Earnings Season Progress: Perception vs. Reality

The lunatics are back in charge. First we had Meredith Whitney upgrade Goldman Sachs. She was rather cautious on the fundamental prospects of the banking sector, but did anyone care? No.

Next, we learned that Meredith has a pretty good contact at Goldman as they reported a blowout quarter. Of course, they're benefiting from the "unfortunate" demise of a few of their key competitors which has resulted in widening spreads and terrific near-term trading profits. How many other large "banks" will benefit from this? A couple. Commercial and residential loans continue to deteriorate. Does anyone care? Not really.

Intel followed. Nice quarter. Revenue was better than expected which helped boost gross margin. Of course, Intel is at the back end of the supply chain and not the best company to listen to when it comes to tech industry guidance (I'd happily wager that they guide down revenue before their next report). We also just learned that AMD posted a fairly poor quarter, so Intel clearly benefited at the expense of a key competitor. That's a different story than a general tech rebound. Does anyone care? Doesn't look like it.

Apple was next to release. Not surprisingly (they always guide low), the company posted a strong quarter with particular strength coming from iPhones. Despite the recession, this is clearly the hottest consumer gadget on the market. Does this have any bearing on technology consumption in general? Not much. In fact, it could easily be argued that the money that cash-strapped consumers are spending on iPhones and monthly calling plans is money not being spent on other products. Does anyone care? Not much.

Plenty of companies have already reported. In general, we're seeing continued weakness on the top line (revenue) with pretty good cost cutting. With analysts having low-balled estimates (at times without company guidance), we're seeing plenty of headlines heralding a slew of earnings beats. With each beat from a high-profile company, the market charges higher.

The bulls contend that corporate America will be nice and lean when the imminent rebound occurs thanks to aggressive cost cutting. Margins will rebound strongly as will earnings. We've also seen a few of the quieter bulls pop up in the media recently. Bill Miller and Mario Gabelli have just sounded the all-clear. In addition, plenty of analysts have been upgrading stocks to "Buy" on the heels of these "wondrous" earnings. Interestingly, these folks were awfully quiet earlier this year. Now that the market has jumped 35% and many stocks have more than doubled, they're telling us that it's safe to wade back in. Different business cycle, same self-serving lemming behavior.

Yes. A few large well-known companies have reported decent earnings, but these companies are not at all indicative of the earnings prospect of the S&P 500. There are unique and one-time explanations for these results, and the weaker reports of many lesser-known companies confirm this. Even the almighty Google reported nearly flat revenue growth. Where was the concern? The market barely budged.

For those of us with a less sanguine view of our economic prospects in the next few years, the continued weakness in revenue is a serious concern. Costs can only be cut so far before margins are impacted.

We've been steadily reducing our exposure to equities during this rally. We were getting paid well to incur risk back in February and March. That's no longer the case.

Does anyone care? Not at the moment. At some point, they will. Sentiment can drive the market in the near-term, but the fundamentals will eventually reassert themselves. Until then, be wary of the lunatics.

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

"Hall"f Baked

I have nothing against Glenn Hall of TheStreet.com personally. I know nothing about him. I'm sure he's a nice guy, but I can't believe some of what he writes. I'm starting to think that TheStreet.com doesn't have an editing staff.

Glenn writes a piece for TheStreet.com that he calls "Today's Outrage." As you can probably surmise, Glenn proceeds in each article to rant, complain, or disgrunt about his topic-du-jour. My turn. I recently read a couple of his pieces that made my jaw hit the floor.

The first one is from today's article entitled "Today's Outrage: Sears Isn't Worth $4 Billion." Glenn writes:

How can Sears be worth $31.84 a share? Target fetches only $29.54, and JC Penney is down to $16.55.

At the other end of the retail spectrum, investors are only paying $6.41 for Macy's, and at the low end, Family Dollar Stores are only trading at $26.

Wal-Mart is one of the few higher-valued competitors, with its shares at $53.

So I have to ask: Who thinks Sears is better than Target or even JC Penney for that matter?

The outrageous spread between Sears' share price and better-positioned retailers may be due for a correction after investors digest today's earnings report from Sears. The company reported a loss of $146 million for its third quarter, which ended Nov. 1, and said sales fell at both its Kmart and Sears chains in the U.S.

This is scary. We're talking Stock Investing 101. Trying to compare the value of different companies by looking at only their stock prices is beyond absurd. Price alone is irrelevant. If you're going to compare equity values of different companies you need to consider how many shares of stock are outstanding. Sears isn't "worth" $31.84 a share. Sears is worth $4 billion (market value). Sears trades at $31.84 a share because Sears has a market value of $4 billion, and the company has 126.4 million shares outstanding.

What would happen if Sears did a 2-for-1 stock split tomorrow? The share count would double to 252.8 million shares, and the price of the stock would decrease by 50% to just under $16. I suppose that this would satisfy Mr. Hall since SHLD would then have a lower stock price than Target, JC Penney, and Family Dollar Stores. Nothing fundamental would change, however. Sears would still have a market value of $4 billion, but for some reason Mr. Hall would be more satisfied with the "spread" between the various share prices. This is the kind of mistake someone completely unfamiliar with stocks might make.

For the record, the following are the market values of the companies mentioned by Glenn:

• Target: $21.7 billion
• JC Penney: $3.6 billion
• Family Dollar Stores: $3.6 billion
• Macy's: $2.7 billion
• Wal-Mart: $208 billion
  

The second piece by Hall that caught my attention is entitled "Today's Outrage: Google-O-Meter Signals Doom." Glenn writes:

The true sign of how bad it's going to get comes from Google, which is throwing its contract workers to the wolves.

The Internet search giant and ultimate barometer of consumer behavior says it will significantly reduce the number of its roughly 10,000 contractors in anticipation of a worsening economy.

No problem here. Clearly, this is yet another anecdotal sign of a weakening global economy. At the same time, good for Google. One of the knocks on the company has been its free-spending ways. If business is slowing, costs need to be cut, and reducing contract workers strikes me as a logical and reasonable place to slice. Glenn continues:

It may be the right thing to do from a fiduciary perspective, but the folks at Google don't seem to realize how damaging it is to the psyche of consumers and investors alike to see the ultimate growth machine scaling back.

He should have quit after "perspective." It's most certainly the right thing to do from a fiduciary perspective. Why in the world should Google be worried about the damage "to the psyche of consumers and investors?" This is investment analysis that only Dr. Phil and Karl Marx could like.

Is Google owned by shareholders, or is it a federal agency? Why is it up to Google to single-handedly repair investor psychology? Maybe Glenn would like Google to ramp up spending and hiring to the point at which net income will be wiped out and the stock completely destroyed (more so than it has already). I wonder what that would do to investor psyche?

I had bought some Google just before their last earnings report and sold it shortly thereafter, so I have no current position in Google. I do, however, applaud the company for getting serious about the cost side of its income statement. This will certainly help them to sustain strong free cash flow generation during the downturn. The day Google or any company starts basing its decisions on "investor and consumer psyche" is the day I short that stock.

Disclosure: The Rubbernecker is long simple math and short Dr. Phil.

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Stock Options: Here We Go Again

A recent Wall Street Journal article has my knickers in a knot again. The article, "Technology Options Sink", deals with the fact that many of the stock options issued by technology firms in recent years are now worthless.

Let me jump right to the punchline. Employee stock options are a form of incentive compensation. In today's environment, management and employees should just be grateful to have a job. The fear of being called into a human resources meeting and then having security walk you out of the building as you carry a cardboard box filled with a picture of your kids, your "Employee of the Month" plaque, your cactus, and a pamphlet on COBRA benefits should be more than enough incentive.

Let's look at a few passages from the story.

At chip maker Advanced Micro Devices Inc., the situation has gotten so extreme the company is planning a shareholder meeting to ask permission to reprice 99% of its outstanding options. AMD, whose stock price had fallen about 76% over the past 52 weeks to $3.16 a share at Friday's close, said this is necessary to prevent key employees from leaving.

Leaving? To go where? Yahoo may be looking for a new CEO, but who else is hiring these days? They're going to quit their jobs and do what? Unless they have an in with the Obama administration or would be happy repossessing iPods for a debt collection agency, they'd be better off keeping their heads down and mouths shut. Most firms are letting people go these days, and these firms would be happy to take volunteers who are unhappy with their compensation. I say let 'em go. It's never been easier to replace any employee, even a "key" employee.

More than 80% of Silicon Valley's 150 largest publicly traded companies had some employees holding options that had fallen below the strike price as of Oct. 24, according to Equilar, an executive-compensation research firm. Equilar said about 90% of chief executives at those companies had underwater stock options.

Ah ha. 90% of these chief executives have underwater options. The clouds have parted and all is clear. The major beneficiaries of stock options are the senior managers of companies. And where does the call for repricing these options come from? Senior management. They dress it up and pitch it in terms of helping to keep their key employees from leaving, but they're really just trying to cut themselves a better deal. "Sure, my 1,000,000 options would also be repriced, but this is really about helping the engineers with their 100 options."

Some companies are trying to pre-empt shareholder opposition, designing "value-neutral" plans that allow employees to exchange existing options for a smaller number of new ones at lower exercise prices. That will help protect part of an employee's grant but avoid large-scale dilution or additional accounting charges, said compensation specialists.

Value-neutral? You gotta love consultants. If by value-neutral you mean exchanging a lot of essentially worthless options for a smaller number of valuable options then, sure, let's call it "value-neutral." Isn't that the kind of math that led to CDOs?

RiskMetrics' Mr. McGurn said investors will be much more sympathetic to plans that don't include executives and directors, many of whom are seen as overpaid. Shareholders also may want to see vesting schedules, the length of time employees have to work at a company before getting their grants, extended in order to entice employees to stay longer.

This almost sounds reasonable. No argument with the part about leaving out executives and directors, but I doubt it would work so smoothly. If the executives needed to be excluded to get approval for the rank-and-file, I wouldn't be surprised to see the issue dropped altogether. Or I imagine we'd see an even larger "catch-up" award for the execs the next time options were issued.

The idea of extending vesting schedules is fine, but that can be done on a going-forward basis with new option awards. There is no good reason to retroactively change the terms of stock option awards. Everyone knew the potential risk and reward when the options were granted.

"I would probably lean toward [repricing] if it would help keep employees," said Ryan Jacob, chief investment officer at Jacob Asset Management, which holds shares in many major technology companies, including Google, Apple and Yahoo.

Ryan Jacob? They're interviewing Ryan Jacob. This is the kid who managed to parlay some incredibly dumb luck during the internet bubble ("investing" in companies with no business plan, no cash flow, and insane valuation) into opening his own "investment" firm. He then proceeded to lose 90% of his investor's money over the ensuing three years. That would have been bad relative performance even during the Great Depression. Does anyone really give a flying stock option what Ryan Jacob thinks about this? How is he even still in business?

The situation is similar at Google. A third of Google's 20,000 employees hold underwater options, according to an estimate by Sandeep Aggarwal, an analyst at Collins Stewart. If Google doesn't deal with the problem, it could lose key staff, he said.

So, even the mighty Google has employees with underwater options. This is supposed to be the place where everyone wants to go and work, but the stock option game is struggling here as well. Where exactly are Googlers going to go if they're already at the best place to work? Ikea? Right now, Googlers should be thrilled that they work at a growing firm with an impeccable balance sheet. For any employee that leaves Google, management will probably have 1000 resumes to pour over.

I would encourage everyone to vote against any repricing of stock options for any reason. The risk and potential reward of these options grants and the trade-off between cash salary and incentive compensation were accepted by all parties when granted. Options are not a form of guaranteed deferred income. They are "option"al.

Management is simply looking to dilute existing shareholders to its own benefit. Don't fall for the "key" employee excuse. There are thousands of "key" employees on the market and many more to come. Furthermore, these "key" employees are often equally likely to be value-enhancing or value-destroying. The senior executives of every failed company and business venture in history were once considered "key" employees.

Disclosure: The Rubbernecker is short Ryan Jacob, "key" employees, and self-serving executives.

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Google - Time To Buy?

I have done fairly well betting against widely-held, high growth, overvalued stocks that everyone loves. Google has been one such candidate. I've been on the short side of Google a few times, and each time it has paid off. I last wrote about Google following their second quarter earnings release. That piece can be reviewed here. With revenue and click growth slowing, a rich valuation, excessive bullishness on the stock, and a slowing economy, my earlier shorts were relatively easy calls.

It's important, however, not to put the blinders on and end up "married" to a position or viewpoint. In keeping with that, the situation with Google is now very different than when I last shorted it. For starters, valuation looks much more reasonable. IF the estimate for 2009 proves accurate, then Google is trading at a 14 P/E. That's down from 20 at the end of last quarter and north of 30 at the beginning of the year. We no longer need ridiculous growth estimates to support Google's earnings multiple.

Also different are investor expectations heading into earnings season. For the first time ever, management admitted last quarter that they were feeling some impact from the economy. It's probably safe to assume that the company has been further impacted by the economy, and it should also be safe to assume that investors are expecting some further negative impact. It shouldn't come as a surprise to anyone. In other words, the rose-colored glasses should have come off following last quarter's conference call. We can see that earnings estimates have come down since then, and analysts are now looking for a flat quarter sequentially. With the stock off 55% from its highs and 37% since mid-year, some healthy degree of headwind is already baked into the stock.

Google will be reporting last quarter's numbers after the close today, and all eyes will be on a few key areas. Click growth, of course, is critical as is cost containment. In the past, management has shown little concern for its stock price or near-term earnings as they've ramped spending regardless of results. It'll be interesting to see if the slowing economy has encouraged management to ease up on spending. Also, the company has been trying to improve the quality of its search results and hopes to earn more from this improvement. We'll get more color on all of this and more at 4:30 p.m. today.

The bottom line is that Google is an interesting buy candidate at these levels. Valuation is reasonable, growth is likely to remain decent, cash flow generation is strong, the excessive optimism in the stock is gone, and they still don't face a serious competitive threat. The market's reaction to Google's earnings will hinge in part on which side of the bed traders got up on this morning, and any large move in the market will almost certainly carry GOOG along with it in the near-term. Regardless, GOOG is finally once again looking intriguing to own.

Disclosure: The Rubbernecker is now long Google stock (for the moment) but short Google's foray into energy and world domination.

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Google and Gas

“When everyone dislikes something it should be examined. When everyone likes something it should be examined.” -- Confucius

One of the biggest surprises to me from the Google conference call was learning that Google employs a Chief Economist. Had I only been aware of this earlier, I would’ve shorted more shares. I’ve been on many hundreds of conference calls over the years, but I’m having trouble remembering any in which a Chief Economist was one of the presenters. This was often one of the few positive qualities of these calls. Whenever I'd find myself struggling to pay attention to the mindless reading of the press release by the CEO, I'd mutter to myself, "Well, at least I don't have to listen to an economist."

The fact that high-flying, vanquish-all-comers, paradigm-changing Google is the first that I can recall offering up an economist to the investment community seems a bit ironic. This is Google! Shouldn't we be hearing from the Chief Envisioneer of World Domination instead? Perhaps this will be one of those little things we’ll point to in a few years as evidence that the days of heady growth for Google were winding down.

I wrote a critical review of Google's first quarter earnings release back in April when the stock popped from $450 to $540 and all of the analysts were tripping over themselves to see who could capture the most headlines with the biggest price target increase. In my conclusion of that piece, I said that I'd be keeping an eye on the stock and possibly buying put options if the stock kept running.

I didn't buy the put, opting to short the stock instead as increased volatility made put buying a little too expensive. And, unfortunately, I didn't short the stock as it neared $600. The short was initiated last week in the mid-$540s. Even though the stock had already pulled back 10% from its recent high, It was just too tempting. GOOG had held up better than the market during this latest downturn, and it seemed that the entirety of the sell-side community and press were bullish and expecting yet another outstanding googlerific quarter. On top of this, the concerns I shared from last quarter hadn't diminished, and the economy had deteriorated further. It was an appetizing recipe for an earnings disappointment.

Of course, the sell-side was out after the call defending their buy recommendations on Google. I haven't seen one downgrade. AmTech Research is keeping its "Buy" rating but lowering its target from $750 to $725. Cantor keeps their "Buy" and lowers their target from $750 to $675. Kaufman Bros. maintains their "Buy" and lowers their target from $680 to a nice round $657. $657? 57? 7? I mean, c'mon. You feel that confident in your $657 target that you didn't want to round it down 0.304414% to a nice even $655? How can anyone take this supposed precision seriously given the multitude of highly variable factors that go into that target in the first place? Asinine.

The average target price of these three analysts/lemmings implies 40% upside in the stock. The last downgrade I see is a beaut. Jefferies downgraded GOOG from a "Buy" to a "Hold" on February 1, 2008, the very day the company issued disappointing earnings and the stock opened 36 points lower. The downgrade also came one month AFTER the stock fell from a high of over $700 to about $520. See the station? See the train? No? That's because it's already gone. Over the following 5-6 weeks the stock traded as low as $412. When did the analyst upgrade the stock? He waited until April 18th, the day Google reported their "strong" first quarter earnings and the stock opened at $535. It would be difficult to try and time this stock worse.

So what about this quarter's earnings release? As you know by now, EPS came in a bit light, even with the benefit of currency and a nice low tax rate. Unlike the denials in the last conference call, the company finally owned up to being impacted by the slowing economy. They also admitted that the U.K. business was now large enough that seasonality was becoming evident. Paid click growth actually declined sequentially, and revenue growth (one of the concerns I highlighted last quarter) continued to slow.


Growth is clearly the overriding issue here. Huge early market share gains that could mask seasonality and economic weakness are quickly evaporating, which shouldn't be a huge surprise given the scale of GOOG. The question then turns to what the company is worth and what is an attractive stock price. With the stock now trading at about 20x 2009 estimated EPS, I don't find the stock particularly compelling, but I also no longer view it as ridiculously overvalued. Because of this, I covered the short today (Friday). I'll be watching the stock with an open mind from here and would be inclined to fade any substantial move in either direction.

As for the "Gas" part of this piece, since exiting my natural gas position on June 20th I've been patiently sitting on my hands waiting for another crack at it. With this sector and the price of natural gas now down over 20% from their recent highs, my patience has worn thin. I dipped my toe back in on Thursday afternoon, buying one of my favored domestic natural gas E&P names. As usual, the plan is to pump up the position should investors continue to bail out of the sector.

Disclosure: The Rubbernecker is happy to once again have a little gas.