Arbitraging Barron's Pt.-II

This week, Barron's offered the second installment of their annual roundtable.  We discussed the first part last week, which we must say was a little dull.  This week was more fun, if for no other reason, then that the various participants actually through out some picks. 

Editor of the High-Tech Strategist newsletter, Fred Hickey, was quite interesting:

Fred, want to take over?

Hickey: Sure. I have three shorts and three longs, just to show I'm a balanced guy. I'll start with the shorts because they are more fun. The first is NetLogic Microsystems, priced around $29. It is a favorite of momentum players, chart gazers and "get shorty" types that ran up this and a lot of other tech stocks at the end of the year. The stock is up 60% since October, 140% since it came public in July 2004. The company makes TCAMs, ternary content-addressable memory chips. They go into networking equipment. When NetLogic's products came out they had an early lead, but that is lead is diminishing. This is a commodity product. Cisco [CSCO] accounts for 70% of NetLogic's business. IDTI [Integrated Device Technology], the market leader, has a stronger product and NetLogic is going to lose share.

How expensive is NetLogic stock?

Hickey: The P/E on trailing earnings is 39. The P/E for this year's earnings is 30, yet the forecast EPS growth rate is just 12% in 2006. The stock sells for seven times sales and 8.4 times book value. There has been a lot of insider selling -- half a million shares in the past six months. My second short is Sandisk, which Barron's wrote about negatively last year. I think my timing will be a little better.

Thanks for the compliment.

Hickey: SanDisk has been tough to short. It's running up on rumors it will have blowout earnings when it reports Jan. 26. The stock was up 152% last year, to 63, and 18% in the first week of January, to 74. It is the world's largest supplier of flash storage cards. It sells primarily NAND flash, used in MP3 players and digital cameras. The stock sells for six times book value, six times sales, 42 times trailing earnings and 32 times '06 estimates.

Hickey also pointed to increased competition in Asia from NAND flash producers, who are ramping up their production big-time in 2006.  His third short is Intel, as he believes that Intel will continue to eat their lunch, and that Dell may begin to start offering AMD chips, since AMD is winning on the high end.

As for one of his longs, how's this for a blast from the past:

Hickey: My last long is a tech name. It's pretty hard these days to find value stocks in tech. 3Com is a highly speculative long, a turnaround story. The company has lost out to networking-industry gorilla Cisco in recent years. It was as high as $25 a share in 2000, and it's now $4. Revenues have stabilized after declining for some time. The company has had four consecutive quarters of sequential revenue growth. The last was 22%, year over year. Again, they make routers and switches, just as Cisco does. They have a strong Voice-over-Internet Protocol [VoIP] product line, which is a hot category. They sell security products, due to the recent acquisition of TippingPoint. Their connectivity-product line has depressed overall results, and is nearly gone. 3Com has a $1.56 billion market cap, and $754 million in cash. The enterprise value is around $800 million, or about one times sales. The company burned through $28 million of cash in the latest quarter, but that's been improving. At this price it is intriguing, especially when you consider the hidden jewel.

The hidden jewel?

Hickey: A few years ago 3Com set up a joint venture with Huawei, the largest networking company in China. Huawei-3Com is growing rapidly, and it's causing Cisco great grief. Cisco talks about the Chinese threat in every conference call. The joint venture has grown to a run rate of $500 million in sales, based on the last quarter and the current one. It has had four sequential quarters of double-digit revenue growth. There are 3,400 employees at this joint venture. Half are Chinese engineers, at an estimated cost of one-fifth of 3Com's engineering talent in the U.S. 3Com owns 49% of the company, with an option to buy another 2%. That option has just come up, and Huawei has approved it. If 3Com buys it, it gains controlling interest. It is awaiting approval by the local Chinese authorities as well as Beijing. Once it buys the 2%, all these fast-growing revenues start showing up on its P&L [profit and loss statement].

Is the joint venture profitable?

Hickey: It's near breakeven, and in the current quarter 3Com expects it to be profitable. It has an estimated 20% share of the networking market in China. 3Com can leverage the cost savings by selling products at significantly lower prices than Cisco. 3Com has the potential to be a massive winner or a bust, but for now there's a lot of cash and no debt.

Speaking of Hickey, his newsletter The High-Tech Strategist is highly recommended, and probably one of the most respected newsletters discussing tech, read heavily by Wall St. analysts.  Interestingly, you can't get it online, only in print, which is probably a pretty good way of avoiding piracy.  Paper is, perhaps, the best DRM.

Also interesting was Marc Faber who offers some hardcore contrarianism, and not of the "buy gold, silver and oil" variety, which hardly qualifies for contrarianism in our book:

Faber: For people who are bullish on the U.S., pharmaceutical companies on a relative basis are interesting. Look at a basket containing Merck [MRK], Schering-Plough [SGP] and Pfizer [PFE], all relatively high-yielding stocks. They are particularly attractive if you compare them to European pharmaceutical companies.

Zulauf: U.S. pharmaceuticals trade at a discount of about 30%.

Neff: Aren't you concerned about poor product pipelines and legislation against price increases? These are not the growth stocks of yesteryear.

MacAllaster: They aren't priced the same way, either. There is value here at 12 times earnings and 4% yields.

Neff: Not unless earnings are going to improve.

Faber: If their pipelines were highly promising, these stocks would sell for more than they do now. Next, I've got some contrarian plays. About nine months ago I recommended AMR [AMR], the parent of American Airlines, which was difficult for me, given the service I get on American Airlines. But it almost doubled. The entire airline industry is not going to go bankrupt. Germany's Deutsche Lufthansa is a good play on airlines. The traffic between western and eastern Europe is increasing dramatically. Last year the company took over Swiss International Air Lines. In the near term it probably will generate a loss, but over the long run it is an interesting play on consumer travel. It's going to be huge -- out of India and China, and also in domestic markets.

Gabelli: You can't have a pandemic and travel. You've got to have one or the other. This must be a hedge against pandemics.

Schafer: Marc, what is the impact, if any, on the big carriers from low-cost airlines like Ryanair?

Faber: It is huge. Ryanair [RYAAY] now has more traffic than British Airways [BAB]. But low-cost airlines carry one segment of the market. They don't carry you and me when we travel on business. OK, maybe you. Both can survive. In Asia, low-cost airlines have not had a big impact on Singapore Airlines [SPAAF]. But cheap tickets have changed the world. You can fly between Bangkok and Hong Kong for $100, which has led to an enormous increase in traffic.

Of course, Faber also recommends shorting the US Dollar and long bonds.

Again, due to the limits of legality and lethargy we won't summarize the whole thing.  Still, some interesting stuff, and always an interesting read.

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