Key highlights from Microsoft's earnings report:

1. Its Server & Tools Division generated $2B in net income, up 17% year over year.

2. Microsoft's Entertainment division lead by Xbox had net income that rose 15%.

3. The company also was hit less by the PC slowdown that analysts had penciled in and its online division continue to narrow its losses.

4 reasons to continue to buy Microsoft at $29:

· Its first phone with Nokia [[NOK]] is generating largely positive reviews and new models will follow shortly. In addition, Windows 8 is on track to be released late in 2012.

· Microsoft provides safety with an AAA rated balance sheet and a 2.8% dividend yield. It also has almost $5 a share in net cash on the books.

· Microsoft still sells near the bottom of its five year valuation range based on P/E, P/B, P/CF and P/S. It sells for about 7.5 forward earnings if you take net cash out of the equation.

· Based on this earnings reports, I would look for analysts to raise their price targets and/or their rating on the stock. Credit Suisse has an "outperform" rating and a $34 price target on MSFT.

1.       The market has finally woke up over the past two days to the fact that the European debt crisis might extend past Greece, Ireland and Portugal. The last few months have reminded me of the scene in Monty Python and The Holy Grail when John Cleese is running across a meadow in full charge. Two guards at the castle are watching this for what seems like an eternity. The charging knight always seems a thousand yards off in the distance until he is fully upon the guards. It seems the problems in Italy were out there for months for anyone to see, it’s hard to fathom the market being so surprised by the obvious.

2.       If that wasn’t bad enough, Spain’s problems are even more problematic than what the market is pricing in. online.wsj.com/article/SB10001424052702303678704576439781802458052.html

3.       Bank of America concerned the market that it may need to raise additional equity due to settlements and losses which was one of the drivers of the financial sector losing over 2.7% Monday. online.wsj.com/article/SB10001424052702303678704576440174275159838.html

4.       Debt ceiling talks are stalling as both parties have painted themselves into the corner. This could have a disruptive impact on the market if not resolved in the next ten days. www.cnn.com/2011/OPINION/07/11/gergen.debt.crisis/index.html

5.       Investment banks are expected to report revenues are down 25% in the quarter which speaks to weakness of the overall credit and underwriting markets and will lead to further job losses among their well heeled flock.www.boston.com/business/articles/2011/07/11/banks_expected_to_report_revenue_drop/

6.       Rail car traffic showed anemic growth in June. Not exactly the harbinger of robust economic growth. calculatedriskblog.com/2011/07/aar-rail-...

7.       Doug Kass came out Monday and advised to sell stocks as investor opinion is much too bullish and the risk/reward is not favorable. www.thestreet.com/story/11179922/2/kass-sell-stocks.html

8.       Good story in the Times Monday on the headwinds from the expiration of government support hits the unemployed and other vulnerable segments of society, which will impact consumer spending. nytimes.com/2011/07/11/business/economy/...

9.       The latest small business survey shows little new hiring plans. Given small businesses provide the majority of new jobs, this does bode well for job growth for the rest of the year. online.wsj.com/article/SB10001424052702303812104576437853543049480.html

10.   After hours, on Monday earnings guidance from Novellus and Microchip Technology were disapointing that led to major losses for both stocks on Tuesday. Electronic Arts purchase of PopTops is likely to depress that technology stock on Wednesday.

Be Careful out there.  The summer is going to be a roller coaster

American Electric Power (AEP) - American Electric Power Company, Inc., together with its subsidiaries, engages in the generation, transmission, and distribution of electric power to retail customers. The company generates electricity using coal and lignite, natural gas, nuclear, and hydroelectric energy. It also supplies and markets electric power at wholesale to other electric utility companies, municipalities, and other market participants. In addition, the company operates barging operations that transport coal and dry bulk commodities primarily on the Ohio, Illinois, and lower Mississippi Rivers, as well as operates nonregulated wind farms.

Valuation and Prospects – AEP goes for 12 times this year’s estimated EPS and around 11.5 times 2012’s consensus. The stock now is in the bottom half of its five year valuation range based on P/B, P/E and P/CF. It yields a robust 4.9% after raising its dividend 9.5% late in 2010. Earnings should continue to improve given the $200mm in rate increases AEP received in 2011. It also should benefit from a gradual recovery in the economy.   AEP currently sells for around $37.50. S&P has a price target of $42 on American Electric and the Street is at $43. Nothing exciting, but this stock is primarily a yield of play.

Merck & Co. (MRK) - Merck & Co., Inc. provides various health solutions through its prescription medicines, vaccines, biologic therapies, animal health, and consumer care products. The company’s Pharmaceutical segment provides human health pharmaceutical products, such as therapeutic and preventive agents for the treatment of human disorders in the areas of bone, respiratory, immunology, dermatology, cardiovascular, diabetes and obesity, infectious diseases, neurosciences and ophthalmology, oncology, vaccines, and women's health and endocrine. This segment also offers human health vaccines, such as preventive pediatric, adolescent, and adult vaccines. Its Animal Health segment discovers, develops, manufactures, and markets animal health products. This segment offers antibiotics, anti-inflammatory products, vaccines, products for the treatment of fertility disorders, and parasiticides for cattle, swine, horses, poultry, dogs, cats, salmons, and fish. The Consumer Care segment develops, manufactures, and markets over-the-counter, foot care, and sun care products.

Valuation and Prospects – Merck sells for less than 9.5 times this year’s projected earnings and just nine times 2012’s consensus earnings. Merck at these levels is selling at the very bottom of its five year valuation range based on P/S and P/B and is in the bottom half of it five year valuation range based on P/E and P/CF. MRK has a double AA rated balance sheet, pays a generous dividend yield of 4.4%, and has a low beta of .7.  Merck has a good drug pipeline including an important new Hep C drug. It also continues to get cost synergies from its acquisition of Schering Plough. In addition, Merck is significantly under analysts’ price targets. Merck is selling at just $35 a share.   Credit Suisse has a price target of $44, S&P is at $42 a share and JP Morgan is also at $44 a share on Merck. 

NextEra Energy (NEE) - NextEra Energy, Inc., through its subsidiaries, engages in the generation, transmission, distribution, and sale of electric energy in the United States and Canada. As of December 31, 2010, NextEra Energy had approximately 43,000 mega watts of generating capacity. The company involves in the generation of renewable energy from wind and solar projects. It also generates electricity through natural gas, nuclear, oil and coal, and hydro power plants. The company serves approximately 8.7 million people through approximately 4.5 million customer accounts in the east and lower west coasts of Florida. In addition, it leases wholesale fiber-optic network capacity and dark fiber to telephone, wireless carriers, Internet, and other telecommunications companies.

Valuation and Prospects – NEE sells for under 13 times this year’s expected earnings and just 12 times 2012’s consensus EPS. Next Era Energy has grown earnings an average of just under 10% a year over the last five years and is currently selling at the bottom quarter of five year valuation range based on P/E, P/B and P/CF. It has an A- rated balance sheet and yields a solid 3.9%. It also has raised its dividend payout an average of 7.5% a year over the last half decade. This growth should continue in line with earnings growth. The company has good growth prospects over the long term in its core customer region of Florida and in its growing solar and wind initiatives. NEE is selling at just over $57 a share. S&P has a price target of $62 and Jefferies is at $62.50.

France Telecom– FTE is selling at nine times this year’s and next year’s consensus earnings. Earnings estimates have increased approximately 5% over the last ninety days for both 2011’s and 2012’s projected net earnings. It low single digit revenue growth is offset by a low valuation and a generous yield of 5.7%.

Telefonica– TEF is selling at roughly ten times both this year’s and next year’s projected earnings. It yields a very rich 5.5%. This is one of my favorite high yield stocks, and I have recommended it in other articles. The stock has been punished due to the problems in Spain. However, the majority of its revenues come from outside Spain primarily in Latin America; where prospects are good. In addition, the company’s efficiency efforts in Spain and throughout Europe seem to be yielding good results and offsetting revenue declines there. I believe this company is well positioned for the future and its high dividend yield puts an effective floor under the stock price.

Nokia – NOK is the riskiest of these three picks, albeit the one with the most upside if it can stage a successful turnaround in the smartphone market through its partnership with Microsoft and/or continues to benefit from its market leader status in the low and medium price point share of the emerging market handset universe. Despites its myriad of challenges over the last two years, it has increased operating cash flow by 40% over that time period. It sells at 13 times this year’s earnings and 12 times projected earnings for 2012. It also has over $3 per share of net cash.

The companies I picked represent various parts of retailing universe. They are Sears, Macys, Best Buy, Abercrombie and Fitch, Walmart, Gap, Amazon, Target, Costco, Lululemon, Tiffany, and Apple. Over the time period of January 1^st, 2008 through July 31^st, 2008 the S&P index lost a little over 12% for comparison purposes. After doing the analysis, these are the results:

1.       Costco and Target lost between 7-8% of their value

2.       Tiffany and Best Buy lost between 14-15% of their value

3.       Sears, Macys, Abercrombie & Fitch, Gap, Apple and Amazon lost between 20-28% of their value

4.       Lululemon lost approximately 50% of its value

5.       Walmart actually gained over 20% over this time period

CONCLUSIONS: So what can we conclude from this limited analysis? (A) Stocks that sell staples like Walmart, Target and Costco should hold up better than the market overall and much better than other retail stocks in an environment with high oil prices. (B) Stores that sell higher end items like Tiffany and Best Buy should move roughly in line with the market. (C) Retailers that sell apparel or basic discretionary items like Sears, Macys, Abercrombie & Fitch, Gap and Amazon should fall harder than the market overall. (D) High beta retailing stocks that sell highly discretionary items such as Yoga wear like Lululemon are likely to be hit the hardest in any kind of oil induced pullback. 
 

Given all the geopolitical and domestic challenges the market currently faces, I would be cautious here. Be careful out there.

 

Prognosis: The stock has dropped nearly 10% today after last night’s earnings report which provided tepid forward guidance and missed on the revenue side.   The stock price is about even from where it was a year ago despite significantly increased earnings and revenues over that time period.

Valuation: CSCO is selling for approximately 12 times this year’s consensus earnings and less than 11 times next year’s projected earnings. It has over $4.75/share in net cash on its balance sheet. It is selling near the low end of its five year range for P/E, P/S, and P/CF.

Catalysts: There are several factors that we believe should provide support for a higher stock price in the near and medium term after the disappointment of its current earnings release fades:

1.     The continued growth of the internet, teleconferencing, wireless, etc…should ensure strong growth; especially outside of the U.S.

2.     Company throws off impressive cash flow and has a large amount of cash on its balance sheet. This gives the company flexibility to buy back stock, continue to invest heavily in R&D and/or acquire new growth assets or technologies

3.     Large established customer base provides geographic diversity and gives them continuous upgrade revenue opportunities

4.     Investments in Telepresence, Physical Security, digital media and other emerging technologies should ensure continued new growth channels

Recommendation(s): Given its low valuation, fortress balance sheet, solid revenue growth and strong cash flow; we feel stock is currently undervalued. In our opinion, the stock should be trading at a more reasonable rate of approximately 12-14 times our estimate for this year’s earnings of around $1.75 after stripping out the $4.75/share of net cash on its books. Our one year Target Price is $26-$30, up from the current price of $21.37.