections fell $300 million short of analysts’ forward looking estimates and earnings were also well below what analysts had predicted. The company cited a slowing economy and a difficult infrastructure spending market as the reasons to expect moderating growth in 2008. Local and state governments are under increasing budgetary pressure, which will only worsen as tax revenue falls during a slowdown. Thankfully, at least for a while, URS can start to work through its backlog of work and should enjoy a “soft landing”. 
Ockham had rated URS as a sell prior to today’s plunge, as our Rationally Expected High for the stock is just barely above $45 based on historical precedents. Since the stock was already slightly overvalued, when disappointing forecasts were released URS took a brutal but justified fall. For now, we think that a fair price target for URS is about $36.40. We are therefore comfortable rating the stock a Hold for the time being, as it may very well have a bit further to fall. However, after today’s drop URS no longer meets a Sell rating.
Intel Brings Personal Computing to Billions

February 26, 2008  |  12:20 PM  

Intel Corp. (INTC) is the world’s leading chip-maker and already powers 70% of its personal computers (PCs). However, most of these PCs reside in the mature, developed economies of the United States and Europe. Intel’s latest strategy is to bring the PC to emerging markets and they have developed the technology to make it happen. Last week Intel unveiled their new “Diamondville” chip, which is expected to be introduced into the market in mid-second quarter 2008. 
The new Diamondville chip will be installed in PCs selling for around $250, and thus will be available to many millions, possibly billions of consumers that would not otherwise be able to afford a PC.   The target markets are the rapidly growing economies of Brazil, Russia, India, and China. The computers that will house the chip are currently being developed by HP (HPQ) and Dell (DELL), and will likely be a small PC with a shrunken keyboard and undersized 7-inch screen.   The actual Diamondville processor will have about half of the power of Intel’s low end Celeron processor, but that is enough to run most standard programs and functions. The Diamondville chip will be inexpensive to produce,  so Intel’s profit margin—their gross margin was 58% in 4Q 2007—will not be heavily impacted. Clearly, this has the potential to be a big revenue generator if it catches on in a significant way and the downside risks appear fairly minimal.
Intel has developed something to excite the techies out there as well, proclaiming the development of its new ultimate motherboard, tentatively titled “Skulltrail”. The motherboard will come equipped with two sockets for Intel microprocessors and each one of those will have four calculating engines, giving the computer an effective total of eight independent brains. Also this new motherboard will allow graphics chips from both NVIDIA (NVDA) and AMD (AMD); this is unusual as co-operation with competitors is quite rare in the chip business. This is generating a buzz among high performance computer users, even though a new desktop with the Skulltrail motherboard will cost about$6000.
These two business lines are promising and we are especially anxious to see if the Diamondville can have the impact that Intel hopes. Ockham has a price target for Intel in the range of $25-$43 based on what the market has historically been willing to pay for the stock. Intel continues to be on the leading edge of microchip design and that will certainly benefit the stock as these designs become sales.
Ambacked?

February 25, 2008  |  3:00 PM  

The stock market has been abuzz with speculation over the possibility of a bailout for Ambac (ABK). Ambac is the troubled bond insurer that recorded $5.2 billion of write-downs in the fourth quarter, and now is in jeopardy of losing its all-important AAA credit rating. Ambac is hugely affected by the credit crisis and is tied to the consumer debt and mortgage backed financial instrument markets, both of which are deteriorating. A sharp increase in defaulted mortgages could spawn a wave of defaults among bonds backed by those loans.  If Ambac were not to keep their AAA rating, then their bond insurance business would struggle to stay afloat. This has ramifications that extend way beyond just Ambac. Citigroup (C), Wachovia (WB), and UBS (UBS) among others need to keep Ambac healthy as the ripple effect from an Ambac bankruptcy would be massive. Oppenheimer estimates that the major banks have $70 billion of exposure to Ambac and the bonds they insure.
Clearly, Ambac losing its credit rating of AAA or declaring bankruptcy would be catastrophic. If the worst were to occur it would make the housing crisis pale in comparison. Banks act as underwriters for billions of dollars in corporate bonds of which Ambac and MBIA (MBI) are the two main insurers. So, it would be disastrous for Ambac, to the point that these banks or the government would likely step in to keep the insurer of over $556 billion worth of bonds surviving in this extremely rough period. The banks are hoping that this $3 billion capital infusion will be enough to cover the liability of those bond sets that are in default. Looking just at the balance sheets of Citigroup, UBS, and WB, for example, shows that in 2006 these banks made almost $40 billion in combined net profit. The potential ramifications of Ambac going under would hurt these banks so badly that they would likely be willing to continue to pour money into Ambac in order to keep it operating. From their prospective, it would be better to have reduced earnings for 2 years or so as an alternative to Ambac defaulting and the disruption that would result.
By any valuation rating system Ambac will appear undervalued compared with its historical normal ranges, but clearly there is reason to be cautious in such an uncertain market environment. We cannot advise buying given the current market climate.   As long as Ambac does weather the storm then it is almost certainly going to rise to more normal valuations, and it appears that Ambac is too important to the financial system for banks to allow it to go bankrupt. The real loser in this could be the bond funds who attempt to identify undervalued bonds, if indeed Ambac does lose its AAA rating the result would be an immediate deflation in bond prices backed by Ambac. These bond funds could very well collapse under the pressure of the portion of their portfolios that is insured by Ambac losing value so rapidly. It will certainly be interesting to watch all of it unfold over the coming few quarters.

 

Don't Give Up on the Stock Market

 

February 22, 2008  |  4:10 PM  

As yet another down week for the stock market comes to a close, it may be time for a pep talk. There’s a lot of pessimism in the financial markets right now and that sentiment only worsened with the release of inflation data this week. Consumer prices jumped 4.3% in January, which may limit the Fed’s options regarding further monetary easing in the months ahead.  Also this week, oil crossed back over $100 a barrel for only the second time in history. There is fear that crude prices will push even higher into record territory when OPEC ministers meet in early March, as some analysts speculate that the organization may agree to production cuts at that meeting. Rising commodity prices combined with  mounting evidence of a slowing economy have stoked the fears of some pessimistic market watchers that the economy may be facing a period of “stagflation”, that dreaded financial phenomenon not seen since the late seventies. 
In times like these, it is worth remembering the adage “this too shall pass”. Bear markets do come to an end and rising stock prices will return. When times are tough, it is easy to be a pessimist (and a majority of investors currently are). However, successful investors are those who see opportunity in all market environments and who take appropriate steps to capitalize. The only way to guarantee a loss in a in a bear market is to sell in the midst of the carnage. On a positive note, stock market valuations are just now reaching more reasonable levels. For example, the market’s price-to-peak earnings ratio is now hovering at around 15x, which has historically been a great level at which to increase equity exposure.
Back in late 2006 through 2007, we had predicted that the market was due for a pullback as valuations could not persist at such high levels indefinitely. Well sure enough, this has happened and now the “experts” have changed their tune from touting the “Goldilocks” economy to bewailing various doom and gloom scenarios. Logically, everyone knows that the stock market cannot always go up. But now, almost six months after reaching its all-time high, the Dow is down 14% and many act as if they believe the roof is caving in.
Do not be swayed by the pundits and experts telling you that the U.S. financial system is fragile and weak. While the difficult housing market is a concern in many important regions, it represents a relatively small (4.5%) sector of the economy. The economy grew last year in the midst of a burgeoning credit crisis. The U.S. economy will remain strong as long as American consumers and businesses continue to spend as consumption is the source of nearly 70% of our GDP. Be wary of falling into the pessimistic mindset that the news outlets are using to drive ratings and readers, because if you do, you could miss a terrific buying opportunity.
 Blackberry Boosts RIMM's Bottom-line

February 21, 2008  |  11:10 AM  

Research In Motion (RIMM) expects to see substantially better growth in their smart phone subscribership base when they report 4th quarter results in April, as reported through Co-CEO Jim Balsillie. The Waterloo, Ontario company credits excellent holiday sales performance of their Blackberry mobile smart-phones. Furthermore, Research In Motion was prepared for a post holiday slowdown in sales, however their fears of slowing sales were not realized.  RIMM was looking to gain an aggressive 1.82 million new subscribers in this quarter, but it appears that they will beat those expectations by 15-20%. This will bring their subscriber base to about 14 million. They have grown quite impressively in a short time; it is hard to believe that in July of 2006 RIM was trading in the low $20’s. 
However, even as the subscriber base increased RIMM refrained from raising earnings expectations from 66 to 70 cents per share. It is possible they are just being cautious so as not to disappoint the market. In addition, RIMM may have overestimated the replacement rates for Blackberry’s as the growth in subscribers has not lead to as many new units sales as they had hoped. Not raising the estimates also reflects a tone of uncertainty about the slowing U.S. economy, which could slow new subscriber growth and unit sales in the coming quarters.
There is no doubt that Research In Motion had an excellent quarter and the stock is starting to recover from a rocky January and early February. The shares are up nearly 10% and have achieved a 7 week high. While we congratulate RIMM on their strong performance, we are not prepared to hop on the bandwagon. Our Ockham rating, reflecting the price before today’s rally, has just turned from a buy to a Hold. Especially after the 10% appreciation today, now is not the optimal time to buy RIMM. Research In Motion is selling within their historical normal ranges of Price-to-Sales and Price-to-Cash. The telecom sector has slipped in out rankings of sectors.  In this case, although valuations are rising in RIMM’s peer group, other sectors are rising more rapidly thus causing the increase in rank to 7th place out of 10 sectors followed. So, if you followed our ratings calls you would be in RIMM right now but as for what to do at this moment; the stock is fairly valued at this point and we do not advocate chasing momentum in just about any instance.
Relief at the Pump: Don't Hold Your Breath

February 19, 2008  |  5:34 PM  

Oil futures surged 4.7% ahead today and crossed over $100 per barrel for the first time since a brief period on January 3rd. The markets main concern is based in speculation that OPEC will cut production when it meets next month. Those fears were fueled by comments by Iran’s Oil Minister, who pointed to decreasing demand as the winter heating needs diminish. There is also unrest in political hotbeds and oil producing nations of Venezuela and Nigeria. Furthermore, the explosion of an Alon oil refinery in Big Spring, TX also elicited a negative reaction. Though the refinery was relatively small—only processing 70,000 barrels a day—the impact on investors was large.   Alon aims to resume partial operations in about 2 months, but the negative supply shock catapulted the price upwards.
So, it appears that there is little relief in sight for oppressive gas prices. Furthermore, oil prices have a broad effect on the economy, far beyond just the price of gasoline. Oil, at least currently, is the energy that our economy feeds off of and when oil gets more expensive it can have a broader inflationary effect. When you combine the waning purchasing power of the weakened dollar with the price of oil rising, it makes for a cash strapped consumer. However, as the saying goes, “if you can’t beat ‘em, join ‘em.” 
While we currently have the Energy Sector ranked as the 8th most attractive of the 10 basic sectors we rank, that is mainly because the energy stocks have not been affected like most by the recent correction, and thus do not appear to be undervalued strictly by the numbers. Even though Ockham rates most of these companies a hold, we expect this tendency to be resilient to economic slowdown to continue among the major diversified oil producers, such as Exxon (XOM), Chevron (CVX), and Royal Dutch Shell (RDSA). These major oil companies are still selling well below price to earnings levels that are the average for the major indexes. Some of the less well known names in the Energy Sector are more undervalued though, some to consider would be Grey Wolf (GW) and Pride International (PDE) in the drilling and exploration business segment.   Petro Canada (PCZ), a refinery, is selling at reasonable price levels to consider buying.
Sony: Blu-ray Redeems Betamax

February 15, 2008  |  3:34 PM  

Sony Corporation (SNE) appears to have learned its lesson from the Betamax/ VHS format war. As some already know, Sony was the primary backer of the Betamax format introduced in 1975 that competed with--and eventually--lost market share to VHS. The VHS format was introduced in 1976 by JVC and it proceeded to wear down Sony to the point where Sony began producing a VHS player in 1988, effectively ending that format battle. There is a similar battle for high definition (HD) movie disc technological supremacy today between Sony’s Blu-ray and Toshiba’s HD DVD formats. This format battle has been going on for almost two years but it is all but determined that Sony’s Blu-ray will win this one.
Wal-Mart (WMT) announced today that they will exclusively carry Blu-ray discs, as they join a chorus of retailers who have made their final decision, including Netflix and Blockbuster rentals. Even more telling, almost all of the major movie studios have made the switch to Blu-ray.  HD DVD is losing both content and retail allies in quick succession. The game console market could also make a difference in the format war. Sony’s PlayStation3, which includes a Blu-ray player, has begun to see sales increase dramatically after a recent price cut. Conversely, Microsoft’s Xbox 360--equipped with an HD DVD--fights for those same consumers and has experienced a slip in sales recently. There is realistically no way for the HD DVD format to compete with the exclusive network that Sony has built around Blu-ray.   Surely, this defeat will hurt the bottom line at Toshiba, an unpleasant feeling that Sony remembers well from the 1980’s.
Sony did not want to make a huge investment in developing a new technology just to lose again, and it appears this time it will have the last laugh. This victory will surely give the stock a shot in the arm. Speaking strictly from a numbers perspective, we have a positive outlook on Sony as it is selling slightly below its rational expected range that we calculate as $46-$80. This range is based on looking at what valuations the market has been willing to buy Sony in the past. So, with the future of HD movies at its fingertips and having many other successful and diversified electronics business lines, Sony’s stock should command a higher valuation in the months ahead.

Comcast: A Stock We Love, a Company Most Hate

February 14, 2008  |  1:44 PM  

Comcast (CMCSA), the cable television and internet provider is generally a company that is loathed by most consumers. For Comcast customers, it is easy to forget about them when their services are working, but it is when service is interrupted that many form unpleasant opinions on the giant.  From personal experience, somehow or another you will inevitably become entangled in a web of customer service people that read from a script of predetermined solutions until finally you reach someone who can operate independently of the script. Comcast is a great example of a company that is easy to hate, but a stock that is very attractive. Some would postulate that the fortunes of a company and its stock are inexorably linked, but as a fundamental research shop we see an opportunity where the two perceptions diverge.
The catalyst for Comcast’s great performance today was that the country’s largest cable provider reported that fourth quarter profits increased 54% aided by an increase in consumer spending for cable TV services. There is more good news as Comcast reinstated its quarterly dividend and also reaffirmed its intent to buy back nearly $7 billion worth of shares. Comcast will not be entertaining rumors of merging with either Yahoo or Sprint, and will instead focus on building on its existing cable TV, high speed internet, and phone platforms. Sales in each of those segments increased; cable TV increased 6%, internet revenues increased 14%, and the relatively new phone service saw revenue gains of 73%.
Comcast is facing increased competition for consumer’s dollars as the economic slowdown churns on, but the services that Comcast provides should be resistant to an economic downturn. Furthermore, in many areas Comcast has a monopoly on cable TV with the only other option being  satellite. So, Comcast has forecast revenue and operating cash flow growth in the range of 8-10%. This would be strong growth for a company that is currently (using a price of $18.55) selling at a discount of 22% to the low end of the normal range for price-to-sales, and a 32% discount to the low end of the normal range for price-to-cash flow. Given the undervalued nature of this stock, Ockham has placed a rational price target on Comcast of about $32 per share.
Coke's Strategy Moves Away from the Fizz

February 13, 2008  |  2:14 PM

Coca-Cola Company (KO) is the world’s largest soft drink maker and undoubtedly one of the most recognized brands throughout the world. Coke’s worldwide brand strength was instrumental in their successful quarterly report released today, which included sales gains of 24% over last year. Much of the increased revenues were a result of gains in emerging markets, especially Mexico and China.  Global sales by volume increased 5% last quarter compared to a 6% gain over the previous three quarters combined.  Interestingly, sales were boosted by a rising consumer class in emerging markets combine with the cheaper Coke products because of foreign exchange fluctuations. The weakness of the dollar—down 10% in the last year-- could be a real strength for KO which can attribute about three quarters of their revenue to sales outside of the U.S., compared to Pepsi that sells 60% of its products in the United States.
Coke has adjusted its strategy to accommodate for a shrinking domestic market for carbonated drinks, which are still Coke’s principal products. Coke management shrewdly noticed that domestic sales by volume have been falling since 2005, as many consumers prefer healthier alternatives. In 2007 Coke introduced Coke Zero, a zero calorie alternative that is designed to taste the same as Coca-Cola. They have been pleased with the development in sales and have targeted the young male market segment to pull them back to soda from sports and energy drinks. 
Coke is diversifying its product mix to include non-carbonated juices and teas, which is an area that Pepsi has taken a greater market share with its Gatorade and Nestea lines. Coke acquired Glaceau; makers of Vitamin Water, for $4.1 billion and these quarterly results are the first to include sales of this new acquisition. To take a gulp of the tea market, Coke added a 40% stake in Honest Tea.
The broad stock market is up today but the Coke report has been received slightly negatively even as they beat estimates. Coke has been a really solid stock for the past few years and we continue to have it rated very positively. It is trading near the low end of its normal ranges of price-to-sales and price-to-cash, which in and of itself does not make it a buy. Coke’s management has proven itself to be more than capable as evidenced by consistently very strong ROE that has stayed above 30% for the last 6 years. The Ockham rationally expected price range lies in the $60-$79, so we believe it still has room to grow.
U.S. Economic Slowdown Bodes Poorly for European Stocks

February 12, 2008  |  10:00 AM

Further proof of a slowdown in the U.S. economy shows up weekly with the most recent release of economic data.  As a result, 61% of the public now believes that the U.S. is in a recession. This belief will certainly have an effect on consumer spending which drives nearly 70% of GDP-- whether or not we are actually in a recession. However, the Federal Reserve has drastically cut rates and just last week politicians agreed to an economic stimulus plan worth $168 billion to spur growth. These monetary and fiscal policy measures should help soften the blow to the economy, and hopefully, help make the downturn short lived. Unfortunately, the European economy--which is now showing similar signs of slowing--is not flexible enough to effectively fend off this downturn.
European inflation is a persistent threat, as it has reached its highest level in over 14 years. It is this inflation concern that has kept the European Central Bank from cutting rates for the last 4 years. ECB President Jean-Claude Trichet has opined that inflation will not moderate until the second half of 2008, so it is unlikely that he will cut rates aggressively until at least that time. Economic concerns go beyond just credit tightening, as retail sales growth is down and so is growth in the service sector. Furthermore, labor practices in Europe are more restrictive to businesses than they are in the U.S. So, it will be much harder for companies to boost their bottom line by cutting payroll costs. The regulatory handcuffing of management should not be understated because management of these companies is ultimately the best hope for salvaging economic growth.
European banks are not immune to the U.S. housing and mortgage market crises, as BNP Paribus SA had to freeze a couple of their hedge funds that were heavily invested in subprime loans back in August. BNP Paribus is just one of a handful of European banks that has been hurt by the same CDO’s and credit problems as in the U.S. and they are an example of the increasingly global nature of finance. However, Europe will have a harder time recovering from these issues because the economic system behind the Euro and their member countries is not flexible enough to quickly react to systemic stresses. So, while we believe that the U.S. stock market is nearing at least a short term low, the European market could take a significant amount of time to recover.
The Other Shoe Drops for AIG

February 11, 2008  |  11:04 AM  

The world’s largest insurer by assets American International Group (AIG) is down more than 11% in early market trading. The catalyst was AIG’s acknowledgement of a “material weakness” in their accounting for collateralized debt obligations. AIG had been advised by PriceWaterhouseCooper LLC, its independent auditor, that internal controls on these investment vehicles needed to be revised as early as December 31, 2007. Essentially, there was not enough information to accurately value these vehicles, so AIG management had latitude in using estimates that are now under question. AIG is not prepared to put a number on the losses in its credit default swaps portfolio, but investors seem to be preparing for the worst.
Credit default swaps are insurance against defaulted loans, and it seemed unlikely that AIG would be able to completely avoid the widespread credit crisis. Concerns about the housing slump have sent AIG shares into a slide accounting for a loss of about a third of the market value over the last year. Up until now, AIG had looked pretty clean in relation to the credit weakness, but with the amount of exposure to risky financial derivatives it has been like waiting for the other shoe to drop. 
This revaluation of their derivative portfolio will be an ongoing process that could last at least few weeks, but the damage has seemingly been done for now. AIG will survive this credit crisis and with the stock selling at ridiculously cheap valuation levels, it could be an excellent buy in the near future. For example, under normal circumstances AIG should be valued at about $112 by our methodology, which should tell you something about how seriously the market is taking the credit crisis. Until the extent of “internal weakness” can be accounted for it is just too uncertain to buy right away. However, there is a good chance that the “bottom” for AIG will happen sooner rather than later, and those with a long term time frame will be pleased getting a quality Dow stock at such low levels.  To be sure, our valuation methodology shows AIG as a very attractive long term buy, but there is such a concern about short term downward action that its powerful enough give us pause.  As with any ratings methodology, valuation must be weighed against real world conditions that sometimes are not reflected in the math.
Cisco Offers "Lumpy" Guidance 

February 7, 2008  |  3:12 PM  

Cisco (CSCO) can be seen as a bellwether for the Technology sector, as they provide the backbone for so many internet systems. CEO John Chambers reported 2nd quarter earnings basically in line with Wall Street expectations in a conference call Wednesday evening. Net income rose 7.2 percent and sales increased nicely by 16.5%. This result would have been even better but sales slowed in January after a solid December.  However, it was his forecast of “lumpy” sales growth in the 3rd quarter that caused the stock to plummet 7% in after-hours trading. What exactly does “lumpy” sales growth mean? Cisco is projecting sales growth of about 10% over the 3rd quarter a year ago, which falls short of Cisco’s long term growth forecast of 12%-17%.
Chambers is now famous for having had his head buried in the sand before the tech bubble burst in 2001. Back then, he continued to project 50% sales growth after it was apparent the tech sector was going down hard. In this case, he is clearly concerned that the slowing economy will hurt sales of Cisco products as customers try to get by with older equipment or buy products from lower priced, less proven competitors such as Juniper and Extreme.  While that is a valid concern, we would like to point out that Cisco enjoyed revenue growth of 53% in Emerging Markets, particularly China, India and the Middle East.  An economic slowdown in the U.S. could certainly hurt their bottom line, but the trend in internet and IT spending in those emerging markets shows little sign of slowing greatly. Also, businesses at home and abroad will need to upgrade equipment in order to support the more data-intensive internet usage of video conferencing and other large file sizes that are becoming more common.
From a value investing perspective Cisco is quite attractive. Price to cash flow is currently 13.58, but the historical range is significantly higher, 20.61-34.14 dating back to 1999 with more recent years given more weight. Price-to-sales is likewise below its normal ranges, albeit to a lesser extent. Given what we already understand about Cisco’s cash, sales, etc. our methodology rationally expects a low-end price target of $33.11. Sales growth has been particularly good for Cisco and even after reducing expectations for the next quarter, 10% is nothing to scoff at. 

 

It's Not Just the New York Giants that are Going to Disney World 

 

February 6, 2008  |  1:42 PM   

The stock market has benefited from the impressive earnings release for their first quarter 2008 from The Walt Disney Company (DIS). Disney’s earnings news counters more recessionary data that lead to an ugly sell-off yesterday, which was sparked by an unexpectedly large plunge in service sector growth as reported by ISM Group. DIS earned 9.1% more revenue than last year, which has carried the stock into positive territory today. This is impressive considering that strong sales growth in late 2006 made for a tough year-over-year comparison and accounted for a 27% decline in Disney’s reported net income.

Conventional wisdom had maintained that sluggish consumer spending would threaten Disney’s theme parks division greatly. But in reality, theme park attendance was resilient and actually increase 3% over first quarter a year ago. Revenue for the theme parks was up 11%, with much of that growth coming from the flagship park, Walt Disney World in Orlando, Florida. Furthermore, Disney was not hit as hard as expected by the now 3-month-old-writer strike. Ad sales remained strong and revenue for the media division, including ABC television, was up more than 10%. 

Disney continues to relate well to the younger generation and has benefited from two hugely successful franchises, Hannah Montana and High School Musical. Both of these multimedia vehicles sell extremely well and propelled the consumer products division to revenue growth of 29%. While the trendy kids shows of today are not guaranteed to be “in” tomorrow, Disney will surely benefit from their popularity as long as they can.
Disney shares are up more than 5% at the time of this posting and they were a catalyst for the short-lived stock market advance this morning. Ockham has rated this stock a “Buy” since mid-November and it is just now reaching our rationally expected low, given current levels of earnings, cash, and sales. Given those current valuation measures we expect it to trade between $32 and $48. While DIS is still undervalued by our valuation methodology, it is by no means the most undervalued stock in our coverage universe. We will continue to monitor the stock closely, but we hesitate to advocate buying it aggressively after today’s run up. 
Super Tuesday and the Market

February 5, 2008  |  3:42 PM  

Today, Super Tuesday, is quite possibly the most important day for Presidential hopefuls outside of the general election in November. As is often the case, the economy was the biggest concern for voters. Nearly 40% of potential voters listed the economy as their number one issue; this is more than double the amount of voters that claimed the Iraq war as their top issue.  The obvious question is how much control does the Commander-in-Chief actually have over the economy?
The two most significant ways that a President can affect the economy is through taxes and government spending. Although, most of that power resides with Congress and the President merely lends a signature at the end of the process to make the proposal law. The President can and will state his opinion on such matters, but ultimate responsibility for fiscal policy is Congress’ alone. Thus, while the President has enormous influence over fiscal policy, Congress is the ultimate authority.
There is no shortage of instances where a President has attempted to adjust the economy to suit a particular political agenda. Most notably, FDR’s “New Deal” attempted to jump-start a broken financial system struggling through the Great Depression. He greatly expanded the size of government through public works projects, regulated the stock market, instituted bank deposit Insurance, and tried to stabilize prices. FDR did not create the problem of 25% unemployment but he did try to fix it; however, his legacy will not be that he lowered unemployment--which remained high until World War II, but rather that he greatly expanded the size and scope of government. Ultimately, the U.S. did not fully recover economically from the Great Depression until World War II, which dramatically boosted production and employment. 
A President does have an important role to play in the macro economy, but much of what a President can affect requires a “trickle-down” effect which may take years to for its impact to be felt. Presidents are politicians and not economists, but so often a boom or a bust is credited to the sitting President when there was little they actually did to create the situation. Often when the President targets a particular goal, such as FDR did in attempting to reign in unemployment, they create a new set of issues. One of the wonderful things about being a politician is that when the day of reckoning comes, it is almost always someone else’s problem.
In conclusion, voters should certainly be aware of each candidate’s economic philosophy and goals, but they must recognize that Presidents are one cog in the political machine. And politics rarely has an answer for a slowdown in the business cycle, inflation, or other economic challenges that are best solved by market forces. If a candidate tells you differently, don’t believe it.  
Take a Close Look at Amgen

February 4, 2008  |  4:42 PM  

It was a relatively slow day for news coming out of the markets, and there is about as much coverage of Super Bowl commercials as anything else. Perhaps Wall Street is a little slow in recovering from a night of partying after the New York Giants pulled off the stunning upset last night. So, in lieu of market commentary, today’s piece will focus on a particularly undervalued stock out of the healthcare sector. Given current earnings, revenue, and dividend levels we could rationally expect Amgen, Inc. (AMGN) to sell in the range of $94 and $138. However, despite this rationally expected range based on historical norms, the stock is trading at just over $47.

At Ockham Research, our methodology focuses on historical price levels that the market was willing to pay for a stock, with the more recent years weighted more heavily. Based on these metrics, Amgen’s historical norm for Price-to-Cash Flow average annual low was 19.37 and average annual high was 27.99, but the current level is just 9.57. Furthermore, current price-to-sales is about 3.5, but that is a far cry from the average range of 6.68-10.15. For additional evidence, look at the price-to-earnings which is 16.8 and near the low end of its historically normal range of 14.6-61.6.

Ockham Research is not only positive on AMGN, but there are also significantly undervalued peers in the sector. AMGN is part of the Healthcare sector and is compared each week, along with its peers, against all of the other sectors that Ockham Research follows. This week, there has been an overall decline in the sector rating for the Healthcare sector reflecting higher valuations. However, this change has not been sufficient on its own to alter the ranking of the overall Healthcare sector. The Healthcare sector still ranks 1st place out of 10 sectors followed.
So, AMGN is undervalued by our methodology and we rate the Healthcare sector as the most attractive sector. Amgen stock has been beaten down over the last 12 months, but as is often the case, the best long term value buys are those that are selling at such cheap levels because of rocky performance. Also, it was announced today that Amgen will sell drug rights to Takeda, a Japanese pharmaceutical company. This should provide cash to assist Amgen during a restructuring where cost cutting is the big emphasis.  As Amgen continues to cut costs and jobs, look for their price to come in line with more historically normal levels.
Microhoo or Yahoosoft? Something is Not Quite Right

February 1, 2008  |  12:32 PM  

Microsoft (MSFT) offered to acquire Yahoo (YHOO) this morning and--if the $44.6 billion offer is ultimately accepted by Yahoo’s board--this will be the largest technology sector acquisition in history. Over the past few years, Yahoo’s stock performance has been uninspiring in the face of stiff competition from the web search, advertising, and online application industry leader Google (GOOG). A few statistics will illustrate Google’s web dominance; Google claims 56% of web queries which is almost double the combine share of the second and third most popular search engines, namely Yahoo and Microsoft. Search engine usage is essential to drive advertising revenue, as Neilson Online reports that searches account for 37% of the rapidly growing online ad market, some analysts expect that online advertising market could double by 2010. Furthermore, for the last 8 quarters Yahoo’s profit has declined each quarter with a 4th quarter 2007 decline of 24%; in contrast, Google has enjoyed substantial profit increases for the last 14 quarters.
It is quite apparent that Yahoo is not able to compete with Google, which seems to make all the right moves and one step faster than anyone else. Yahoo is trailing in their most important markets:  web searches and ad revenue.  Microsoft is also in need of some retooling because Google has begun to take a bite out of their market share for word processing, spreadsheet and other applications that Google offers for free to anyone with an internet connection. Microsoft Office is one of the cornerstones of their business model, but Google is constantly improving their free version with nearly the same functionality.  Furthermore, Microsoft cannot afford any more slip-ups after the somewhat disappointing release of Vista last year.
It is probably a wise decision for Microsoft to combine its efforts with Yahoo in order to compete against Google. Microsoft’s offer to pay a 62% premium over last night’s closing price for YHOO shareholders represents an immediate windfall for a struggling stock that will be hard to turn down.  The companies investigated merging in 2006 but abandon the effort in early 2007 and Yahoo CEO Jerry Yang has been known as antagonistic toward Microsoft for years. A representative of Microsoft claims that the companies would save $1 billion in annual synergies resulting from eliminating overlapping efforts in Research and Development costs to expand online ad sales. 
In the opinion of Ockham Research, the two companies will need to find many such “synergies” in order to compete with Google. We expect this merger to be an organizational nightmare, which will require serious restructuring and job cuts. Also, both corporations have entrenched cultures which will likely prove difficult, if not impossible, to merge. For example, can you imagine the Microsoft Word product team relinquishing power to a Yahoo Documents team in order to make their services more web friendly and thus more competitive with the ever innovative Google Docs? Even if the Microsoft and Yahoo teams successfully implement their union, will their combined bureaucracy allow them to innovate faster than Google? Note that the combined headcount for both Microsoft and Yahoo approaches 90,000 compared with Google’s nearly 17,000. It is our belief that this merger is worth a shot, but can be seen as recognition of both companies’ past failings to structure their business lines in order to compete in an increasingly web-dominated market.
 
 
Last updated by ndouthat on 4/4/2008