Ming Lo Investing

Stockwatch: Tracking the ITT Breakup

Posted by admin on November 27, 2011  |  No Comments

Many articles speak of the opportunities in break ups, but in my experience, capitalizing on them can been challenging.  I’ve been tracking the ITT breakup in previous posts:

http://www.minglo.com/investing/2011/01/stockwatch-itt-choices/

http://www.minglo.com/investing/wp-admin/post.php?post=1217&action=edit

As a refresher, let’s take a look at where we were at the time of the split announcement:

At the time of the breakup, which was January 2011, the thought was that the sum of the parts was a total of $62-70.  Over the last year, ITT traded as high as $64 the day the split was announced, and since then, has traded as high as $60 three times, but failed to go above that level.  Since August, the weakening global outlook has cut the trading ranged to the the mid-$40 area.

A year later, that value seems far away.  Of course, the macro environment has changed severely, so that has to be taken into account.  Still, as an investor, it’s good to think about what the best strategy would have been.  Let’s take a look at where things are now:

On the left hand side we have estimates provided by Bank of America/Merrill Lynch analysts.  Before November 1, 2011, when the split occurred, they placed the total value of the stock at $45 or so, around where the stock was trading just before the breakup (the ITT had a reverse 2-for-1 split, so adjusting for post-split, the prices of the three stocks post breakup would total $54 based on BAC/ML estimates).   This represents some of the information available before a break up to aid us in decision making.  Prior to the break up, there’s not much information available other than company estimates and the work of a couple analysts.  Consensus estimates are limited, and obviously, little trading information is available other then when-issued prices in the days prior to the split.

The figures on the right show what has happened since.  Consensus estimates vary from BAC/ML’s estimates, showing that reliance on any single analyst opinion has limited use.  It also shows the limited ability to predict prices before a split.

On the day of the split, on November 1, 2011, the three stocks traded as high as $57.81 in total.    Keep in mind that this is not equivalent to the pre-split price because one of the stocks, ITT, had a reverse 2-for-1 split.  To accurately compare, you would take the ITT price of $18.80 on the day of the split and subtract half, or $9.40, for a total of $48.41 as a comparable number.

Since then, ITT has risen slightly, while the other two, Exelis (XLS) and Xylem (XYL) have fallen.  Exelis, the defense portion, has fallen the most – 25%, which may be due to the fears regarding defense budget cuts in Washington.  Xylem, the water business, has fallen 15.8%, which is actually the piece that many were favoring pre-split.  The water business may have been hurt by international exposure.  The stub ITT, which was considered respectable and didn’t really get much buzz, is the outperformer, up 1.4% even in a bad month for the S&P.

In total, the three stocks are down 12% since the split.  Of course, you also have to remember that the S&P has had a fairly serious pullback in November.

What can we learn from all this?  Based on what we see so far, and keeping in mind that this is just one data example, we can derive the following hypothesis for trading the next spin-off opportunity:

(1) As we have often preached, macro conditions outweigh any considerations of value.  Selling at resistance of $60 has been been the best choice so far, especially given the recent corrections in the market.

(2) With the weakened outlook, the highest price was achieved on the day the split was announced.  Therefore, it’s not clear that holding until the split is a good course of action unless the market is in an upswing.

(3) The stock rose somewhat into the split, and the three stocks together achieved the highest price on the day of the split.  Afterwards, two of the three stocks faded.  This makes sense because many of those who were in the stock for the split exited on the of the split and the days following.

(4) The ITT stub has fared the best, while the much ballyhooed water business has faded.  Macro fears may be a major factor here, but it goes to show that pre-split predictions play second fiddle to macro concerns.

(5) It is difficult to say whether the three stocks have stabilized given the highly volatile environment.  So we need to continue tracking to derive more hypotheses about how to handle spin offs.  Also, many have speculated about takeover possibilities, a scenario which may not materialize for some time.

One of my clients is long ITT, XLS and XYL.

Stockwatch: ITT Choices

Posted by admin on January 19, 2011  |  1 Comment

Recently I wrote about ITT, which had just announced a spin-off.  A client of mine holds a large amount of ITT, so I follow it with interest.  Plus, I believe there are often opportunities in spin-offs, but they involve a lot of decisions.

As the chart below shows, on Wednesday, January 12, 2011, ITT announced a spin-off and it quickly shot up to almost to $64 before closing the day at about $61.50 or so.  Since then, it has drifted downward, closing at $58.30 today, January 19, 2011.

I wrote in my last piece that a known event – a spin-off at the end of the year – can be a mixed blessing.  The break-up value of ITT has been estimated at anywhere between $60 – $74, with the possibility of further value if the spun-off entities are acquired in the future.  The problem is, it can take a long time to realize that value.  If we were to take the high end of the break-up value, say $70, that value can’t be realized until ITT is broken up and the spin-offs can be valued independently (and then their values would total $70).  In the meantime, the fast money – the traders and the arbitrageurs – were in and out of the stock on Wednesday, January 12, when the gapped and traded between $60 and $64 on volume of $20 million (compared to $2.2 million normally).  Other traders are getting out of the stock, figuring that not much will happen in the meantime.  This accounts for the slow drift downward.  Note that this could have gone either way – if the market thought that there was value on the table, the stock would be drifting upward.

In retrospect, it would have been best to sell the morning of the announcement, but hindsight is 20/20.  Now we know the market’s opinion, given the stock’s downward drift.  The question now is, hold  or sell?  The stock could continue to drift downward, since many will expect not much to happen until the spin-off is close to being realized.  The only other known catalysts would be earnings.  Plus, much of the market feels that a correction is due.  So that’s the argument for selling.  If we believe in the future value of ITT, then we could buy it back as the spin-off approaches.

Is there an argument for holding?  Let’s look at the potential upside and downside.  In terms of upside, unless earnings are exceptional, I think we’re unlikely to get much upward movement until the spin-off approaches.  If you don’t hold the stock, you would buy if (1) you think earnings are exceptional; or (2) you would buy for the spin-off, in which case you may wait until summer, closer to the actual spin-off date.  On the downside, if we look at the long-term chart of ITT, we see that the $58 level has been long-term resistance, which could now turn into support.  So if the stock builds a base and stays at the $58 level, then we could hold.  But if it breaks below $58, it may make more sense to pocket some profits.

Stockwatch: ARM Holdings (ARMH) Overvalued

Posted by admin on January 17, 2011  |  No Comments

ARM Holdings has been getting lots of press lately, so it was with interest that I watched Bill Griffiths interview Aalok Shah of D.A. Davidson and Brian Colello of Morningstar on Friday, January 14, 2011.  Their thoughts on ARM Holdings:

• Clients include Qualcomm, Broadcom, Texas Instruments, Nvidia and recently announced Microsoft
• Major Intel competitor
• ARM doesn’t make chips, but licenses design.  Every time a chip sold, 1-2% royalty fee (usually 1%) plus license fee
• Great business model, especially as market shifts to smartphones with 3, 5, sometimes 8 chips with higher price content
• Tablet market could also be huge, estimate 50 million tablets, $60 of chips per tablet, ARM earns 1%
• Acquisition unlikely because involved in so many companies, too many anti-trust issues
• Overvalued, to justify valuation, have to think tablets will wipe out PC or Intel won’t make a chip to fight back
• ARM dominates mobile market, but Intel is strong and has lots of cash
• Colello’s price for ARM is $16, vs. $26 today. Estimates that tablets may be a 200 million units, but handsets could be 1.5 billion units, so tablet space might not be as fruitful as expected
• Shah thinks that ARM is overvalued, there’s a takeover premium in the price and it’s time to take profits

I do not own any shares of ARMH.

Stockwatch: INTC Gets No Love

Posted by admin on January 17, 2011  |  1 Comment

You would think Intel would be a great stock to own.  It’s a leader in tech, a bellweather, a hallmark of the computer age.  And if you looked at Intel’s earnings report from Thursday, January 13, 2011, you would think you’d be very enthusiastic.  Intel beat expectations, and it’s Q1 forecast crushed analyst predictions.  And yet, the stock has failed to rally, and is in the red on high volume.  Hmm…

Let’s first look at the results of the Q4 report:

- Q4 2010 revenue of $11.5 billion, vs. $11.37 billion estimate from the analysts, and above the midpoint of Intel’s $11.0 – $11.8 billion forecast

- EPS of 59 cents, vs. analyst estimates of 53 cents

- Gross profit was 67.5%, vs. analyst estimates of 66.7%

- Q1 2011 revenue estimates are $11.1 billion to $11.9 billion, vs. consensus estimates of $10.74 billion and EPS estimate of 44 cents

- Intel sees revenue growing 10% for the full year

It didn’t long for cold water to be thrown on the party.  A series of worries immediately followed:

- concerns that tablets would put a dent into PC growth, and that Intel was overestimating PC sales.  ”We have a difficult time seeing a mid-teens growth year for PCs in 2011… We believe Intel is underestimating the impact that tablet sales will have on the PC market,” writes BMO Capital Markets analyst Ambrish Srivastava.  He estimates 7% revenue growth, vs. Intel’s 10%.

- worries that despite Intel’s increased capital spending, the company will not be able to fight off ARM based chips not only in the tablet market, but also in the Windows-based PC market.  Microsoft’s announcement that it would support the ARM architecture only amplified this concern.

- the belief that despite the new Sandy Bridge platform, Intel will have a hard time gaining share, given that it already has 93% of the PC market and 86% of the notebook market.  Plus, prices declines average 10% per year in this market, inventories are rising and lots of capital spending.

In sum, the bear punditry says Intel is the “old” architecture that will soon be taken down by the new wave, smartphones and tablets.

On the bullish side, the pro argument includes:

- a continuing PC refresh, especially from emerging markets

- strong growth in chips for corporate servers for cloud computing centers.  The servers are needed to handle the massive growth in data traffic

- ramp up of new products, including the Sandy Bridge architecture with higher speeds and integrated graphics, as well as Ivy Bridge, the smaller 22 nanometer design (compared to 32 nanometer today) scheduled to hit the market in the second half of the year.

- some analysts believe that Intel can fall short of the 10% revenue target but still hit EPS targets.  Plus, there’s some benefit from buybacks.

- other analysts believe that Intel will still have strong earnings without any tablet or smartphone revenues.  So if Intel makes any headway in tablets and smartphones, or manages to come up with products that challenge the ARM architecture, there will be upside in the stock.

- valuation is low at 10.8x 2011 EPS estimates of $1.96 and 10.0x 2012 EPS estimates of $2.10, based on Friday’s closing price of $21.08.  Also, there’s a dividend of 63 cents, or 3%.

Personally, I think it’s important not to underestimate a major player like Intel as well as the cash and resources it brings to the table.  And often, reports of the death of a dominant, ingrained technology are often exaggerated.  Nevertheless, I do expect Intel’s stock to be under pressure for some time.  It’s now entered the “show-me” mode – prove to us you’ll still a winning team and not some old, washed up one ready for retirement.  Because of the limited upside in the short- to medium-term, this makes Intel a good call-selling candidate if you already own shares.  We do have identifiable catalysts coming up – Sandy Bridge in Q1 – Q2, and Ivy Bridge in the second half of the year.  Plus, I do think it’s Intel is gearing up to fight ARM.  This would argue for holding Intel for possible upside in the second half of the year.  Downside support is around $19, and the 150-day moving average is at about $20, so if Intel falls to $19-20, this would be a good buy range.

I own shares of INTC.

Stockwatch: ITT

Posted by admin on January 13, 2011  |  No Comments

Today, ITT announced that it would split into three independently traded companies: a water-related business, a defense segment and an industrial company.  The stock jumped 16.5%, from $52.78 to $61.50 on the announcement alone.  As it happens, one of my clients has a fairly large position in ITT.

Much was said in the press about how this signaled the end of the conglomerate age.  That may very well be true, but as an investor, the important question is, “What is ITT worth?”  Alex Roepers, of Atlantic Investment Partners, estimates that the water business is worth $5.5 – $6.0 billion; its motion-and-flow control units are worth $2.0 billion; and the defense business, based on a multiple of 6-7x, would be worth $4.0 – $5.0 billion (see Barron’s “Backstage Power” from Friday, December 24, 2010).  That puts ITT’s breakup value at $63-$71 based on 183.6 million shares outstanding.  An analyst for Deutsche Bank estimates the break-up value at $60 – $70.  KeyBanc believes the breakup value could be as much as $73 per share.  As we get closer to the break-up date, we will no doubt get more details.  In the company’s press release, ITT estimates the proforma revenue of the water business to be $3.6 billion; of the industrial business to be $2.1 billion; and of the defense business to be $5.8 billion.  The chart below shows the math:

Many believe that the individual parts will be acquired once they are split up.  For one thing, with revenues of $2.0 – $6.0 billion, the parts are digestible by many companies.  General Electric, Parker-Hannifin and Danaher could be buyers for the water business.  Lockheed Martin could be a buyer of the defense business.  An acquisition premium of 15-25% wouldn’t be unusual, but of course, that all depends on the likelihood of buyers stepping forward.

As for timing, ITT, in its statement, said that it expects to execute the transaction “by the end of the year”.  An acquisition, if it takes place, will likely occur within the year after the break-up.

So what’s an investor to do?  If you already hold the stock, this is a good problem to have.  Usually, a spin-off does not realize its full value until sometime after the breakup.  That’s because the spin-off’s earnings must stabilize to realize their theoretical value.  If that theory is correct, then the spin-offs might reach a total value fo $70 in about a year an a half to two years, for a potential 33% gain from the pre-split closing price of $52.78 over a two year period (conservative estimate).  If there is any multiple expansion within the next year because of the economic recovery, that could add a little bit to the potential return.  Plus, the dividend is $1, or 1.6%, so there’s a little be there.  So the argument for holding is pretty good.

What about valuation?  2010 EPS estimate is $4.31 and 2011 EPS estimate is $4.75, meaning that ITT trades at 14.3x 2010 EPS and 12.9x 2011 earnings.  If we were to assume that ITT were to achieve a more market comparable multiple of 15x by year end 2011, then we have a $71.25 stock, or a 15.8% gain from today’s price of $61.50.  Add the yield of 1.6%, and we’d be at 17.4% projected return (assuming no discount in the market at the end of the year for the spin-off).  So the argument even for buying is respectable, although a wise investor (like Buffett) would want an even higher return so that there’s a margin of safety.  Again, a potential future acquisition could make it even more interesting for a buyer.

In the shorter term the stock could trade either way, a known impending event is sometimes a mixed blessing.   Still, this smells like a situation where there might be something good in the kitchen.

Stockwatch: MHS

Posted by admin on January 11, 2011  |  No Comments

MHS -(Medco Health Solutions) CEO David Snow appeared on CNBC today.  The salient points:

- largest mail order pharmacy in the US

- serves about 65 million Americans

- 2011 guidance is 12-17% GAAP EPS growth for $65 billion

- drivers of growth: generics (small), medicare growing well, mail, net new sales, Accredo business (biotech specialty) grows well, international (infancy), UBC clinical research company also growing

- November 11, 2011 Lipitor goes off patent, full year impact in 2012; Plavix plus five other drugs going off patent in 2012; Mr. Snow seemed to say that up to 60 cents a share impact in 2012 (he didn’t finish his sentence)

- why are businesses picking MHS?  retention rate is 99% in last two years.  It’s because of clinical innovation, how to manage and reduce costs, makes medicine more precise, way healthcare is evolving.

- biotech will growth from 17% of drug spend up to 40% of spend (611 biotech drugs in clinical phase 2 and 3).  also because small molecules are cheap in biotech.

- United represents 17%, contract up  in the summer, Mr. Snow does not expect to lose them as a client.

I am long MHS for a client.

Stockwatch: Dell Earnings

Posted by admin on November 18, 2010  |  No Comments

Dell reported earnings today, Thursday, November 18, 2010, with results that surprised Wall Street.

Revenue came in at $15.4 million and actually missed analysts’ consensus estimate of $15.7 billion.  What surprised Wall Street was the profit number: earnings of 45 cents a share (excluding certain items) vs. estimates of 32 cents a share in the fiscal third quarter.  Dell benefited from cheaper component prices and corporate spending.  Consumer spending remained weak, and public spending was respectable.  Cisco, which had recently announced disappointing results from the public sector (down 25% from a year ago, down 48% from the previous quarter), had led to worries that Dell’s public business would also be impacted.

Here’s the quick summary:

Revenue: $15.4 million vs. $15.7 consensus estimate

Gross Margin: 19.5%, vs. 16.6% in the quarter ending 7/30/10; vs. 17.3% in the year-ago quarter ending 10/30/09

EPS: 45 cents per share vs. 32 cents per share consensus estimate (excluding certain items)

Consumer Products: + 4%, representing 19% of Dell’s business

Large Enterprises: + 27%

Small- and Medium-Size Businesses: + 24%

Public Sector: + 20% (includes government, hospitals and other institutions; includes results from Perot acquisition)

Dell’s mobile products unit will be closed and merged into other parts of the company.  The head of the unit, Ronald Garriques, is expected to leave the company.

Here’s my commentary:

The most interesting aspect of this report is that after years of what seemed to be a shotgun acquisition approach, Dell seems to be settling and trying to focus on its strengths.  What gives me that impression?

- Lower component prices implies a greater focus on execution and supply chain management.  Dell does say that they expect prices to bottom next quarter.

- Dell has stated that it declined contracts where they might actually lose money.  So, they’re not going for share at any cost.

- They are shutting down the mobile division after disappointing results.  So they are admitting that its not working as well as they would like and moving on.

Interpretation:

Does this mean Dell is on track for a recovery?  Here are my takeaways:

- Dell remains focused on the corporate customer, where it has the bulk of its sales.  It’s likely to be buoyed by the refresh cycle, which seems to be moving along (and bodes well for Intel, HP and Microsoft).

- Despite Dell’s attempt to expand the consumer business, that remains weak.  It’s hard to tell whether that’s because the consumer is weak or because Dell has done well in this area.  Probably a bit of both.

- Some of the acquisitions are beginning to pay off.  The results include the Perot acquisition, so that is working.  Remember that many said Dell was overpaying and playing catch up.  That may be true, but it’s helping now.  Also, to be truly accurate, we have to consider that acquisitions may be acting as a buffer.  For example, the 20% growth in the public sector includes results from the Perot acquisition (by the way, a fact missed by many of the news summaries).  One wonders if the results would have been more like Cisco’s if Dell had not been on the acquisition hunt.

Outlook:

- Dell expects continued growth from “ongoing client refresh among large corporate accounts and strong growth in enterprise products and services”

- Q4 revenue expected to track in-line to slightly up from Q3; commercial demand remains stable while consumer demand remains more muted

- Full year revenue expected to be mid-point of 14-19% range set earlier in the year (outlook re-affirmed)

- Non-GAAP operating income growth of 28-32%

Stock Evaluation:

All this is interesting because it makes Dell an acceptable stock to hold, as opposed to an off-limits (i.e., a hold instead of a sell).  I still think there are better plays, but its not as bad as it was.

DELL PE @ $13.67 (today’s close, probably higher by tomorrow): 9.5x 2011 earnings, 11x 2010 earnings.

HPQ PE @ $41.69 (today’s close): 8.2x 2011 earnings, 9x 2010 earnings.

MSFT PE @ $25.84 (today’s close): 9.6x 2011 earnings, 11x 2010 earnings.

So purely on a numbers basis, HPQ remains the better buy.  Dell looks comparable to Microsoft on a PE basis, and I would say Microsoft is more stable.  So as mentioned, not a clear winner of a stock, but potentially no longer an outcast.

I am long DELL.

Stockwatch: Citi (C)

Posted by admin on October 19, 2010  |  No Comments

Citigroup had good earnings this Monday morning, but the stock got caught up in (1) “foreclosuregate”; and (2) the market pullback today.  A shame, because as of today, the government resumes selling its shares of Citigroup.  The government is slated to sell 1.5 billion shares until the next blackout period preceding earnings, starting December 31, 2010.  Afterwards, the government will still have another 2.1 billion Citigroup common shares to sell.

As an investor, this means that you would see selling pressure on Citigroup shares until at least the end of Q1, and perhaps even into Q2.  So if you want to be a trader, we have the same pattern that we’ve been seeing: buy prior to the blackout period; expect Citi to rise during the blackout period; and then sell before the end of the blackout period as the selling pressure resumes.  This will continue into Q1 or Q2 when the government finishes selling its 3.6 billion shares.

I own Citigroup (C) in my account and for my clients.

Stockwatch: Hewlett-Packard (HPQ)

Posted by admin on September 28, 2010  |  No Comments

Today, Hewlett Packard told analysts:

- EPS for fiscal year ending next October is expected to be $5.05 to $5.15, compared to the $4.99 projected by analysts

- Revenue will be $131.5 – $133.5 billion, a little stronger than the $131.4 billion estimated by analysts

HP has been hit recently by several concerns – the departure of former CEO Mark Hurd, weakness in the computer industry.  At a 9-10x multiple, this would put HP stock at $45.45 – $50.05.  I like HP here, and the appointment of a new CEO within the next month should give the stock a small boost.

I own HPQ for myself and for my clients.

Stockwatch: Credit Cards (V, MA)

Posted by admin on September 27, 2010  |  No Comments

So I’ll tell you  upfront that I favor credit cards.  The long-term thesis seems very strong to me – the world is using more and more plastic; emerging middle classes around the world will use more plastic.  Even with mobile, I think the main players – Visa and Mastercard – will get involved and dominate that arena as well.  I do own Visa for myself and my clients.

Now the question is, what to do about this thesis – when to buy (or add) and how much?

Let’s look at the current situation.  And for the moment, we’ll look at the chart of Visa (Mastercard’s price action has been very similar).  Visa stock was chugging along at the beginning of the year, hitting a recent closing high of $96.59.  Then the flash crash and the European debt fears hit, and the stock tanked with the rest of the market.  Visa stock fell to the $70 level, about a 28% drop, as the market fell to 1040 on the S&P from the 1217 level, a 15% (or so) drop.  So Visa fell by much more than the market.  Still, by mid-June, Visa looked like it was making a comeback, rallying back to about $80 on June 21.  The next day, the Durbin admendment on interchange fees was revised, and it seemed that the legislation, which wasn’t expected to pass, would make it into the final version of the financial reform bill.  Visa promptly sank again, heading back to the $70, which for much of the summer served as resistance.  But as you can see from the chart below, Visa had a series of declining highs while maintaining the $70 resistance level.  To technicians, this is a very negative pattern and implies that eventually, the stock would break the $70 level to the downside.

In August, Visa broke $70, but rallied back to the downward trend line.  Finally, in September, analysts gave in and downgraded the stock.  This drove the stock decisively below the $70 mark, and frankly, things didn’t look good.  In my opinion, here was a case where Visa would do fine in the long-term, but the market could do some real damage to the stock price in the short term.  Also, similar legislation had been passed in Australia, and in that case, the credit card companies adjusted and consumers paid more fees.  Still, analysts were very negative, and some were arguing that the basic credit card processing model would suffer irreparable damage.  Here’s a sampling of the commentary:

(1) On September 8, 2010, Bank of America Merrill Lynch analyst James Kissane downgraded Visa to underperform and cut his price target to $70 from $81. “here is growing risk of a discontinuity in the growth and margin profile of the networks…”  For Visa’s fiscal 2011 year, “we forecast that Visa will generate 58.8% operating margin. With less pricing power, more pushback from large customers and potential disintermediation, we believe margins will plateau over the next couple of years and then likely decline.”

(2) From www.thestreet.com on September 9, 201o, “5 Credit Card Stocks to Sell”: “From a technical perspective, shares of Visa just broke below some big support levels at around $70 to $68 a share. This is very significant because these support levels had offered refuge to the bulls for almost five months. I believe that when it’s all said and done, Visa will retest $40 a share, if not fall even further. A downtrend for this stock has completely taken over right now, and buying shares for anything but a trade is going to be a risky proposition.” Here’s the link: http://www.thestreet.com/story/10856768/3/5-credit-card-stocks-to-sell.html. (thestreet.com isn’t a Wall Street analyst shop, but it’s interesting how negativity gets amplified.  I don’t think any Wall Street analyst would have called Visa at $40 a share.)

(3) On September 13, 2010, Sanford Bernstein analyst Rod Bourgeois cuts his ratings on Visa from “Outperform” to “Market Perform”.  He also cut his price target on Visa to $77 from $93, and on Mastercard to $216 from $268. Tiernan Ray from Barron’s summarized Bourgeois argument as follows: “There is a high probability both Mastercard and Visa will see negative consequences, perhaps in a year from now, as their ability to raise fees on debit cards is “largely eliminated,” Bourgeois notes. There is also a high probability the two will face increasing competition in the “PIN” debit business” as the Durbin regulations impose “no exclusive networks” and “no routing restrictions” requirements on the market.  There are also overseas threats, such as Europe “permanently” regulating interchange rates — rates charged to merchants — on cross-border transactions, writes Bourgeois.”  Bourgeois further writes, “We think investors in upcoming periods will be eager to see if V and MA will try to raise prices, and we think investors will increasingly conclude that their pricing power is impaired…  Moreover, we see meaningful risks of additional negative surprises… and we reiterate that V and MA investors will need to get used to substantially-lessened pricing power (detracting substantially from the bull-case of the past)”  Here’s the link to the Barron’s summary: http://blogs.barrons.com/stockstowatchtoday/2010/09/13/visa-mastercard-bernstein-cuts-to-hold-bad-surprises-in-store/?mod=yahoobarrons.

All very negative, to say the least.

But then, the tide of bad news started to turn.

(1) On September 14, 2010, Mastercard announced a $1 billion buyback plan and projected 20% annual EPS growth from 2011-2013.  Deutshebank, Susquehana and Barclays all cut their revenue and EPS estimates for Mastercard.  However, Oppenheimer & Co. analyst Glenn Greene maintained an “Outperform” rating on the stock, maintained his $260 price target, and said that the stock was “highly attractive” because it was trading at 13x his fiscal 2011 earnings estimate.  Mastercard also said that the Durbin amendment would not have a material impact in the short term, and debit opportunities would increase in the medium term.

(2) On September 14, 2010, Visa stated its belief that the Durbin amendment affects PIN debt rather than signature debt.  PIN debt – involving transactions that use a PIN – represent about 16% of revenue.

(2) On September 20, 2010, Discover (DFS) reported earnings of 47 cents a share for the three months ending August 31, 2010, compared to the average estimate of 38 cents from analysts.  The company released $187 million of funds reserved to cover future loan losses, while write-offs for loans considered uncollectible fell $101.5 million to $899.5 million  from $1 billion in the previous quarter.  In sum, Discover was more profitable than expected and credit improved.

This combination of news implied first, that credit trends were improving; second, that the Durbin legislation could affect a smaller percentage of review than the market was anticipating; and third, that significant revenue growth (20% by Mastercard’s account) was still possible over the medium- to longer-term.  To be sure, risks remain.  The rules are still being written and we may not know their full impact until the latter half of 2011.  But the market may also have overestimated the potential damage, at least for the next 6-12 months.

As we can see from the chart, Visa stock started to rebound, and broke above the downward trend line.  Visa may very well have bottomed for the time being.

Let’s look at one other component before we finish here: valuation.  90 days ago (so about June), 2011 estimated EPS for Visa was $4.69 per share.  I actually don’t have the April estimate (when the market topped and Visa was at $96.59, but let’s assume it’s the same, or $4.69.  That would imply that Visa may have been trading at 20.5x earnings in late April 2010.  Today, Visa is trading at $73 with a consensus estimate of $4.72 per share in 2011 EPS.  This implies a 15.5x multiple.  In reality, these numbers could be misleading because analysts estimates lag market price action.  But this does say that if Visa can acheive a 15-20% EPS growth rate, then the stock would be inexpensive.

If so, then we have a very classic, and almost textbook case of a high-flying stock, knocked down by the macroeconomic environment and by regulatory fears.  As the story goes, investors sold first and asked questions later.  The drop in Visa was swift and severe.  Very late in the game, analysts downgraded the stock, and in this case, that may very well have been the signal that we were near a buy point.  As it turns out, when the companies finally reported the estimated impact of legislation, reality was not as bad as the fear.  That being said, I have to re-iterate – volatility has not disappeared in the credit card stocks.  Economic weakness and regulatory uncertainty remain.  We still may see rules that could significantly dent the earnings power of these companies.  But at this point, that is more a possibility than a certainty, in my opinion.

As mentioned, I own Visa for myself and for clients, but do not own Mastercard or Discover.