Dell Shares Look Excessively Cheap

It has been a long time since I can recall seeing a blue chip company like Dell (DELL) carry such a meager stock market valuation. It is true that Hewlett Packard (HPQ) has been stealing market share from Dell in recent years, and even overtook them as the world's leading computer maker, but investors seem to be pricing Dell stock as if they are no longer relevant in the computer hardware marketplace. Given that Dell remains number two worldwide in PC shipments, I think pronouncements of their death may be greatly exaggerated.

Just how cheap are Dell shares? Well, Dell currently has about $8.8 billion of net cash on their balance sheet, which equates to nearly half of their share price ($4.50 per share in net cash versus a stock price of $10 and change). Total cash of $5.50 per share (excluding debt) is more than 50% of their current share price. I can't name another profitable blue chip company that trades at just two times net cash.

Given the low stock price, Dell's operations must be going horribly wrong, right? Well, not really. For their latest fiscal year, which ended January 31st, Dell earned an operating profit of $3.2 billion. Subtract out income taxes and Dell's operating businesses are earning about $2.4 billion per year. This compares very favorably to their enterprise value of around $11 billion. At $10 per share, Dell stock trades at less than 5 times operating earnings. Is it a stretch to think it could fetch twice that price sometime down the road? Not in my view.

Now, something could certainly get in the way of this analysis. Excess cash is a great thing to have, but it can easily be wasted by management. Dell has been doing many smaller acquisitions in recent years to beef up its product line. If management did a large deal (using their cash war chest) and it turned out be a bad idea, shareholder value could be destroyed rather quickly.

Another risk is that they use their excess cash to beef up research and development. I say this could be a negative because the new products might not pay off. For instance, there have been rumors for months that Dell is developing a cell phone line. As a shareholder, I don't care for this idea. The cell phone market is crowded and Dell has no experience in it. If they spend hundreds of millions on something like that, and it fails, a once large cash hoard could quickly shrink without much to show for it.

Regardless, Dell stock looks very cheap to me, especially if management spends their money wisely in coming years. Finding such strong companies at discounted prices isn't always easy, but in this case Dell looks to be a bargain. Feel free to let me know what you think.

Full Disclosure: Peridot Capital was long shares of Dell at the time of writing, but positions may change at any time.

First Quarter Best Quarter Ever for Wells Fargo

No wonder the market is up huge today. Before the bell, Wells Fargo (WFC) announced that it would earn a profit of $3 billion in the first quarter, making it the best quarter in the company's history. Even more impressive, that result includes $372 million in TARP preferred dividends paid back to the government.

Some numbers from their press release:

Revenue $20 billion (+16%)Pre-tax, pre-provision profit: $9.2 billion

Provision expense: $4.6 billionPre-tax profit: $4.6 billion

Net earnings: $3 billion

Allowance for future loan losses: $23 billion

Why isn't the Wachovia deal killing them? As I have pointed out before, purchase accounting lets you write-off loans when deals close, so Wells was able to take most of the Wachovia losses up front, which boosts earnings in the future quarters. As we can see, this is the first quarter for the combined company and they are really executing well.

Full Disclosure: No position in WFC at the time of writing, but positions may change at any time

Why I Have No Problem With The Government Firing Rick Wagoner

Call me skeptical that since the Obama administration's auto task force ousted General Motors CEO Rick Wagoner it means the government is going to take over and ruin the auto industry. I think Wagoner's list of accomplishments (or lack thereof) shows that he deserved to be gone long ago. After all, GM stock went from $60 to $2 under his tenure as CEO.

As for whether the government should have the right to force him out, why shouldn't they have the same power that any other creditor or investor would have when trying to help a company avoid bankruptcy? Private equity invests in distressed companies all the time and as a condition of such investments always has a say in the turnaround plan, including replacing a chief executive. Having such power is the only way they feel comfortable that adequate changes will be made to somewhat protect their investment.

The government is unfortunately in the drivers seat in this case because nobody else will come to GM's aid in its current form. By doing so, however, they should have the same rights as anybody else. No more, no less. Whether they should have even tried to prevent a GM bankruptcy is another question entirely, and a very valid one at that. I have no problem with someone arguing against that, but that really has nothing to do with the Wagoner situation.

The Obama team has decided to continue the public aid that the Bush team started, probably to try and avoid further destabilizing the financial system and economy. Reasonable minds can (and are) disagree over whether that is the right thing to do or not, but Rick Wagoner had to go regardless. Don't forget, under his leadership, even when the economy was booming GM North America was in the red.

What about Wagoner's replacement, Fritz Henderson? Well, I don't think the government had a hand in choosing him. He openly and proudly announced that he was a lifelong GM'er and that Rick Wagoner was his mentor. Yikes, I guess the jury is still out on whether that is change we should believe in or not.

Full Disclosure: No position in GM at the time of writing, but positions may change at any time (I don't expect this to change in this case)

Unconventional Wisdom: Consumers Reduce Debt During Recession

The conventional wisdom has been that as the recession deepens and more people lose their jobs, they will rely more heavily on credit cards, etc to fund their expenses, consumer debt will rise, and banks will struggle with more and more debt that is less likely to be repaid.

Well, based on the graph below from the April 13th issue of Business Week, the consumer is de-leveraging, not borrowing more. This trend is also seen in the savings rate, which has spiked in recent months. As a result, consumers might be in better financial condition after the recession than before, ironically enough.

After a Brief Break, Here's A Merger Arb Trade For You

Regrettably I was out of town for several days and as a result it has been awhile since I've posted anything. So, I decided to give you all a conservative trade idea now that the market has had a huge run over the last four weeks. We are definitely getting overbought here, so tread carefully.

Anyway, I am a big fan of arbitrage opportunities and I think there is a merger arb play right now with the pending merger between Merck (MRK) and Schering Plough (SGP). The deal should close by year-end and the agreed upon cash and stock ratio (SGP shareholders get $10.50 cash and 0.5767 shares of Merck for each SGP share they own) implies a total deal value of $25.76 for each SGP share. That represents a premium of 9.4% based on Friday's closing prices for both stocks.

Normally, someone wanting to make this trade would simply short ~58 shares of MRK for each 100 shares of SGP they were long, wait for the deal to close, use the new Merck stock they receive to cover the short position, and pocket the 9.4% financial spread as profit. In this case, the actual return would be slightly less because Merck's dividend yield is above that of Schering.

However, there is another way to play this (and a more profitable one) because Schering Plough has a convertible preferred issue (SGP-PB). This security pays a higher dividend than the common (7.1% versus just 1.1%) and converts into SGP common in August of 2010. By that time, it will actually convert into Merck stock, since Schering will no longer be an independent company.

The attractive thing about the convertible preferred is that it too trades at a discount to implied value upon conversion. The convertible currently trades at $210 but would convert into $214 of SGP stock if converted today. Add in the $15 annual dividend and the spread is even higher.

How would an investor play this? Simply by buying the SGP preferred instead of the common when simultaneously shorting MRK common. Rather than using common stock from the merger to cover the short, you can simply wait until the preferred converts into common in August 2010 to cover the short. In the meantime you can collect the 9.4% deal spread, a 7.1% annual dividend as well as the 4% spread on the convertible security.

Full Disclosure: Peridot Capital has positions in both SGP and MRK at the time of writing. Positions may change at any time.

Best Buy Shines Even In Weak Economy

Back in November I wrote that Best Buy would be a prime beneficiary of Circuit City's bankruptcy and given that they were already one of the best run retailers in the country, the stock was cheap at a single digit P/E (around $25 per share). Today Best Buy reported blowout fourth quarter earnings and predicted 2009 earnings of $2.50 to $2.90 per share, which is well above current estimates of below $2.50.

Best Buy shares are up $5 (15%) today to more than $38 per share, which brings the gain since November to over 50 percent. If you have been riding this trend, the shares look close to fair value from my perspective. Taking the middle of the earnings guidance range and applying a 15 P/E (a bit higher than I would choose normally, due to the recession) I get fair value of about $40 per share, so it appears the stock's huge move is largely behind us.

Full Disclosure: Peridot Capital was long shares of BBY at the time of writing, but positions may change at any time

Reducing Unused Credit Card Lines Is Probably A Good Thing For Everybody

Meredith Whitney, long time bear on the banking sector, is pointing to the possibility that reductions in credit card lines could result in a sharp drop in consumer spending over the next year or two. In a recent television interview she predicted that outstanding credit card lines in the United States would drop from $5 trillion to $2.3 trillion by the end of 2010, a drop of more than 50 percent. Having less available credit, Whitney argues, will result in even less consumer spending and major problems for the economy.

While I don't disagree that credit card issuers are going to reduce credit lines (we are already seeing this trend and there is no reason to think it will cease anytime soon), I am skeptical about how much this will really impact consumer spending. The main reason is because there is only about $800 billion in outstanding credit card debt in the U.S. right now, and that figure has not been growing as fast as may have thought in recent years. While this is clearly a large number ($2,600 per person), it is dwarfed by the credit lines currently outstanding and as a result, the credit line reductions should not really have a major impact on day-to-day spending.

Essentially, Whitney is predicting that the credit utilization rate will increase from 16% currently (800 billion divided by 5 trillion) to 35% within two years. For someone with $2,600 in credit card debt, that means their credit limit will be reduced from $16,000 to $7,500. While that may make the consumer a little less confident that they have a huge cushion of credit to fall back on in the case of an emergency, I don't really agree that it will result in a significant pullback in regular spending habits.

Additionally, this action by the nation's leading credit card companies may in fact help them as well as our consumers, who hopefully will realize that they should have a few thousand dollars in a savings account in case of an emergency rather than assuming they will get cards should something unexpected happen. This would be a welcome event for our banking system, which benefits greatly from an increasing deposit base. As for Whitney's assertion that a credit card bubble is the next shoe to drop on our economy; call me a skeptic. The data simply isn't all that scary to me and if we slowly lower our dependence on credit cards, our economy will be on stronger ground as a result.

Suncor/Petro-Canada Combo Could Be First Of Many Energy Deals

Today we learned that two of Canada's largest oil producers, Suncor (SU) and Petro-Canada (PCZ), are merging in a $15.5 billion deal due to close in the third quarter. More large commodity-related deals, especially in the energy sector, could be coming. Despite the global recession, the long-term fundamentals for the commodities sector remain intact. Lower demand is clearly going to have a large effect on demand near-term (prices have already come down a lot in most cases), but unless you think the global economy will not recover, commodities will serve as an economic barometer going forward, in both directions.

When you couple temporary price declines (in the actual commodity as well as the stock prices of the large producers) with long term bullish industry trends and supply limitations (lack of credit availability limits exploration and drilling projects used to boost supply), mergers in the current environment are going to look attractive to CEOs who are anticipating the commodity markets will rebound when the economy does.

While I don't have specific companies in mind that have a better chance of being acquired than others (I would have preferred Suncor to be a seller rather than a buyer, given Peridot's long-term position in the company), but I would expect this energy deal to be just the first in a series of large deals in the next couple of years.

Full Disclosure: Peridot was long shares of Suncor at the time of writing, but positions may change at any time

How The Financials Are Greatly Masking the Market's Earnings Potential

Some people are making the case that the stock market can rally meaningfully even without the financial sector recovering. I disagree simply because earnings are being negatively impacted so severely by loan losses and mark to market writedowns at the large financial institutions that investors won't get a clear picture of what a reasonable expectation for S&P 500 earnings are until financial sector earnings at least stabilize, if not climb back toward breakeven.

Jeremy Siegel, well known Wharton finance professor and author of "Stocks for the Long Run" (an excellent book) had an opinion-editorial piece in the Wall Street Journal recently that was titled "The S&P 500 Gets Its Earnings Wrong" (subscription only) that made some interesting points about the currently depressed level of earnings for the S&P 500.

Dr. Siegel explains that while the S&P 500 is market value weighted (larger companies are weighted more heavily in the index than the smaller ones), Standard and Poor's does not use the same methodology when calculated the index's earnings. Instead, a dollar of profit from the smallest stock is treated the same as a dollar earned by the largest. As a result, the losses being accumulated by a small portion of the index are negating the profits being generated by the majority, which is making the S&P 500's earnings look overly depressed.

Consider the data below, taken from Siegel's column:

Siegel is suggesting that the absolutely abysmal financial performance of the market's worst stocks last year (mostly from financial services firms, of course) is giving the appearance that corporate profits have absolutely fallen off a cliff in every area during this recession. He is quick to point out that 84% of the largest 500 public companies in the U.S. (420 out of 500) are actually doing quite well. That fact is going unnoticed because $1 of earnings from the smallest stock in the S&P is treated the same as $1 of earnings from the largest component, even though an investor in the S&P 500 owns 1,300 times more of the largest one than the smallest.

I'm not sure if Siegel is suggesting that they should actually go ahead and change the way they calculate S&P 500 earnings (and if so, I'm not sure I would even agree with him), but I do think this data is very helpful in seeing just how much the financial sector is masking corporate profits from other sectors.

My personal estimate right now for S&P 500 fair value is around 1,050 (14 to 15 times normalized earnings of between $70 and $80). I came up with those estimates before reading Siegel's article, but the data he provided give me comfort in the estimate. After all, if you assume the bottom 80 companies get back to breakeven and the other 420 companies maintain their 2008 profitability (both are conservative assumptions when the recession ends in my view), we see that S&P 500 earnings would range from $67 (if you use GAAP earnings) to $81 (if you use operating profits).

As you can see, any relief for the financial sector with respect to mark-to-market accounting principles could temper the writedowns going forward. Even getting the financial sector to breakeven by 2010 would reduce the negative earnings impact from the bottom 6% of the S&P 500, clearing the way for earnings to rebound pretty quickly from the $40-$50 level analysts are projecting for 2009.

Cash Flow Accounting Isn't So Terrible, Really

Last night on Larry Kudlow's CNBC show, the guests debated how proposed changes to fair value accounting would impact the stock market. The full clip is below, but the main argument was whether using cash flow fair value accounting (most likely what any proposed changes out of FASB will look like) is really that much worse than mark-to-market accounting. I have written about this before and I really don't understand the argument that somehow a cash flow based valuation of asset backed securities lacks transparency and allows bankers to value their assets at whatever number they want.

Gary Schilling, the bear on Kudlow's panel (who is predicting 600 on the S&P) argues that fair value accounting is just a forecast and you can't accurately forecast the cash flows from an asset backed security. This view baffles me. After all, non-packaged whole loans that banks hold are valued using cash flow projections. In fact, that is standard practice. If you have a loan that is being paid on time consistently, there is little reason to think you won't be repaid in full, and therefore that loan is reserved for much less aggressively than a loan you have where the borrower is delinquent.

The idea that one can't accurately forecast the cash flow from a loan (or an asset backed security) ignores reality. Every loan has an amortization schedule, so you know exactly how much principal and interest you are due to receive and when. Obviously, you have to build in some loss assumptions based on the economic environment, delinquency trends, credit history, etc, but it is far easier to predict cash flows from loans you hold than it is other assets like goodwill and other intangibles, or even equities.

The idea that someone else selling a loan makes every loan like it worth that exact amount ignores the fact that credit trends differ between banks, regions, etc. If you hold loans that are current on both principal and interest, there is no reason you should be forced to write down the value of that loan simply because a distressed seller, completely unrelated to you, is forced to sell their loans at a discount to get rid of them quickly.

Fortunately, the updated FASB guidelines should go a long way to solving this issue in the coming weeks. Banks lose money on loans all the time, and that will continue with or without mark-to-market accounting. There is no reason a financial services company should be forced to take an accounting loss on an asset if they are still being repaid on time and as expected.

Later this week I will illustrate why adjusting these accounting rules on financial services companies will do a lot to alleviate investor fears and bring some stability back into the stock market, which we have already begun to see in the last week or so.