Toro's Running of the Bulls Market Blog

Dell, HP – Something You Won’t Hear Me Say Anytime Soon

“I want to buy Dell and HP stock.”

Apart from the breathless announcements from CNBC flashing on my screen regarding the bidding war between Dell and HP for 3Par – a company that makes data storage equipment – I have only tangentially been following this farce. 

Frankly, I will proclaim my ignorance.  This may be The Greatest Acquisition in the History of Mankind.  But I am skeptical.

The “winner” to buy 3Par – Hewlett-Packard – will have the privilege of purchasing a company whose stock flatlined around $10 a share over the past year for $33 a share, a full 242% above 3Par’s closing price on August 13 of $9.65 when the bidding frenzy began.

For those not paying attention – which is impossible if you have had CNBC on for more than 10 minutes – HP and Dell have been engaged in a spectacular bidding war for a company most people have never heard of.  On August 16, Dell offered to buy 3Par for $18 a share, nearly double the prior trading day’s closing price.  A week later on Monday August 23, Hewlett-Packard offered to buy 3Par for $24 a share.  On Thursday of that week, Dell upped its bid to $24.30 a share.  Like an antsy day trader who just can’t wait to buy, eight hours later, HP offered $27 per share for 3Par.  Dell then matched HP’s offer the following morning.  Determined to show Dell exactly who was the Baddest on the Block, HP offered $30 a share two-and-a-half hours after Dell's bid.  Both sides cooled their heels over the weekend, and with rumours of Dell readying to up its bid yet again, HP today jacked up its offer to $33 a share, effectively bidding against itself.

In the midst of all this, HP announced a buyback program to repurchase $10 billion of its shares.

Oh, did I mention that HP does not have a CEO?  Former Hewlett-Packard CEO Mark Hurd resigned on August 6 amidst sexual harassment allegations, though both he and the alleged accused denied the charges, which then morphed into accusations that Hurd abused his expense account. So HP has been engaged in a frenzied auction with nobody at the helm.

Surreal.

This frenzied bidding tells me that both companies are saying “We have no growth left so we are willing to crazily bid for a company that the market did not rate three weeks ago.”

HP closed at $39.69 on Thursday.  Dell closed at $12.36.  Ten years ago, HP traded at $62.50, Dell at $43.

Neither will be found in the Toro Portfolio anytime soon.

Intel Rocks the SOX

I have been getting aggressively short the semiconductor stocks the past week.  Intel did me a huge favour by purchasing a software company this morning. 

Intel Corp. agreed to buy McAfee Inc. for $7.68 billion, its largest acquisition, adding security software to its chipmaking arsenal.

McAfee investors will receive $48 a share in cash, Santa Clara, California-based Intel, the world’s largest chipmaker, said in a statement today. That’s 60 percent more than McAfee’s closing price yesterday. Both boards have unanimously approved the deal, Intel said.

Buying McAfee, which trails Symantec Corp. in security software, gives Intel a leg up on rivals that don’t provide computer protection, said Hans Mosesmann, an analyst at Raymond James Associates in St. Petersburg, Florida. The deal may also help Intel Chief Executive Officer Paul Otellini in his drive to expand beyond PCs by breaking into mobile handsets and landing more chips in other mobile devices.“Security is becoming a really big deal,” Mosesmann said.

“The security threats that are out there are not going away -- you could argue that they are going to get worse -- and having a tightly coupled hardware and software is a strategic advantage.”

Frankly, I cannot figure out why a semiconductor company is buying a software company.  Perhaps Intel is losing confidence in the future of the PC.

This purchase tells me that Intel would rather buy a software company than a semiconductor company at this point in the cycle.  And I am betting that that sentiment is correct.

For signs of the flagging health of U.S. consumer spending, look no further than Taiwan.

At Taipei-based Acer Inc., the world’s second-largest maker of computers, sales plunged 38 percent in July from a year earlier. Micro-Star International Co., a maker of boards that connect computer components, recorded a 15 percent drop.

Sales at Asian computer makers, which account for more than 80 percent of computer and parts imports into the U.S. each year, indicate American shoppers aren’t likely to boost the spending that accounts for 70 percent of the world’s largest economy. Already, consumption is growing at the slowest pace of any recovery since 1945. ...

Tristan Gerra, an analyst at Robert W. Baird & Co., last week cut his ratings on Intel Corp., whose chips run more than 80 percent of the world’s personal computers, following an earlier downgrade on Texas Instruments Inc.

“Everything is slowing down,” said Gerra, adding the slowdown in orders for chips extended into August and that the “initial visibility of orders into September is getting worse.”

UBS AG last week halved its third-quarter volumes forecast for Asian computer makers, known as original design manufacturers, predicting a 6 percent quarterly increase instead of 12 percent projected six weeks earlier.

If a slowdown is happening – and I believe it is – the OEMs and re-sellers are going to see inventory builds, especially with rumours over the past several months of double-ordering for chips.  As demand slows, orders for semiconductors will fall off a cliff and the stock prices of semiconductor companies will collapse.

The usual caveat applies – I could change my mind tomorrow, close out all my short positions and not tell you about it.  However, I have traded this group successfully for the past 15 years, and what I have learned is to buy the semis when they are getting bombed out and stocks are cheap relative to book value, and to sell them when things are good or beginning to deteriorate and the stocks are no longer cheap relative to book.

After a big upward move, this group has gone sideways for a year.  Once the chips start moving sideways after a huge move higher, their next big move is usually down.  I think we are at such an inflection point, and I am looking to increase my short position.

 

Crash

I have no idea what caused the collapse intra-day today, whether it was a bad trade or the withdrawal of liquidity by the machines or what.  What I do know is that it was amazing to watch.  At one point, the Dow was down nearly 1,000 points.  I have never seen anything like it.

I got lucky.  On Monday near the close, I hedged out all my equities positions to net flat.  I had also been buying gold calls the past week and have been long the dollar since the beginning of April.  So my book since Monday's close has been long gold, long the dollar.  

I closed out most of my dollar long position and have kept only a small position.  That does not mean the euro is going to rise.  In fact, it will probably keep melting down.  Remember, it was 85 cents several years ago.  And on a purchasing power parity basis, it is worth $1.15-$1.20, so it is still expensive.

I am a long-term bull in gold but have traded in and out of the yellow metal over the past eight years.  I started buying a week ago when the price action was acting very well.  I expect that we will go back and re-test the $1225 highs, back off a bit, then blast through it.  I expect to add to positions on a break to new highs or on a light pullback.

My equities book right now looks primarily like this - long small banks, long semiconductors, short the S&P 500 and Russell 2000. 

Over the past year, I have been buying banks, primarily very small banks.  My criteria for banks has been to buy stocks trading below tangible book value that made money through the crisis and are forecasted to make money this and next year.  I own 14 banks, most that trade by appointment.  I hope to add to my bank position during this sell-off.

My semiconductors position is now a residual of a basket that I began building in 2008, and continued to buy through the end of the year and into the Spring of 2009.  At one point, I owned 18 different chip companies.  I have sold most of my basket and now own six names.  I will sell into strength.

The hedges I own are the Direxion Russell 2000 3X Bear ETF, ticker TZA.  I own the double inverse Horizons S&P 500 Bear Plus ETF in my Canadian RRSP account, ticker HSD.TO.  I also hold the double inverse Horizons S&P/TSX 60 Bear Plus Fund, ticker HXD.TO for other accounts I manage in Canada. 

My intention in buying the leveraged inverse ETFs was not to short the market but to eliminate equity beta.  Since Monday afternoon, my net position became net short, so I peeled a small part of my hedge.  Interestingly, during the 600 point 20-minute plunge this afternoon, I tried to sell some TZA, which is normally pretty liquid.  However, it did not get filled, even though I kept it open for 20 minutes. I pulled the order as the market bounced.

I have been expecting a 5%-10% correction for some time now.  Today, we got it, with the S&P 500 down 13% intra-day from the highs of a few weeks ago.  I had thought it would merely be a correction in the midst of a cyclical bull market. I'm not so sure now.  This may be a correction within a cyclical bear market but I must respect the action, and the market action today was just horrible, no matter what the reason for the sell-off. 

Sovereign debt crises are very serious, and must be respected.  I expect more downside pressure in the near-term.

Critical Undersupply in Semiconductors Coming

So sayeth the head of the World Semiconductor Council.

The head of the World Semiconductor Council warned yesterday that recent aggressive capacity cuts in the D-Ram memory chip sector were likely to result in a severe shortage by the end of the year that could disrupt shipments of computers and other electronics.

The global D-Ram sector faced its biggest crisis in its 16 years of existence last year as industry over-expansion coincided with a drop in demand for computers.

But Frank Huang, chairman of the World Semiconductor Council and also of Powerchip, one of the biggest Taiwan D-Ram makers, said the industry would begin to recover by the second half of this year, and downstream producers of PCs and other electronic products would face "a shortage bigger than I have ever seen in the past 16 years . . . this will affect global PC shipments".

Last year's crisis, reflected in the price of D-Ram falling by more than half to below cost for most producers by the end of the year, led to a store of 1bn unsold D-Ram chips and nearly $10bn in total losses by the industry.

This prompted the biggest manufacturers, mainly in South Korea and Taiwan, to cut production. Others, such as Germany's Qimonda, fell into bankruptcy.

Nearly half of world production had been cut since the beginning of the year, said Mr Huang. This means that by June, the 1bn stockpiled chips will all be sold and by the end of the year there will be a global shortage of 2bn chips, equivalent to the D-Ram needed for 100m computers.

"It has been a difficult time but we can finally see spring coming," said Mr Huang.

Part of the reason for the impending shortage, he said, was that most D-Ram companies were facing financial difficulties and would find it hard to revive production quickly. The other reason was that "wolf has been cried too many times [on a market recovery]. Everyone is too cautious," he said.

I am very, very long semiconductor and semiconductor equipment companies.  They are, by far, my largest industry exposure.  I own a basket of 17 names, including four I have mentioned as net cash plays.

I began building a position in the chips too early, scaled back a bit, started adding more, and have been buying heavily over the past several months.

I have tended to do best buying companies in industries that have been bombed out.   Valuations are extremely low in the semis and some names in my basket could be 5-10 baggers. 

Because of extremely low valuations, I care not what happens in the near-term. I am looking 2-4 years out, not 2-4 weeks or 2-4 months.  So I sit and wait.

Another Cash Play Gets Taken Out

Three of the four cash plays in the semiconductor industry I wrote about in November have been subject to buyouts by competitors in 2009.  SiRF Technologies (ticker SIRF) and Avanex (AVNX) both caught a bid earlier this year.  And last week, Tundra Semiconductor also agreed to be bought.

Gennum Corp (GND.TO) is buying intellectual property firm Tundra Semiconductor (TUN.TO) in a cash and stock deal worth C$86 million ($69.4 million), the companies announced late on Thursday.

The deal values Tundra at C$4.43 a share. Tundra's shares closed at C$3.07 on the Toronto Stock Exchange on Thursday.

The other stock of the four was O2Micro (OIIM).

Returns since November 12 for each stock have been

AVNX  -5.0%
OIIM  53.7%
SIRF  83.2%
TUN (C$)  41.3%

Average return 43.3%

The average return far outpaces the return of the broad market or the semiconductor index.

That is what buying stocks at or below net cash can do.

Reasons to be Bullish

Frankly, I am having a hard time being bullish because everything feels so bad.

I was in the office on President's Day and watched the S&P 500 futures tick down to near-term support at 806, such that futures are indicating a 20 point decline at the open on Tuesday.  Now, it appears the market has formed a short-term double-top, and with stocks continuing to reach lower highs, it feels like we are about to break to the downside and re-test the November lows.

Emotionally, selling feels like the right thing to do.  However, cerebrally, since I have a time frame longer than my nose, there are many reasons not to sell at these levels, and to in fact buy stocks.  But it is difficult not to walk away in disgust, especially after last week's action, which was just horrible.

Everyone knows why you should be bearish - the credit crunch continues, the economy is terrible and earnings estimates continue to come down.  The reasons to hate stocks are very well known.  So I made a list of reasons why stocks could be substantially higher within the next year or so.

• Credit spreads have improved.  Credit remains tight, but spreads have come in.  Over the past 50 years, the average gain to stocks has been 18% when credit spreads are falling.

 

• Cash spreads are improving.  The TED spread and swap spreads are at levels last seen before the crisis began last fall.
• Treasuries are backing up and yields are rising.  The bond market has experienced a violent sell-off in the long end of the curve, while short-term T-bills - which were yielding negative returns a few months ago - have seen rising yields.
• The yield curve is steep.  When the curve is this steep, it almost always signal economic expansion over the next 12 months.
• Corporations issued the highest volume of debt in January than in any month since May.  In fact, debt issuance was greater than the last four months of 2008 combined.
• The dollar may be topping.  Some may argue that this is because of all the debt that the Treasury will flood onto the market.  However, a rising dollar has also been indicative of fear and a flight to safety.  A falling dollar may indicate that fear is seeping out of the market.

• The euro/yen cross has been moving sideways for months and may be basing.  The euro/yen carry trade had been popular over the past several years as investors bought higher-yielding euro-denominated bonds and financed the purchases by borrowing in lower-yielding yen.  This carry trade has been seen as a proxy for risk appetite in the global capital markets.  It may be signaling that investors are becoming less fearful.

• The gold/silver ratio has fallen below 70.  The ratio was as high as 80 a few months ago.  Both gold and silver have been rising the past few months, but silver has been rising faster than gold.  From September through November, silver fell 30% to the trough whereas gold fell 10%.  Silver is a thinner market but it is also an industrial metal and more exposed to the general economy than gold.  Gold is a haven during crises.  Silver prices rising faster than gold prices may be signaling that the economy is going to get better in the future and/or investors are less fearful about financial markets.
• Metal prices may be bottoming. Though it is still early, a bottom in stocks is sometimes presaged by a bottom in metals and commodity prices. 
• Commodities may be bottoming.  Oil may be putting in a bottom as well.

 

• Canadian stocks may be bottoming.  Energy and metals comprise roughly half of the total market capitalization of the Toronto Stock Exchange.  Materials stocks in Canada have been performing fairly well.

• Chinese stocks may be bottoming.  Stocks in China have been acting well as of late.  I am long the FXI.

• Semiconductor stocks have been outperforming and may be in the beginning of an uptrend.  Semiconductors are often an early indicator of the health of the technology industry.  I am long a basket of semiconductor and semiconductor equipment stocks.

• The VIX is acting like it wants to break below 40.  On Thursday's intra-day reversal, the VIX closed sharply down.  On Friday, when the market sold off during the last 20 minutes of the day, the VIX gave up less than half the decline of the prior session.  This may be a sign that investors are getting more confident of the future.

• Asset allocation by individuals towards equities is at or near all-time lows whereas allocations towards cash is at or near all-time highs.  The public is generally positioned like this at bottoms.
• Cash levels are at multi-decade highs.  There is nearly $9 trillion in cash on the sidelines currently.
• Hedge funds are heavily in cash.  There are very few hedge funds that are bullish now.
• Private equity investors are sitting on their hands.  After incurring large losses in their portfolios and wary of the cash crunch of their limited partners, private equity funds are doing little.  It seems that everyone is waiting for a turn before investing.
• Everybody whom I talk to is negative.  I have had in depth discussions with two dozen highly knowledgeable investors this month, and they are all overwhelmingly and uniformly bearish.  Every.  Single.  One.  Even those who are buying because they see value in the market are bearish on the market and the economy as a whole.  I had to talk a friend and a 20-year veteran of the business off the proverbial window ledge last week.
• Reversion to the mean suggests at least a bounce.  Last year was one of the worst years on record.  Tremendous selling usually begets a significant rally.
• Stocks are cheap.  Whether you want to measure by the 10-year moving average of earnings, Tobin's Q, or measures of book, sales and normalized earnings, stocks are inexpensive.

Now, as I tell you all this, I think there is a fairly good chance - 60% or 70% perhaps - that the market is about to re-test the lows over the next week or two.

Even after I listed all those points above, I cannot tell you that I feel bullish.

Maybe that is a sign a bottom is near.

Cash Plays Updated

Three months ago, I highlighted four stocks trading below net cash.  Since that time, two of those companies have been subject to buyout offers, the second coming today as the British company, CSR, offered to buy SiRF Technologies.  Let us see how each has performed since, starting with SiRF.

SiRF Technologies (ticker SIRF)

Price on date of mention: $1.25
Closing price: $1.68
Return: 34.4%

SIRF was perhaps the most problematic of the four examples, given that the company had lost several court rulings regarding their GPS navigation patents.  Despite their problems, CSR offered to swap 0.741 shares for each share of SiRF.  It is not hard to see why.

Currently, SIRF has $98 million in cash net of debt on its balance sheet, 62 million shares, $163 million of shareholders equity, and $137 million of tangible equity.  At the close yesterday, SIRF stock was quoted at $1.08. 

CSR trades on the London Stock Exchange and closed today at 198p.  With the pound trading at $1.45, the value of the offer for SIRF closed at $2.13, valuing the equity at $136 million, a 27% premium, reflecting the lack of financing for risk arbitrage.  With $98 million in cash, CSR is effectively paying $38 million for SiRF, the book value of all tangible assets excluding cash.  Thus, disregarding any asset writedowns, CSR is getting SIRF's technology for free.

With the stock closing at $1.68 today, shareholders who bought at $1.25 when SIRF was highlighted in my post have earned 34%.  If the arb spread closed tomorrow, the return would be 70%.

I do not know much about CSR.  However, the financial metrics look very appealing.  After the merger, the company will have net cash of $361 million, or $2.01 per share.  With the stock trading at 198p, or $2.88 after currency conversion, net cash represents 70% of total market capitalization.  The combined company would have been free cash flow positive over the past 12 months.

The stock is dirt cheap on other metrics.  The new company trades at 0.56x sales and 0.61x book value.

Semiconductor companies are highly cyclical.  At the prior peak in 2006, CSR traded at 7.43x book value.  With a book value of the new company at $4.70, at the prior peak multiple of book, the stock would trade at $34.89, a 1,112% return from today's levels.  Owning SIRF would yield a return of 1,977%.

I do not know if CSR will reach that peak again.  However, I have no doubt that the semiconductor cycle is alive and well, and one day, chip stocks will be markedly higher.  Even if CSR retraces a quarter of its prior peak, owning SIRF now will be incredibly profitable some time in the future.

Avanex (AVNX)

Price on date of mention: $1.61
Closing price: $1.68
Return: 4.3%

Two weeks ago, Avanex was subject to a bid by Bookham.  Avanex shareholders will receive 5.426 shares of Bookham for each share of Avanex.  Bookham trades at $0.32 per share.

Shares outstanding for Bookham are currently 101 million and 16 million for Avanex.  Post-deal, the new company will have 186 million shares outstanding for a market capitalization of $73 million.  The combined company will have $73 million in net cash.  Thus, Bookham/Avanex is currently trading at the cash value of the new entity.  The combined company would have been slightly free cash flow negative over the past 12 months.

Bookham printed $128 million in shareholders' equity in their last filing while Avanex had shareholders' equity of $63 million, giving the combined company a total book value of $190 million.  The company currently trades at 0.3x book value.

At the previous peak in 2006, Bookham traded at 3.85x book value.  If the stock hits the same peak at the height of the next cycle, the share price will be $3.94, giving equity holders a return of 1,130%.

O2Microdevices (OIIM)

Price on date of mention: $2.18
Closing price: $2.77
Return: 27.1%

Tundra Semiconductor (TUN.TO)

Price on date of mention: C$3.29
Closing price: C$3.15
Return: 4.4%

A basket of the four stocks equally weighted would have returned 17.6% since November 12.  On that day, the S&P 500 closed at 852.30.  With the index finishing at 827.16 today, the market has fallen 2.9% since then.

I am long all four stocks.  With potential returns of 500%-1,000% over the next several years, and the stocks all trading near or below cash value, I could not care less about the technical action, nor do I care about market levels.  I sit and wait.

Semiconductors Hit Decade Lows

Today, the Philadelphia Semiconductor Index, aka the SOX, took out its 1998 low of 182, closing at 177 this afternoon. 

In other words, Mr. Market is telling us that no value has been created over the past decade in the semiconductor industry, even though at the lows in 1998, chip stocks were trading at lows on book value and nearly at cash levels.

The 1996 low was 170.  The 1994 low was 139.

I am a buyer of semiconductor and semiconductor capital equipment stocks.

Panic

I woke up this morning, groggily turned on CNBC, and noticed that the futures were down 60.

"The Dow is down 60 this morning," I thought, "that's not bad."

Then the Dow futures flashed "Dow down 546."

Those were the S&P 500 futures that were down 60.  Lock-limit down.

The Great Hedge Fund Liquidation / Investor Panic continues as global markets are melting down across the world, with indices falling 8%-9% today.

My skill at picking a near-term bottom appears to be lacking. (A lot appears to be lacking. - ed.) However, I remember the 2002 bottom when you would wake up in the morning and see the futures getting crushed before the open whereas all the crushing in equity prices in the days prior occurred in the cash market when the market was open.  Could we be approaching a bottom now?

I have no idea.  However, I have spent much of my time since I started this blog telling you how markets were getting stupid, most recently in commodities - here and here - and also real estate - here and here.

Now, stock markets are getting stupid on the downside. 

Stocks are being thrown out the window because the margin clerks are in control and retail investors are in panic mode.

I have been in two minds about this market recently.  On the one hand, I have a trading long, and want the market to go up.  On the other hand, I want the semiconductors to get crushed so I can back up the truck for the inevitable cyclical upswing in a year or three hence, and its much easier for the chips to get hammered when the market is getting whacked.

I am eying a basket of semiconductor and capital equipment companies as well as the ProShares Ultra Semiconductor Index, ticker USD.  The USD closed at $15 on Thursday.  It was $100 last summer.  I expect it will approach those levels again in the future.

Apple

Okay, things are getting silly again in the stock market.  Stocks are being taken out and shot indiscriminately because of the Giant Hedge Fund Liquidation, regardless of quality.  Many, if not most stocks, are now on sale.

Take Apple, which reported a great quarter yesterday but gave conservative guidance (as it usually does).

Apple closed today at a shade under $97.

Apple has 887 million shares and a market cap of $86 billion.  As of the end of the most recent quarter, the company had $24.5 billion in cash and no debt.  Thus, net cash per share is $27.  Cash is 28% of the company's market capitalization.

The company earned $5.48 over the past 12 months.  On trailing earnings, Apple is trading at 17.7x earnings.

Net cash, the stock is trading at $70 per share.  Apple is trading at 12.8x trailing earnings net of cash. 

Analysts are expecting the company to earn $6.50 next year.  At $97, the stock is trading at 14.9x earnings.  Net cash, the stock is trading at 10.8x earnings. 

Let's say analysts' estimates are too high.  Instead, Apple earns $6.  On that number, the stock is trading at 11.7x earnings.

Right now, Apple is perhaps the greatest consumer company in the world.  Well, if not the greatest consumer company, then certainly the greatest consumer technology company.  10x-12x earnings net of cash seems down right cheap to me.

Does that matter?

No, of course not.  Valuation means squat in the short term.  The stock could fall to $50 for all I know, especially given the irrational selling that is hammering the market almost every day. 

And I'm not buying the stock now, nor am I recommending anyone buy anything at the moment (even though I have been buying).

But great values are being created all over the market for anyone having a time horizon longer than a week.