An iPod from Microsoft?

Evidently Microsoft (MSFT) is developing a digital music device and download service to compete with the iPod and iTunes from Apple (AAPL). Headlines like these show that Microsoft is feeling the heat and believes it must reinvent itself. I would agree completely with that assessment, but I also disagree with their apparent strategy.

Merely copying successful products that have already attracted scores of competition is not going to reinvigorate growth at Microsoft. They need to play offense, and by that I mean, develop new technologies and products. They should aim to be first to market, and force others to play defense by copying them.

Adding another video game system to the market is not very innovative. Adding another mp3 player to the market is not innovative. Ditto for a music download service. The companies that are taking aim at them today aren't doing so by copying. They are doing so by innovating. Google changed the online advertising market, has the best product out there, and now dominates.

Google's beta of a new, free, online spreadsheet program isn't merely an imitation of Excel. You can see where Google is going with this. Low end computers nowadays can cost as little as $300 with a monitor included. However, if you want to put a copy of Microsoft Office on your new home machine in order to do work on weekends, the software package could easily double your system's cost to $600.

Large corporations have big pockets, so they will likely continue to equip all new systems with the full version of Office. Consumers though, hate paying hundreds of dollars for software that is oftentimes essential to do anything productive on their computer. Microsoft may have a monopoly on desktop software, but their dominance has nowhere to go but down the drain as other companies innovate. An online spreadsheet program complete with free storage space on Google's own servers could ultimately dent Microsoft's Office business, though it will take time.

Selling video game consoles and imitation iPods might make up for some of the business Microsoft will undoubtedly lose to companies such as Google, but the margins will be so much lower that it will never completely make up for it. Right now Microsoft gets nearly all of their operating income from Windows and Office. Those businesses are under attack, but do you really think the way to reinvent the largest software company on the planet is to go after the iPod?

Caterpillar Sets Growth Goals

Yesterday at their annual meeting Caterpillar executives laid out a growth outlook for the next five years. The headline peaked my interest because it seemed aggressive. Cat CEO James Owens announced that sales will grow to $50 billion in 2010 and earnings per share will grow at a compund annual rate of 15%-20% between 2005 and 2010.

For a fairly large, mature business like Caterpillar, as much as 20% annual EPS growth over a five year period sounded very optimistic to me, but upon doing a little further number crunching I realized that the plan really wasn't all that aggressive after all. Current estimates for 2006 and 2007 imply earnings growth of 31% this year and 13% next year. This comes on the heals of a 40% surge in 2005, the first year of the period in question.

So, from 2005 through 2007, earnings are expected to grow 28% per year on average. In order to hit the midpoint of the 15-20% annual goal for the entire six year period, profits in 2008-2010 will only have to average about 7% annually.

Given this outlook, are Cat shares a buy at the current $68 per share price tag? Let's assume the midpoint of the growth plan is achieved (17.5%). That puts 2010 earnings at about $7.30 per share. Let's assume a modest 12 P/E on those profits, given that we are talking about a cyclical heavy machinery company. We get an implied share price of $87 four years from now, about a 30% gain from current levels.

Not a horrible return, but not as good as you might expect based on the headlines we saw yesterday. This also assume that the global economy remains strong for many more years. A global recession will likely hurt very cyclical businesses like the one Caterpillar dominates.

Getting the Froth Out

Over the last year or so the markets have done well despite the rally being very narrowly focused. Consider what was working up until May. International, energy, gold, copper, industrials. The investment banks did great too as M&A activity hit record levels. What about other areas? Healthcare, technology, telecom, media, banks, retail. Not a lot of performance in those areas, even though they make up a huge portion of the U.S. market.

The result of such a narrow market was that everybody began chasing what was working and shunning everything else. The copper move from $3 to $4 a pound was probably solely due to hedge funds piling in. The moves were parabolic, especially in commodities and international stocks. Finally we have reached a point where people are getting nervous, nervous enough to reduce risk. This is leading to extreme selling in the areas that have done best. Basically, we are getting the froth out of the market.

It is this explanation, and not anything fundamentally wrong with the companies, that is causing the massive sell-off. Goldman Sachs (GS) reported a great quarter this morning. The stock is down 6 points. GS is still doing well. In fact, they advised on the Maverick Tube (MVK) buyout announced this morning. The market action has been violent, but prices are getting a little out of whack with reality at these levels, unless the world really is headed for horrible times. Not impossible, but it's tough to make that case at this point.

Uptrend Intact, For Now

If you look at the last month or so, you might want to quit the market entirely. However, it's always a good idea to put things in perspective. An easy way to do that is to take a longer term view and see where we've come from in order to gauge how bad a pullback really has been.

Here is a three-year chart of the S&P 500.

As you can see, the uptrend has not yet been broken, even though we are pretty darn close. I don't know if we'll hold and make a bottom around this level or not (by me putting this chart up, it could jinx that scenario a little bit), but it is an interesting chart, especially for any of you that like technical analysis.

As far as what could help us in the quest for a near-term bottom, I really think it is in the hands of Bernanke at the upcoming Fed meeting. My thesis for why the market made new highs in April, despite many apparent headwinds (soaring commodity prices and rising interest rates), was that equities were pricing in an end to the rate rising cycle.

As soon as it became clear that 5% might not be the top in Fed Funds, we lost nearly 100 points on the S&P 500. As you know, the market hates uncertainty, which is what we have right now. Some are predicting a Fed pause in late June, whereas others are calling for 5.5% or even 6% Fed Funds this year.

If Bernanke would just quit it already, we could very well hold the trend line in the above chart and make our way back to where we were the last time investors thought rates were finished going up. Conversely, if we get another rate increase and more uncertain talk from the Fed in a couple of weeks, it's unlikely we'll see better times on Wall Street anytime soon.

Note to Microsoft: Fire Steve Ballmer

It made perfect sense for Bill Gates to be replaced as CEO of Microsoft (MSFT), and renamed Chief Software Architect. Gates is a technology guy, not a traditional business executive. When you surpass General Electric (GE) as the most valuable U.S. company, as Microsoft did back in the technology stock hey day, you should have people focusing on their core competencies. For Gates, that was software.

In stepped Steve Ballmer to take over as CEO. How is he doing? Horribly, if you ask me. Now I don't own Microsoft stock (thank goodness), but if I did I would be infuriated. The shares have done nothing in 8 years. They trade in the low 20's, same level they were in 1998. Any investor will tell you that shareholders can share in the success of a public company in two ways, through share price appreciation, or through the return of capital.

For some reason, however, Ballmer does not particularly like either one of these forms of building shareholder wealth. Microsoft has nearly $35 billion in the bank and another $10 billion or so in investments just sitting on their balance sheet collecting dust. It's like he doesn't care about the shareholders one bit, despite the fact that they own the company and he works for them.

And that is why I think he should be fired. That doesn't mean he needs to leave Redmond entirely. Rather, orchestrate a similar migration to the one Gates embarked on several years ago. Ballmer's core competency clearly isn't working for the shareholders as CEO, so he should be working for someone else, his successor.

Not only has Ballmer been completely unfriendly to shareholders since he took over, he doesn't seem to care that they are upset with Microsoft's huge cash balance. When asked about the issue Ballmer told investors and analysts "It is likely I will continue to have to discuss with you for many years why we have as much cash as we do."

That quote says two things. One, we will continue to treat shareholders like crap. And two, he obviously thinks that it is a chore to "have to" have these discussions, proof that has no idea who he is working for or what his objectives should be.

Ballmer will likely try to make the case that they need all of that cash to invest heavily in R&D. Anyone who has paid attention to Microsoft in recent years knows that they are not doing much innovating at all compared with their competitors. The majority of their income still comes from Windows and Office. Their other ventures, like XBox for example, are losing money.

Most of what is going on in Redmond seems to lack strategic sense. Why are they in the video game business anyway? Why do they own billions in Comcast stock? Why do they have a bank account with $35 billion in it? It's no wonder Microsoft stock has done nothing for 8 years. If shareholders ever want to make decent money on their MSFT stock, they are going to have to fire Steve Ballmer.

Yesterday's Capitulation

If a market is oversold you always want to see signs of capitulation as a tell that a short term bottom has been made. Yesterday's action surely looked at lot like people throwing in the towel to me. After dropping more than 170 points, the Dow actually finished the day higher by 8 points. It looked like a good example of a selling climax.Where did that sell-off put us in terms of the market correction? The S&P 500 hit 1235, which is 7% below it's 2006 highs. Other indices such as the Russell 2000, which have led the latest bull run, are down far more than that. Yesterday that index of small cap stocks traded at 685, nearly 13% from it's all-time high.

The overall market action has been interesting lately, to say the least. That said, and despite the fact that I have talked about it a lot recently, I am still not taking much action here. As I've said before, I am a long term investor, so most of my time is used monitoring companies and their specific business fundamentals, not market technicals. These companies are still doing well, even though most of their share prices have been flat-to-down since reporting Q1 earnings in April.

I only mentioned the overbought nature of the market a few weeks back to explain why I was raising cash levels in the portfolios I manage and to prepare my clients for a rather sharp sell-off. After all, they haven't seen one since early 2003, and many seem to forget how ugly they can get. I have put some of that cash to work in recent days, but still have slightly above-normal cash levels.

Where do we go from here? Hopefully we have put in a short term bottom. I would still welcome a 10% correction on the S&P 500 to under 1200, and I think the odds are still good that we get that in coming weeks and months. However, yesterday's trading action indicates we could get a bounce here before we head to that level.

L-3 Shares Rally Despite Succession Uncertainty

"L-3 Shares Climb After CEO Death" - API can't make this stuff up. That is the headline of an Associated Press story talking about the $5 jump today in shares of L-3 Communications (LLL), a large defense contractor. L-3 has been a small Peridot Capital holding for several years. I wrote back in November that a sell-off from $85 to $74 was overdone. The stock subsequently hit a new all-time high of more than $88 per share.

L-3's CEO Frank Lanza, 74, passed away suddenly yesterday and when I saw the headline this morning, I figured we would see some selling pressure today. Lanza co-founded and led L-3 on an acquisition spree that built the company into a $12 billion a year defense giant. Given Lanza's age and lack of a solid succession plan in place, many investors have been wondering what would happen if Lanza left, or worse, passed away.

Such uncertainty usually breeds fear on Wall Street. Not so today, however, as the stock is rocketing ahead by 7 percent. L-3 itself has been rumored to be an acquisition target, and with no clear leadership in place right now, investors seem to think one possible succession plan will be to sell the company. I'd put the odds at no better than 50/50 that such a scenario materializes.

Do Nardelli's Actions Warrant Selling Home Depot?

Home Depot's recent annual meeting went pretty horribly if you are a shareholder. For CEO Bob Nardelli, it probably went pretty well. He refused to answer any questions, didn't reveal the results of the shareholder votes, and after 30 minutes he bolted for his private jet. None of the other board members were there because Nardelli told them to stay home.

Now I don't own Home Depot stock personally, or for my clients, but a lot of people do. Should investors sell the stock after these recent developments? After reading about how Nardelli ran the meeting, I want to say "yes." However, the stock is pretty darn cheap. That doesn't mean I would give it a ringing endorsement. After all, Nardelli's recent actions sure do smell of guilt (of what exactly, I'm not sure, maybe excessive pay, maybe just embarrassment). Trading at 11 times fiscal 2007 earnings, HD shares seem to have limited downside from their current $37 quote.

Share price valuation aside, should his excessive compensation scare investors off? To me, this issue is very difficult. Is Nardelli worth $120 million over 5 years? Of course not. But is Alex Rodriguez worth $250 million over 10 years? Doubtful. These two men are essentially being paid the same amount to do their jobs and the average American finds compensation like this to be completely unfair.

In the baseball world, salaries are determined by what the market will bear. Since fans are willing to pay money to see athletes play, paying them high salaries can actually result in the team earning a profit, so the high salary is "worth it" to the team owner. It's the market-based economy. It's capitalism.

Is A-Rod's job more important than a school teachers' job? Not at all. However, there are many more people who can teach than can play all-star caliber third base, and nobody is willing to pay $50 to watch someone teach a math class for three hours.

Now I'm not saying A-Rod deserves $25 million and I'm not saying that school teachers don't deserve to earn more money. But, since how much someone makes is not up to me, I have to simply understand why the system is working the way it is.

As for executive compensation, it is a much more difficult issue to tackle. How much is Bob Nardelli worth to Home Depot? I have no idea how we can begin to figure this out. Therefore, I have no idea how much CEO pay is fair. Are chief executives in this country overpaid? Absolutely. But what is the right number? I just don't know.

I can tell you one thing, though. In my opinion, stock price performance should not be the only determinant of executive compensation levels. Many are saying that the fact that Home Depot stock has fallen since Nardelli took over in late 2000 proves that he is overpaid. I have to take issue with this.

In Nardelli's first five full years as CEO, it is true that the stock fell 8%, from $43.88 on 01/01/01 to $40.33 on 12/31/05. However, such poor performance is Nardelli's fault. Sales during those five years rose 52% to $81.5 billion. Net income and earnings per share fared even better, rising 93% and 111%, respectively.

The poor performance of HD stock is simply due to the fact that the stock was overvalued in 2001, trading at 34 times forward earnings. Investors who bought shares then and lost 8% over the subsequent five years have nobody to blame for that except themselves.

All in all, Bob Nardelli has done a very good job running Home Depot. The only problem is, we really don't know how much that is worth to the company's shareholders in terms of compensation. All we know is that $120 million sounds like a lot when the median family is America earned less than 1/500th of that amount during the same period.

Another Twist to the Failed Vonage Deal

Now we are hearing that Vonage customers who took the company up on its offer of IPO shares at $17 each are planning on backing out and not paying after the stock cratered upon issuance. Vonage's response? They'll reimburse their underwriters for any shares not paid for by their customers. Wait, what?

I don't care how desperate you are to keep your customers happy. If they refuse to pay for their stock, you go after them. Now I have not seen the agreement that went along with the IPO offer. I am simply assuming that they had to sign something that bound them to purchase shares. If there is indeed some sort of contract, how can you simply say, "you know what, you were stupid for thinking $17 was a fair price for our stock, so don't worry about paying us."

When are individuals going to take responsibility for their actions? Rather than pay consequences for bad decisions (like paying $17 for Vonage), Americans now blame others first, opt for lawsuits, or in this case they simply try and stop payments on their checks. I don't know what's worse, Vonage pricing their IPO so ridiculously high, or allowing (and supporting) their customers to act in such an irresponsible way. Either way, I wonder if there are any shares out there to short yet.

Different Paths Taken by Enron's Past Management

Last week Ken Lay and Jeff Skilling were found guilty on numerous charges related to the demise of Enron. Today we hear that Richard Kinder is heading up a bid to take Kinder Morgan (KMI), his energy pipeline company, private in $100 per share deal. It's very interesting that these two events are coming only days apart.

For those of you who are not familiar with Richard Kinder, he was the President and Chief Operating Officer at Enron ten years ago and was seen as CEO Ken Lay's successor. However, Kinder left in 1996 after a falling out with Lay, and Jeff Skilling took his job. We all know how that ended up.

Kinder, however, always saw the future of Enron as a dominant pipeline company. Owners of oil and natural gas pipelines act much like toll booths, collecting fees as energy is transported over their infrastructure, regardless of the price of the commodity. Conversely, Lay wanted Enron to focus on energy trading and much more risky ventures.

Kinder, along with partner Bill Morgan, co-founded Kinder Morgan Inc (KMI) and actually bought Enron's pipelines from Lay. It's not hard to see which strategy turned out to be right. Kinder is the majority owner of KMI and sees so much value in the company that he wants to take it private for $13.5 billion. Enron is, well, completely worthless.