Paulson Threatened To Remove Ken Lewis If He Backed Out Of Merrill Lynch Deal

Some people are worried that President Obama is going to try and run the banks and credit card issuers but how about this little tidbit from the Wall Street Journal:

Then-U.S. Treasury Secretary Henry Paulson threatened to remove Bank of America Corp. Chief Executive Kenneth Lewis and the bank's board of directors if the bank backed out of its merger with Merrill Lynch & Co. last year, New York Attorney General Andrew Cuomo said.

Mr. Lewis had informed Mr. Paulson on Dec. 17, 2008, that Bank of America was planning to invoke a material adverse event clause in the merger agreement that would allow it to call off the deal, Mr. Cuomo said. Three days before, Mr. Lewis had learned that Merrill Lynch's financial condition "had seriously deteriorated at an alarming rate" since Dec. 8, 2008, Mr. Cuomo said.

The difference between this news and the ouster of GM CEO Rick Wagoner, of course, is that the government is a creditor of GM and without having lent them money, GM would have filed bankruptcy a long time ago. Forcing shareholder-owned companies to merge simply to prevent possible instability in the financial system is questionable at best and completely inappropriate at worst. I hope the Obama administration doesn't repeat these types of things. Fortunately, pushing for a credit cardholder bill of rights, as discussed today in Washington, does not fall into such a category. Let's cross our fingers it stays that way in the future.

Q1 2009 Earnings Exceeding Estimates So Far

Are you surprised that the market is acting as well as it has lately, especially with earnings season having begun? Still waiting for that overbought correction after six weeks of gains in stocks? Me too. Why the relative strength? Well, according to Bespoke Investment Group first quarter earnings are coming in well above estimates so far (20% reporting):

"A fifth of the companies in the S&P 500 have reported earnings for the first quarter, and so far earnings are down 16.6% versus the first quarter of 2008. While down, this is much better than the -37.3% expected at the start of earnings season. When comparing actual earnings versus estimates, Consumer Discretionary, Financials, and Energy are leading the way. On the downside, the Industrial sector is the only one where actual earnings have come in weaker than expected. Earnings season still has a long way to go, but the fact that growth has come in better than expected thus far has been one factor driving the market higher."

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