Martha Stewart Living (MSO): Upgrades to 2 STARS (sell) from 1 STAR (strong sell)
Analyst: William Mack, CFA
We think the planned merger between Sears (S) and Kmart (KMRT) has favorable implications for Martha Stewart's merchandising unit. The company has partnerships with each, but we see royalty revenues via its long-term licensing agreement with the latter comprising more than 60% of all operating profits through 2006, assuming the merger receives necessary approvals and is consummated. We are raising our sum-of-parts-based target price to $18 from $15, reflecting a resulting per-share increase in Martha Stewart's overall value that we estimate at $150 million.
Sears, Roebuck (S): 3 STARS (hold) from 1 STAR (strong sell)
Analyst: Jason Aseada
Sears and unranked Kmart Holding (KMRT), headed by financier Eddie Lampert (See BW Cover Story, 11/22/04, "The Next Warren Buffett?"), signed a definitive agreement to merge into a new retail company named Sears Holding Corp. Sears shareholders will have the right to elect to receive $50 in cash or 0.5 share of Sears Holding for each Sears share; elections will be prorated to ensure 55% conversion into Sears Holding shares. The current value of the transaction for Sears shareholders is about $11 billion. The merger is expected to close by the end of March, 2005, subject to shareholder and regulatory approvals, and customary closing conditions. Pending approvals, we believe the merger would have product, cost, and competitive synergies. We think these are achievable but see integration and execution risks, given the companies' divergent cultures and customer mix. Sears believes the cash option at $50 offers an attractive premium to its historical mid-$30's share price. Based on the companies' conference call, we conclude that Sears' dividend will likely end after the merger. Nonetheless, our opinion remains hold, since some metrics, including price/sales and real estate valuations, suggest a competing bid is not out of the question.
Merck (MRK): Reiterates 2 STARS (sell)
Analyst: Herman Saftlas
Merck's debt ratings were cut to AA- from AAA by S&P Credit Market Services (CMS, a separate entity from S&P Equity Research Services), citing pipeline and Vioxx litigation risks. Agreeing with CMS, S&P Equity Services reiterates its sell opinion on Merck, based on our view of the company's lackluster pipeline, probable flat to lower earnings over next few years, ongoing Vioxx headline risks, and uncertainty over sustainability of $1.52 dividend (a 60% payout based on our 2005 estimates). Our 12-month target price remains $23, based on blend of our forward p-e and discounted-cash-flow models.
Vornado Realty (VNO): Reiterates 3 STARS (hold)
Analyst: Raymond Mathis
Vornado has a stake in Sears, which with Kmart announced a merger pact. Subject to approvals, Sears holders would get either $50 cash or 0.5 share of the combined company. Vornado recently began buying Sears shares and call options. We calculate that its gain on Sears shares could be about $11.9 million. The Sears options have a strike price that rises based upon LIBOR plus a spread, and are more difficult to value. However, we think Vornado's potential gain on the options is about $80 million. We see a likely 70 cent per share benefit to Vornado, which may lead to another special dividend.
Cisco Systems (CSCO): Reiterates 4 STARS (buy)
Analyst: Ari Bensinger
According to data released by independent research firm Dell'Oro Group on Nov. 16, Cisco gained meaningful share during the third quarter across all categories of the $11 billion Ethernet switching market. In layer 2, representing 50% of the Ethernet switching market, Cisco increased its dominant share by 2.5% to 81.9%, with no other vendor having market share more than 5%. In layer 3 (47% of the market), Cisco garnered a 66.5% share, up 1.9%, despite intensified pricing competition from Asian manufacturers. In the small but emerging layer 4-7 (4%) segment, Cisco increased its share by 1.6% to 43%.
Hewlett-Packard (HPQ): Reiterates 3 STARS (hold)
Analyst: Megan Graham-Hackett
The technology bellwether posted pro forma Oct.-quarter earnings per share of 41 cents, vs. 36 cents one year earlier -- 6 cents above our reduced forecast. But we note that 2 cents of that upside was due to a lower tax rate and fewer average shares outstanding; the rest was due to expense cuts. Revenues of $21.4 billion were above our model as the company improved execution in its Enterprise unit and capitalized on backlog left over from last quarter. But gross margin missed our estimate. H-P sees first half fiscal 2005 (ending October) EPS of 72 cents to 74 cents, slightly above our forecast, on a lower tax rate. However, we are cutting our full-year fiscal 2005 EPS estimate by 7 cents to $1.50 on a lower gross margin assumption. With the shares trading at price to sales ratio of 1 times, below the peer average, we would hold H-P.
Network Appliance (NTAP): Reiterates 2 STARS (sell)
Analyst: Richard Stice, CFA
Network Appliance posted October-quarter earnings per share of 16 cents, vs. 9 cents, 2 cents above our estimate. Revenues rose 4% quarter-over-quarter, aided by low-end offerings. Gross margin widened on a more favorable product mix, as software accounted for over one-third of total revenue. We are raising our fiscal 2005 (Apr.) earnings-per-share estimate by 3 cents to 62 cents, and our 12-month target price by $2 to $21. While October-quarter results were above our expectations, we remain concerned with competitive challenges, valuation and earnings quality. Shares recently traded in excess of 40 times our calendar 2005 earnings-per-share estimate, about 2.5 times the level of the S&P 500.