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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Tuesday, March 18, 2008

Google's Valuation Finally Reasonable

Google Inc (nasd:GOOG) $439.16- Google shares have dropped about 40% from its high around $750 due to concerns of slowing growth. Considering the long-term picture, coupled with GOOG shares historically being overvalued, Google’s current valuation is attractive. Google a the dominant player on the internet with a strong competitive position that will provide sustained growth and high margins for many years. In the internet space, Google is a must-own, and finally its valuation is reasonable.

Online Advertising Market Growth:
The internet is still growing in terms of users and usage- More people are spending more time online. Devices such as the iPhone, are contributing to this trend. Online advertising only accounts for 10% of total ad spending. As advertising on the web continues to grow, Google stands to capture a significant amount of expenditures.

TV advertising is facing major battles. Popularity of DVR devices is leading to declines in live viewer-ship as more people are recording content to watch later. It’s very likely that a significant number are skipping through commercials while viewing their recordings. According to an IBM study, 25% of US households own a DVR device, and 53% claim the majority of their TV viewing are recordings.

In addition, the proliferation of available television channels and content has dispersed the audience around the dial. This implies that on any given channel, there are less viewers. Audience dispersion encumbers advertisers seeking a mass audience in a single place (network TV). Declines in TV advertinsing will result in increases in web advertising.

User-generated content, such as videos found on YouTube are boosting web usage. The explosion of blogs, as well as more free content from the media and press are also catalysts. Print readership, newspapers and magazines, is declining, yet readership online is growing. Advertising spending will follow audiences online, and Google is well-positioned to benefit.

Market Share Growth:
Google’s share of online search is more than 65%, while Yahoo, the closest competitor, is only around 20%. Google’s share has been rising, while Yahoo’s has been falling. Google’s search engine is far superior to the alternatives, so much that “Google it” has become part of the English lexicon. As the web continues to expand, search is critical for navigation, thus Google will always be relevant.

Google dominates the paid-search category, which generated high ROI for advertisers. Yahoo has been stumbling for the past few years which has allowed Google to build a sizable lead. The fact that Microsoft is making a bid for Yahoo, is an admission that it can’t compete with Google. I don’t know that buying a company that can’t compete with Google either, will help Microsoft. I believe that the merger discussions are a distraction for both, and are giving Google the opportunity to further increase its lead.

Google’s growth potential is just not limited to paid search. Implementing ads in YouTube videos presents another avenue for growth. The acquisition of DoubleClick will boost display advertising revenues. In addition, Google has been experimenting with online applications for software as a service (SaaS) possibilities.

Valuation:
According to Yahoo Estimates, Google is expected to earn $19.98/share for FY08 and $24.91/share for FY09. Google trades at 22x and 17.6x FY08 and FY09 EPS, respectively. A 22x multiple is attractive considering the growth potential and its duration. Google is highly profitable, with operating margins over 30% and a net margin around 25%.

In comparison, Amazon’s multiple is 46 and Yahoo is trading at a 60 multiple. Google is more profitable, and I believe has better growth prospects than the two.

My discounted cash flow model returns a fair value of $537. Sales are assumed to grow 25% per annum for the next five years, then for years 6-12 growth steadily decreases to 3%. Operating margin assumption is 30% for the next five years then decline to 18% in the next 7 years. I believe these are conservative assumptions and suggest that Google is undervalued by almost $100.

One caveat, is that current earnings estimates may be too high, thus Google’s actual multiples are higher. While this might make Google less attractive, I think the focus should be on Google’s industry position, industry growth and duration.

Risks:
A significant risk is that Google will squander shareholder value by making poor investments. Google is actively exploring multiple new forms of growth, which can be both positive and negative. Firms must take risks to create value; however, taking the wrong types of risks can be detrimental.

Summary:
Google’s strong brand and dominant position in search guarantees strong growth and profitability for many years. Online advertising will continue to increase, and Google is well positioned to capture those ad dollars. Google’s valuation is attractive, 22x this years estimated EPS given 28% growth. Even if Google’s growth turns out to be less than expected, the length of time that growth will be above average, will be longer than expected. This is primary point that the market is missing.

Friday, March 14, 2008

Festival of Stocks #79 @ Fat Pitch Financials

This week’s 79th edition of the Festival of Stocks is at Fat Pitch Financials. Be sure to check out this week’s articles!

My article Chesapeake- Top Energy Play was included in this week’s edition.

Special thanks to George for hosting this week’s festival.

You can catch up on past editions by visiting the Festival of Stocks homepage. There you can also find out how to submit an article for next week’s Festival or learn about how you can volunteer to host an edition of the Festival of Stocks on your own blog.

Friday, March 7, 2008

Chesapeake is a Top Energy Play

Chesapeake Energy (nyse:CHK) has risen more than 20% since the end of January and hit an all-time high. CHK shares have been driven mostly by the rally in natural gas prices and strength in the energy sector. Short interest has been increasing, as some investors are betting on a pullback, yet the CEO has been taking the other side of the trade buying more shares. Natural gas is on an upward trend and may find a higher sustained price range. In follow up to my earlier writings on CHK: CHK- Earnings and CHK- Smart Money, here are some other bullish points.

Natural Gas Price Momentum.

Natural Gas prices have been on a tear recently. There has been an increased, longer-term bullishness on the commodity. One reason stems from bloated storage levels that are being worked off. Current levels are about 5% higher than the 5-year average, down from levels that were nearly 35% above 5-year average. Gas has a difficult time moving higher when excess supply exists.

Demand should strengthen as well. Natural Gas is a clean energy, and there has been no shortage of “green” dialog recently. This heightens the pressure for utilizing the clean resource in place of dirty fuels when feasible. Coal energy is a target. Investment bankers are expressing reluctance to engage in bond deals for new coal power plants. Bankers express apprehension about future legislation on carbon emissions that could financially penalize power plants. The fear is that revenues that go towards paying down the bonds would be diverted to paying for carbon credits or some type of pollution permit. (see WSJ article) Five coal powered projects in Florida have already died in the last year, forcing utilities to shift to gas.

Crude oil generates 6 times as much energy than an equal amount of natural gas. This implies that natural gas should trade at 1/6 the price of oil, and historically this has somewhat been the case. Currently, the ratio is almost double. With crude at inflation-adjusted all-time highs, there should be a push towards exploring the use of natural gas since it’s relatively cheap. For applications where natural gas substitution is possible, stronger efforts will be made to use the cheaper alternative. Crude has shown no signs of backing down, and likely will only go higher. Certainly this will be the case in the long-run as accelerating demand continues to outstrip decelerating supply. Natural gas is cheaper, produced domestically and abundant.

Natural gas has been stuck in the $6 to $8 range the past two years, but the CEO believes a multi-year trend is emerging that will result in natural gas prices in the $8 to $10 range. Futures prices support McClendon. Generally, NG prices pull back during the summer months when demand drops, and storage withdrawals switch to injections. However, the future curve depicts higher gas prices all the way out to March 2009. Not only does this suggest higher prices in the future, it also benefits CHK now since it’s an active hedger. CHK applies more coverage than most its peers, reducing sensitivity to the commodity. While this can cap gains to the upside, it limits downside exposure that could destroy a producer. I think it’s a very smart move. Management is placing certainty on an uncertain variable. Natural gas prices are set by the market, and CHK has no control as price-taker. While many companies rely on volatility as a source of profits, CHK focuses on aspects it can control, such as its competitive advantage it drilling.



Increasing Production and Higher Cash Flow

In the last several years, Chesapeake went on an acquisition binge. The company snatched up land at favorable prices during a time when natural gas prices were falling. CHK funded a significant amount of this land expansion with the use of debt and preferred instruments that eventually convert into equity. This has resulted in the share count to almost double over the past five years. Since then, net income has increased five-fold, yet EPS has only doubled. The dilution has caused frustration for some investors. However, share dilution is not always negative, as the term often has a negative connotation. As long as the capital raised from the dilution creates more value than the amount of value diluted, then it’s a positive move. For example, if EPS is $1, but a share issuance doubles share count and reduces EPS to .50, then value will be enhanced when the proceeds generate new $1 EPS, increasing total EPS to $1.50. Dilution caused the outstanding shares to double, yet investors are better off because EPS increased 50%.

Chesapeake has completed its land acquisition phase and is now focusing on development of those reserves. Production will increase, and in a pro-rata basis, capital needs should be reduced. Increased production will generate higher levels of cash flow further reducing needs for external capital. CHK has also announced its intentions of using asset sales as a source of funds, and not access the public capital markets. Not only with this drastically slow the rising pace of the share count, but enhance value though the asset dispositions. Reserves that have little or no future upside for CHK can be sold at almost 2x the level as implied by CHK’s share price. Going forward, CHK will capitalize on the assets that came at the expense of diluting the equity and produce returns justifying those actions. This should quell apprehension among investors and remove any overhang in the stock price that may have arisen from it.

CEO Continues to Buy Stock

Chesapeake’s CEO, Aubrey McClendon, is not stranger when it comes to insider buying. McClendon has been buying aggressively recently, purchasing 600K shares in the last week of February even while CHK shares are hitting all-time highs. Back in January, McClendon picked up more than 500K shares around $36. Barron’s reported earlier in the week that since July 2003, McClendon has bought 254 million in stock at an average price of $28.61. He has been an astute investor as well: data from Thompson Financial indicates that CHK shares have increased 40% in the 6 months following McClendon’s 61 prior buying occasions. He is halfway there on the January buys.

The CEO thinks shares are poised to keep moving up, and he has a track record of being right. It’s often a good idea to follow the smart money. We, as investors, will never have as much information and tools to analyze CHK as McClendon, thus his investment opinion will always be more qualified and informed. Opposed to a gradual rise, CHK’s share price increases in spurts, followed by longer periods of sideways movement. It appears CHK is embarking on its next leg up to a new trading range.

Short Interest Continues to Increase

Chesapeake’s short interest has increased for the past two periods, which has proved to be a poor bet as the share price has risen. I wouldn’t bet against CHK. Certainly not for the long-term, as I am very sure CHK will go much higher. In the short-run, I can’t be so sure. A pull-back is highly possible, and obviously that is what the shorts are betting on. However, the energy sector is exhibiting strength in a very weak market and economy. There are fundamental and technical factors supporting CHK shares. The strong momentum could continue to drive CHK higher. In addition, the increased number of shorts could add pressure if momentum continues, further contributing to higher share prices from a short-squeeze. Hence, in my opinion, the short interest is positive since it represents future share demand, and is not a result of fundamental problem with the company of sector.


Disclosure: long chk

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