Danaher Reaffirms Outlook
Posted by Eddy Elfenbein on February 16th, 2006 at 1:53 pm

One of the easiest stories to ignore is when a company “reaffirms” its outlook. Don’t. This is one of the most underrated things a company can do. I love seeing out stocks reaffirm guidance. Don’t ever worry that they didn’t “guide higher.”
Yesterday, Danaher’s (DHR) CEO confirmed guidance of 59 to 64 cents a share for this quarter, and $3.02 to $3.12 a share for this year. Danaher earned $2.76 a share last year.

Dell’s Earnings Preview
Posted by Eddy Elfenbein on February 16th, 2006 at 1:44 pm

Today is D-Day for Dell (DELL). The company reports earnings after today’s close.

Analysts surveyed by Thomson First Call are forecasting Dell will earn 41 cents a share on $14.8 billion in revenue, up from 37 cents a share and revenue of $13.5 billion a year ago.
In early trading Thursday, Dell shares fell 13 cents to $31.64.
But Dell has had a difficult time meeting or exceeding forecasts in the past year because it has faced more competition from Hewlett-Packard Co., International Business Machines Corp. and even Apple Computer Inc.
And Dell’s stock suffered, slumping 29% in 2005.
In November, Dell reported third-quarter earnings fell to $606 million, or 25 cents a share, from $846 million, or 33 cents, a year earlier. Excluding $442 million in one-time charges, Dell earned 39 cents a share, in line with its revised forecast.
Revenue rose to $13.9 billion from $12.5 billion a year earlier, but slightly below the $13.97 billion expected by Wall Street.

I really don’t have a good idea of what Dell will report. Probably, 41 cents a share. I still think that the reaction to Dell’s “troubles” has been greatly exaggerated. The stock fell from $42 to $29 over a few pennies a share. Expect to hear a lot of silly talk about Dell losing market share. In my opinion, a rational price for Dell is about $35. Remember that Keynes said, “the market can stay irrational longer than you can stay solvent.”

HP Earns 48 Cents a Share
Posted by Eddy Elfenbein on February 15th, 2006 at 4:34 pm

Whaddaya know? Hewlett-Packard (HPQ) earned 48 cents a share for its fiscal first quarter. The (cough) estimate was for (cough) 44 cents a share. Now HPQ shareholders should be happy, right?
Sorry to spoil the party. Those estimates were low-balled (as I said yesterday). The important number to look at is sales, which rose just 5.6%. The company guided higher for next quarter on the bottom line, but not for revenues. I wonder if that’s some sort of hint.

The Hottest Stock Market in Europe
Posted by Eddy Elfenbein on February 15th, 2006 at 11:22 am

The Brazilian stock market continues to be the hottest stock market in the world, but the hottest market in Europe can be found in Malta.
No, seriously. Malta.

The Economist has more:

Local officials say that, as a new member of the European Union, Malta would like to repeat the success of Dublin or even Luxembourg. The record of the Malta Stock Exchange (MSE) has helped. Its equity index surged by more than 60% last year, after a 40% rise in 2004 (see chart). But for a 7% limit on the daily movement of individual share prices, it might have risen faster still: a number of stocks were trading near the top of the range “regularly” last year, says Mark Guillaumier, the MSE’s chief executive, a descendant of a French sea captain who landed in the 18th century to trade with the Knights of St John.

Morningstar Sees Value in Cendant
Posted by Eddy Elfenbein on February 15th, 2006 at 10:59 am

I will never understand the appeal of Cendant‘s (CD) stock. I think people are determined to see value there no matter what reason and logic say. The stock just took a hit again, on lowered guidance. Here’s part of a new report on Cendant from Morningstar:

Cendant reported fourth-quarter results Monday that were in line with its lowered guidance. The company also reduced its forecast for the first quarter of 2006, citing weakness in its real estate and auto rental divisions. Cendant’s overall revenue and profit expectations for 2006 are consistent with ours, though, and we see no reason to change our $23 fair value estimate. We believe the shares, which have steadily declined in recent months, offer a highly attractive risk/reward trade-off now. Uncertainty is likely to remain high in the near term, owing to concerns surrounding the cooling real estate market, the woeful performance of the travel distribution business (notably online agent e-bookers), and the impending four-way split. Because we are convinced that the core elements of our Cendant thesis still hold–its businesses generate lots of free cash flow and solid returns on capital–we think this uncertainty has created a compelling opportunity for investors. We have reviewed several valuation scenarios and are confident that Cendant is worth $22-$25 per share; in light of recent poor execution and earnings disappointments, we think it’s prudent to err toward the lower end of this range. The real estate and hospitality divisions will be spun off in the second and third quarters, respectively, while the travel distribution arm spin-off will be completed in October.

James Stewart on the Yield Curve
Posted by Eddy Elfenbein on February 15th, 2006 at 10:53 am

From the WSJ:

The most prevalent explanation is that buyers of the long bond accept the lower yield in anticipation of a recession, which is likely to drive long rates even lower. In this theory, such expectations in the markets become self-fulfilling. But I have yet to see any empirical data to support this notion.
In any event, inverted yield curves rarely last long. At this juncture, either long rates will rise, short rates will fall, or some combination of the two will occur, restoring the normal upward slope. You don’t want to own long-term bonds when rates are rising.
To me, this makes it even more paradoxical that investors were so keen for those low-yielding 30-year bonds. It wouldn’t take many cuts in short-term rates for the Fed to restore the slope of the yield curve. But how much lower can long-term rates fall? True, rates in deflationary Japan got close to zero, but the possibility of deflation in the U.S. seems a distant memory with gold trading at well over $500 an ounce. The likelihood that long-term rates will go above 4.48% over the next 30 years strikes me as close to a certainty.
And what if the yield curve turns out to be wrong this time, and there isn’t any recession? Not only will economists return to the drawing board, but that means economic growth will continue, putting more upward pressure on long-term rates.
This seems yet another argument for investing in shorter maturities at today’s relatively high rates. Short maturities, like the one- to three-year bank certificates of deposit I’ve recommended, have little risk of principal erosion even if rates rise. Meanwhile, you can collect close to 5%, and if the Fed continues its rate-rising campaign, you’ll soon be able to earn even more.

AFLAC Increases Its Dividend
Posted by Eddy Elfenbein on February 14th, 2006 at 8:15 pm

The market had a great turnaround today. The Dow broke 11,000. The S&P 500 broke 1,275 and closed up 1.00%.
Expeditors (EXPD) had a strange day. First, the stock opened 46 cents higher on its earnings news. It then fell to a loss of $1.57 a share. But the market changed its mind and decided that the earnings were good, and the stock then rallied to a gain of $2.22, an all-time high. Before the end of trading, that gain was halved and Expeditors finished with a still-impressive gain of $1.09. The stock is up nearly 14% for the year. I love this stock, but I’m afraid it’s getting a bit rich.
Donaldson (DCI) also plugged higher to a new all-time high, and SEI Investments (SEIC) is within striking distance of a new high.
After the bell, AFLAC (AFL) announced that it’s raising its dividend for the 24th straight year. That’s another reason to love this stock. The new quarterly dividend is 13 cents a share, an 18% increase over the old 11-cent dividend. The company will also buy back 30 million shares of stock.
Hewlett-Packard (HPQ) reports tomorrow. I hope this company can manage its business as well as it manages Wall Street. Investors are in love with this stock. Wall Street’s earnings consensus, so we’re told, is for 44 cents a share. Please. HPQ should easily report, I’ll say, 46 cents a share. The crowd wants permission to love the stock some more, however, I wouldn’t be surprised to see the stock pull back in the next few days.
I’m always skeptical of turnarounds. Not that companies don’t turn around. They do. But in HPQ’s case, it’s still HPQ. Once they stop improving their margins (hey, you lay off 15,000 people, your margins will improve, too), how fast can the company grow? Ten percent tops. I expect to see that sales rose about 5%, and that’s probably what they’ll do next quarter. This is not a great business to be in. There are only so many profiles you can read about CEO Mark Hurd.

S&P Says Home Depot Is Worth $52
Posted by Eddy Elfenbein on February 14th, 2006 at 2:09 pm

From Business Week:

Even though the shares have lost ground thus far in 2006, we think it’s possible to build a strong case for Home Depot. First, we think that a low unemployment rate and robust wage growth should continue to propel the U.S. economy (and, more importantly, consumer spending) at a modest clip. Second, while we’re slightly concerned with the recent rapid increases in housing prices, we believe demand will remain strong enough to avert a major problem.
Finally, we think the valuation is very compelling, with the shares trading below the broader market, despite sporting a higher growth rate and stronger balance sheet. The stock carries S&P’s highest investment ranking of 5 STARS (strong buy).
Home Depot is the world’s largest home-improvement retailer and the second-largest retailer in the U.S., in terms of sales. As of October 31, 2005, it operated 1,972 stores, including 1,913 Home Depot stores (of which 126 were in Canada and 49 in Mexico), 34 EXPO Design Centers, five Home Depot Supply stores, 11 Home Depot Landscape Supply stores, two Home Depot Floor stores, and seven Contractors’ Warehouse stores.
NUTS AND BOLTS. Home Depot stores sell a wide assortment of building materials, as well as home improvement and lawn and garden products. The company also provides installation services. Typical stores average 106,000 square feet plus 22,000 square feet of garden center and storage space, and stock 40,000 to 50,000 items, including brand name and proprietary items.
The flagship Home Depot stores serve three primary customer groups: Do-It-Yourself (DIY) customers, typically homeowners who complete their own projects and installations; Do-It-For-Me (DIFM) customers, homeowners who purchase materials and hire third parties to complete the project and/or installation; and Professional customers, consisting of professional remodelers, general contractors, repairmen, and tradesmen.
By product group, plumbing, electrical, and kitchen (29% of fiscal 2005 revenues) represents Home Depot’s largest source of revenue. Hardware and seasonal (27%), building materials, lumber, and millwork (24%) and paint, flooring, and wall coverings (20%) make up the remainder.
R.I.P. CONSUMER? We believe several factors bode well for the company in 2006, including a resilient consumer, the company’s shift in focus away from the cyclical domestic housing market, a dramatic 2005 hurricane season, and an economy on solid footing.
Some economists and investment professionals have been quick to point to the national savings rate, which has now been negative over the past seven months, as a key indicator of the impending retrenchment of the U.S. consumer. While this lack of savings is justifiably a cause for concern and could become quite problematic over the long term, we think the near-term ramifications of this statistic may not be that significant at all. Because the savings rate excludes capital gains on investments, we suspect the recent wealth that was built up as a result of the stock market in the late 1990s and real estate boom over the last five years will continue to drive spending over the coming years.
In addition, the job market remains very healthy, in our view, so we think it’s unlikely consumers will feel the need to drastically tighten their purse strings any time soon. Furthermore, while increased interest rates make refinancing a less likely option for consumers in 2006, we expect home-equity loans will continue to buoy spending. S&P predicts that consumer spending will increase 3.2% in 2006.
HOUSING VALUES. While the current status of the housing market has been well documented — and a topic of discussion at many cocktail parties — we foresee only a modest decline in new home activity in 2006. S&P economists predict an 8.8% decline in housing starts for 2006, following a 6.2% increase in 2005. We also predict that declines in real estate values may occur in certain geographic “pockets,” but that, overall, little attrition will occur. We believe it may take several years for houses to “grow” into their current values, but we don’t foresee a dramatic decline in overall prices.
Also, government spending on the reconstruction of New Orleans will be the most expensive such effort in U.S. history, with estimates ranging from $100 billion to $200 billion. We believe Home Depot will benefit substantially from this increased spending.
For Home Depot, the biggest development over the past year, in our view, has been the aggressive push by the company to expand its Home Depot Supply business in the $410 billion professional market. In July, 2005, the company acquired National Waterworks, the leading distributor of water and wastewater transmission equipment in the U.S. Then, on January 10, 2006, it agreed to purchase Hughes Supply (HUG ; $46) for $3.47 billion (including the assumption of debt), which would be its largest acquisition ever.
MOVING ABROAD. While these acquisitions may appear puzzling to many investors, as they go well beyond Home Depot’s core retail business, we believe these investments will ultimately prove to be net positives for the company. For one, both are expected to be slightly accretive to earnings. In addition, we believe they will reduce the cyclicality of Home Depot’s business, which is strongly correlated with housing turnover. We’re confident that Home Depot can properly integrate both companies.
We think international expansion is another major focus for Home Depot, and will likely be one of the future growth drivers for the company, as the domestic market approaches saturation levels. It has followed an acquisition-based strategy when first entering a new market, followed by organic growth. We expect continued organic growth to occur in Canada and Mexico, where Home Depot is the market leader, and expect the company to make an acquisition bid for a Chinese company sometime in the first half of this year.
In fact, according to an unconfirmed report in the Financial Times on Feb. 13, Home Depot is in talks to buy up to a 49% stake in Chinese retail chain Orient Home, for more than $200 million. We expect the company to work diligently on securing a foothold in China’s $50 billion retail home improvement market.
U.S. PULLBACK. At its annual investor and analyst meeting on Jan. 19, Home Depot announced that it would open between 400 to 500 new stores over the next five years (with total square footage growth of 40 million to 55 million). This is a significant deceleration from the rapid pace at which Home Depot had previously been opening stores, and indicates to us that the company believes the U.S. market is nearing saturation. We view positively this difficult decision by HD to slow new store growth, and believe it will relieve some of the pressure on same-store sales results from stores in overlapping markets.
Furthermore, we think this decision should free up the cash that Home Depot will require to grow in the Professional and international markets. While we expect Home Depot to finance the majority of its expansion plans from the significant cash flow it derives from operations, we do think it’s likely that the company will assume a greater debt load in order to accomplish all of its objectives.
We’re projecting EPS of 56 cents in the coming January quarter (results to be released on Feb. 21). Overall, we expect the company to earn $2.67 in fiscal 2006 on sales growth of approximately 11% and a 0.6% improvement in operating margins. Fueled by acquisitions, we expect fiscal 2007 sales to increase about 15%, driving EPS to $3.05.
EPS FORECAST. In our view, the quality of Home Depot’s earnings, as indicated by our proprietary Standard & Poor’s Core Earnings per share model, is high. In the absence of pension-related adjustments (the company doesn’t have a defined benefit pension plan), the main impact to earnings quality comes from the expensing of stock options.
After deducting stock-option expense, we arrive at S&P Core EPS of $1.78 for fiscal 2004 and $2.19 for fiscal 2005, representing a divergence of 5.3% and 3.1%, respectively, from GAAP-based EPS for the two fiscal years. This differential compares favorably with that of other constituent companies of the S&P 500.
We see Home Depot’s earnings quality improving further, as the company has already begun expensing options. Therefore, our estimates of option expense in fiscal 2006 and 2007 are for un-expensed options granted in previous years. Our S&P Core EPS estimate for fiscal 2006 is $2.63, indicating a 1.6% impact to our operating EPS estimate of $2.67. For fiscal 2007, we have incorporated the unexpensed stock options into our operating EPS projection of $3.05.
BALANCED BALANCE SHEET. Recent selling pressure has Home Depot shares approximately 3.5% lower since the start of 2006. We believe that a strong January-quarter and robust guidance will help fuel investor enthusiasm in the shares once again.
The shares are currently trading at 14.7 times our fiscal 2006 EPS estimate and 12.9 times our fiscal 2007 EPS estimate, below the S&P 500 and well below the stock’s historical average of 22 times. Home Depot shares have historically traded at nearly a 15% premium to the broader market due, we think, to the company’s above-average sales and earnings growth, along with its strong balance sheet. Currently, the shares trade at a 15% discount to the S&P 500.
We believe the company has one of the stronger balance sheets in our specialty-retail coverage universe, with over $1 billion in cash and manageable debt levels. In addition, its asset base is formidable, with the company owning 86% of its stores, a huge point of differentiation in the world of retail, in our opinion. Lastly, the company’s commitment of returning cash to shareholders is exemplary, we think. Home Depot has returned nearly $13 billion over the past five years in the form of dividends or share repurchases, or approximately 58% of the company’s cumulative earnings.
LEVEL BOARD. Our discounted cash-flow (DCF) valuation suggests an intrinsic value of $52 for Home Depot, about 33% above the recent price, and approximately 17 times our fiscal 2007 EPS estimate.
In general, we view Home Depot’s corporate governance positively. Several of the practices that we view positively are: the expensing of stock-option grants, the lack of a poison pill, and the fact that the nominating and compensation committees are entirely comprised of independent outside directors. Furthermore, 10 of the company’s 12 board members are independent outsiders, which we believe promotes a greater amount of objectivity and reduces conflicts of interest. However, we do view executive compensation as excessive, given the stagnant stock price over the past five years.
MICRO AND MACRO RISKS. There are several risks to our recommendation and target price, in our opinion. First and foremost, a modest decline in real estate values would likely adversely affect Home Depot. With U.S. savings rates near (or below) zero and a rather flat stock market, we believe consumers will be much less apt to spend on home-improvement projects should their net worth decline. Rising interest rates could be a catalyst to the bursting of a housing bubble, as many recent mortgages have been financed as interest-only or adjustable rate mortgages (ARMs). These rising rates would have the effect of driving up mortgage payments, thus reducing discretionary income.
Non-macro-related risks include currency movements and poor execution while entering new growth markets such as China. In addition, acquisition risks exist if Home Depot overpays for an acquisition or fails to integrate it properly and cost-effectively.

Expensing Stock Options
Posted by Eddy Elfenbein on February 14th, 2006 at 12:44 pm

You may to check out Barron’s Online this week. The site is free-for-all for a limited time. Andrew Bary has a good article on the impact of expensing stock options, especially in the tech sector:

Tech outfits tend to be generous dispersers of stock options. At Intel and Cisco, the value of these are expected to equal about 13% of profits this year, versus 3% at Pfizer (PFE) and less than 1% at General Electric (GE).
Cisco reported “pro-forma” profits, excluding option expense, of 26 cents a share for its quarter ended Jan. 28, and of 22 cents, with option expense. Some investors and analysts, hoping for earnings that would justify a high stock price, still focus on Cisco’s pro-forma results.
Nonetheless, says David Bianco, the chief equity strategist at UBS. “There are not too many investors out there who think stock options aren’t an expense.” Option grants have been falling in recent years — Cisco, however, issued more in its latest fiscal year than in the prior one — and Bianco wonders how much further they’ll slip now that expensing is mandatory. He estimates that options will cut profits for the S&P 500 by about $2 this year, off an earnings base of around $80. That’s a hit of roughly 2.5%. The hit in tech will be an estimated 15%.

Random Market Stat of the Day
Posted by Eddy Elfenbein on February 14th, 2006 at 11:36 am

It’s hard to overstate the impact of long-term interest rates on equity prices. As long as long-term yields head lower, the stock market does well. But when rates rise, it’s like running into the wind.
Since 1962, there have been over 2,300 weeks of trading. The yield on the 10-year Treasury bond has fallen for 1,060 of those weeks. During those weeks, the S&P 500 is up a combined 6,187%, which is about 22.5% on an annualized basis.
The 10-year yield was unchanged over 129 weeks. During that time, the S&P 500 was up just 4%, or 1.6% annualized.
And for the 1,112 weeks of rising yields, the S&P 500 was down 72.3%, or 5.8% a year. When you separate out the data like this, you can really see the impact that bond yields have on the market.
Perhaps the most important fundamental aspect of this market is that long-term interest rates have been remarkably flat for so long. For the last two-and-a-half years, long-term yields have traded in a band between 3.68% and 4.87%. Over 75% of the time, the yield has been between 4.0% and 4.5%.
In other words, stocks aren’t getting any help from bonds.