London-based publisher of The Financial Times and Penguin Books Pearson PLC (PSO) is reportedly looking into the possibility of selling their 61% stake in Interactive Data Corp (IDC).  Pearson is signaling that IDC, while a fairly large portion of their business is non-essential to the company’s strategy going forward.  In their view it seems IDC as a market data and analytics provider does not mesh with their other assets which are largely educational (about 60% of revenue) and mainly sold to retail clientele.  In contrast, IDC’s clients are mostly large financial institutions.  The Bedford, MA based Interactive Data Corp could find a number of potential suitors in firms that reach a similar clientele such as McGraw-Hill (MHP), Bloomberg LP, Thomson Reuters (TRI) or even private equity.

Pearson’s stock is trading slightly higher today as this may help them streamline their business and provide about $1.5 billion in capital.  IDC is surging about 13% in afternoon trading.  Pearson will not guarantee that anything will happen or any sort of time table, as they are simply exploring their options at this point.  However, the market is clearly excited by the prospect that IDC may be sold (potentially outright) in such a move.  An analyst at UBS (UBS) said that the sale of Pearson’s stake would allow IDC to utilize cash flows more appropriately to focus on better growth areas.

Coming into the day, we had a Fairly Valued rating on Pearson and an Undervalued rating on IDC.  IDC is clearly priced less attractively following the surge in today’s action but we think it may still have value based on the company’s strong underlying fundamentals.  For example, in the past ten years the market has been willing to pay 3.4x to 5.0x revenue per share, and after today’s run-up the stock is just now touching the bottom end of that range.  On a price-to-cash earnings basis, the stock has historically traded for 13.4x to 19.9x, but as of the time of this note, the current metric was only 12.6x.  Based on the current fundamentals, we think that IDC could reasonably sell for $34 per share.  It will surely take time to more fully understand the future for these two companies, but as of this moment the market seems to be cheering on the possibility of a sale.

Despite a very challenging retail environment, Target (TGT) is moving full steam ahead with its store expansion plans.  They are scheduled to open 26 new stores on October 11th, a move that will reportedly create some 5,000 jobs.  Five of the stores will be SuperTarget stores, meaning they will have a full-grocery offering, the rest are general merchandise stores. 

Target is hoping to take a large portion of holiday shopping, and they are optimistic that shopping trends at Target are starting to firm after consecutive monthly declines.  August same store sales showed a decline of 2.9%, but that was far better than the 5.1% projections.  Store traffic was flat for the month of August, which is encouraging compared to dismal second quarter results. 

Target stock was downgraded by UBS (UBS) to “neutral” recently based on what the analyst termed a “tarnished image” and “long-term concerns over Target’s perception amongst consumers.”  In order to back up what seems to be subjective reasoning, they cited studies showing that Target has lost 14% of its customers over the last several years and of those shopping at Target 31% are spending less.  At Ockham, we find these data points to be a reasonable, but a little bit flimsy as justification of a downgrade.  With consumer spending on the decline for a number of quarters, we would be interested to see these numbers compared to an industry benchmark.  The analyst does concede that September same store sales should benefit from the Labor Day shift, and the stock may get a boost from it.

We believe that the all important holiday quarter could be a good one for Target.  They are trying to become more aggressive on prices to make them more competitive with Walmart (WMT), and the two retailers have already started a price war on toys.  Target is never going to be able to beat out Walmart on pricing alone, but Target is known to consumers as a higher- end discounter.  Consumers subconsciously evaluate stores for the best price-value combination, and Target can use its higher perception of quality to its advantage.

As of this week’s report, we are maintaining our Undervalued rating on Target.  Even though the stock has appreciated massively, 87.5% since the market’s March nadir, we think that there is further potential there.  The new store openings and the aggressive pricing is a signal to the market that Target is doing everything it can to turn the corner and earn an even bigger slice of holiday shopping.  Based on the current fundamentals, Target is trading slightly below its established historically normal price-to-cash earnings and price-to-sales metrics.  We think that even with a slower recovery than many are expecting, Target could trade in the low $50’s in the next year.

“Another story we’re closely following today and that is involving Charles Schwab. New York Attorney General Andrew Cuomo expect today sue Schwab the company for civil fraud according to the Wall Street Journal.  Auction rate securities, we talk about them, fixed income vehicles, value reset at auction, allegedly sold like cash, and many have settled over this. They said they’re like cash, easy to sell, but when the markets, froze up behind the credit crunch in February and they did stop supporting the auctions and several brokerages agreeing to buy back from clients.  Charles Schwab has not and we’ll see what comes from this. We’ll keep an eye on that.” Fox Business Network 8/17/2009

New York AG Andrew Cuomo’s crusade against brokers and investment banks who peddled Auction Rate Securities has hit a road block with Charles Schwab (SCHW).  While most banks who have been targeted by the investigation have been anxious to settle and make this problem go away, Schwab is holding their ground.  The trouble started last year when the credit crisis struck, and the market for auction rate securities became extremely illiquid.  The market was controlled by a small number of Wall Street banks who stopped making a market for the securities, in light of the risks associated with them as the credit market was in crisis last summer.  Institutions and wealthy individuals who had been sold the securities had believed that they were relatively safe and highly liquid instruments, but were left holding the bag in the summer and fall of 2008.  The lawsuit alleges fraud in the way that the ARS were marketed to clients.

Schwab is the first firm to really stand up against the accusations of wrong going in any meaningful way, as Citi (C), JP Morgan (JPM), Bank of America/ Merrill Lynch (BAC), UBS (UBS), and Morgan Stanley (MS) have all settled.  In most cases, the settlement included the banks buying back the ARS’s from clients at par value.  Charles Schwab contends that it did nothing wrong and could not have predicted the financial crisis that brought the credit market and ARS market to its knees.  Furthermore, form Schwab’s point of view, it simply distributed the securities and any fraud that occurred was with the underwriters.  Clearly, the firms listed above who have settled have played a different role in the crisis than Schwab as underwriters, and perhaps should be punished differently.

The total amount of ARS held by Schwab clients totaled $789 million, but now with the impending law suit Schwab will need to set aside a pretty penny in legal fees as well.  According to the Wall Street Journal, “The lawsuit, filed in New York State Supreme Court in Manhattan, alleges Schwab knew or was reckless or negligent in not knowing about rising problems in the auction-rate securities market beginning in August 2007.”  It will be extremely interesting to see how the courts will handle this case, because Schwab’s defense seems to be bordering on negligence saying that they were unaware that of the risks of ARS.  That being said, we are not attorneys and would not suppose to understand the intricacies of this case.

Schwab stock is down a little more than 4% today, and we have reaffirmed our Fairly Valued rating on this stock.  Schwab has certainly stuck its neck out on this one, and taking on Mr. Cuomo is risky as so many others have been anxious to sweep this under the rug. 

On Tuesday, we wrote about Deutsche Bank’s (DB) earnings release which signaled the bank was protecting itself against further difficulty ahead (A Cautious Tone for Deutsche Bank).  The bank worried investors by devoting a great more resources to loan loss provisions than any analysts had expected, a seven-fold increase.  The stock is down 13% this week, and it has suffered downgrades from UBS (UBS), FBR Capital, and Morgan Stanley (MS).  Just a few days later the largest German bank’s CEO Josef Ackermann explained the rationale behind the move.

“The crisis is not over.  When one looks at the developments of global economic growth, then it can be expected that starting in the second half of this year we slowly move into the positive territory. But we’re still moving on a low level…

We were disciplined in our considerations about what risks which we should take.  If we had played it out to the full extent, we could have earned significantly more.” – Josef Ackermann

Ackermann assessment hinges on rising delinquencies among both consumer and corporate borrowers.  Being the CEO of the largest German lender, Ackermann thinks it is prudent to shrink the balance sheet and set more reserves aside for the prospect of any further economic weakness.  Clearly, Deutsche Bank could have made more money in the last quarter were they more aggressive, but eurozone unemployment continues to rise and we think cautious behavior should not be ostracized after the financial meltdown we experienced last year. 

We are not recommending Deutsche Bank shares at current levels, and the risk averse methods of the bank will impact profitability if economic conditions continue to improve.  That does not mean that Ackermann is wrong though, and we have gained respect for his ability to stand in the face of the conventional wisdom that recovery is on the way.  We tend to agree with Ackermann that there are still quite a few difficult headwinds for lenders that will put pressure on banks’ balance sheets once again.  It seems that Deutsche Bank’s board is okay with taking the more defensive tact as they have recently extended his employment contact through 2013.

Harley-Davidson, Inc. (HOG) has endured some very bitter comments from analysts in the past couple of trading sessions.  On Friday it was a downgrade to “Sell” from a Citigroup (C) analyst that sent shares tumbling 7% on the day.  On Tuesday a research note out of UBS (UBS) piled on the bad news, as they revised their earnings estimates downwards because second quarter sales results appear to be worse than anticipated.  However, in contrast to the sell-off instigated by the Citi analyst, today the stock fell close to 10% in the morning and then battled back throughout the day to end nearly even for the trading session.  The fact that HOG shares rebounded so strongly could be a signal that the bulls are taking control and the shares will be resilient to further weakness.

It is no surprise that this market environment is a very difficult one for the iconic Harley-Davidson brand.  The company’s sales are slumping down 35% from last year in the second quarter, as referenced by the UBS analyst.  The obvious problem is that no one needs to buy an expensive motorcycle, and there is no doubt that sales of luxury goods are going to struggle in a recessionary spending environment.  Furthermore, the secondary market for Harley’s has never been more active as cash strapped Harley owners look to unload their bikes for cash, and even worse for Harley, used bikes that have been repossessed from less than creditworthy borrowers.  Which brings us to the anchor that has weight down Harley more than any other, Harley Davidson Financial Services or HDFS.  HDFS was greatly effected by the credit crisis as the secondary market for Harley loans vanished.  At the same time, HDFS was making loans to sub-prime borrowers in order to boost slumping sales as we detailed back in December of 2008 in Not So High on the HOG.  That was a recipe for disaster as evidenced by the stocks substantial decline.

“Take a look at stories we’re following. UBS is cutting full year earnings forecast for Harley-Davidson telling clients that the reducing of the motorcycle makers profit outlook is now to 96 cents a share down from $1.49 because sales in the U.S. have hit a wall. Harley-Davidson shares tonight down a fraction.” CNBC’s Closing Bell 6/9/2009

When looking at Harley-Davidson from a value perspective a lot of the traditional valuation metrics look promising, including price-to-sales of .73x versus the historical range of 1.95x to 3.21x.  Price-to-cash earnings look similarly depressed compared to historical norms for HOG stock.  After all, the greatest value investor of this generation Warren Buffet is standing behind Harley with a $300 million debt purchase.  However, there is more than meets the eye to that deal, Buffet is receiving 15% annual dividend payments which is more than twice the interest rate normally associated with junk bonds. 

Value investors must try to pick stocks that are not only beaten down, but also have good prospects for a recovery.  That is what separates a value stock from a value trap.  In that way HOG can be a polarizing stock, on one side of the argument you have those that believe the Harley-Davidson model is broken and baby boomers will need to put more capital towards rebuilding their retirement than buying an expensive motorcycle.  On the other side you have those that believe that the significant strength of the Harley brand will enable it to thrive once again, and this is simply a temporary set back as many other companies are experiencing now.  The fact that the market shook off the disparaging comments from UBS regarding Harley’s disappointing sales could mean that the optimistic value investors had the upper hand today but that could change tomorrow. 

At Ockham, we value companies from a long term value perspective, which yields an Undervalued rating for Harley-Davidson shares.  That does not mean that the worst is over for Harley as 2010 could present new challenges for the Harley’s fiance division, but an improvement in the economy and the credit markets would help this stock with a beta of 2.15 rebound relatively quickly.