Keith McCullough's  Instablog

MORNING HIGHLIGHT:  TECH SPEC AND THE RISE OF THE BANKER  

I first started calling for a re-emergence of Tech M&A in late March (March 24th to be exact) and we’ve seen this thesis play out in spades thus far in the 2Q.  I listened to The 451 Group’s M&A call yesterday and here are some interesting stats along with my sense of where we go from here.
 
The month of April was the biggest month in terms of deal activity since June 2008 and April activity outpaced the prior 4 months – combined.  In April, there was more than $20Bn dollars of deal flow versus roughly $16 billion the prior four months.
 
Thus far in the 2Q09, there have been 612 deals for a total value of roughly $43Bn versus 646 deals done in 1Q09 for a measly $9Bn.  Clearly the big deal is back and while the first quarter was the first quarter in years to not have a $1Bn dollar deal, we’ve had 8 thus far in the June quarter (including eBay/Gmarket, Oracle/Sun and now Data Domain).
 
Deal valuations have compressed in a meaningful way (1.8x Price/TTM Sales in 1H08 versus ~1x Price/TTM Sales in YTD1H09) – but the floor’s been set and we are off to the races.  Median valuations in the 1Q09 were 0.9x Price/TTM sales versus 1.2x this quarter thus far. 
 
As I see it, this is just beginning.  First, it is interesting to note that we have a bar-bell of sorts unfolding.  We have sales of distressed assets (JAVA) and deals of high-quality growth companies (DDUP) – so buyers have a breath of appetites.  What’s more, some of these deals have been game changing (i.e.:  Oracle/JAVA) and this puts further pressure on the sector to consolidate.  Whether it started with EMC’s purchase of VMW (as some have argued) or Cisco’s move into Servers, status quo doesn’t cut it any longer and both vertical and horizontal consolidation will unfold over the coming quarters and years.  Tech companies with liquid balance sheets and a desire to thrive in the next cycle are going to continue to look for IP to acquire, distressed assets and/or potentially game changing deals.
 
I’ve discussed the below before, but as a reminder - some of my favorite Tech Spec names include:
 

Palm (PALM): The smart phone and mobility secular tailwind is massive and global and software will be a key differentiator. PALM owns its operating system, has core software competencies, dedicated developer following and differentiated product. This is an asset that can’t be duplicated overnight, if at all – so it is clearly an attractive takeout candidate from that standpoint. The Pre is just the beginning of PALM’s return to relevancy. The company boasts a solid management team. Short interest is massive (less relevant for this discussion, but at 29% worth noting). With an Enterprise Value of roughly $2.4 Billion, the EV/Total Addressable Market (TAM) is compelling.

 

Red Hat (RHT): Open-source and cloud compute are share gainers within the Enterprise compute market. RHT boasts a compelling position within the Linux/open-source community and will prove a key enabler of cloud compute. With roughly $3.50 per share of cash on its balance sheet – this is a profitable and strategic asset. Importantly, the Oracle/JAVA transaction serves as a wake-up call to the industry – both in terms of a shifting competitive landscape as well as the relevance of strategically-oriented outflank-initiatives. If IBM doesn’t snap-up RHT, someone else will.

 

BMC Software (BMC): BMC represents another strategically placed, relevant Enterprise software vendor that should benefit from the Oracle/Sun Microsystems transaction. The company’s portfolio of products and toolsets are differentiated, competitive and relevant. Great margins, $4.00+ of net cash and a “not too tough to swallow” valuation land BMC squarely in the Two-Banger bucket.

 

Electronic Arts (ERTS): Solid portfolio of first-party properties (great content) and seculars which are misunderstood. While investors are focused on “this cycle is over”, management teams with a long-duration will quantify the value of the content and appreciate that the industry seculars are changing in positive ways (shift to mass-market increases TAM and shift to console-less improves economics). ERTS has a solid balance sheet with net cash, compelling margin potential and digestible valuation.

 

Atmel (ATML): Strategically well-positioned semi company with a clean balance sheet and market share gaining products and technologies. Microchip and On Semiconductor wanted to buy Atmel for $2.3Bn in October of 2008 – current market cap is under $1.8Bn. The cycle is just beginning; buy low. 

Disclosure ERTS

Research Edge Position: Long COW

I suspect that Keith is a Canadian cowboy at heart. I arrived at this suspicion based on several clues: 1) last Halloween he came in to the office dressed in full cowboy regalia, 2) when he and I first met it turned out that one of the few friends that we had in common was the former two-time national Bull riding champion of Canada (it takes one to know one principle, myself notwithstanding), and 3) his tendency to shout "Hoowah!" when trades work out better than anticipated.

Thus when he first asked me what I thought about the ETN COW last year, I realized that I had to take it seriously, because it might well end up in the portfolio.  Since then it has remained on the back burner of my market universe. Our decision to go long this week was based on a convergence of factors: Keith was attracted by the technical set up that it was presenting, several underlying fundamentals looked compelling, and it ties in with our overlapping macro view on reflation and the US consumer.

COW tracks an AIG commodity sub-index that consists of Live Cattle and Lean Hog front month futures contracts. The mix is currently 62.27% front month Live Cattle, 37.73% front month Lean Hogs. 

SEASONAL INFLECTIONS:

Although earlier today I wrote that I have a bias against historical comparables, for agricultural commodities, the seasonality is undeniable.

Traditionally, US beef consumption is greatest during cold weather months, and supply levels are driven by the spring calf breeding cycle/late summer slaughter cycle. The start of slaughter cycle coincides with lower consumption patterns to drive prices down in late summer, while prices tend to rise in March and April when demand typically is still  high but supply is at its lowest after the slaughter cycle has ended and the breeding cycle just begun.

In the chart below I illustrated the 20,15,10 and 5 year average indexed price returns for the front month LC contract under the current year. Although earlier today I wrote that I have a bias against historical comparables, in this instance the seasonal inflection is undeniable. Clearly the futures are currently underperforming historical seasonal averages as macro factors weigh on anticipated demand.

Pork demand also follows a seasonal pattern, but the price pressure inflections for that market are different because the breeding and slaughter cycle tends to be based on the corn harvest since farmers breed heavily in advance of the cheapest feed prices. As such, supply is at its lowest in midsummer during comparatively low demand.  Like cattle, Lean Hog futures are currently outside typical seasonal inflections.

Now keep in mind that these are just general rules based on long term historical observations (which I have stated on multiple occasions that I tend to discount), but in agricultural markets it is dangerous to ignore seasonality.

CURRENT ENVIORNMENT:

• Current USDA forecasts anticipate that both Beef and Pork production will be reduced for 2009 based on statistical data showing declining slaughter and carcass weight measures.
• Canadian Pork exports are forecast to decline more sharply than US production as overlapping local factors have driven feed prices higher simultaneous to a strengthening Currency versus the US Dollar. Next Friday's quarterly USDA Hog report should provide a better picture of the developing import situation.
• Argentina's Ministry of Agriculture officially estimates that cattle production will decrease by 13% this year due to decreased demand from customers like Russia. Unofficially the disastrous policies pursued by the Kirchner regime have driven Argentine farmers to despair and it has been reported by some media sources that the country may become a net importer for the first time since 1871. Getting hard data on the impact will be difficult as the Ministry stopped generating monthly data in November of last year.
• Although the work Howard Penney is doing in the restaurant sector shows that the dining industry continues to face a challenging environment, the data continues to suggest that the situation has not deteriorated to levels initially anticipated for mass market food retailers as cheap gasoline; cheap food prices and cheap money have left broad domestic consumption patterns relatively unscathed.

OWNING THE COW:

So now we have COW in our portfolio with supporting seasonal inflections, a solid technical setup and a some positive fundamental data points. That doesn't mean there aren't risks involved, primarily tactical in nature. For starters there is always a liquidity risk trading livestock futures, and during summer months the volume can get especially thin. Also, since the ETN tracks the Index, during each delivery month the product must "roll" into the next series: this roll impact will result in a divergence between the continuous front month levels and the ETN performance.

For now we remain long US livestock and will continue to own the COW for as long as the data supports our thesis.

Yipppie Kay Yay.

Yesterday's CPI buys more time for the "free money" cycle. Buying time can be expensive.

Keith and I talk about history frequently. I know a bit about a fairly broad range of economic and political history, in part because of my education and in part because of my interests. Like many students of history, I have a tendency to massively discount its importance in the decision making process. To my mind, the more you know about past events, the more you understand the unique factors involved with each and, as such, the less confidence you will have in drawing conclusion solely based on corollary. When discussing yesterday's consumer inflation data I told Keith that the current environment seems anomalous to me, and those looking for clues in the reflation puzzle will be frustrated by historical comparisons.

At -1.28%, yesterday's CPI reading arrived at the lowest level since 1950 when the massive deflation/reflation cycle that followed the end of WW2 were wreaking havoc on global commodity markets (see chart below).

This reading leaves the fed with ample room to keep easy money train rolling at next week's board meeting and also provides the market with clear signals that the return of year-over-year inflation growth will not arrive until mid to late Q4. This breathing room gives the economy more time to recover but that time may come at a steep cost:  with the scales tipped so far in one direction, even modest catalyst could trigger inflationary pockets rapidly, providing a nasty "snap-back".

One of our core ideas coming into 2009 was the demise of correlation of returns for different asset types, and this will be critical in our approach as we position ourselves to profit when inflation does finally raise its head.  We anticipate significant divergence inside the commodity matrix as overlapping demand factors and currency valuation throw the momentum mentality that worked perfectly in the 07-08 boom out the window in favor of market specific fundamentals. In other words, in the cycle that we see on the horizon, soybeans won't necessarily go up because Chinese demand for coal increases, and gold won't necessarily go down because the Brazilian cotton crop is larger than expected. 

As such homework will be required and, if history is any guide, many investors will not do the assigned work and fail the exam.