Reader Mailbag: Is Salesforce.com (CRM) a Good Short Candidate?

Tim writes:

"Hi Chad, you've probably looked at CRM as a "short," any chance we'll see a blog update with your thoughts on this one?"

Thanks for the question, Tim. I have several thoughts that pertain to Salesforce.com and other high-flying, excessively priced growth stocks in general.

Shorting these kinds of stocks is very dangerous. As a value investor, I certainly believe that excessive valuation is a huge red flag for any stock, but the key question is whether or not that sole factor alone is enough reason to bet on the price declining meaningfully, as opposed to simply avoiding it completely on either side. Unless there is a clearly identifiable deterioration in the company's fundamentals, I tend to avoid shorting stocks merely because they are extremely overvalued.

The problem is that the market tends to give high growth companies elevated valuations as long as they keep delivering results. As a result, the short trade can go against you for a while, making it such that you must time the trade very well, and market timing is tricky. It is quite possible you will lose money for a while, and even if you are eventually right about a price decline, most of your gains by that point might only really recoup the losses you sustained initially. Without a negative catalyst (a breakdown in the operating business) it is very hard to time valuation-based short trades well enough to make good money consistently.

Now, in the case of Salesforce.com (CRM), the stock trades at about 90 times 2011 earnings estimates. Even for a company that is well positioned to grow for many years to come, one could easily argue that even at an elevated price of 40 or 50 times earnings, there is plenty of room for downside here. And I would not disagree with that. It really is just a matter of whether you want to explicitly bet on a huge decline, because you not only need to be right about the price, but you need such a decline to begin relatively soon after you short the stock, because momentum names like CRM can keep rising for longer than most people think.

Unless the market in general has another huge meltdown, these situations typically result in the stocks moving sideways for a long time, in order to grow into the hefty valuation Wall Street has assigned to them, assuming that their business fundamentals are not deteriorating. While I do not follow CRM as closely as many others do, I am unaware of any reason to think their business is set to take a dive. If that thesis is correct and the company continues to grow nicely, I would feel more confident betting on the stock moving sideways even as rapid growth in their software business continues.

To illustrate this idea, let's consider past examples of stocks that were excessively priced, but still burned the shorts since the business fundamentals remained strong. Amazon.com (AMZN) is a prime example of a stock that many people have tried (unsuccessfully in most cases) to short in recent years. Amazon has continued to post phenomenal growth as it takes market share in most every category it expands into. In fact, just over the last few years many investors have argued it was a prime short candidate (and still do, at the current price of 52 times 2011 earnings estimates). As their business has continued to grow, Amazon shares have actually risen from around $70 two years ago to $165 per share today. Shorts over this period have gotten crushed.

If we go back in time, however, we can see that Amazon shares really have underperformed (relative to their underlying business fundamentals, anyway) for a long period of time. The stock peaked in December 1999 at $113 per share, when Amazon's annual revenue was a mere $1.6 billion. Today, more than 11 years later, Amazon's sales are on track for $45 billion annually, but the stock is only about 50% above 1999 levels. This is entirely due to the fact that the valuation in 1999 was so high that it already factored in years and years of stellar growth. Sales at Amazon have grown 28-fold (2,700%) since 1999, but the stock is up only 50% during that time. Believe it or not, that makes the investment a disappointment for those who had the foresight to predict Amazon's explosive growth potential a decade ago. The valuation simply mattered more because it was already factoring in tremendous growth opportunities. Perhaps the same situation may be brewing with Salesforce.com.

As a result, I would personally prefer to avoid CRM rather than short it today. In more cases than not, shorting a stock based on valuation alone can get dicey pretty quickly, whereas finding a company with deteriorating fundamentals AND a high valuation has a much better risk-reward profile. Think Crocs, circa 2008, as one example.

Biglari Holdings: You Can't Be Serious!

This week marked the first time in my investing career that I have felt the need to write to the management team of a publicly traded company. Not only that, but I even surprised myself a little bit by actually going ahead and doing it. After reading a corporate press release from Biglari Holdings on Tuesday morning, I was absolutely irate. What could make me so upset that I actually wrote a two page letter and mailed it off to the CEO, despite the fact that collectively my clients and I own about 0.005% of the company's stock?

Biglari Holdings announced this week that it was planning to reverse split its stock (which was already trading above $450 per share) 1-for-15, which would send the price up to nearly $7,000 per share and reduce the total shares outstanding to less than 100,000. The end result (other than an insanely expensive stock) is that anyone with fewer than 15 shares of the company (again, nearly $7,000 worth) would be forced to accept cash in return for liquidating their investment. That's right, the company was forcing its smaller shareholders to sell and they had no say in the matter. At least if you own stock in a company that has agreed to a merger you can vote "yes" or "no" to the deal.

To my knowledge, I don't know of any other company that has ever had the audacity to force its shareholders to sell all of their stock. And since all but two of my clients who are invested in Biglari Holdings own fewer than 15 shares (myself included) I just had to speak up, even though it clearly won't matter to the company what I think. Still, if there was ever a time that small shareholders should complain to management, I have to think this would be that time.

Rather than post the letter on this blog, I chose to submit it for publication on a larger site (Seeking Alpha) with the hope that other upset shareholders might join me in voicing their discontent. A copy of the letter can be read here: An Open Letter to Sardar Biglari, CEO of Biglari Holdings.

Coinstar Shares Look Very Cheap After Guiding Down Earnings Expectations

Consumers should know Coinstar (CSTR) very well as the maker of coin counting machines found at grocery stores and more recently the owner of the Redbox DVD rental kiosks found in even more retail locations such as McDonald's and Wal-Mart. I believe the stock, which has gotten hammered lately after an earnings miss for the fourth quarter, represents tremendous value. CSTR gives investors a rare combination of value and growth potential.

At around $39 per share (down from $67 late last year), Coinstar stock fetches only 6 times trailing cash flow. To put that in perspective, Microsoft sells for 7 times, Cisco for 8 times, and IBM for 9 times. Investors are clearly getting a valuation that is otherwise reserved for larger, slower growth businesses. This despite the fact that the company just reported that 2010 revenue soared 39% on the heels of a 50% jump in DVD rental sales (the more mature coin counting business grew by 7%). Despite giving more conservative guidance going forward after the company missed Wall Street's fourth quarter expectations, Coinstar expects 2011 revenue to jump by about 24% with cash flow rising by 18%, as it continues to invest in growing the business. If management can deliver on these numbers this year (and after an earnings miss we should think they might give out forecasts they feel quite confident in reaching), the stock trades at only 5 times current year cash flow, unheard-of for a company growing like Coinstar.

Now, as with any investment, expectations and forecasts of future growth and valuation are not the only things to consider. Analysts would be quick to argue (and I would not disagree) that movie rentals are moving from disc-based to cloud-based, with the emergence of Netflix and other streaming platforms. Any market share gains that Coinstar's Redbox kiosks might see with the pending bankruptcy of Blockbuster could very well be negated by more and more people signing up for Netflix streaming.

However, I still believe that the market for Redbox kiosks is bright, for two main reasons. First, with nearly 25,000 kiosks installed in grocery stores and retail outlets across the country, the convenience and cost ($1 a day) of Redbox rentals will make them attractive to both cost conscience movie watchers (if you only watch a couple movies per month you will likely opt for Redbox over an $8/month Netflix streaming plan) and those who enjoy the convenience of grabbing a movie on their way out of McDonald's, Wal-Mart, or their local grocery store (just picture how easy children can convince mom and dad to get a movie for $1 before they leave the store).

The second reason I think it will be years before physical disc rentals will become completely obsolete is that there are still millions of Americans who are afraid of technology to a large degree (either due to things such as identity theft, or simply out of not being comfortable with operating high tech toys such as wi-fi enabled DVD players). To illustrate this point, let me share an encounter I had with a woman a couple of weekends ago.

After noticing that several Blockbuster locations were being liquidated near where we live, my fiancee and I decided to stop by and see if we could land any ridiculous deals (they were literally selling the store's shelves as well as the DVDs sitting on them). Everything was for sale, and if you had a spare $350 sitting in your bank account you could buy the giant gum ball machine from your local Blockbuster store (we saw one being carried out by a man as we entered the store).

As I was perusing the aisles I helped explain the pricing structure to a woman in her 50's or 60's who was confused. We got to talking and she was mostly rambling about how disappointed she was that this store was closing because all of the other DVD rental places had also closed and now there was nowhere for her to go. I mentioned Netflix and she immediately dismissed it as a viable option "because you need a credit card for the box." She was clearly confusing Netflix with Redbox, but the fact that she refused to use a credit card to rent a movie told me that Netflix would not be any better in her mind.

I bring this up because I think people like this woman are exactly the ones who will shun new technology like Netflix streaming. Eventually she will have to cave and start using Redbox for movie rentals most likely, and think about how many people like her there are out there. Not only that, but even if she felt comfortable using the Internet to order movies by mail (I don't see her using Netflix mail order anytime soon, given that her explanation for why that wouldn't work for her was that her printer has been broken for months and she can't figure out how to fix it), I really don't think she would proactively adopt such a technology when there are other "lower-tech" ways of getting a DVD such as Redbox (granted, a credit card will still likely be required).

In short, I think there will be room for both technologies for several years to come. While I subscribe to Netflix and have never actually used a Redbox kiosk, there are plenty of middle aged and older Americans who will. Not only that, but the Redbox kiosk in the grocery store I visit is often crowded with college kids as there are several universities in the area. Cost is probably the main factor there, as young kids can certainly operate Netflix streaming movies, but more likely lack the discretionary income to afford an expensive box with wi-fi and a monthly plan. So, there is definitely a market for Redbox with younger people too.

With Blockbuster in liquidation, Redbox should continue to grow, although Coinstar's current stock price seems to not fully be factoring in such strong demand for their kiosks. I do not see any reason CSTR shares should not fetch 7-8 times cash flow, which makes a stock price of $60 quite a reasonable expectation.

Full Disclosure: Long CSTR at the time of writing but positions may change at any time

Kodak: Horrible Fundamentals But Too Cheap To Short

At first blush shares of Eastman Kodak (EK) appear to be an attractive candidate to short. Digital cameras have essentially eliminated the company's largest and most profitable revenue generator (traditional film) and sales have been declining for years. Kodak's answer to a disappearing business has been to focus on digital hardware such as their own camera line as well as a foray into the world of ink jet printers and cartridges. The glaring problem with this strategy is that they are shifting from a very high margin, uncompetitive area (film) to a very low margin, highly competitive one (consumer electronics). The results thus far have been predictably poor. Over the last five years EK stock has plunged from $30 to under $4 as sales have declined and profits have all but disappeared during what they dubbed a "digital transition."

Since I really do not envision the fundamentals for Kodak improving, it is a prime choice to look into as a potential short candidate. After such a dramatic fall, however, coupled with 24% of the outstanding float already sold short, there does not appear to be much room to the downside, in the near term anyway. This is mainly because Kodak has managed to successfully clean up its balance sheet in recent years (an imperative when a business is in decline) to the point where they now have net cash (cash on hand less gross debt) of about $150 million. And while revenue is certainly declining, they still bring in about $7 billion a year in sales. Such figures make the current stock price ($3.75) and equity valuation ($1 billion) look reasonable enough that shorting now is not all that exciting to me.

Considering Kodak's current equity value of $1 billion and revenue run rate of about $7 billion annually, the company only needs to earn a net profit equal to 1.4% of sales to earn $100 million annually, which would give the stock a P/E ratio of 10. Therefore, in order for a short position to work well at current prices, the P/E would have to drop far below 10, sales would need to fall off a cliff, or they would have to start to bleed cash. While the business fundamentals are poor, none of these scenarios seem like a high probability event in the near term. More likely, Kodak will continue to slowly lose revenue, run the business at break-even or slightly above, and the stock will trade at a discount based on their weakened market position. While these facts would not make Kodak stock a good investment at current prices, there does not seem to be a huge amount of downside either, barring some unforeseen event.

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

Why Education Was Stressed So Heavily in the State of the Union

I think these figures from the BLS tell it all:

Apple Stock Can Easily Reach $450

I often get a little bit of flak from a handful of fellow value investors when I write about owning tech companies such as Apple (AAPL) or Research in Motion (RIMM). How can you call yourself a value investor and own growth stocks like these, they ask? For me it all comes down to valuation, not growth rates. If RIMM trades at 9 times earnings, why would I not want to own it as a value manager? It trades at a huge discount to the market and its peer group. Isn't that what value investing is all about, finding stocks trading at a discount? If two stocks I am looking at both trade at 9 times earnings, but one is growing at 5% a year and the other is growing at 25% a year, I am going to favor the one growing at 25% a year (all else equal) because it has even more upside. That should not mean that I am abandoning my core investment strategy. When the stock reaches a market multiple and no longer trades at a discount, I will sell and move on.

Which brings me to Apple. How can I justify continuing to own Apple after the enormous move the stock has made over the last decade? Because for some strange reason it still trades at a discount. The company just reported quarterly earnings of $6.43 per share, more than $1 above estimates, giving them an annual earnings run rate of nearly $26 per share. Even after a solid after-hours rally the stock sits at $344 which is really more like $280 after you net out the $64 of cash and no debt on their balance sheet. Apple stock, therefore, trades at an astounding 11 times its annual earnings run-rate,  a 20% discount to the S&P 500 index, which is why my clients still own it.

When will I sell? Well, if we assign a 15 P/E to nearly $26 of earnings and add back $64 per share of net cash, we get about $450 per share. At that price the stock would no longer trade at a discount to either the market or its peer group, so I will move on. Even at $450 growth investors will likely still argue that Apple is "cheap" based on their growth rate (they often are willing to pay up to a P/E of twice a company's growth rate), but that is a growth investor's mentality. And although it is hard for some to belief, it is not the one I use when allocating clients' investment capital.

Full Disclosure: Long shares of Apple and Research in Motion at the time of writing, but positions may change at any time

Motorola Doubles Down on Cell Phones with Mobility Unit Spin-Off, But Should Investors Tread Carefully?

Motorola's long-planned corporate break-up became official last week as the stock split into two distinct business units; Motorola Mobility Holdings (MMI) and Motorola Solutions (MSI). The former will encompass Motorola's consumer unit (cell phones and cable set-top boxes) whereas the latter will serve the enterprise sector.

Analysts have been praising Motorola Mobility as a way for investors to play the rise of Android smartphones and Motorola's success with the Droid product line. In fact, just this morning Bank of America Merrill Lynch initiated coverage of MMI with a buy rating and $38 price target (the shares currently trade around $32).

Making a bet on a cell phone pure play, without a stronghold on a certain niche of the market a la Apple or RIM, seems risky to me. After all, this industry is extremely competitive and aside from Apple and RIM, companies make very little money selling cell phone hardware. Palm was forced to sell itself to HP and after their success with the RAZR phone many years ago, Motorola struggled mightily before their Droid came along. Other giants in the space like Samsung and LG have diversified electronics product offerings so they do not need to rely on cell phones for strong profits. And new competitors enter the market all the time. We just learned that LCD TV maker Vizio is planning to launch Android phones and tablets and HP is set to launch a line of phones this year based on the Palm webOS operating system they acquired.

Perhaps the biggest reason to be cautious about Motorola Mobility is the fact that Apple is set to give Verizon the iPhone shortly. The Droid has done pretty well on Verizon in large part due to the fact that Verizon is the largest U.S. phone carrier but has not had access to the iPhone before. Loyal Verizon users have been using Blackberry and Droid phones but that could change dramatically when Apple's products are made available to them.

All in all, it seems that everyone is jumping on the Android bandwagon. This is definitely good for consumers but I have to question how all of these players are going to make good money by selling what is essentially the exact same commoditized product. Is a Motorola smartphone or tablet computer running Android really going to be able to differentiate itself from an Android-based product from Samsung, LG, Dell, or anyone else? Seems unlikely, and without doing so these hardware companies are going to be at each others' throats, which reduces pricing power and mostly importantly, profit margins. Computers makers like Packard Bell and AST have long been extinct because they could not outsell their competitors with largely identical products (Windows-based computers). Why would the tablet PC market or the phone market be any different?

Digging into Motorola Mobility's numbers hardly paints an overly bullish picture either. While it is true that the company has stemmed losses in its cell phone division, which was losing hundreds of millions of dollars just a few short quarters ago, the business is still not making money (operating margins were 0% last quarter). With a strong launch of the Droid and reduced competition within Verizon's customer base, Motorola still isn't making a dime selling smartphones today. It is hard for me to see how that situation improves materially after the iPhone launches on networks outside of AT&T, but Motorola's long-term goal is an operating margin of 8-12%. Seems overly optimistic to me.

The overseas markets could potentially be a strong area of focus for Droid, but Motorola Mobility gets 68% of their revenue from North America, so they are not big players in Europe or Asia. MMI is also more than just cell phones, with one-third of their revenue coming from a leading market share position in the cable set-top box market, but that industry seems poised for competition too. Would it surprise anyone if Apple or Google eventually launched their own cable box to compete with digital cable? Growth potential in set-top boxes seems lackluster and Motorola's leading market share could come under fire. In fact, I just read that companies are already working on ways to build cable box technology directly into television sets, thereby eliminating the need for cable subscribers to have a separate cable box at all.

All in all, color me pessimistic about the outlook for Motorola Mobility, the company's new pure play cell phone company. At $32 per share, MMI shares trade at 28 (corrected 11:50am) times 2011 earnings estimates of $1.16 and given that the company lost money in 2010, I think those projections for future quarters may prove difficult to achieve. MMI does give investors a strong balance sheet ($3.5 billion in cash and no debt), but given high research and development costs, coupled with a cell phone business that is only breaking even right now, and it is entirely possible that their cash hoard may dwindle over time.

Full Disclosure: The portfolio that Peridot Capital manages on Wealthfront was short shares of MMI at the time of writing, but positions may change at any time

Large Brokerage Firm Recommendations Performing Poorly, Again

Another piece of data supporting the idea of contrarian investing, this time from Bloomberg.

The money quote:"

Companies in the Standard & Poor's 500 Index that analysts loved the most rose 73 percent on average since the benchmark for U.S. equity started to recover in March 2009, while those with the fewest "buy" recommendations gained 165 percent, according to data compiled by Bloomberg. Now, bank favorites include retailers and restaurant chains, the industry that did best in last year's rally and that are more expensive than the S&P 500 compared with their estimated 2011 profits."

Sears, Urban Outfitters Smart to Consider Rival Bids for J. Crew

According to reports out of Bloomberg today, J. Crew Group (JCG), the upscale clothing retailer run by former Gap CEO Mickey Drexler, could receive competing buyout offers from the likes of Sears Holdings (SHLD) or Urban Outfitters (URBN). J. Crew has already agreed to a private equity buyout for $43.50 per share in cash, but the deal included a "go-shop" provision,which allows the company to solicit higher bids until January 15th. This Bloomberg report signals that other parties are indeed interested to some degree.

I have been following the situation closely because J. Crew is a current holding in a portfolio I manage for Peridot Capital on Wealthfront. Normally with the stock of an acquisition target trading less than 1% below the agreed upon buyout price I would have long sold the stock, but the price J. Crew accepted made me hold on with hopes of another offer. JCG agreed to sell out for less than 7.5 times trailing cash flow, which may be in line with their peer group, but JCG is not just an average run-of-the-mill retailer. The company's upscale apparel, coupled with the merchandising abilities of CEO Drexler, make the company a very hot commodity in retail. The original purchase price of $43.50 seemed low to me, given that one would expect a buyout to fetch a premium price for such a wonderful asset within the retailing arena.

As a result, the Bloomberg report that other retailers are poking around and weighing offers should not be overly surprising, but the two parties mentioned are very interesting. Sears, you may recall, was taken over by Eddie Lampert in a move widely expected to result in him diversifying away from their legacy Sears and Kmart stores. Investors (myself included) were excited about the potential for Lampert to siphon off cash flow from Sears' retail stores and expand into other areas with better growth prospects, but became disgusted and bailed on the stock after he did very little to move away from those two chains. Other than a bid for Restoration Hardware several years ago, Sears has squandered an opportunity so far but perhaps their interest in delving into J. Crew's books signals a much needed shift in strategy. Not only would J. Crew give Sears a new upscale brand with much more growth potential, but the company's lower end J. Crew factory outlet line could sell quite well in Sears and Kmart stores, which would boost J. Crew's reach almost immediately.

Interest from Urban Outfitters is also interesting because it would fit in with the company's Anthropologie stores as an upscale brand with a middle age target consumer. Rather than building new brands from scratch, which is what Urban has chosen to do in the past, buying an established company like J. Crew (and getting Mickey Drexler) would really mesh well with the company's image and overall direction in the industry.

While there are no assurances that a rival bid will actually emerge in the next 10 days or so, this story is certainly one to watch. Not only could a company easily justify a purchase price 10-20% above the $43.50 that J. Crew has already accepted, but in the case of the specific companies rumored to be sniffing around, the strategic fits are quite obvious, which cannot always be said in the world of M&A.

Full Disclosure: Long shares of J. Crew and Urban Outfitters with no position in Sears at the time of writing, but positions may change at any time.

Least Surprising Prediction for 2011: Wall Street Strategists See Market Rally of 10%

According to data compiled by Bloomberg from twelve of Wall Street's largest investment banks, strategists expect the S&P 500 index to rise by about 10% next year, which would mark the third straight year of double-digit gains for U.S. stocks. Their figures, based on operating earnings in the low 90's for the broad index, equate to a year-end P/E of about 15 times, in-line with the market's historical average.

Investors well-versed in market history may not feel like these predictions are all that interesting. After all, the market averages a 14-15 P/E ratio over the long term, and the mean return for the S&P 500 since it was created is about 10% per year. These Wall Streeters are clearly not going out on a limb with these estimates, which is hardly surprising given their nature to hedge their bets in an effort to protect their jobs (by rarely differing very much from the consensus view).

Since consensus viewpoints typically will not make us money, it is helpful to think about whether the odds are that the market does better or worse than these predictions. Personally, I would guess the odds are better that we see single digit returns in 2011, as opposed to a better-than-expected gain. I say that because P/E ratios are unlikely to rise given that interest rates are headed higher. Couple that with the fact that analysts consistently overestimate forward earnings growth (by a factor of nearly 2 times). A long term study by the consulting firm McKinsey has found that long-term earnings at public companies grow by about 6% per year on average, versus projections by industry analysts of 10-12% heading into any given year.

All in all, U.S. stocks are far from overvalued, but with strong earnings growth in 2011 already expected and a ceiling on multiples seemingly close by, returns in the year ahead should be decent but not fantastic, especially given that we are coming off two above-average years in a row for the U.S. stock market.