Microsoft: Listen to Your Heart (And Ignore the Bean Counters)

Posted on April 27, 2008 by BMWFan

Microsoft surprised no one with their unsolicited offer for Yahoo! in January 2008. What surprised some Wall Street observers was the premium Microsoft was willing to pay for Yahoo’s then share price. At that time the $31/share offer represented a 62% premium over Yahoo’s then share price of $19.18. What surprised the same observers was that, even that premium was not enough to sway Yahoo’s board in Microsoft’s favor. It will help to take a step back and put the offer in its historical context to understand the action of different players.

Yahoo’s History: Massive Fortune Swings

Long term Yahoo stock holders are no stranger to massive swings in its stock price. As one of the pioneers of the internet age, Yahoo’s legacy is enshrined in history.

One of the first darlings of the internet, it saw its stock price rise to stratospheric heights of $120+ at the peak of the .com bubble only to collapse to less than $5 in 2001. Since then the stock has recovered, reaching a high of $40+ in 2006, and traded as high as $34 last fall. The stock price fell significantly over the past six months as the Nasdaq sold off on the fear of an economic slowdown. Further, Google’s continued dominance and the failure of Yahoo’s internal initiative created further downside.

According to Alexa, the most popular web-sites in the world

are: yahoo.com, google.com, youtube.com, www.live.com (Windows Live), and msn.com. Based on Microsoft’s earnings reports, its online division is still not profitable even though they have the #4 and #5 web-sites in the world. Yahoo on the other hand, strongly lags Google when it comes to monetizing its traffic.

Yahoo’s Future: Is Growth Possible?

Yahoo detractors believe that the inability of Yahoo to monetize the eye-balls shows that it should not continue as an independent company and share-holders should accept Microsoft’s generous offer. The Yahoo supporters believe once Yahoo starts taking more drastic actions, including strategic partnerships with other firms, it will be quite easy to monetize the traffic and boost the share price. The online revenue model is highly levered and once the fixed costs are accounted for, a bulk of the revenue after the cost of sales falls to the bottom line. A 15% increase in average monetization per visitor, can almost double Yahoo’s earnings.
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Google’s Earnings Expose Wall Street’s Limitations

Posted on April 27, 2008 by BMWFan

The past two weeks have been full of earning report, and more significantly, earning surprises.

While the stock market has been on a roller coaster ride many investors have been on the sidelines, confused by Wall Street’s reaction. Traders are making merry; buy the dips, sell the rips seems to be working really well.

In this context I felt it was important to see how individual investors can profit from limitations of Wall Street.

Wall Street is a bonus driven environment where time horizon stretch to the end of the current quarter (for management fees) and the current year (for trading bonuses). Any perspective beyond that gets little mindshare in this uncertain markets. I in this article I will focus on what is happening in the internet space where Google, Yahoo and Microsoft are duking it out.

Google Beats by a Mile

Google reported its financial results Wall Street on April 17, handily beating the consensus earnings estimate of $4.52/share by 32cents/share. The stock reacted by making a $75 move the next day and has tacked on another few percentage points since then.

Google has risen almost 25% from its mid-March lows, though it is still about 28% below the high set late last year. During this period the company has not issued any statements which could have justified the massive price swings.

Private Equity Model and Wall Street Analysts

It is not too hard to figure out why Wall Street goes through such massive sentiment swings when it comes to Google. Unlike a majority of publically traded companies, Google does not offer forward guidance about its financial results. Google sees Wall Street’s obsession with quarterly results as a distraction towards its goal of building a strong company and long term shareholder value. Similar sentiments are also shared by many private equity firms who believe that the focus on quarterly earnings artificially constrain public companies and hamper efforts to build stronger companies. Google operates under a private equity model while being a publicly traded company.

Since Google’s does not offer guidance, Wall Street analysts have to step out of their comfort zone when making projections about Google’s business prospects. Google business model is unique: it is a technology company while earns its revenues from advertising. Since Google has not faced an economic slowdown, there is very little historical data which can be used to estimate its performance in the current slowdown.


However, the magnitude by which the analysts were wrong is indeed surprising, especially since there are a lot of metrics which can be used to evaluate Google’s performance.

Wall Street’s Thesis on Google’s Eminent Collapse

The financial press was gaga over Google last fall, as it raced to new highs in the 700s.

Henry Blodget, a master in attracting attention with outrageous projections, said that Google might go to $2000 (the fine print said in 2020).
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Housing, Credit and the Economy: At an Inflection Point

Posted on April 13, 2008 by BMWFan

Sub-Prime Mortgages have been at the top of the air-waves for about a year now. The collapse of two hedge funds run by Bear Sterns started the procession. Numerous Wall Street executives have lost their jobs and banks have been writing down about $250B in losses attributed to products linked to sub-prime mortgages.

Last week two major the chief executives at two major Wall Street firms made some encouraging statements about the current situation. Goldman Sachs’ CEO Lloyd Blankfein feels that the markets are probably in the late stages of the credit crisis though he did not predict when exactly the crisis will end. Morgan Stanley’s CEO John Mack was more definitive in his statements. He used a baseball analogy to say that the sub-prime crisis is at the bottom of the eighth or the top of the ninth innings. He feels that the broader crisis will go on for a few quarters more.

These views are significant since both these firms made the headlines during the crisis.

Goldman Sachs was adroit in circumventing the crisis and booked handsome gains in betting against the sub-prime mortgages. Morgan Stanley also bet against sub-prime mortgages but their strategy underestimated the magnitude of the problem and the firm ended up taking losses of more than $9B. It also led to the departure of an entire chain of executives from the MD leading the desk which made the bet all the way up to the company’s co-president Zoe Cruz.

Sub-Prime Rate Reset Shock: No Longer a Major Issue

A note by Morgan Stanley research has reduced the reset cash-flow step-up (extra payments needed after resets), by 50% from what they estimated last year. The lower interest rates are making a difference since the mortgages are no longer resetting to a significantly higher rate.
A bulk of the sub-prime loans were 2/28 ARMs which reset after two years to a rate equal to LIBOR (6m) + 6%. The initial so called teaser rates were in the range of 7-9%, significantly higher than what a prime borrow would have paid.

During 2006 and 2007, the 6m LIBOR was in the range of 5-6%, which meant that after resets, the rate went up to 11-12%. With the housing market slowing down and a lot of home owners caught with little or no equity, the sub-prime borrowers could not refinance into better priced mortgage products and were stuck with monthly payments which were significantly higher than their original teaser rates.

Sub-Prime borrowers whose mortgages reset during this period were stuck in between a rock and a hard place, and many were unable to keep up with their mortgage payments.
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Roundup: Credit Markets Unfreeze; Online Retailing and Search

Posted on April 8, 2008 by BMWFan

The credit-markets are showing signs of life again.

The buy-under of Bear Sterns (BSC) and subsequent actions by the Fed to allow Investment Banks to access the discount window using asset backed paper as collateral seem to be having the right effect.

The market cheered when Lehman Brothers (LEH) was able to place an offering

of preferred convertible stock at reasonable terms. This was followed by news of Thornburg Mortgage (TMA) and Washington Mutual (WM) raising equity capital to continue their operations.

Though the terms were highly dilutive for the existing equity holders, the fact that the firms were able to raise capital without the intervention of the US government or Sovereign Wealth Funds was a welcome sign.

Leverage Loans: Market Unfreezing

Citigroup (C) is close to completing a transaction to place more than $12B of leverage buyout related loans to a group of private equity investors. The loans were sold at around 90c to the dollar, a much better price than the 15-20% loss which was being projected earlier. The amount placed amounts to about 25% of all leverage loans Citigroup is currently carrying on its books.
A few weeks ago it would have been impossible to imagine that a beleaguered bank like Citigroup would be able to place such a large amount of loans at such reasonable terms. This is another indication that the credit markets are now unfreezing. Private capital is now sensing a once in a lifetime chance to pick up high quality paper at deep discounts and they are now diving in by

This deal has the potential to be the harbinger for more placements, as other buy-side firms, itching to put their money to work, start scooping up the leveraged loans. Given Citigroup’s beleaguered negotiating position, this deal also establishes a floor for pricing of such placements in the future. This bodes well for banks who are sitting on a huge amount of leveraged buyout paper, which was fuelled by the private equity boom of 2006-2007.

The placement also means that the leverage buyout market will gradually start opening up again.

Perhaps the biggest benefactor will be the buyout of Clear Channel Communication (CCU) which is currently stuck in litigation. The private equity firms taking CCU private were unable to agree on the financing terms with the funding banks. The banks were desperately looking for the flimsiest pretext to renege on their funding commitments since they expected to book 15-20% loss as soon as the deal closed.

Write-Ups Anyone?

A few weeks ago I had written a post which explored the level of write-downs taken by banks to account for the sub-prime related assets. My conclusion was that the write-downs were extreme since they were based on extremely pessimistic marks in a dysfunctional market. As a result there is tremendous potential for write-ups as the credit markets start functioning properly.

A number of market observers are now talking about the same thing, with the Fast Money crew specifically noting that Morgan Stanley (MS) was extremely aggressive in booking the $9B+ write-down and will see

an upside within a year.

Online Shopping and Google

CNBC’s Margaret Brennan had an interesting piece about the effectiveness of marketing dollars in online retail.

“
…
What is interesting to me are the different ways that Internet stores are reaching customers to bring them “in store” — online.
One of the most effective ways is also one of the cheapest: Forrester’s Research shows that e-mails sent to repeat customers by stores involves the cheapest marketing cost ($6.85 is the average cost per order), while yielding a high average order value ($120.27 average order value.)
Search engine shopping is also among the cheapest ($8.63 average cost per order) while yielding a high return ($109.73 average order value.) These cheap marketing tools are helping retailers maximize profits.


…
“

Earlier this year, I had written a post in response to an article by Henry Blodget, where I had suggested that during an economic-slowdown, marketing dollars will increasingly move online since they allow retailers to get the quickest bang for their marketing dollars. The data from CNBC seems to confirm that search is a highly effective method of generating sales, especially among new customers who traditionally have much higher acquisition costs than existing customers.

Though online retail grew by 17% year over year, it still represents just 7% of the total retail market, leaving a tremendous amount of upside.

High gas prices are also pushing customers to shop with their mouse instead of driving to a store. They not only save the time and the gas money, but are also able to comparison shop to get the best deal. Many online retailers do not charge sales-tax for out of state residents, and offer free or discounted shipping which is helping push more shoppers online.

The effectiveness of search as a medium to drive sales bodes well for the undisputed leader in search, Google (GOOG). Google’s stock has been under immense pressure this year with questions about how the economic slowdown will affect online advertising.

Financial and mortgage related firms have been cutting back on their online marketing.

The unfreezing of the credit markets and government actions to spur mortgage refinancing means that we are sitting on the cusp of another big boom for mortgage vendors. I expect the mortgage vendors to come back aggressively into the online advertising market to make up for the lack of business over the past year.

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Investment Banks Update: Lehman Brother’s Preferred Offering

Posted on March 31, 2008 by BMWFan

Lehman Brothers has announced a preferred

stock offering to raise $3B in new capital.

The preferred will have a yield between 7-7.5% and a conversion premium of 30-35% over the common stock. Though the deal has not closed yet, the word is that the offering is three times oversubscribed.

Lehman is running the book themselves so there is no underwriting fees to be paid here and all the capital raised will go to increase Lehman’s equity base.

Lehman’s stock has been under considerable pressure following the run on Bear Sterns.

There was massive out of the money put purchases which contributed to the fear cloud. This has also attracted a lot of retail shorts who are expecting another Bear Sterns type buy-under.

Perhaps they do not realize that even deep out of money puts ($25 strike with stock at $40) can easily double or triple in value with a $5 movement in stock-price; the increase in volatility in large downward moves increases the value of the puts.

The news about the preferred sale sent Lehman’s share down as much as $35.30 from their 4:00PM close of $37.64. The Fast Money crew raised questions about why Lehman had to raise capital in this environment if they were not facing any liquidity issues. Some investors are concerned about the dilution faced by the common equity holders; others are concerned about the potential effect on the dividend for common equity holders.

Asset Sale versus Raising Capital

I think it is important to review the offering in the broader context. It is very clear that Investment Banks will have to deleverage.

They can do that by either selling assets or raising more equity. In the dysfunctional markets we are in, selling assets is not the most profitable option. However interest rates are low, so raising equity capital via preferred offerings is not that expensive.

Why Raise Capital No

w?

Some observers have questioned the need to raise capital when Lehman has been outspoken in announcing that their liquidity situation is excellent. However, we are in an environment where well capitalized investment banks can generate high return on equity with very little risk.


Investment Banks now have access to the Fed’s balance sheet where they can borrow from the Fed against a variety of collateral, including asset backed securities. The result of the first Term Securities Lending Facility Auction showed that investment banks borrowed at a spread of 33 basis points, i.e. they could use their investment grade bonds as a collateral and get treasuries (as good as cash) at a rate equal to the yield of the treasury plus 0.33%.

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Dealing with Foreclosures: Government Chartered Rental Agency?

Posted on March 16, 2008 by BMWFan

The airwaves are brimming with stories about the financial loss incurred by investors and financial firms due to the mortgage market meltdown.

What is often ignored

is that foreclosures also have a debilitating effect on communities. Home values fall reducing the tax receipts of local governments; empty homes become an eye-sore for the entire neighborhood and invite vagrants. Investors and owners of foreclosed homes will have to endure the pain of their imprudent financial decisions. However, the impact of foreclosures on communities can be reduced by creative planning.

In the past mortgages were held by local banks who could work with homeowners in trouble to delay foreclosure till the hard times pass. However, in the days of securitization the owner of the mortgage is a business entity, a trust created to buy mortgages and issue securities. There are mortgage servicing organizations who handle the book-keeping aspects but they do not have any skin in the game. They do not have enough financial incentive to help homeowners stay in their homes.

Root Cause Analysis

Many home owners who are in trouble took sub-prime Adjustable Rate Mortgages (ARM) with teaser rates which reset after two or three years. After the reset point, the rates would go up to 500 to 600 basis points above the LIBOR rate (typically the 12 month LIBOR). Even the initial teaser rates were in the 7-9% range, much higher than what most prime home-owners pay.
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The Run on Bear: Time for Federal Agencies to Start Swinging

Posted on March 15, 2008 by BMWFan

Friday morning was shaping out to be the much awaited follow-though day for the 400 point Dow rally on Tuesday.

The equity markets had retraced a bulk of the gain and then bounced back on Thursday. The CPI number on Friday morning was benign and we seemed to be set for the races.

A few minutes before the market opened the news about the Fed led bail-out of Bear Sterns came out. Bear was under pressure throughout the week with rumors of a liquidity crunch. Bear’s CEO Alan Sch wart

z had tried to dispel these rumors earlier this week; however his public statements seemed to have worsened the situation.

Bear’s prime brokerage customers started pulling their cash; traders cut back on trades with Bear as a counterparty. There was a run on Bear and on Thursday night Bear’s executive decided to seek help.

A firm using a large amount of leverage needs time to unwind them. With the credit markets in a spin, it was not possible for Bears to raise the cash.

Bear’s downfall was being predicted in the options market. There were tens of thousands of March put contracts bought at strikes of $20 to $30 below where Bear Sterns was trading. The put-buyers were confident that something big was going to happen very soon. It is not known who bought the puts but I will not be surprised if it were entities related to those who were pulling their cash out from Bear.
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Sub-Prime Write-Downs more than 50% done: Are Write-Ups Coming Next?

Posted on March 13, 2008 by BMWFan

S&P was out with a report today saying that the banks are more than half-way through in recognizing losses attributed to sub-prime mortgages. They revised their estimate of total losses up to $285B from $265B but this is much less than the estimates put out by investment banks: $325B from JPMorgan Chase, $400B from Morgan Stanley and Goldman Sachs, and even $600B from UBS.

This week different government agencies have started taking serious action to introduce liquidity into the MBS secondary market. The Fed’s decision to allocate $200B to exchange AAA rated MBS held by investments with Treasuries helped stabilize the market. Later today, news came out that Congress was considering more efforts to stabilize the mortgage market.

A proposal which will allow the FHA to offer $300B more in guarantees to help refinance distressed mortgage got some attention. Treasury Secretary Paulson introduced proposals to introduce rules to regulate over the counter markets which are currently unregulated, to restore confidence in counterparties and prevent future bubbles.

The message being sent is that the Fed, the Congress and the Treasury are now serious about intervening in the MBS market to ensure stability. The equity market rallied and Treasuries sold off after digesting the news of Carlyle Capital Mortgage Fund’s liquidation. This indicates that the markets are now internalizing the beginning of the end of the credit-crunch. The equity markets were frozen because of the credit-crunch; the attention shift away from credit problems bodes well. Investors can now start looking at the fundamentals of equities instead of being stuck in a technical trader driven market.


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Google Bashing: Reaching a Peak?

Posted on March 8, 2008 by BMWFan

This weekend’s Barron’s has article by Jacqueline Doherty titled “Google’s Next Stop: Below 350?” The main thesis of the article is that analysts have not reduced earnings estimates for Google to account for the expected reduction in clicks and corporate ad spending. The article recommends staying clear of the stock until Wall Street recognizes that Google’s revenues will be hurt by an economic slowdown and management starts cutting expenditure in non-core areas. To be fair the author acknowledges that Barron’s (specifically she) has been consistently wrong about Google in the past; others have called her out for her hand-waving articles.

Further her assertion that Wall Street have not come down is incorrect. Yahoo!

Finance shows that earnings estimates for the current quarter have fallen from $4.86/share to $4.65 over the past 90 days. Estimates for FY08 have fallen from $20.69 to $19.98.

I feel that one big challenge which Google faces is that they have consistently spurned Wall Street. Google’s IPO was not managed by the big banks that lost out on

the massive underwriting fees big IPOs generate. They do not provide earnings guidance to make the job of analysts easy. Wall Street is forced to follow Google because of its performance; not because Google reaches out to them.

Similarly the financial press is not too enamored of Google. Google represents the biggest threat to Madison Avenue and traditional media advertising. As a result whether it is raising privacy concerns or questioning their future growth, it has a tendency to put a negative spin on Google.

In an earlier post I had wondered whether Wall Street properly values the brand loyalty which Google inspires. Barron’s comment’s on spending in non-core areas seems to highlight that the financial press and Wall Street continues to refuse to see the forest for the trees. In this article I will try and translate Google speak into Wall Street speak to help them understand a few things.
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The Thornburg Tragedy: Time for Resolution Trust Corporation Redux?

Posted on March 5, 2008 by BMWFan

Shares of Thornburg Mortgage are down more than 40% to 2.01 in the after hours after the company said that it was unable to meet a $28 million margin call from JP Morgan Chase, one of its lenders.

JP Morgan has decided to exercise its right to liquidate the collateral under a $320 million financing arrangement Thornburg defaulted on. This notice of default from JP Morgan triggered cross-defaults with other lenders who can now demand their money back. Unless a white knight emerges, this might be the end of Thornburg Mortgage as we know it.

The contrast with other companies failing due to the sub-prime mortgage mess could not be more ironic. Thornburg is a well respected mortgage lender with high lending standards and one of the lowest default rates in the business.

It primarily lends to high income individuals who take out Jumbo mortgages on their homes and rarely suffers a l

oss on its portfolio. Company insiders have been on a buying spree since last fall and have purchased more than 1.26 million shares in the open market.


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