Pandora IPO Reminds Us What 1999 Felt Like

We have a long way to go before another bubble in Internet stocks emerges but the recent IPO of LinkedIn (LNKD) and today's debut of Pandora (P) serve as reminders of what the late 1990's brought us. Back when Yahoo! (YHOO) was worth more than Disney (DIS) and AOL (AOL) was worth more than (and bought) Time Warner (TWX) there were plenty of bullish pundits arguing why the dot-com versions were indeed worth more because they had far more growth opportunities. While plenty of Internet companies proved to be worth those sky-high valuations, many more did not, including the aforementioned duo.

This morning Internet radio sensation Pandora has seen its stock jump nearly 50% from an IPO price of $16 per share. As a result, Wall Street is valuing the company at a stunning $3.75 billion despite revenue estimates for 2011 of only about $250 million (and more importantly, no profits). How does that compare with some non-dot-com radio competitors? Both Cumulus Media (CMLS) and Sirius XM Radio (SIRI) are valued at about 3 times revenues (including net debt). Cumulus, the more traditional radio play, has about the same annual revenue as Pandora (but has positive cash flow) and carries an enterprise value of around $700 million, approximately 80% less than Pandora.

Sirius XM may be the more relevant comp given that just a few short years ago they were considered the new age upstart in the radio business (and they adopted the subscriber model that many believe holds the key to Pandora's future success). Sirius XM does have a public market enterprise value of $10.4 billion, three times that of Pandora, but with that comes annual revenue of $3 billion (12 times more than Pandora) and over $800 million in annual operating cash flow. Put another way, Sirius's operating profits trumps Pandora' operating revenue by a factor of three.

As was the case back in the late 1990's, some of these new Internet companies will grow into their valuations and not leave early public market buyers hanging out to dry. That said, nearly $4 billion for Pandora seems more excessive than even LinkedIn, which is currently valued at $7 billion. I would not buy either one at current prices, but given their addressable markets, business models, and competitive landscapes, LinkedIn seems to have more relative promise at current valuations. Time will tell.

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

Goldman Sachs Targeted Again, Entire Rebound Post-SEC Settlement Gone

So much for nailing that call on Goldman Sachs (GS) after the company settled with the SEC last year. The investment bank agreed to pay a $550 million fine last year on charges that the company engaged in fraud while selling mortgage-related investment products. The stock fell to around $130 per share at the height of the scare last July before rebounding nicely to the $175 area early in 2011. And yet here we are nearly a full year later and other lawyers are looking to get into the game. Unrelenting articles in the financial media from publications such as Rolling Stone don't help either.

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Unfortunately, I thought we had gotten past this issue, at least to the same magnitude as in 2010. Wishful thinking on my part. Most of the GS stock I bought for clients last year remains in their accounts, so this latest sell-off related to additional fraud investigations by the New York U.S. Attorney's Office and the U.S. Justice Department has been painful. And with the 2012 election cycle ramping up, what better time to go after the big Wall Street banks yet again?

The interesting thing is, the issues haven't changed much since last year. It is still fairly difficult to proof Goldman Sachs committed fraud because the clear evidence that they lied directly to those buying their mortgage-related products in 2007 and 2008 is scarce. People assume that since Goldman identified a bubble about to burst, while others didn't, means that Goldman must have broken the law. And maybe they did, although the evidence I have seen is flimsy (even experts agreed that the SEC didn't have a strong case). It could just be that Goldman Sachs is smarter than most of the other players in the marketplace (a theory that has been born out for years, by the way). Every transaction requires a willing buyer and a willing seller, which means there will be a winner and a loser in every trade. Just because Goldman was the winner does not mean that they defrauded the other party in the transaction.

As was repeated numerous times during the Congressional hearings prompted by the SEC investigation last year, Goldman Sachs acts as a market maker and a securities underwriter in these deals, not as a fiduciary. As a result, they are not required to put their customers' interests ahead of their own when selling securities. All they must insure is that the investors know what they are getting and how much they are paying. Whether or not it is a good investment for them is up to the buyer to decide, not Goldman Sachs to advise them on. If there is evidence that Goldman lied to the buyers about what they were getting, then clearly the legal issue is only going to get worse for them, but again, there is hardly any evidence of that.

Even the SEC case, which resulted in Goldman agreeing to a large settlement, revolved around Goldman omitting data pertaining to which people structured the deal. All of the details of the security, including what exactly the buyer was getting, were disclosed and known by all parties involved. There has to be personal responsibility, right? If you choose to buy something and are told exactly what it is ahead of time, it should be your responsibility to decide if it is a good investment or not, and if it turns out not to be, you should expect to lose money.

Now, I am not going to pretend to know exactly what evidence will lead to what legal outcomes over the next year regarding these mortgage-backed security transactions. All I can say is that Goldman stock is now all the way back to where it was during the height of the SEC worries last year. It has given back the entire 40-point gain that was recouped after that case was closed. The company continues to have the smartest people in the investment banking universe and be the premiere firm to do business with. Their profits remain strong and the stock trades near tangible book value after the recent correction. Goldman Sachs since their IPO in 1999 has proven again and again they can create shareholder value in all market cycles. Consider the chart below, which shows GS's book value per share growth since the company went public more than a decade ago. As you can see, the company is run superbly well, which usually warrants a sizable premium to book value.

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For long term investors it appears to be a great buying opportunity, the same conclusion I made at about this time last year. Of course, if the stock should rebound 40 points again after more lawsuits are resolved, perhaps it would be wise to take some more money off the table, as this issue doesn't seem like it will be going away anytime soon.

Full Disclosure: Clients of Peridot Capital were long shares of GS at the time of writing, but positions may change at any time

Actually, Ballmer and Chambers Haven't Been Running Microsoft and Cisco Into the Ground

With Microsoft's just announced $8.5 billion acquisition of Skype and recent troubles at long time tech darling Cisco, their respective CEOs are taking a lot of heat in the financial media lately. The assaults usually start by comparing stock price returns over the last decade or so, mainly because such data makes it easy to point the finger at the top brass. It is true that Microsoft stock is trading at the same price as it did way back in 1998 (don't forget this excludes dividends, many reporters do) but that fact alone is not reason to conclude that the CEO has failed their shareholders.

The fact of the matter is that CEOs have control over certain things and no control over others. Their stock price's starting valuation at a certain point in time is something they have no control over. Most of these 10-year stock price comparisons work to proof a point because the ten-year period just happens to begin near the peak of the internet and tech bubble of the late 1990's, a time when most tech stocks fetched 50 or 100 times earnings. Not surprisingly, if you bought tech stocks at those valuations, you have a horrible investment on your hands, but that is true regardless of who was CEO.

So how can we fairly determine how well a CEO has done creating shareholder value? Earnings per share, plain and simple. Many CEO's fail because they look at overall sales to determine how well they have done, but you can grow the size of your company without making shareholders a dime, so that is an irrelevent statistic for investors. Stock prices are based on two things; valuation multiples and earnings per share. Simply put, the market determines the former and the CEO plays a huge role in the latter.So, how have Ballmer and Chambers done in the context of earnings per share growth over the last decade? Contrary to media reports, not that bad. I assembled the chart below which shows how fast earnings per share have grown at seven different large technology companies for the ten-year period from fiscal 2000 through fiscal 2010. The results may surprise you.

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As you can see, Microsoft and Cisco have not been run into the ground by Ballmer and Chambers over the last decade. In fact, given that the long term average corporate earnings growth rate has been 6% annually, most of these tech companies have performed quite well.

Not surprisingly, Apple leads the way in terms of average annual earnings per share growth and Oracle, despite Larry Ellison's huge pay packages over the years, has done very well too. Former internet stock analyst Henry Blodget over at Business Insider wrote this morning that John Chambers has failed as CEO at Cisco, largely basing his view on the stock's performance, but the numbers don't really support that. Again, a CEO really can't influence P/E ratios that much. Opinions about a company's future prospects are largely based on recent history, so if a CEO has done well in the past, the odds are good that their stock's P/E will be above average, which ironically will hurt stock performance in the future.

While Microsoft is not near the top of the list above, Ballmer has kept pace with other rivals such as HP and IBM, so calling him a complete failure seems unfair. One could certainly argue that he could have done a lot better given the hand he was dealt, but the numbers still show he is about average in the tech world and above-average compared with all of corporate America.

The real surprise from this analysis is the clear loser of the group, Intel. The chip sector is definitely cyclical, more so than the hardware, software, and services industries which dominate this list, but Intel has unquestionably been the dud in the group, growing earnings at about half the historical rate of 6% for all U.S.corporations. If any management team should be criticized in large cap tech land, it should be the folks who have been running Intel.

All in all, a very interesting exercise.

Skype Deal Doesn't Help Microsoft Jump Up on a Large Cap Tech Buy List

Large cap technology stocks are cheap, really cheap. Some of them haven't traded at current valuations ever in their history as publicly traded companies (Cisco, for example). Microsoft (MSFT) is often included on such a list, and for good reason (the stock is dirt cheap), but the company rarely gives investors confidence that their strategy is right in the ever-changing tech world. Very smart investors like David Einhorn have added Mister Softee to their portfolios but the stock continues to be dead money in the mid to high 20's. Today's announced deal to buy Internet calling giant Skype for $8.5 billion does little to change the landscape for the stock.

Microsoft's biggest problem is that it really doesn't innovate very much anymore. Using the massive cash generation from Windows and Office, the company has merely copied their competitors in other areas. Their online services division continues to bleed red ink as Bing, Live, and other initiatives are simply me-too product offerings. The Zune music player was a complete bust and there is little reason to think the Windows Phone operating system will get any traction. The X-Box gaming system has been the company's lone success outside of its core products, but with only a couple of competitors, that was an easier market to make progress in. And with the consoles facing new competition, that market is only going to get more difficult.

If anything, this Skype acquisition is interesting in that it signals a potential shift in strategy. Rather than continuously trying to build a Skype-like product that stands little chance of gaining traction against Skype and Google Voice, Microsoft has decided to just buy one of the giants in the space. Although the price tag seems excessive at $8.5 billion (and very few would argue that point), they likely had to overpay to wrestle it away from other bidders. In my opinion, it makes more sense for Steve Ballmer to overpay for Skype than plow hundreds of millions of dollars into a Microsoft clone that will be dead on arrival. In fact, Microsoft investors should hope that the company stops sinking billions into its unprofitable internet services division and uses that cash to buy other well established companies. There will still be a risk that Microsoft will tinker with Skype and any other future acquisitions, which would increase the odds that they lose their leadership position, but there is far more money to be made with Skype than with Bing, as one example.

As for the stock, this Skype deal does little to change my view that Microsoft is near the bottom of the list in terms of attractive large cap technology companies. I don't dispute the stock is very cheap, but capital allocation has not been a strong suit of the company in recent years (and that is putting it mildly), and as a result, investors should have little confidence that Microsoft is on a path to building up more large, profitable business units. And with the continued assault from Google and others on their Windows and Office monopolies, that is what Microsoft must do if they want to see their stock price get out of the doldrums.

Charles Schwab's Purchase of optionsXpress Highlights Value in E*Trade Shares

Although most investors and analysts see no reason to get near shares of online brokerage firm E*Trade Financial (ETFC), I have been attracted to the stock for a while now. The company got into trouble during the housing boom as it decided to make home loans to its brokerage customers in order to expand its client relationships. Given that many of its clients were residents in tech-centric California, and E*Trade's underwriting standards for mortgages and home equity loans wasn't very strong, the company nearly went out of business under the weight of massive amounts of soured loans. After restructuring the company's loan book, which is now in run-off, E*Trade has turned its attention back to their core (and very profitable) brokerage business, and is well on its way to making a full recovery.

Still, investors are leery as E*Trade still has about $16.2 billion of old loans on their books. About $1.8 billion of these are delinquent and the company has set aside about $1 billion to cover losses (loss rates tend to max out at around 50-60%). The bullish argument for the stock is that the loan book is in run-off, the company has set aside plenty of reserves to cover losses, and since these loans were made 4-6 years ago, they are mature and delinquencies are actually falling fairly dramatically (down 21% in 2010, from $2.3 billion to $1.8 billion).

So, assuming that the loan book continues to shrink until it's immaterial to the company, is E*Trade stock cheap based on false worries about the health of the company's balance sheet? That has been my investment thesis for months now and we recently got some more data to back up such an assertion. Charles Schwab (SCHW) announced on March 21st that it is acquiring OptionsXpress (OXPS), a small online brokerage firm, for $1 billion in stock. This deal serves as an excellent proxy for how to value E*Trade, whose core business is not lending, but rather online brokerage services. While OptionsXpress sold for $1 billion, E*Trade is much larger and has a market value currently of only $3.5 billion.

Here are some interesting data points supporting the view that E*Trade is undervalued at today's market price:

*E*Trade has $189 billion of customer assets, versus just $8 billion for OXPS

*E*Trade's 2010 revenue was $1.3 billion, versus just $231 million for OXPS

*E*Trade has 4.3 million client accounts, versus just 400,000 for OXPS

*E*Trade's average account size is $44,000, versus just $21,000 at OXPS

*E*Trade's brokerage business earns $700 million+ in annual EBITDA, versus just $89 million for OXPS

Based on this Schwab acquisition, I have even more confidence that E*Trade is extremely undervalued at $3.5 billion or around $15 per share. If OXPS could fetch $1 billion, there is no reason E*Trade should not be valued at 5-6 times that figure, if not more, which would equate to at least $22 to $27 per share.

Full Disclosure: Long shares of ETFC at the time of writing, although positions may change at any time

If Conservatives Succeed in Phasing Out Medicare, HMO Bull Market Will Continue Unabated

Contrary to what opponents of the Obama Administration's healthcare reform law argued originally (that the "government takeover" of healthcare would drive private insurance companies out of business), HMO stocks have been on fire over the last two years, as this chart of the Morgan Stanley Healthcare Payor index shows:

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The reason, of course, is that the new law was about as far from a "government takeover" as one could get. Instead, Americans are being required to buy insurance from the private sector, which not surprisingly, is a huge boon to the HMO companies (hence the stocks are soaring).

With healthcare costs rising far faster than inflation, and the long term costs of Medicare serving as the single biggest problem for our federal government's long term budget issues, Republicans led by Rep. Paul Ryan are unveiling a new budget proposal. At the heart of the plan is a phase-out of Medicare for Americans who today are under the age of 55. In its place, the government would subsidize the cost of private insurance plans that retirees would purchase on their own. Think of it as the same employer-based system you have now at work, except that the government would pay some of the cost of the plan after you retire, and you would be responsible for the rest.

This concept is sure to face a ton of backlash, as it shifts the burden of surging healthcare costs from the government directly into the pockets of the middle class America. However, imagine how great it would be for the insurance industry and the HMO stocks. Not only would the HMO companies operate in an environment where people were required to buy a plan from them, but all of the country's retirees would become their customers, whereas today they don't sell plans to any retirees who qualify for Medicare.

This is surely a development to watch, not only from the standpoint of future retirement planning, but also in terms of how you analyze potential healthcare investments in the future. The U.S. healthcare system is already run based on how much profit can be generated (not how to give the best care for the lowest price) and this new plan would transfer even more wealth from the pockets of Americans to the coffers of the insurance industry. Not good for us, but great for the HMO stocks!

Did David Sokol Lie About His Lubrizol Trades on CNBC?

It appears David Sokol picked a bad time to resign from Berkshire Hathaway (BRKA) to start his own "mini Berkshire" investment firm. After appearing on CNBC this morning to try and get out in front of the media blitz regarding his trading in Lubrizol (LZ), Sokol didn't do himself any favors on national television. Oddly, perhaps the most least talked about detail in press reports today was the explanation Sokol gave on CNBC when he was asked why he bought 2,300 shares of Lubrizol on December 14th, sold them a week later, and then bought them again two weeks after that (in early January). On the air Sokol claimed the sale was for "tax planning purposes" and nobody seemed to question that.

Of course, the problem with that explanation is that when you sell a stock at a loss and want to use that loss to cancel out other gains for the year (which is what Sokol was referring to when he said "tax planning"), you must wait 30 days before buying the stock back again. This is a very well known law called the "wash sale rule" and there is no way Sokol (or his tax advisor if he uses one) is unfamiliar with it. It appears that Sokol may been hiding the truth when he used the "tax planning purposes" defense. Either he is lying about his reasons for selling the stock, or he is unaware of the tax rules and routinely deducts losses even when he violates the wash sale rule.

And to think Sokol was considered a leading candidate to take Warren Buffett's place. Berkshire Hathaway shareholders really caught a break there...

Update (6:30pm)

The first commenter below has pointed out that Sokol appears to have earned a profit of about $5 per share from his initial LZ sale. In such a case, wash sale rules would not have applied. It is a shame that Sokol did not provide a crystal clear and more detailed explanation for his actions, as opposed to having others speculate. But in terms of this particular speculation on my part, it does appear that Sokol sold the 2,300 share lot of LZ in order to avoid paying taxes on the gain, as opposed to offsetting gains elsewhere with a loss on the LZ position. Thanks to Michael Kelly for the insight. -CB

Sokol's Lubrizol Trades Sure Look Illegal, And Buffett Needs To Change Berkshire Hathaway's Internal Trading Policies Immediately

I would not go as far as some people have and suggest that Warren Buffett's Berkshire Hathaway has lost its way, but there have certainly been some developments in recent months that should give people pause. First, a young, unknown investor is named as one of Buffett's likely successors, and now we learn that one of the firm's most highly regarded internal candidates has resigned from the company over what appears to possibly be insider trading accusations.

After looking at the timeline of events surrounding Berkshire's discussion to acquire Lubrizol (announced March 14th) and Sokol's trading in the stock while he was serving as the point person for those talks, it is hard to argue that Sokol's trades are not illegal. Not only that, it appears that Berkshire Hathaway has no internal controls regarding how managers trade stocks they may have inside information about, which is also troubling. Although it is reasonable to assume that high level people at the company should know what would fall under insider trading and what would not, given the fact that Berkshire's main source of growth is through acquisitions, the firm should have a specific personal trading policy in place for all of its employees. If anything, to avoid situations like this, where it appears that Sokol made a big mistake and Buffett is pretty much defending him by saying he didn't see anything wrong with the trades.

So why is it most likely insider trading? According to a timeline of the Lubrizol deal compiled by the Wall Street Journal, Sokol met on behalf of Berkshire Hathaway, with their investment bankers (Citigroup), on December 13th. At this meeting the two parties discussed a list of 18 companies that the bankers had put together as a possible deal targets for Berkshire and Sokol told Citigroup that Lubrizol was the only company on the list that he found interesting.  Sokol also told them to contact Lubrizol's management to inform them of Berkshire's interest in exploring a possible deal.

At that point it should be obvious to anyone, including Sokol, that he and the bankers are in possession of material, non-public information. Sokol has decided that Berkshire Hathaway would like to explore the possibility of buying Lubrizol and he has instructed his bankers to inform Lubrizol of their interest. It is painfully clear that a deal could result from these discussions, and only a few people are aware of these private plans. Now remember, this meeting occurred on December 13th.

So when did Sokol first buy Lubrizol stock for his personal account? On December 14th. Seriously? Seriously. Sokol bought 2,300 shares of the stock the day after telling Citigroup to call them and express interest in a deal. Interestingly, Sokol sold those shares on December 21st. He didn't wait very long to buy them back though. During the first week of January Sokol bought 96,060 shares of Lubrizol. Lubrizol's board met to discuss the interest from Berkshire Hathaway on January 6th and Sokol met with Lubrizol's CEO face-to-face on January 25. The deal was approved on March 13th and announced March 14th. The purchase price was 30% above where Sokol bought the stock for his own account.

Not only is Sokol going to have trouble on his hands here, but Buffett's reputation is also on the line. Even though Warren didn't know about these trades as they were happening, the very fact that Sokol is allowed to trade in the same companies that he is looking at as possible acquisition targets for Berkshire Hathaway (and at the same time!) screams of lax oversight.

GE is the Poster Child for Why the U.S. Must Revamp Its Income Tax System

News that General Electric (GE) earned more than $5 billion from its U.S. operations last year and yet paid absolutely zero in corporate taxes should disturb everyone who is concerned with the federal government's budget deficit, or even just fairness more generally. Yesterday's New York Times story entitled "GE's Strategies Let It Avoid Taxes Altogether" sheds light on yet another way the lack of common sense in Congress is costing us financially. Here is one of the more astonishing facts from the article:

"While the financial crisis led G.E. to post a loss in the United States in 2009, regulatory filings show that in the last five years, G.E. has accumulated $26 billion in American profits, and received a net tax benefit from the I.R.S. of $4.1 billion."

And yes, many people are complaining that the U.S. corporate tax rate of 35% is too high and must be lowered for us to be more competitive with the rest of the world. And if every firm paid that rate, I would certainly agree, but we need to change the system so that everyone pays their fair share and the number of tax lawyers you can afford to hire does not determine how much income tax your company forks over. If that is accomplished by closing loopholes and simultaneously reducing the corporate tax rate (provided firms actually pay that rate), then we should be all for it. There is absolutely no excuse for one of the country's largest and most profitable companies to not pay a dime in corporate taxes.