Further Thoughts on Insight’s Shorts of Amazon and Centex

In previous posts we have written of shorts of Centex and Amazon in Insight’s model portfolio. Both these companies recently reported earnings. We continue to believe that Centex has at least 10-15% downside from current levels. Based on the company’s shrinking operating earnings per unit, we can easily make a case for operating earnings in the $5.50 per share range for Centex’s 2007 year, even with the company’s stock buybacks. This estimate is well below the company’s guidance of $7.00 per share. As reported in its 8K, the company’s buybacks in the last quarter were at average prices well above its current stock price. Thus, those buybacks were not value enhancing to shareholders. It should also be remembered that buybacks serve to increase leverage, and make the company riskier, as bondholders are well aware. An LBO of Centex is a possibility, but we don’t see the case for it. If we were an acquirer we would be hesitant to buy a homebuilder in this environment, given their risky cash flows. We project that if operating earnings per unit continued to fall at the rate they did in the just completed quarter, Centex’s eps would be well below $5.50 per share. Even if we were determined to buy, why not wait for the stock to trade down to below book value where it has traded before? Centex’s leverage acts as another disincentive for a prospective buyer. We reiterate our view that Centex has 10-15% downside from here. With regard to Amazon, we noted in our post on our blog on 7/12/06 that we were short the stock. This position has been a big winner for us, but the question is where we go from here. We analyzed the stock today in our discounted cash flow model (DCF). Given the company’s lower guidance on operating earnings for 2007, we have lowered our assumptions about EBITDA margins. On that basis, we can see the stock having downside potential to 25 or less. One way to understand the stock being down 5 points today is to understand that given the company’s lower guidance, we estimate that ten cents per share in projected earnings for 2006 may be lost. Given that the company traded for about 40X earnings for 2007, if a 40 multiple is put on ten cents that equates to a reduction in price of $4.00, which is in the range of how much the stock has been down today. But even if we amend our earnings estimate to $.75 for fiscal 2007, the stock is still trading for over 30X that number. As we have said in our previous post, that is a rich valuation. If we were to place a 20X multiple on an estimate of fiscal 2007 earnings of $.75, that would imply a price target of $15.00. Our DCF analysis projects a higher price for Amazon than does our PE analysis. Why? As we stated on our blog on the 7/12/06 post, when the market gets "nervous", it "believes" less in future cash flows. Cash flows are what drive the DCF model. When the market gets "nervous" it relies more on what "is" the case in the present, that being earnings in the near future. Though there may be a short-term bounce from here, we think further price deterioration in Amazon is a real possibility.

 Philip Frank, PhD
President and Portfolio Manager
 Insight Asset Management LLC
e-mail: insight-asset@earthlink.net

Insight is Short Centex/ Shorting and Leveraged Buyouts/ Understated Inflation

Insight has been adding to its short of Centex, the homebuilder. This stock has previously traded below book value, and we see no reason why in this environment it should trade above book. Centex is also one of the more leveraged of homebuilders which makes its position more precarious, and less a candidate for a leveraged buyout. Leveraged buyouts are the bane of fixed income investors, and also of short sellers, and one does need to assess the potential for a leveraged buyout in shorting stocks. Still, given Centex’s leverage, and the instability in homebuilder's cash flows, we don’t see much of a risk of an LBO currently. We think the nasty correction in real estate has far from run its course. When consumer and investor sentiment turns negative on real estate it's very hard to change. It will take something dramatic to turn the tide on real estate, like sustained rate decreases by the Federal Reserve, which Insight does not see happening anytime soon. That said, there is much bearish sentiment on homebuilders, and any glimmer of hope in the economic numbers could set off a short-covering rally in the stock. Still, we think there is 10% more downside in the stock, given the stock trades at about 108% of book, and book value may well be overstated given the homebuilders’ use of options on land, which are off-balance sheet. Shorts now constitute about 30% of long positions in our model portfolio, which reflects our cautious view of the US economy. Some of the most severe geopolitical tensions in the past 25 years further buttresses our cautious view. While too many hedge funds do not truly hedge risk but rather increase it, in our view a truly hedged portfolio composed of longs and shorts can significantly diminish risk in a professionally managed portfolio. We did not view the producer price index number yesterday as positive, the market’s rally yesterday notwithstanding. While the core PPI number was in line with estimates, including food and energy the PPI number was higher than expectations. When food and energy prices are in sustained rises as we believe is the situation presently, the notion of excluding food and energy from inflation numbers is tenuous and serves to understate inflation. Inflation in these two items is causing real pain for consumers, which in our view will contribute to a slowing economy. As we have stated in a previous post, we think Wall Street’s current view that when the Federal Reserve stops raising rates everything will be ok, is incorrect and pollyanish. The Fed will stop raising rates only when there are very clear signs that the economy is in trouble. And when economies do get into trouble, as Japan has taught us well, an upturn can be a long time in coming.

Philip Frank, PhD
 President and Portfolio Manager
 Insight Asset Management LLC
 e-mail: insight-asset@earthlink.net

Why Insight is short Ebay and Amazon

Insight believes there are a number of themes sweeping the US stock market that make shorts of Amazon and Ebay attractive. As our post of July 6,2006 brings out, we have concerns about the health of the overall US economy. Within that theme, as money managers gravitate to more defensive stocks, cyclical and consumer dependent companies are more at risk. One of the lessons of the stock market decline of 2000-2003 was that technology companies are indeed cyclical in nature, and not immune to the fortunes of the overall economy. So we think the tech sector as a whole is risky. We also believe that when the market gets "nervous" high PE stocks become increasingly vulnerable, as the market "believes" less in the certainty of future cash flows. PE multiples afterall are only a proxy for the market’s views of a company’s growth prospects. As well, we believe that the declining PE of Microsoft, a bellwether of the tech sector is having important ramifications. Comparable company comparisons are a major way in which companies are valued. As one company becomes more or less valuable, other companies are correspondingly affected. The forward PE of Microsoft is now 16, down from a PE ratio as high as 70 in 2000. This contraction is having reverberating effects throughout the tech sector. With Microsoft at a forward PE of 16, certainly Amazon’s forward PE of 43 becomes less defensible, and even Ebay’s forward PE of 22 is at a large premium to Microsoft’s. We also do believe that as the economy gets tougher, and given low barriers to entry in technology businesses, tech companies hungry for growth will encroach on each other’s domain. We are seeing it with Google v. EBay, in respect to Google’s new payment software. Strategically, we are also far from convinced of the utility of EBay’s acquisition of Skype. We think Skype faces many challenges from competitors, in an area with few barriers to entry. Amazon too faces forays from competitors, and it is a retailer when all is said and done, making it subject to an economic slowdown. In general, we believe Google, with its entrepreneurial culture and intellectual firepower, casts a long shadow over companies like Ebay and Amazon. There is no sector in the online commerce world which is immune from Google’s aspirations.

Philip Frank, PhD
President and Portfolio Manager
 Insight Asset Management LLC
e-mail: insight-asset@earthlink.net

Thoughts on Berkshire Hathaway

Berkshire Hathaway is a holding in Insight's model portfolio. I heard Buffett speak at a news conference with Melinda and Bill Gates. He talked of the effect of his donation of Berkshire stock on the stock price. He strongly hinted that with the increase in float as a result of the gift that Berkshire would now be a greater candidate for inclusion in the S&P 500. I think this is correct. One stock that I follow Consol Energy was recently added to the S&P 500, and jumped by more than 10% on the announcement. More broadly though for the last several years Berkshire has shown little price appreciation, and I think the big concern has been succession after Buffett dies. My concern had been that after Buffett, Berkshire would be in the hands of Buffett's family who would be resistant as he is to financial engineering such as spin-offs, a sale to an acquirer, a going private LBO, etc. which I think is crucial to unlocking value in Berkshire. Now with the donation and Buffett no longer ultimately a huge controlling block of the stock, there may be some selling as the Gates foundation sells the stock to fund their goals. But in the long run Berkshire stock now has a greater chance to end up in the arms of hedge funds, for example, who could exert the kind of pressure required to unlock value, and I do think the stock is 10% undervalued, perhaps more. So net net I see the donation as a positive development for the stock, though because the donation will be made incrementally over a number of years, it may take some time for the stock to begin to move.

Philip Frank, PhD
President and Portfolio Manager
 Insight Asset Management LLC
 e-mail: insight-asset@earthlink.net

Views on the U.S. Stock Market July 6, 2006

Insight's view is that the stock market is believing now in a goldilocks, soft landing. If the economy strengthens too much, it's not good because the Fed raises rates; if it weakens too much there will be worry about recession. What is the probability that the Fed can pull off a soft landing? Their history is not great. And because of the lag effect of their raising rates, the economic numbers should be weaker going forward. And even if the Fed does stop rasing rates, historically the market has been down months after the stoppage, presumably because of a weaker economy. So though Wall Street is rallying because of its belief that the Fed will pause, historically this has not been a plus for the market. Paradoxically a weaker housing market is going to make the inflation numbers look worse because of the rise in demand for rentals and thus higher rents, so the Fed may have trouble pausing even if the economy weakens. The only thing that's really changed over the past few weeks is the belief that the Fed will not let the economy go down the drain (if it can help it) , and will not be focusing solely on inflation but on the health of the economy as well. Insight believes in this environment it is prudent to be maintaining shorts in a professionally managed portfolio.

Philip Frank, PhD
President and Portfolio Manager
Insight Asset Management LLC
e-mail: insight-asset@earthlink.net



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