Apple, Not Amazon, Should Buy Netflix

Rumors of a merger between Amazon (AMZN) and Netflix (NFLX) have been rampant for months now, with the latest sending Netflix shares up over $25 each last week. However, with Blockbuster (BBI) lowering prices on their online movie rental service, Netflix is slumping back down to $20 per share. Amazon seems to be trying to get their hand in everything these days, which is probably why rumors of a Netflix purchase won't go away. However, given the price tag that it would take to land Netflix (about $1 billion after accounting for the company's $400 million in cash), I think it would make more sense for Apple (AAPL) to make the deal.

Obviously, the mail order rental business won't be around long term given the move to digital media distribution, so the value in Netflix is their subscriber base. It isn't clear which method of digital home movie watching will win out five or ten years from now. The retail storefront is already dying, thanks in part to the mail order business, but video-on-demand (VOD) from cable companies like Comcast (CMCSA) seemed like the most reasonable candidate to take over the movie rental industry.

However, Apple TV might throw a wrench into that idea. Being able to purchase movies online, download them to a set-top box, and watch them on your television as well as your computer, iPod, or iPhone could be a game changer. We also learned this week that Apple is in discussions with the movie producers about electronic movie rentals through iTunes, rumored to be $3.99 for a 30-day rental. If Apple can perfect both renting and purchasing movies online, video-on-demand might have a tough time competing since the cable companies would house the content on their own servers, allowing for a lot less mobility and flexibility.

If Apple is serious about rivaling VOD, a purchase of Netflix could make a lot of sense. The mail order business will likely do well until new digital technologies become mainstream, at which point converting users over to a digital model wouldn't seem to be very difficult. After deducting the cash on Netflix's balance sheet, an acquirer is paying less than 1 times revenue for their millions of subscribers. I think a Netflix-Apple combination would really match up well against Blockbuster and the cable companies. Netflix is already trying out some new digital download technology to distance itself from Blockbuster, so Apple would be a great partner on that end. An Amazon deal just seems to make less sense, which is perhaps why that rumor seems to never come true.

Full Disclosure: Long shares of Apple at the time of writing

Goldman Sachs Buys Huge Stake in RadioShack

Through SEC documents filed Monday we learned that Goldman Sachs Asset Management has bought a 12.6% stake in electronics retailer RadioShack (RSH). Normally this would not be very newsworthy, as the largest asset management firms usually have big stakes in companies that require reporting. Fidelity is the largest mutual fund manager and is on top ten institutional holders lists all the time. What is interesting about this Goldman disclosure is that they bought a lot of RSH and did so very quickly.

As of March 31, 2007, with RadioShack trading at $27 per share after being the best performer in the S&P 500 during the first quarter, Goldman owned just 1,755,884 shares (about 1% of the company). In a little more than two months they have increased their holdings by a factor of ten to become the second largest holder (behind Fidelity's 15%) and that news helped send the stock up nearly 2 percent on Monday.

Should investors go out and buy RSH on this news? Not at all. Such heavy buying explains why the stock has remained strong in recent weeks. Given that Goldman filed with the SEC, we can assume they are done buying large blocks of stock. Investors in RSH who own it for the potential for further earnings per share gains (above current estimates) are justified, but a purchase just for the sake of following Goldman is a bit too late.

Recently I trimmed some RSH positions in accounts where it got to be a top holding. I still expect the stock to move toward $40 per share, but the bulk of the gains for 2007 are likely behind us, unless something unforeseen happens. Interestingly, I have been looking closely at the other electronics retailers recently and RSH is not the only one that looks attractive from an investment standpoint. Perhaps I'll go into more detail in a future post.

Full Disclosure: Long shares of RSH, as well as January 2009 $10 LEAPS

Will People Switch to AT&T Just to Get an Apple iPhone?

Frankly, I never thought I would still have long positions in Apple (AAPL) with the stock at $124 per share. I have been trimming it as the stock has climbed, but somehow I still have not managed to close out the positions completely. Despite the fairly high valuation, there is still a lot of momentum at Apple and a high probability that numbers are still too low. Macintosh sales are growing faster than any PC brand, and it is entirely possible that the company can give video-on-demand (VOD) and Netflix (NFLX) a run for their money.

That said, the iPhone hype is a little worrisome. Not only is the stock running up heading into the late June release date, setting it up for a pullback in coming weeks as investors sell the news, but iPhone projections seem to be getting a little optimistic. I am not going to bet against Apple, because they have proved naysayers wrong over and over again, but let me give you an idea as to why I am beginning to wonder if they can live up to the hype this time.

Apple shares got a boost recently when Piper Jaffray analyst Gene Munster upped his price target to $160 and projected 2009 iPod shipments of 45 million units. He came up with the latter number by assuming a 7 percent North American market share for the iPhone, a 3 percent share on the other continents, along with the average retail price falling from $542 this year to $338 in two years. Munster has been overly bullish (and right) on Apple for a while now, but I wonder if that will cause him to stay on the train longer than he should.

My hesitation in accepting these projections as easily attainable is in large part due to the exclusive service contract Apple signed with AT&T (T) for U.S. distribution of the iPhone. In order for Munster's numbers to be right, it appears international sales will have to be breathtaking. In the United States, the big four (Verizon, Sprint/Nextel, AT&T/Cingular, and T-Mobile) have the vast majority of wireless customers (about 200 million as of the end of the first quarter). AT&T only represents 30 percent of that total, so if the other 70 percent of people want an iPhone, they will have to wait five years or switch service providers.

Switching might not be a big deal, but AT&T gets some of the worst customer satisfaction ratings in the industry. When AT&T bought Cingular they were the two worst in terms of satisfaction and network reliability, which caused many to poke fun at the merger. Just how many people will want to switch to AT&T just to get an iPhone? To me, that is one of the top obstacles Apple will have to overcome if the rosy forecasts coming from Wall Street are going to be met. And even if Apple does sell 45 million iPhones in 2009, does the stock price already reflect those expectations?

Deciding whether or not to sell the rest of my clients' Apple shares has been a tough decision. For now I have trimmed back larger positions to be average-sized at most. For now there is enough potential for me to hold onto some shares, but given I am getting a little skeptical, Apple is no longer is a large position in the accounts I manage.

What do you think? Will a five-year exclusive deal with AT&T hurt iPhone sales? If you are an AT&T customer, are you planning on buying an iPhone? If you are with another provider, will you switch to AT&T to get one?

Full Disclosure: Long shares of Apple at the time of writing

Nobody is Right All of the Time

To me, the above statement is pretty obvious. Today a reader left an anonymous comment on my latest post about Google (GOOG) that said the following:

"Yeah, GOOG is up some 13% or so, about the same as KFT is up since you bashed it a couple of months ago saying it was not a good buy. .... Trust me, you will actually gain more credibility with your readers if you admit your mistakes."

I decided to expand on this issue in a separate post, in addition to my answer to the reader.

First, I think the reader's characterization of the Kraft (KFT) post is a bit unfair (you can read it here: Kraft Shares Still Not Overly Attractive, Even After Altria Spin-Off Selling Pressure). I didn't "bash" Kraft stock. The shares dropped from $32 to $30 as investors were set to sell the small pieces they received from the Altria (MO) spin-off. Given the drop was likely to be temporary in nature, I decided to take a look and see if the pullback presented a buying opportunity.

I concluded that the stock didn't appear to have much value even after the $2 drop. It traded at 18 times forward earnings and was only growing in the low to mid single digits. That type of valuation failed to persuade me to suggest readers take a look at it as a potential purchase. In the two months since that article, Kraft stock has made up the two points it lost and had added two more, taking it to the current price of $34 per share.

The reader is correct in pointing out that I did not write another post alerting everyone that Kraft went up four points. And perhaps there are more people out there that would have preferred that I had done that. However, I'm not sure that the conclusion one should reach from that is that I refuse to admit when I am wrong. I can't think of a time when I tried to deny being wrong. If you read the post about Kraft when it was $30 and now see the stock at $34, you are well aware that it went up. Just because a stock doesn't interest me, it doesn't mean it won't go up.

The reason I didn't go out of my way to point out the rally in Kraft shares is pretty simple; nothing changed. The stock still trades at 18 times forward earnings. Nothing is fundamentally different at the company and nothing has changed my opinion on the stock. I still don't think it is a good value, based on valuation and growth prospects, and I would not be surprised if it continues to trail the market.

As far as Google goes, I tend to write more about stocks I recommend than those I don't. When I recommend stocks on this blog, some people do wind up buying them after reading my views and doing their own due diligence. Since I know that those people are curious about when my opinions change (they email me and ask), I will often write updates when things change. Google shares rallied more than fifty points in a very short amount of time. I thought it was relevant to let people know that I was not selling, despite the quick move, and how much further I thought it could climb.

By no means does this mean I am unwilling to admit mistakes. If I was, there would be little reason for me to run a blog. My opinions are out there for everyone to see, over 400 posts since I started. I have been wrong a lot and every one of those posts is still sitting in the site's archives. In the last six months alone I thought Amazon (AMZN) was overvalued in the high thirties, Express Scripts (ESRX) was close to fairly valued in the mid eighties, and liked Amgen (AMGN) at 16 times earnings. Amazon has doubled, Express jumped twenty percent, and Amgen is down to 13 times earnings.

I'm pretty sure the vast majority of my readers understand that writing this blog is the last thing I would do if I wanted to hide the track record of my investment opinions. But since not everyone seems to realize that, I figured I would address the issue. If anyone has any suggestions on how to make the blog better, please let me know. I'm always interested to hear what readers have to say.

Full Disclosure: Long Amgen and Google at the time of writing

Prudential Shuts Down Research Department

One of the themes I have written about on this blog is the worthlessness of most sell side equity research. Most firms use their research departments to push stocks they have underwritten, and most investors understand that and discount their opinions as a result. Prudential (PRU) didn't believe in that model, and they were right. They decided a while back to put their equity research group out on its own, not joined at the hip with investment banking. I'm sure the thinking was that their research will carry more weight since it is unbiased, and therefore will be a valuable product.

We learned Wednesday that Prudential has shut down its equity research, sales and trading business known as Prudential Equity Group. This move speaks much more loudly than my comments ever could regarding the value (or lack thereof) of analyst research. If the product was valuable, people would buy it and it would make a profit. The fact that sell side research is given away for free to clients should tell you just how valuable it is.

I really do think it is that simple. The last study I read showed that analyst recommendations not only trailed the returns of the S&P 500 index, but did so with more volatility. Hardly a ringing endorsement. Expect other research departments to be shut down now that someone got the ball rolling by being the first.

Full Disclosure: No position in PRU at the time of writing

Amgen Announces Another Acquisition

If you wondered what Amgen (AMGN) would do with the extra $1 billion it raised through a recent bond offering, now we know what they had in mind when they finalized the numbers. The company issued $4 billion of debt and simultaneously announced a $3 billion share buyback. It appears the extra $1 billion will be used for acquisitions.

After buying Ilypsa for $420 million on June 4th, Amgen announced Wednesday it would buy Alantos Pharmaceuticals for $300 million in cash, raising its shopping spree to nearly three-quarters of the available billion dollars. As I've said before, I think these small deals make sense for the company. If even one of them results in a significant product approval in the next few years it will be well worth the investments they have made.

Full Disclosure: Long shares of Amgen at the time of writing

Google Hits New All-Time High

Last month I wrote that the risk-reward in shares of Google (GOOG) looked extremely favorable. It just so happened that the stock bottomed two days later and has soared 57 points since. Technicians will likely be pleased to see that Google hit a new all-time high on Tuesday, breaking through a previous double-top.

Hopefully some readers took advantage of Google trading in the low 460's. If you did, where to from here? Well, I have not sold any of the positions I initiated when I wrote the last article. I think a P/E of 30 is very reasonable given Google's growth prospects. With 2008 earnings estimates north of $19 for the company, there is no reason to doubt that a price objective of $575-$580 is attainable in the intermediate term.

Full Disclosure: Long shares of Google at the time of writing

In the Face of Adversity, Amgen Buys Ilypsa to Bulk Up Product Pipeline

It has been a tough year for Amgen (AMGN) but the world's largest biotechnology company is not standing still while its anemia drug franchise is under attack. After cutting operating expenses by hundreds of millions of dollars and issuing $4 billion in debt to boost its share buyback program, the company announced yesterday that it will acquire privately-held Ilypsa for $420 million in cash. Ilypsa, based in San Francisco, specializes in renal care drug discovery, an area that fits very well into Amgen's existing business.

Strategic acquisitions are the third act that shareholders should want to see after an FDA panel started a process of pulling the reins on Amgen's anemia drug business. The reduction in operating expenses and the share buyback will help tremendously in buoying the stock price short term should it lose significant Aranesp sales due to stronger warning labels proposed by the FDA and more stringent reimbursement criteria from the government. Getting new drugs to market is also an important longer term step Amgen must focus on to get back on track, and this acquisition is the kind of thing that could help them do that.

That said, it will take some time to determine if the Ilypsa purchase pays off. The company's lead compound (for patients with chronic kidney disease) is in phase two trials, with a handful of other potential products slightly further behind (another product will enter phase one this year). Still, Amgen needs to take some risks. Until recently, Amgen was able to ride the coattails of its wildly popular (and profitable) anemia franchise. However, as happens quite often when success is achieved, some people believe you are making too much money at their expense.

As far as Aranesp is concerned, targeting and trying to discourage off-label use due to potential negative health implications makes sense. Amgen won't refute that, although they will lose a small amount of revenue from such an objective. What has been disconcerting is that some people are taking the task too far and it could result in the government not paying for the drugs in situations where there is no evidence that there are elevated health risks. That is just something that Amgen is going to have to fight the best it can.

The reaction on Wall Street has been harsh, but that should not come as a shock given how Wall Street acts at the first hint of bad news. As time goes on I continue to believe that the financial implications will be far less detrimental than many think. With patients who are reacting well to treatment, in situations when they are using the drug as directed (which has been proven safe), I don't think we will see dramatic changes in the way doctors prescribe the drugs. There will surely be lost revenue as off-label use is curtailed, and to a larger extent if the government follows through and discontinues coverage for some patients who are using the drugs as intended.

However, Amgen has cut nearly $1 billion from its annual operating expense budget and will be aggressively buying back stock in coming months. If these actions can put a floor in the company's earnings in the short term (Amgen will give updated guidance in July but recently reiterated their 2007 projections in an SEC filing), and their product pipeline delivers with help from acquisitions like the just-announced Ilypsa deal, Amgen shareholders should see better days.

Full Disclosure: Long shares of Amgen at the time of writing

Experiencing a Google Acquisition Firsthand

Undoubtedly, one of the reasons Google (GOOG) decided to go public was to secure a currency (both cash from the IPO and shares to exchange) that could be used to fund strategic acquisitions in order to continue to grow and maintain a leadership position within the Internet services marketplace. The company has taken advantage of that financial flexibility time and time again, as seen with YouTube, the pending deal with DoubleClick, and a smaller deal announced today, the acquisition of FeedBurner.

You always hear about how hard integrating acquisitions can be, from corporate cultures to product lines, but rarely do you get to experience that integration firsthand. This FeedBurner deal is interesting to me on several fronts. Sure, I am a shareholder so I want the deal to make sense, both strategically and monetarily, but moreso this combination is important to me because I am a FeedBurner customer and thoroughly enjoy the company's suite of services. FeedBurner manages this blog's rss feed and email alerts subscriptions from top to bottom.

Accordingly, I am very curious to see how exactly Google integrates FeedBurner into their operation. Will FeedBurner be able to remain autonomous enough that they can continue to innovate in a way that pleases users? Will Google's resources enhance the FeedBurner product offering without replacing it? I am hopeful that this deal was not done simply to secure a user base and migrate them to Google's products.

Oracle (ORCL) has been doing that very thing in recent years, essentially buying up competitors, starving innovation at those companies, and moving users to Oracle products. I can't speak for them, but I doubt customers were all too pleased. One of the reasons I enjoy FeedBurner is because they aren't Google. They are very focused on a single area (distributing online content off-site) and they do it very well.

As both a shareholder and a user of services from both Google and Feedburner, I can say they would be well served to collaborate with the FeedBurner team and innovate alongside them. At the same time they should keep the FeedBurner heart pumping. That little company is alive and well, and users deserve to see that continue.

Full Disclosure: Long shares of Google at the time of writing

Round Two from Round Rock: 8,800 Layoffs at Dell

Earlier this week I wrote about the push by Dell (DELL) into the retail channel as a way to boost sales and gain traction against Hewlett Packard (HPQ). On Thursday the company beat estimates for their first fiscal quarter and announced the second prong of their turnaround plan; 8,800 layoffs (10 percent of the workforce). Although Dell has perfected the very efficient direct model, evidently the company has some fat it can trim, which should help offset any margin pressure from their plan to sell lower end desktop PCs in Wal-Mart (WMT) locations starting in mid June.

Assuming the consumer experience won't be adversely affected by the job cuts, this appears to be a good decision, from a shareholder perspective at least (some employees obviously might feel otherwise). Dell stock jumped more than $1 in after-hours trading to over $28 per share. The stock isn't cheap enough to peak my interest, but I wanted to take a quick look and see what kind of upside investors should expect if the turnaround proves successful. The moves the company is making have a good chance to give the company some upside to currently low expectations this year and into 2008. But how much is the stock worth?

The reason I say Dell shares aren't that cheap is based in part to where companies like HP and IBM (IBM) are trading (15x and 14x 2008 estimates, respectively). What kind of P/E should Dell get based on those comps? I would say 15 to 16 or thereabouts, but the good ol' days of a 25 or 30 P/E for Dell seem to be over.

As far as earnings go, I decided to be pretty aggressive on this assumption, giving the company the benefit of the doubt regarding its new restructuring plan. Current forecasts call for about 2% revenue growth this year, followed by 6% in 2008. Changes at the company likely won't produce results overnight, so a re-acceleration in sales is likely to be more pronounced in 2008. Let's assume they can grow sales 10% next year, to more than $64 billion.

Furthermore, let's assume that Michael Dell can get the company back to peak operating and net income margins. Profits peaked at 6.4% of sales in 2005 before dropping to below 5% last year. Assuming 6.4% margins on $64.3 billion in sales for 2008, the company gets to earnings of $1.83 in 2008, well above current estimates of $1.49 per share. Assign a 16 P/E and the stock price would be above $29 per share. Even if we stretch the P/E to 18 (Dell used to trade at a premium when they were tops in the industry, so this is plausible if they regain their former glory) there is upside to $33 per share, about 16% above the current quote of $28 and change.

The bottom line: Dell stock could definitely keep rising if their turnaround efforts pay off in coming quarters, but make no mistake, this isn't going to look like the 1990's by any means.

Full Disclosure: No positions in any of the companies mentioned at the time of writing