Chesapeake - Never Boring

At the beginning of 2008, Chesapeake had a market value of $23 billion. Four months ago this company had a market value of $43 billion. A few weeks ago, that market value had fallen to $7 billion, and today it stands at $12.7 billion. I'm getting a bout of vertigo just typing these numbers.


I know what you're thinking. "What's the big deal? All of the banks are getting killed these days." That's fine, but this isn't a bank. This is the largest independent producer of natural gas in the United States. They have a strong exploration and production track record and hold some large and interesting acreage positions.

$43 billion to $7 billion in a few months. That's a decline of over 80%. That works out to over a 300% annualized loss (it's the new math). Immediately, one's thoughts wander to Enron. These guys must have been cooking the books. They must have overstated the amount of natural gas reserves they own, right? Wrong. So what's going on here?

For starters, we have to put that 80% decline in context. The market overall hasn't been exactly kind to anyone since the end of July. From the time of CHK's peak to its bottom earlier last month, the S&P 500 fell about 30%. It didn't help that natural gas prices fell 53% over this same time period in sympathy with oil prices (down 43%) as the global economy continued to sputter. XOP, the SPDR S&P Oil & Gas Exploration & Production ETF, was down 62% over this period. Still, CHK has outdone itself by falling further than any of these.

There is an added wrinkle to the CHK story. Chesapeake's CEO, Aubrey McClendon, owned about 32 million shares of CHK on October 8th. A couple of days later, most of those shares were gone. Loss of confidence in the company? Not exactly. McClendon was hit with a margin call. Amazingly, this billionaire thought it wise to keep adding to his already sizable CHK stake by buying on margin as the stock started falling this summer. You have to admire his belief in the company while questioning his money management strategy.

It boggles the mind that a billionaire would risk his fortune by buying stock on margin and not diversifying his holdings, but that's what McClendon did. This is a massive failure in Financial Planning 101. Amazingly, he wasn't alone. We've been learning of executives at other firms (see BSX, CPE, DNR, LTM, PROV, PHM, and WSM) also experiencing margin calls, although of a lesser magnitude.

McClendon was forced to unload 31.5 million shares between October 8th and 10th at an average price of just over $18/share. He sold 1.8 million of those shares as low as $12.64 on the 10th. Ouch. With the stock now back at $22, that forced sale has "cost" McClendon another $125 million. Ouch. It doesn't help that this margin call occurred as the market was gapping down to a new low on the 10th.

You can see in the chart below that from the peak on the 9th to the low on the 10th, CHK lost about 50% of its value. With about half of McClendon's shares hitting the market on the 10th, it's pretty safe to assume that the extra 15 million share of selling pressure somewhat exacerbated the stock's decline. Not surprisingly, with that selling pressure now abated and with the market a bit higher, CHK has rebounded a tremendous 83% from its intra-day low on the 10th.


This is all water under the bridge at this point. The more pertinent issue is what to do with the stock now. Is the stock attractive at this level, or is this a value trap? As I've shared in the past, if I can't figure out that a company is inexpensive on the back of an envelope then it isn't worth my time or money. And, as always, I encourage everyone to do their own work.

With that said I'd like to share a couple of comments from last Friday's quarterly earnings conference call (10/31/08) that caught my attention. Chesapeake CEO, Aubrey McClendon, started off the call with an interesting statement:

First, we open the third quarter with a bang, in announcing a very innovative sale of 20% of Chesapeake's Haynesville acreage position in the Plains for $3.3 billion in cash and drilling carry. This was a great transaction for both parties and established a $13 billion value for our remaining 80% in the Haynesville, a value that today ironically exceeds our entire market cap. That does seem very unusual to me.

What makes this even more intriguing is that the Haynesville play accounts for only 20% of the company's total proved and risked unproved reserves. We can argue all day and night about the pros and cons of shale gas production, but this is an actual deal with a knowledgable buyer, so it's hard to dismiss it. To be fair, however, this deal was struck back when natural gas prices were near their peak, so I don't believe for a minute that the company would fetch $13 billion for its remaining 80% today. In defense of management, however, their timing on that sale was impeccable, or impeccably lucky.

McClendon continued,

Second, in early August, we completed another innovative JV transaction, this time in the Fayetteville Shale with British Petroleum to whom we sold 25% of our Fayetteville assets for $1.9 billion, leaving our remaining 75% position in the Fayetteville worth about $6 billion or roughly $10 per share which is about one half of our stock price today. For the record, only about 4% of our proved reserves are booked to the Fayetteville yet this transaction alone established a remaining Fayetteville value equal to 50% of our stock price; again, very unusual.

Again, natural gas prices have fallen since that time. Still, these transactions provide a bit of support and some margin of safety. The company has more of these deals in the works. It will be interesting to see what type of value they receive and its implications for the entire company's valuation.

As I always stress, I don't pretend to know what any stock or market will do in the short-term, but this is the type of situation I like. We have a real company with real assets that is currently out of favor due to a recession of questionable length and severity. If you believe that the recent flood of bad economic and financial news around the world is a sign that the rapture is near, then you'll probably want to pass on this stock (and every stock). Of course, if you believe the rapture is near, why are you wasting your time reading this? If you believe that the economy will eventually recover and you have a long-term horizon, then the following points are worth considering:

• As with many stocks, this sector is best bought when it's out of favor. Check.
  
• Current natural gas prices aren't too far from average industry all-in cost levels. This may provide some price support.
  
• Natural gas wells deplete fairly quickly, on average. This helps to balance supply when activity slows due to excess demand.
  
• Most everyone is expecting the rig count to continue falling in the coming months, further reducing expected natural gas supply.
  
• Natural gas is much cleaner than oil and much closer to home. Demand is likely to resume growing following this recession.
  
• CHK's balance sheet looks fine. They have no large near-term debt maturities, they have a nice chunk of cash, and they should generate significant excess cash in coming years.
• Valuation looks very attractive on a number of metrics.
  
• McClendon has to be angry given how much money he recently lost. He probably has a nice-sized chip on his shoulder right now. I wouldn't bet against him.
  

Importantly, natural gas is a self-correcting market. Lower prices result in less drilling which leads to less supply which leads to higher prices. The only real question relates to the length of time it takes for this to occur, and that depends on how far and fast natural gas prices decline, how quickly firms pull back on their drilling, how quickly wells deplete or are shut-in, and how severe the fall off in demand is. But make no mistake, the stage is again being set for a period of tight supply, higher natural gas prices, and higher equity valuations for this sector.

Disclosure: The Rubbernecker is long CHK and short the rapture.

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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.

Dear Freddie

Dear Freddie,

By the time you read this, I’ll be gone. I’m sorry for doing this, but it’s for the best. I know this might come as a bit of a surprise to you, especially since I’ve been so happy lately. I’ve certainly benefited from our relationship, but I’ve gotten as much out of it as I should reasonably expect. Although we could have dragged this out a little longer, I think it’s in my best interest to move on.

I’ve come to realize that our association isn't healthy as it was built only on lies, misleading communication, and our differences. Even when it came to finances, we never really clicked. I’m financially independent and you’re not. I’m fairly frugal, but you just can’t stop spending. I care about quality and value while you like chasing the latest fad. I prefer to save, and you prefer to borrow. Furthermore, you’re not nearly as popular as you used to be, you don’t make as much money, your credit score is falling, and you’re always arguing with your supervisor.

Anyway, I’m going online to peruse the Edgar filings for some new friends. I’d still like to keep in touch. Who knows. In another time under different circumstances, maybe I’ll look you up again.

Yours,

MR

P.S. Rumors that I've been seen hanging out with your cousins, Fannie and Sallie, are completely false. They're both girls of low moral character.

Ok. Let's get serious. Per my recent quarterly portfolio commentary, I began reducing short positions in the financial sector at the end of last quarter, and I mentioned that I would be looking for opportunities to further reduce exposure if the sector continued selling off. Today's 20%+ decline in Freddie Mac shares provided just this opportunity.

FRE - One year

FRE Today

credit: BigCharts.com

From the New York Times today:

Shares of Fannie Mae and Freddie Mac, the largest providers of funding for United States home mortgages, plunged Monday on concern the companies need to raise more capital amid larger-than-expected losses.

The corporate “federal agency” debt obligations and mortgage-backed securities guaranteed by the companies also plummeted relative to government debt as investors thinned positions, analysts said.

Today's collapse holds a special place in my heart. My first post on the Market Rubbernecker actually dealt with FNM and FRE and the issue of their capital adequacy. In that post, I took issue with the sharp rebound that the shares experienced in mid-March (see chart above) following the announcement that their capital requirements were actually being reduced which would allow them to expand their portfolios in the midst of a housing bust.

Those concerns about capital adequacy have clearly been weighing on investors after that mid-March climb as shares have lost about 50% since then, with another 20% getting lopped off today. As I stated back in March, there is a very good chance that the equity holders of FNM and FRE will be wiped out, and I still believe that may happen. Despite that, Aspera's clients have had a very nice gain from the FRE short, and I usually prefer to exit a position a little early and leave a little something for the next guy (FRE was sold today in the $11.30-11.40 range).

I still have a short position in Wachovia, but I've now covered most of the financial shorts. I also reduced exposure to TWM intraday for clients that were overweight the position (double inverse Russell 2000 ETF) as it was up another 5% over the past few days.

We need to remember that bear markets are always punctuated by strong short-term rallies like we experienced this past spring. It would not be at all surprising, from a contrarian stance, to see another rally in the near future given the increasingly pervasive bearishness in the market. Regardless of which way the market moves in the near-term, I suspect that the increased level of volatility will result in further outstanding investment opportunities, both long and short.

When The "Expert" Needs An Expert

How comfortable would you feel with your plumber if he had to call another plumber to fix his own running toilet? How about a CPA who hired another accountant to do her taxes? What if your pediatrician didn't feel competent enough to examine his own child?

These are the questions that immediately came to mind today when I read that Wachovia has just hired Goldman Sachs to "perform analytics on our loans to evaluate various alternatives." I think Saturday Night Live's Seth and Amy can probably sum it up best. "Really?! Wachovia. Really?"

I wonder how the good folks at Wachovia are responding today to customers walking into their branches around the country.

"You'd like to open a savings account? Um, can you hold on a minute while I call the teller over at Bank of America to find out what our rates are?"

"Yes, we can offer auto loans, but would you mind running over to Vinnie's Used Cars and Bait Emporium to see what size loan we can offer you?"

"A personal loan? Well, let me see if I can get in touch with the CEO who I think plays golf with one of the senior bankers over at Morgan. I'm pretty sure that guy has a gardener who knows a personal trainer who thinks he heard some rumor about whether we're still offering those."

"A mortgage? No, we don't do those anymore."

This is just sad. I'm embarrassed for Wachovia and its employees. If you're a large bank with a large securities and investment banking division and you don't feel qualified to evaluate your own balance sheet or market your own portfolio, isn't it pretty much time to just hang it up and go into the dog grooming business? No offense to dog groomers.

The only thing cushioning my pain is that I've been short Wachovia these past few months. I was thinking it might be time to cover. Now I'm not so sure.

The author is short Wachovia and long dog groomers and emporiums.

So Many Words, So Little To Say

Like many portfolio managers, I spend a good part of each day just keeping up with the news flow on the companies that I own, the stocks on my watch list, the markets, the latest Bollywood gossip, and the global economy. Most of the "news" out there is nothing more than noise, and sifting through the garbage can be time consuming.

One of the "news" outlets that I gave up on years ago is CNBC. When I saw how they turned from somewhat serious reporting to out-and-out stock pumping during the tech bubble, I lost my lunch. When they started to rewrite history during the market collapse and claim that they had done a terrific job of being balanced, I lost my wife's lunch. It was a nice reminder that there really isn't much worth watching on TV. My wife and I canceled our cable.

I'm also not a big fan of TV Jim Cramer and TheStreet.com although I do enjoy the writing of contributor Doug Kass. I'll save a more detailed review of Jim and TheStreet for another time, but let's just say that I've done fairly well fading (doing the opposite of) a number of his recommendations. One of my main complaints about Cramer is very similar to one of my major complaints about Wall Street analysts, strategists, and economists -- there is an ever-present pressure to have a strong opinion about a stock, the market, or the economy, but no one can know everything about everything (unless she's married to me). It's great for generating commissions but not so great for investment performance.

With that out of the way, let's turn to an article just highlighted on TheStreet.com. The article is written by Tony Crescenzi and is entitled "Big Rally Possible." Normally, a junk title like that would be enough to keep me away, but it's a slow news day. Now, I don't know anything about Mr. Crescenzi, so I checked out his bio. He's a chief bond strategist, so that's one knock against him. He did write a couple of books I'm not familiar with, but so did Madonna, so...I'm not really sure what to make of that. Most importantly, Tony Crescenzi is a name straight out of "The Sopranos", so I'm going to change my locks and avoid making direct eye contact with anyone for a few days. Let's look at what he wrote:

There is a scenario that has a low but reasonable chance of occurring next week that could result in a very large rebound in share prices and risk assets next week and the week after, say 500 points or so in the Dow.

If the G-8 delivers a communiqué strong enough to reinforce the recent message on the dollar, and if OPEC's meeting with consumers results in more oil production, the combination could boost the value of the dollar, jolt the commodities markets, and thus bring a huge sigh of relief to investors. U.S. Treasury Secretary Paulson has resisted opportunities like this before, particularly following the April 11 G-7 meeting, which produced a communiqué that French Finance Minister Lagarde said was on par in importance with the 1985 Plaza Accord. Any effort to boost the dollar would be welcome worldwide, given the recent surge in commodity prices. Massive intervention would cap it off.

Ok. Trying to be tactful. Let's start with the first sentence. "There is a scenario that has a low but reasonable chance of occurring next week that..." What doesn't have a low but reasonable chance of occurring next week?! Oil could hit $150, we could attack Iran, gold might retake $1,000, the Pillsbury Doughboy could go on the Atkins Diet, Lehman could collapse, the Fed might raise interest rates (just kidding), I could be killed in a tragic dirigible accident. The list is endless.

So what specifically might happen according to Tony? The Dow could rally "500 points or so." Well...sure. First of all, that would be about a 4% increase. Given the recent volatility in the markets, I don't know that anyone would be shocked by a 4% move either way "next week and the week after." The market fell by 400 points this past Friday alone. It's not like calling for another Black Monday when the Dow lost 22.6% of its value in one day.

What's going to cause this big rally? Apparently, IF the U.S. and G-8 get super serious about the dollar with strong words and massive intervention and IF OPEC starts pumping a lot more oil, then commodity prices would get whacked and money would flow into the U.S. market.

Could it happen? Sure. But the very opposite is at least as likely to happen. Paulson and Bernanke are already starting to talk tough about the dollar, but I have a hard time believing that they're going to raise interest rates or intervene in the currency market to support the dollar given the weakness in our economy and financial markets. Raising rates certainly won't help the economy recover, and the Fed has shown this to be of primary importance. A higher dollar would also harm U.S. exports, which have been one of the few GDP bright spots. So, until proven otherwise, this is just talk. Words are their only weapon since they don't have the cojones to raise rates. Once the market figures this out, I would expect the dollar decline to resume.

As for OPEC suddenly pumping more oil, I've addressed this in prior posts. Does anyone seriously think that there is one OPEC country sitting on idle production with oil prices this high and climbing? No way. First of all, these guys remember $10 oil in the mid '90s. They're going to make hay with current prices. Second, high oil prices are ultimately bad for OPEC as they encourage lower demand and the development of alternatives, and OPEC is well aware of this. If OPEC had the power to drive oil prices lower, they would -- not to $20, but back towards $100 seems reasonable. The only way they could do this is by further opening the spigots. I think the fact that oil prices continue to climb well beyond a level that OPEC is comfortable with points to the likelihood that the spigots are already open. OPEC is fairly powerless right now to combat rising oil prices (how ironic) and is not likely sitting on idle capacity. In fact, it's possible that some countries are producing at rates that are too high for the long-term well-being of their oil fields.

Of course, anything can happen in the short-term. So, should the market rally in the next week or so because of a dollar-led commodity price collapse, I'll be more than happy to take the opposite side of both of those trades and further short the dollar and add to commodities.

As for Tony's article and for others like it, they just don't serve a useful purpose. I know that it isn't easy writing in a public forum and opening yourself up to criticism, but idle speculation about possible big moves in the market that might or might not happen over a ridiculously short time period if certain other things do or don't occur really doesn't add a lot of value. This type of article could just as easily have been written about the possibility of a 500 point drop in the market if the things Tony discusses don't come to fruition.

Before I go, let's consider Tony's employer. Tony works for Miller Tabak + Co., LLC, which according to their website, is "a twenty-four year old institutional trading firm specializing in the discrete handling of stock purchases and sales, portfolio rebalancings and listed options." He works for a trading firm, and he's out with an article that (at least implicitly) encourages short-term trades. Coincidence? Perhaps. Either way, there appears to be a strong negative correlation between the number of articles/posts someone writes and the quality of opinions expressed in said posts (present author excluded, of course). Tony appears to be a prolific writer.

Finally, people seem to be more disposed towards remembering correct predictions/recommendations than the predictions that don't work out. The fact that Joe Battipaglia still has a career as a Chief Investment Officer following his disastrous pronouncements during the tech bubble and collapse is testament to this. Although calling for a 500 point move isn't terribly bold in the current environment, Tony will get a ton of credit (and perhaps press) if it happens. If it doesn't happen, who will remember? There is no downside. From an "investment" perspective, his minor investment in a few paragraphs of words has tremendous upside and no downside. Tony may be wrong, but he ain't stupid.

The author is short the G-8, Battipaglia, and the dollar and long OPEC, Bollywood, lunch, and cojones.

Agriculture Stocks - Pulling Back as Expected

It looks like we're getting the pullback I was expecting in the agriculture/fertilizer companies (see last week's post "This Sector is Full of Sh*t"). In the past couple of days, Potash (POT), Agrium (AGU), and Monsanto (MON) have pulled back about 10%, and Mosaic has pulled back about 15%. As suggested, I did modestly reduce exposure to these names and was lucky enough to do so pretty close to their recent highs.

Today, Potash reported outstanding results. The fundamentals of this industry remain terrific with companies enjoying strong pricing power and cash generation. Given the pullback in the sector, today I started adding back the position I just sold a few days ago with purchases of POT and MOS. Should the group continue to retrace (certainly possible), I'll likely continue to add to these names opportunistically.

UPS and Downs

UPS is the world's largest package delivery company, so their business results are certainly reflective of economic activity. The company reported first quarter earnings this morning. They met earnings expectations this quarter but lowered guidance for the balance of the year.

The falling dollar is helping their export business, but it's clear from their earnings release and conference call that they see no signs of an economic rebound. Specifically, management commented on how quickly volume fell off in February and the negative impact of rising fuel costs.

Here are a few snippets from the earnings release:

A sharp decline in U.S. economic activity, however, led to a 9.4% drop in diluted earnings per share to $0.87 compared to a prior-year adjusted $0.96.

...consolidated average daily volume remained flat at 15.1 million packages per day.

"U.S. economic activity deteriorated more rapidly than expected during the quarter," said Scott Davis, UPS chairman and CEO.

The slowing U.S. economy not only reduced average daily volume in the U.S. by 0.3% for the quarter but also contributed to a shift away from premium products.Volume declined 3.8% for Next Day Air(R) and 2.9% for Deferred, while increasing 0.3% for Ground.

"We see no signs of economic strengthening in the second quarter," said Kurt Kuehn, UPS's chief financial officer.

Export volume increased approximately 10% in local operating days, which drove a 15.7% revenue increase.

Google - A Contrarian View

We saw quite a love-fest for Google on Friday following their Q1 earnings release. Given how important this report was for the market and for psychology, it's worth spending a little time on it.

Earlier in the week, comScore released a report in which they estimated Google's paid clicks grew only 2% during the first quarter. Concerns about this slowing had led to a sharp decline in the stock price of Google since the beginning of the year, falling from just over $700 to about $412 last month. With Thursday's earnings release, Google disclosed that its paid click growth actually increased 20% in the quarter. With revenue and earnings coming in above the whisper numbers (GOOG doesn't provide earnings guidance), we saw a huge relief spike in the stock.

There is plenty of positive press out there, so there's really no point in just rehashing it. Let's have a little fun instead and play devil's advocate.

• Even though paid click growth came in well above expectations, the 20% increase is a marked deceleration from last year's 43% growth rate. The bulls and the company argue that this is due to an intentional move by the company to decrease the quantity and improve the quality of presented ads. They hope to charge more for the fewer higher quality ads to offset the volume decrease. When asked about this on the call, management essentially said that the improvements were made later in the quarter, and it was too early to judge their impact. Fair enough on pricing, but then why the decline in paid click growth to 20%?
  

• ComScore claims that they only monitor US consumer growth, but Google's paid click data includes international. It seems very likely that US growth has matured and slowed dramatically while international growth remains very strong. If so, the fact that the huge US market has slowed so dramatically and so soon should be very concerning.
  

• Year-over-year revenue growth has been steadily declining.

• The company was adamant that they have seen no impact from the slowing of the economy. I don't really get this. Overall growth at GOOG is clearly slowing, and it appears that U.S. growth is slowing dramatically. How the company can be sure that the economy isn't a factor isn't at all clear. It seems logical to think that the economy has played some role and that growth may have been even stronger had the economy not weakened. Investors are typically less likely to pay a premium multiple for an economically-sensitive growth stock.
  

• GOOG is trading at 26x this year's EPS estimate. That's not particularly cheap, especially given the slowing growth trends (EPS growth is much lumpier, but it too has been slowing).

• Let's not forget the law of large numbers. Growing $5 billion of revenue at a 40% rate is much harder than growing $100 million at the same pace. Let's make sure expectations are realistic. Were Google to increase revenue at a 40% annual clip, they would overtake the current GDP of the U.S. in just under 19 years. That's not going to happen. As can be seen from the price action of GOOG stock this year, the market doesn't take kindly to strong growth stocks that falter. It's just a matter of time given their revenue base.
  

• As for this quarter, the company did benefit from a tax rate that was 1% lower than last quarter due to international growth (and weaker US?). That boosted EPS by about 7 cents. Also, though it wasn't discussed, clearly the company was a big beneficiary of the weaker dollar in the quarter. That's fine, but it isn't growth driven by improving operations. So, the quality of the earnings beat wasn't quite as dramatic as the press would have you believe.
  

Bottom line: We saw a huge relief rally when the paid click number came in much better than feared and the company exceeded revenue and earnings expectations. This was a case of the bar being set pretty low and being relatively easy to hurdle. The market had priced in worse numbers than the company posted, so the stock rallied. However, the quality of the beat was not as solid as indicated in the press, and the longer-term trend of slowing growth continues.

I'll be keeping an eye on GOOG and possibly adding a long put position as we move through the quarter should the stock continue climbing and volatility moderate.

The Bank of Microsoft

What do you do when your customers are stretched too thin to afford your product and can't get the money from their bank? Apparently, you lend them the money yourself. That's what Microsoft is doing.

This is one of those things that just doesn't sit right in the gut. If banks won't lend your customers money, doesn't that say something? I know liquidity is an issue, but good credits can still borrow at reasonable terms. And what skill does a software technology company have in assessing credit risk? Given these issues, it would be shocking if Microsoft didn't experience a relatively high loss rate on these loans.

I guess I'm just a little old fashioned. You know, stick to your knitting. If you're a software company, focus on making the best software possible. If you're a bank, focus on making quality loans and accurately assessing risk. Keep the chocolate out of the peanut butter.

From the Wall Street Journal:

With small-business customers finding it harder to finance high-tech purchases, Microsoft Corp. plans to increase the amount it lends them for purchases, by as much as 60%.

The move -- coming amid a historically tight credit market and at a time when other technology giants are considering selling their financing units -- raises the risk for Microsoft, which says the number of defaulting loans will likely rise and that its exposure to bad credit is "approaching materiality."

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Microsoft said it expects to issue $1.25 billion in loans in 2008, compared with the $780 million in financing it extended in 2007. The increase may help the Redmond, Wash., software giant prop up an important sales channel for the company. "The decision to do all this was tied to the macro situation," said Brian Madison, general manager of Microsoft Financing. "Information-technology buyers keep accelerating their leasing and financing, so we see this as a time when we can make a big difference by making things easier."

Microsoft offers an array of loans between $100,000 and $500,000 -- a "sweet spot for small businesses," Mr. Madison said. Still, the financing Microsoft expects to extend in 2008 represent only about 2% of the company's expected fiscal 2008 revenue.

As credit becomes harder to come by, especially for smaller businesses, financing programs like Microsoft's are becoming a key part of the way companies buy technology products. Research firm IDC expects technology buyers to finance 38% more of their high-tech purchases by 2011, with financing reaching $111 billion, or 8% of all high-tech spending.

The strains caused by the credit-market meltdown have exposed the frailties of some tech-financing arms. Some lenders caught up in the subprime mess were also heavily involved with technology financing. Dell Inc., meanwhile, has said it is exploring strategic options for its financing arm.

IDC analyst Joe Pucciarelli expects that in three years, at least a third of the current providers of financing for technology purchases won't exist. "The broader and more important point here is that the overall IT leasing and financing market remains stressed," he said.

This Sector is Full of Sh*t

Monsanto

Potash

Agrium

Mosaic

The fertilizer companies have been on a tear for a while now but have recently started going parabolic. This is largely due to the increasing amount of news and attention being paid to the global food crisis. Just today, Reuters reports:

China slapped massive tariffs on fertilizer exports on Thursday in a bid to control rapidly rising domestic agricultural costs and inflation, and above all to ensure it grows enough grain to feed its 1.3 billion people.

Beijing's 100 percent-plus tariffs on some fertilizer exports should temper domestic costs but may drive up prices in world markets that depend on China's supplies, the latest in a series of commodities-related protectionist moves around the world that risk fueling rather than cooling global food costs.

They're exactly right. A number of countries have started imposing export restrictions on certain types of food and now fertilizer. These types of restrictions are often accompanied by price caps, tariffs, and hoarding. Hoarding certainly will lead to short-term price rises. More importantly, to the extent that producers are restricted from selling their food and fertilizer at prevailing world prices they are also less incented and financially able to increase their production.

These agriculture/fertilizer stocks have been some of our best performers (AGU, POT, MOS). The longer-term thesis is still attractive, but the stocks are likely a bit ahead of themselves near-term. These are some of our larger positions given their appreciation. In this situation, we're likely to pare our position very modestly, taking some of the recent gains off the table. We plan to keep a sizable position in this space since the thesis is still attractive, and we would look to add should the stocks pull back.

Sallie Mae I? No, You May Not.

I noticed SLM popped 9% this morning after their earnings release and conference call. You've got to be kidding me.

The student loan market is in disarray.

• Cuts made to the federally guaranteed loan program have hurt.
  
• The credit crisis has resulted in less funding being made available to the student loan companies.
• The lack of liquidity in the market has made it difficult for lenders to package and sell (securitize) their loans in the asset-backed market. The securitizations that they can sell are being done at very high spreads (they're very expensive to the lender). As a result, new loans are being made at a loss.
  
• Fifty-seven lenders have dropped out of the program, and 19 lenders have suspended private student loans.

With that, let's take a quick look at Sallie Mae's (SLM) press release from last night. To their credit, in the first paragraph they state that, "Under current conditions, however, loans can only be made at an economic loss. Reflecting this environment, the company is assessing how best to balance its resources and its mission to provide access for higher education."

In the next 4 paragraphs they go on to discuss "core earnings" and explain how according to "core earnings" they registered a nice $0.48 in EPS for the quarter. Finally, in the 8th paragraph, they get around to discussing GAAP earnings. Turns out they managed to LOSE $0.28 share according to GAAP.

Basically, they tell us that we should ignore the markdown they took on their derivatives position and forget about their intangible assets. Leave out the bad stuff and things don't look so bad.

Some other points. The loss provision they took didn't look overly conservative given the environment. The company admitted that they can't write new business at a profit. The company isn't sure whether any legislation coming out of Washington would help or hurt them. The company's reliance on forbearance continues to increase. Their access to reasonably priced capital continues to deteriorate. Equity is a whopping 2% (that's sarcasm) of assets. Even "core earnings" are expected to be at the low end of their range (I'd be surprised if they even hit that.).

With all that, the stock is up 9%, north of $17.50. Apparently, the market feared something worse than what the company reported, and this is some sort of relief rally.

Given the risks and uncertainties surrounding this company and its business, this would not be a good investment for your kid's education fund given what we know today.

IBM - The Falling Dollar Ain't All Bad

If you want to see the benefit of the falling value of the U.S. dollar just take a peek at IBM's earnings release today. The headline is that they destroyed the analyst estimate of $1.45 by reporting $1.65. True enough, but lets look at the details and the quality of those earnings.

First off, revenue reportedly increased 11%, but if you take out the currency gain that growth shrinks to 4%. So, of the reported $2.5 billion increase in revenue, $1.6 billion of that came from currency.

Next, relative to the same quarter last year the company benefitted from a 1.0% lower tax rate.

If you take out the currency and tax benefit the company would have reported EPS of $1.29 instead of $1.65, barely ahead of last year's $1.23.

The other part of this is that the company has been a steady purchaser of its own stock. The purchases over this past year benefitted the company by another dime.

So, tonight and tomorrow when you're reading all of the glowing reports about how IBM knocked the cover off the ball, just remember that a minority of the strength really came from improved operations. This isn't a high quality beat.

JP Morgan - Will the Real EPS Please Stand Up

I just finished going over the JP Morgan earnings release and listening to the conference call. Here's a summary of what stood out to me:

• The company reported EPS this quarter of $0.68 versus expectations of $0.64. This is down from $1.34 for the same quarter last year. That's a 49% decline. Furthermore, $0.27 of this quarter's earnings came from a one-time gain from the sale of Visa shares in its IPO, so operating EPS was more like $0.41.
  

• This next part is a little tricky. According to fair-market accounting rules, firms get to report a gain when the debt that they've issued weakens. According to a recent Barrons article, "Here's how the accounting works: When a company's credit weakens and the yield on its debt rises relative to risk-free Treasuries, the debt becomes worth less to the holder. The financial company, which is the debt issuer, then takes a gain, because theoretically it could buy back its debt below face value." This quarter, JPM recorded a $949 million benefit from this accounting treatment in its investment banking treatment. Management stated that there was an offsetting amount in several other business lines to the tune of "several hundred million dollars." No one followed up on this during the call, so we don't know the exact figure, but let's assume that the company's net benefit from this was $500 million. That works out to about $0.10 of EPS.

• Any financial company has a bit of latitude in massaging its earnings due to their control over the amount of money they set aside for loan losses. This is as much an art as a science. Overall, JPM added $2.5 billion to its credit reserves which isn't terribly surprising. When you look a little closer at the pieces, however, there are a couple surprises.
• The Card Services division actually had a lower provision for losses (by $112 million) this quarter than last quarter even though net charge-offs increased from 3.89% to 4.37% and the 30-day managed delinquency rate was 3.66% vs 3.48% last quarter. Given the stress on the consumer in the current economic environment and the fact that the company's loss experience is deteriorating, I would think the loss provision should be increasing. The managed portfolio did shrink by 4% over this period, but the reserving here could have been much more conservative.
• The allowance for loan losses in the Commercial Bank segment was essentially flat with last quarter at $101 million even though nonperforming loans increased by $300 million. The net charge-off rate rose sharply from .21% last quarter to .48% this quarter.
  
• Every $100 million in loss provision works out to about a $0.02 swing in EPS.

• The Commercial business is growing nicely. This could be a bit concerning given the deterioration in the economy. The company stated that they're not doing much real-estate related business, and they specifically mentioned government and non-profit business as areas of recent focus. The charge-offs in this division have started rising, so this needs to be watched closely. The company claims this recent increase is just a normalization from very low levels of losses. We'll see.

• Their page on Prime Mortgages was very disconcerting. The 30-day delinquencies have been moving up strongly from just under 1.00% last June to over 3.00% this quarter. The company has obviously been tightening underwriting standards, but this is troubling.
  

• The Bear Stearns acquisition remains a big question mark. It's expected to close June 30, 2008. Time will tell whether this turns out to be a terrific buy or an albatross.

JP Morgan management made it clear on the call that they're open for business, and they're using the current financial turmoil to opportunistically expand their business. Should the financial markets and economy not suffer a severe recession, JPM stands to be a big winner. However, if we do suffer a severe recession and credit deterioration continues to expand, their purchase of Bear and continued balance sheet growth could do some serious damage. This is ignoring the potential ramifications of their huge derivatives book. Either way, JPM is clearly too big too fail.

I expect this stock to move with the financials which will continue to be subject to violent swings in sentiment. We seem to alternate between "The worst is behind us. It's time to buy!" and "Run for cover! Here comes another wave of write-downs!" At some point, the financial sector in general will again be a buy, but for the time being I'm comfortable opportunistically adding to my net short position.

A Blockbuster of a Short Circuit

Circuit City 1-Year Chart (credit Bigcharts.com)
Blockbuster 1-year Chart (credit Bigcharts.com)

Blockbuster reported yesterday that it had made a preliminary offer to acquire Circuit City for at least $6/share in cash. Today, Circuit City acknowledged receipt of the offer and also disclosed that Blockbuster had previously made another private offer for Circuit City. From the two charts above, it's pretty clear that both of these companies have been floundering. Circuit City has been constantly rejiggering to try and compete with Best Buy, and Blockbuster has had its lunch eaten by Netflix. What to do? Of course! The failing Blockbuster should buy the failing Circuit City!

According to the Blockbuster press release:

The transaction would allow both companies to benefit from the revenue growth generated by their complementary products, while the resulting synergies would substantially improve consolidated financial performance, thereby increasing shareholder value.

Blockbuster Chairman and Chief Executive Officer Jim Keyes said, "Our proposal offers Circuit City a significant premium to its existing stock price and creates a game-changing retail concept with a sustainable competitive advantage. We believe the combination will result in a compelling consumer proposition that will drive significant revenue and margin enhancements as well as cost synergies."

What? Benefit from the revenue growth generated by their complementary products? I guess all the people who aren't going to Blockbuster will be able to buy all the products that the people who aren't going to Circuit City aren't buying. And vice versa.

Maybe I'm not being open-minded enough. Let's see. The CEO is telling me this will create a game-changing retail concept. Renting videos and selling technology/electronics products at the same location. Of course! I don't want to go to Blockbuster, and I don't want to go to Circuit City, but put them together and.....................wait a sec, I still don't want to go there.

As for Circuit City's response, the following is from today's press release:

Circuit City, Blockbuster and their respective financial advisors have been in a process of exchanging information regarding the proposal, but to date Blockbuster has been unable to satisfy Circuit City and its advisors that Blockbuster's proposal could be financed. In particular, Blockbuster's proposal appears to contemplate a rights offering of unprecedented size relative to the issuing company's market capitalization and at a price that is at a significant premium to Blockbuster's current market price. Circuit City's advisors have noted that most rights offerings, of which there have been very few in the United States, occur at discounts to market.

So, Circuit City is justifiably concerned about how Blockbuster would finance the purchase. Given how far below the offer price Circuit City stock is trading, the market is also skeptical of the deal.

As for how to play this, I see no reason to get involved, especially on the long side. Both companies have so far failed to accurately anticipate or respond to competitive market forces. It's difficult to envision 1 + 1 summing to much more than zero in this case. The only winners, as is often the case, are likely to be the investment banks, consultants, and lawyers.