The Inquisitive Mind

The air-waves are full of talk about recession, inflation and stagflation. Longer term interest rates are increasing while the Fed continues to cut the Fed Funds Rate, to bring short term rates down. A number of observers are questioning whether the Fed’s decision to focus on growth rather than inflation is the right one. Conventional thinking suggests that lower Fed Funds Rate will increase inflation since it spurs economic activity and growth. However, there is not much written on the mechanics of inflation, and the amount of control the Fed has to manage inflation.

In the current context, I would like to view inflation along the following three dimensions:
• Commodity Costs: The cost of the basic natural resources
• Labor Costs: The cost of wages paid to workers
• Infrastructure Costs: The cost of using existing (or building new) factories, hospitals, or computer networks

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The tech-ticker on Yahoo! Finance had an interesting article about Apple zealots posting extremely critical messages in response to an article by Barron’s Eric Savitz which highlighted negative comments by Toni Sacconaghi, a Berstien Research analyst. It got me thinking about why companies have such loyal fanboys?

Two Silicon Valley companies come to mind, Apple and Google. The stock for both these firms has been hammered by recession fears. Though the sell-off after the big run-up of last year was expected, the size of the fall has taken many by surprise. Having spent time working both in the valley and Wall Street, I often wonder whether Wall Street put sufficient value to the value of the brand which each company represents.
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Apple’s COO Tim Cook made a presentation at the Goldman Sachs Technology Investment Symposium earlier today. The call was very bullish and tore to shred all the doubts that had been raised by different analysts about Apple’s business prospects. MacDailyNews has live notes about the call.
Some highlights:

• iPhone sales target of 10 million affirmed
• Mac has huge headroom and has immense mind-share. Apple passed Dell as the largest provider of portable computers to higher education.
• iPod revenues grew 17% year over year. 40% of all iPods sold to consumers who did not own one.
• iPhone contracts may not be exclusive in other countries; a lot of carriers are interested in the phone since it is driving data-plan usage with web-usage orders of magnitude higher than other smart phones.

The stock is reacting positively and is up about 4% from its 4:00PM close of $122.96.
AAPL also announced a special event on March 6 to discuss the plans for the long awaited SDK for the iPhone. The announcement emphasized ‘Some exciting enterprise feature’; ; perhaps referring to the long awaited integration with the Exchange server and the catalyst for the corporate adoption of the iPhone.

Google, the other Silicon Valley darling under cloud, will also be presenting at the Morgan Stanley Technology Conference in Dana Point, CA. The session is scheduled for 9:30 a.m. Pacific Time on Monday, March 3, 2008. If the response to AAPL’s conference call is any indication, it would be prudent to anyone short Google to cover!

Google’s stock has been hammered over the past two weeks and Henry Blodget blog posts have been in the thick of the action. Last October when Google was on a bull run, Blodget had come out with a post about Google going to $2000. He had followed up with another post on November 27, where he did felt that a price target of $1000 was very plausible. However, his tone has become increasingly negative over the past two weeks.

Blodget identified a revenue miss warning in Google’s 10K on February 19, and quoted an entire paragraph to illustrate that Google talking revenue expectations down. As it turned out only one sentence in that paragraph was new and he subsequently clarified that.

He followed it up with a post on February 22 about Google’s exposure to the recession based on an insider (who turned out to be a digital-ad industry insider). He was very suspicious of Google’s tweak to the AdWords algorithm in his posts on February 24 and 25. But he beat his own prolific output on February 26th.

February 26th was an eventful day. The day started early (5:40AM) for Henry with a grumpy post about Google’s participation in the trans-Pacific cable. But he really hit the panic button with his post reporting the lower Comscore estimate of paid clicks at 7:16AM. He followed it up with a post at 10:58AM dismissive of analysts’ efforts to defend Google’s stock.

However a strange thing happened as the day wore on. Google’s stock made a V shaped bottom at around $450. Blodget’s next post at 12:22PM highlighted the bullish call from RBC’s Jordan Rohan. There was a follow-up post confirming the reversal at 2:02PM which talked about the bargain Google was at 32x Future Cash Flow.

So do have we hit a near-term bottom on Google? The candle-stick today had the hammer formation on huge volume, which often signals a reversal. A lot of institutions have also lightened up on Google over the past few months and they may be looking to come in again. And Blodget has also reversed….

Henry Blodget is out with another post claiming that industry insiders are telling him that Google is extremely vulnerable to an economic slowdown. The main thesis of the article is summarized below:

A consumer who had $100 to spend before the recession and now has $50 to spend will either:
1. Click on fewer links (resulting in less Google revenue) OR
2. Click on the same number of links but spend less (resulting in a lower advertiser ROI).

There is no doubt that slower consumer spending will lower the amount of money spent. This may translate to lower ROI per click. However, just because there is a lower ROI per click during a slowdown, does not mean that the return is no longer attractive to the advertiser. What the advertiser is looking for is relative effectiveness of different media. During a slowdown, internet advertising will outshine traditional media and emerge even stronger.

Immediate Gratification: Generate Revenue Quickly

If a business is struggling for revenues, its focus will be to cut spending on items which do not generate immediate revenue. Businesses will have to compete for a greater share of a stagnant pie and will adjust their plans accordingly. Strategic projects which will not return an immediate benefit will suffer.

When it comes to advertisement, the focus will be to generate the greatest immediate bang for the buck. This is very internet advertising outshines other media. A consumer searching for a particular item on the internet is much more likely to buy soon. So even if the ROI per click may go down, the need for that return (even if it is smaller) will be a lot more. Businesses will sacrifice margins to generate revenue; without revenue there is no business.
The cut-backs in advertising will be on strategic and brand-building campaigns which are oriented towards traditional media.

Consumer Behavior: Where is the best deal?

Another aspect to keep in mind is consumer behavior. When times are tough, people are more likely to shop for deals. And the internet beats traditional shopping and media hands-down when it comes to shopping for deals. I expect the market-share of internet retailers to increase during a recession, since consumers will be price-conscious and will be looking for the best bang for the buck.
Both these trends bode well for internet advertising. It is clear that on a relative basis, online advertising will emerge the clear winner during a slow-down. Further advertisers are much more likely to sacrifice margins rather than lose sales to a competitor.

Of course if the slow-down is deep and extends for a long time, the entire consumer economy will be in trouble. However, Google is likely to emerge in a much better shape than others.

Trading Analysis

Google’s stock has been trading in the range I specified in my previous article. The support around $500 has held and the resistance around $514 is yet to be broken. Using out of the money calls to trade these moves is turning out to be a very profitable strategy.

Google’s stock was down almost 4% today (Feb 19) on below average volume. The fall is being attributed to a post by the infamous Henry Blodget on his blog claiming that Google’s 10K filings are talking down future revenue. Blodget’s post was picked up by a number of other blogs and soon made it to the headlines page of Yahoo! Finance and other news sources. Analysts tend to comb through Google’s 10K since Google does not officially provides estimates or guidance.

Blodget’s initial post claimed that Google’s 10K had new content saying the following:

…we may continue to take steps to improve the relevance of the ads displayed on our web sites and our Google Network members’ web sites. These steps include removing ads that generate low click-through rates or that send users to irrelevant or otherwise low quality sites and terminating Google Network members whose web sites do not meet our quality requirements. In addition, we may continue to take steps to reduce the number of accidental clicks. These steps could negatively affect our near-term advertising revenues. Both seasonal fluctuations in internet usage and traditional retail seasonality have affected, and are likely to continue to affect, our business…

However, he later clarified that the only additional sentence is “In addition, we may continue to take steps to reduce the number of accidental clicks”. and not the entire paragraph!

This is old news. Google shared their efforts to increase the quality of its publishing partners (Google Network Members) and the desirability of the ad-clicks in their last earnings call. Google is already the dominant player by volume in the on-line ad-space. The focus on better return on the customer’s dollar will also make them the quality leader and will help Google maintain its lead over the competition.

Google’s two main competitors, Yahoo! and Microsoft are distracted by the merger talk; the chances of a long drawn out proxy battle is going up everyday. This gives Google a window to strenghten its market leading position.

Retracement Analysis: Google’s stock hit a recent low of 488.52 on Feb 5. It bounced back to reach a high of 541.04 on Feb 14. The stock has been retracing since then, closing remarkably close to the Fibonacci retracement levels. On Feb 15 the stock closed at 529.64, very close to the 23.60% retracement point of 528.65. On the next trading day, Feb 19, it closed at 508.95, just above the 61.8% retracement point of 508.58. The next retracement level (76.40%) is at 500.92 which should provide some support; the near term upside retracement levels are at $514.78 (50%) & $520.98 (61.80%) which might provide some resistance.

Trading Strategy: There is a lot of cash waiting on the sidelines to be deployed and HP’s stellar results are going to provide a short term lift to the technology sector. I feel it is time to start taking long positions in Google. Out of the money calls for the March 2008 expiry look promising; the 540, 550 and 560 strikes are worth considering. The expiry date for March options is March 20, which is a full five weeks from last week’s expiration. This has resulted in longer time to expiry for the March options, and consequently lower time decay (theta) in the short term. These options will not lose a lot of time-value in the next one week but will capture most of the upside.

Microsoft came out with its long anticipated bid for Yahoo! earlier this month. From a strategic point of view, the deal makes sense for both Yahoo! and Microsoft. Thanks to Google’s dominance in the online search space, the deal is unlikely to face anti-trust issues in the USA. Though Microsoft is still grappling with European regulators, it will not be easy for the regulators to come with up with defensible reasons to block the deal.

Yahoo! has already rejected the original bid for $31/share. However Yahoo!’s strategic options are rather limited, and the whisper is that Yahoo!’s board is angling for a better price. Microsoft has reiterated their plans to continue pursuing Yahoo! and Wall Street analysts are suggesting that Microsoft may raise its offer to the mid-30s to nudge Yahoo! along.

Yahoo! closed at $29.63 on Tuesday, up more than $10 from its closing price the day before Microsoft’s offer became public. Assuming the deal gets done in the mid 30s, Yahoo!’s stock offers an upside potential of about 20%. On the flip-side, if Microsoft withdraws its bid, Yahoo!’s stock is likely to fall into the mid to late teens, a downside potential of about 40%.

Options on Yahoo!’s common stock are another way of trading the merger. I discuss three different strategies with different risk-reward profiles.

Vertical Spreads: The January 2009 $30-$35 spread is being quoted at an Ask price of $2.06/share. Assuming that the deal closes by January 2009, your investment of $2.06 per share will result in a return of $5/share. If the deal does not close, and Yahoo! stock continues to languish your loss will be limited to your initial investment of $2.06/share.

Calendar Spreads: The January 2009 -January 2010, call spread at $30 has a Bid price of $0.60. You can short this spread (buy Jan 2009 call and sell Jan 2010 call) and will get $0.60/share. Assuming the deal is completed by January 2009, 50% (the cash part of the buyout offer) of the extra time premium of the cash portion of for the January 2010 call is yours to pocket. Further the large movement in stock price will significantly reduce the time premium of the January 2010 option.

If the deal fails to complete, initially the time premium for the January 2009 leg will decay much faster than the decay for the January 2010 leg. However, the large downward movement of the stock price will also adversely affect the time premium for the January 2010 call, giving you ample opportunity to cover the short position without a significant loss. However, unlike the Vertical Spread, your downside risk is not limited.

Note that the end results in the calendar spread depend on the exact terms of the deal. If the terms of the deal change to all cash, the entire time premium of the January 2010 option will be yours to pocket. However if the terms of the deal are changed to increase the stock exchange component, the time premium component you pocket will be smaller and will depend on the stock price movement above the $30 strike price.

Diagonal Spreads: The January 2009-January 2010, $30-$35 spread has an Ask price of $1.75/share. You will go long the January 2009 $30 option and go short the January 2010, $35 option. This has the upside potential of the Vertical spread ($3.25/share) in case of an all cash deal. But the downside risk is similar to that of the Calendar Spread. Do note that in case the cash component of the offer does not increase, the decay in the time component of the January 2010 $35 call is going to be smaller when compared to the $30 strike call used in the Calendar spread. As a result, unless the stock price increases significantly above $35, the remaining time component of the January 2010 option will decay less than the option with strike price of $30 used in the calendar spread.

Fears of slowdown in the US economy have pumelled the shares of leading technology companies. CSCO, APPL, GOOG, INTC and MSFT are trading significantly below (25-40%) their highs reached a few months ago. A number of these stocks had done exceedingly well during 2007 so some of the pullback is expected. However the market has been very unforgiving about slower forecasts.

In the age of SOX, you expect CEOs to be very cautious about any future predictions. Further, when the air-waves are full of doom and gloom prognostics about a recession CEOs can not go out and claim that everything is rosy. However the market reaction is overdone.

Even in an economic slowdown, companies continue to invest in technology. This is because technology investments have a strong correlation with growth in productivity and companies can not get behind the curve for too long. Further, inspite of the economic slowdown, corporate balance-sheets are still looking good.

The other big factor is that the technology companies have get a lot of their revenues from emerging markets. And these segments are growing faster than ever. Cisco reported 24% growth in orders from emerging markets for the second quarter. Though this number is smaller than the 35% growth reported in the first quarter, it is still a good number for a company as large as Cisco.

It is also clear that the in this election year the Congress and the White House will try their best to stimulate the economy. The question is not whether they will act but how big will the stimulus package be. Efforts are underway to shore-up the financial system too and the Fed has finally realized that they were behind the curve and is aggressively cutting rates. Lower interest rates, higher confirming loan limits and programs to help distressed home owners will help cushion the effect of the negative HPA (Home Price Appreciation). So any recession in the US economy is going to be short.

A lot of investors still have painful memory of the burst of the technology bubble earlier in this decade. However, the valuations then were astronomically high and bear little resemblence to the current situation. It is time to start buying the dips in the technology sector. The valuations are compelling and the prognosis sounds much worse than it actually is.

My wife is a big fan of Anthony Robbins programs. Though she has not attended a live presentation, she finds the audio books very uplifting. I too have listened to some of his CDs. Though the ideas put forth are quite simple, Antony provides a framework to help you put them in practise. Anyone looking to get out of a rut should spend some time listening to what he has to say. It is definitely worth the time and the effort.

Anthony has been one of the few people who have successfully practised the philosophy they preach. I was glad to hear that he won a defamation law suit against a Canadian paper who called him a hypocrite. The media often crosses too many boundaries with little fear of any blowback. Though Mr. Robbins spent a lot of money fighting the case, the moral victory would have been worth it (and he does not need the money)

Read more about the The Alkaline Weight Loss Program by Anthony Robbins! Go Green Today!

The TATA Nano was finally unvieled today. I was surprised at some of the negative press the car got:

• It is unsafe
• It is environmentally unfriendly
• Who will supply the gas

This article in the American does a great job in dispelling these myths.

The folks who are talking about this have no idea about where this car will be used. This car is supposed to be replacement for people who currently drive two wheeled vehicles. Often entire families would load themselves up on a two wheeled vehicle. These folks are completely unprotected: a large pot-hole, an oil-slick or an errant driver often results in serious injuries. An enclosed car, even one without Airbags, provides the safety bubble which a two-wheeler can never provide. Most car currently in Indian road do not have airbags too.

The fuel effeciency of this car is comparable to many of the two wheelers currently plying on the Indian roads. Plus the car will not take that much more road space compared to a two-wheeler; it is not that long (10 feet). Further most drivers are forced to leave a much bigger cushion around an exposed two-wheeler when compared to an enclosed car.

Bring it on Tata.