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