Strength Returns

This week, the pessimism of the prior two weeks gave way to a look at economic data that don’t look unhealthy, and don’t change the odds of another interest rate increase next month.

For the week:

Dow +1.2%
Nasdaq +0.8%
S&P; 500 +1.0%
S&P; Midcap 400 +0.4%
S&P; Smallcap 600 +0.8%

Monday and Tuesday brought no economic news and the market floundered in the vacuum, wringing its hands over the prior week’s sea of red ink. The Nasdaq fell 1.6% to a six-month low. Technology bore the brunt of the selling. We took advantage of the weakness to pick up shares of eBay on Monday at $29.

On Wednesday, we finally got some fresh economic data. April durable goods new orders dropped 4.8%, more than expected. The slower pace got a few people thinking that the Fed might not raise rates in June.

Then, April new home sales came in at 1.2 million, a surprisingly strong 4.9% gain. That’s the highest this year. A strong housing market over the past few years has boosted consumer spending with mortgage refinancing and home equity cash. Its inevitable slowdown has been expected to curtail consumer spending and, therefore, hobble the economy. So far, though, the housing market shows no weariness. Consumers can keep their shopping lists and gas tanks full, and that’s good for the economy.

On Thursday morning, the mood got even better at 8:30 when first quarter GDP was revised upward from its initial 4.8% annual growth rate to an even stronger 5.3%.

“Now, wait a minute,” you say. “I thought we wanted to see a slowing economy so the Fed can stop raising interest rates.”

You’re right. What’s missing in the above facts is that economists had expected a revision up to 5.8%. Coming in at 5.3% was the economist’s version of a bowl of porridge for Goldilocks: it wasn’t too hot and it wasn’t too cold, it was just right. It shows an economy that grew faster than we thought, but not so fast that extreme braking is required to keep it in control. Growth without inflation is about as good as it gets in economic circles, and Thursday morning delivered it.

The market rose, led by technology. A multi-year advertising and online payment partnership between eBay and Yahoo, and an agreement between the top computer maker and Google (GOOG) that will include Google search software on the maker’s computers, brought more buyers onto the scene. Shares of eBay rose 12%. Among the big indices, the Nasdaq rose the most at 1.3% for the day.

Nothing follows good economic news like more good economic news, and we got it on Friday morning. The core-PCE deflator, an inflation gauge favored by the Fed, rose 0.2%. That’s less than economists feared it would be, but actually not very low. The Fed wants a year-over-year increase between 1.75% and 2%, and this latest installment puts it at 2.1%, up from 2.0% in March. The market’s positive reaction shows how much the mood changed in a week. Had the report happened a week earlier, the focus would have been on the “above 2%” angle rather than the “less than feared” angle.

This may be the first time you’ve seen the term “core-PCE deflator.” PCE stands for personal consumption expenditures, and is the amount that people spend on goods and services. The Fed likes it more than the consumer price index (CPI) because it tracks a variable basket of goods while the CPI tracks a fixed basket. A deflator is a statistical tool that changes current dollars into inflation-adjusted dollars so we can easily compare prices over different time periods.

May has provided a textbook lesson in market moods. In the last four weeks, we went from ebullient to depressed to cheerful. On May 10, the Fed raised rates and said that it would watch incoming data before deciding its future actions. Because that language didn’t say that the Fed was leaning toward ending rate increases, the market got worried…and started obsessing over incoming data.

But so far, those data have been mixed:

  • The U.S. trade deficit narrowed to $62 billion, lower than the expected $67 billion. (That was good for the economy, but meant that GDP would be higher, which could be inflationary.)

  • The University of Michigan consumer-sentiment fell to 79 in May from 87 in April, the lowest since October’s score of 74. (People buying less is good for keeping inflation at bay, but bad for economic health.)

  • The core consumer price index (CPI) increase for April came in at +0.3%, 0.1% higher than expected. (That showed an inflation risk.)

  • First quarter GDP was revised upward from its initial 4.8% annual growth rate to 5.3%, lower than the 5.8% feared. (A higher GDP could be inflationary, but being lower than feared was a bright spot.)

  • The core-PCE deflator rose 0.2%. (That’s less than economists feared, but puts the year-over-year increase at 2.1%, higher than the Fed’s 1.75% to 2% comfort zone.)

After digesting that mixed bag, Fed funds rate futures hardly budged. They still expect another 0.25% rate increase.

What changed on Wall Street was the mood, not the facts. Remember this well, for it’s the persistent theme of markets. Changing moods change prices, and provide intelligent investors with opportunities. I’m sticking with my forecast for strength in early summer, trouble in August/September, and a rally at the end of the year.

Let’s take a closer look at the leading computer maker, eBay, the number-one semiconductor manufacturer, the Japanese stock market, and an online media giant.

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Leading Computer Maker (SYMBOL, $24.81)

Tue -1.2% | Fri +2.1%

The Kelly Letter bought Investments are shown only to KELLY LETTER subscribers. Click to try the letter for one cent. on Nov. 9 at $29. So far, we’re down 14%.

This week brought two pieces of news from this company. The first is that it’s going to open full-size retail stores. The second is that it’s going to bundle search software from Google on its computers and make Google its default online search page.

The company’s store idea expands on its existing chain of 160 kiosks in airports and shopping centers that have been in place since 2002. Like the kiosks, the new stores won’t carry inventory. Instead, they’ll offer customers a chance to try out the company’s array of products and then order them in the store, online, or by phone. Products will still be delivered to the customer.

The kiosks have done well and the larger store format is just an extension of that retail model. It comes at a good time in the company’s product expansion. While people are familiar with buying PCs and printers online, they are not as comfortable with large-screen TVs and notebook computers. Consumers prefer seeing and touching those items before making a buying decision. The stores give them a chance to do so, while still keeping the company’s direct-sales model intact.

Part of this decision had to come from the fact that arch-rival Hewlett-Packard (HPQ) is selling notebooks at a faster clip than this company, and it’s doing so through retail channels. HP has said for a while that selling by retail as well as direct gives it an edge. It looks as if this company is conceding that point.

That makes perfect sense from a strategic view. After all, every PC maker has copied the company’s direct model and inventory management techniques. That’s why competing firms have lowered their costs and reduced the company’s cost edge. Now, the company is simply copying an aspect of what has worked for its rivals.

Consumers provide just 15% of the company’s earnings. However, they provided most of last year’s growth in the PC market. With business purchases, buyers generally just look over a list of features and pri
ces and do what’s best for the business. With personal purchases, though, the buyer has a stronger interest in getting everything just right including color, style, and feel in addition to features and price. They can do so better in a store than online.

Now, this is not a RadioShack (RSH)-like rollout of thousands of stores across the land. Initially, the company will open just two 3,000-square-foot shops, one in Dallas between July and September and the other in West Nyack, New York between August and October. Dallas I get, but West Nyack? That seems an odd choice. It might be that Dallas is big and West Nyack is small, giving the company a complete picture of the American landscape. According to the 2000 census, only 3,300 people live in West Nyack and its land area is just 2.9 square miles. The median household income is nearly $100k, though. Perhaps that had something to do with the decision to open a computer store there.

The company’s existing kiosks measure just 10 by 12 feet and are staffed by two or three people who provide information and help to place orders. The new stores will be 25 times that size, on a par with Apple’s (AAPL) successful retail outlets. In addition to providing information and making sales, Apple also offers product support in its stores. The company isn’t sure yet if it will follow that lead.

On Thursday, the company and Google announced their deal to put Google software on the company’s computers. Google will also become the default online search for the company’s computers. Each company will share in the revenue, but it won’t amount to much.

The deal appears better for Google than for this company. It will make Google more visible in search, which is important in the firm’s increasingly heated competition with Microsoft. Google is worried that Microsoft will use the new Windows Vista operating system to make using MSN Search easier than other search services. The Justice Department dismissed Google’s concerns earlier this month. Now, it appears that Google has decided to beat Microsoft in the market rather than in the courts. Two weeks ago in Note 42, that’s exactly what I argued Google should do.

The company also benefits from the deal in a small way. It gets a bit of extra profit on each computer shipped. In a nice turnaround, instead of Google receiving income on a pay-per-click ad basis, it will pay the company on a pay-per-ship order basis.

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eBay (EBAY, $34.20)

Thu +12.2%

The Kelly Letter bought eBay on Monday at $29. So far, we’re up 18%.

This week confirmed precisely why we’ve been building a technology portfolio for the past eight months. Tech is beaten down, given up for lost in the shadows of rising commodity prices. In the past several years, however, technology has improved dramatically, markets have expanded, earnings have increased, and yet stock prices have either gone nowhere or gone down. That means the companies have become cheaper while getting better.

They’ve also become a bigger part of the economy and of our lives.

On Thursday, eBay and Yahoo (YHOO) formed a partnership to create mutual growth opportunities.

There are four areas of business covered by the multi-year agreement:

  • Search and graphical advertising
  • Online payments via PayPal
  • A co-branded web browser toolbar
  • Research around “click-to-call” capabilities

Yahoo will be eBay’s exclusive provider of third-party graphical ads on eBay.com. eBay’s PayPal will power Yahoo’s online wallet service.

The latter part should provide a boost to PayPal’s profits. Hundreds of thousands of Yahoo advertisers will now have the ability to pay via PayPal. Customers of Yahoo’s other paid services including premium email, fantasy sports, DSL, and dating will also be able to pay with PayPal.

Parts of the agreement will be in place this year, with the remainder coming to fruition in 2007. There will not be much of an impact on this year’s results.

While I find this to be a great development, I think eBay benefits more.

The extra profits to PayPal are obvious, but equally impressive is the whole new market being created in the form of graphical ads. eBay has a tremendous amount of traffic on its network of sites. Carefully placed ads will provide yet another way to monetize that traffic.

A dissenting opinion on the merger came from Henry Blodget, the former Merrill Lynch internet analyst famous in the late 1990s for his bold calls as dot coms rose, and then infamous for those same bold calls as dot coms collapsed. In 2003, he was charged with civil securities fraud by the SEC. He settled and is banned from the securities industry for life. Nonetheless, he remains an interesting voice in the internet investment discussion. His blog is at www.internetoutsider.com.

Blodget thinks that rather than working with Yahoo, eBay should just sell Skype to Yahoo because the VoIP company would fit a lot better with Yahoo’s communication offerings than it does with eBay’s store. With the proceeds, he suggests that eBay buy Amazon.com (AMZN). He argues that Amazon is going to have a heck of a time in the upcoming battle between eBay/Yahoo, Google, and Microsoft (MSFT). Both eBay and Amazon are stores, so together they’d be a more powerful store and would own that category. That, he thinks, is better than trying to be big in several categories.

There are two problems with that idea, though. First, Amazon might not want to sell. Second, eBay just bought Skype and purports to have high hopes for it. Yahoo’s strength in communications via mail and messenger are, presumably, the reason the two companies are exploring click-to-call capabilities together. Maybe Yahoo brings the marketing muscle and user base while Skype brings the technology. Evidently, eBay thinks there’s more long-term money in collaboration than in just selling the company.

I trust eBay’s judgment over Blodget’s.

Earlier in the week, Prudential Equity Group upgraded eBay from neutral to overweight, citing a compelling valuation after the steep price drop. The firm’s price target for the shares is $40.

Getting there from our entry at $29 would give us a 38% gain. I’m more optimistic. I expect us to make at least 50%, which implies a share price target of at least $43.50.

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Number-One Semiconductor Manufacturer (SYMBOL, $18.22)

Mon -1.9%

We bought Investments are shown only to KELLY LETTER subscribers. Click to try the letter for one cent. on Nov. 16 at $25, on Jan. 31 at $21.50, and on Mar. 3 at $20. Our average buy price is $22.17. So far, we’re down 18%.

I’ve been looking to buy again at $18, but haven’t placed an order yet. The stock moved around the $18 mark for most of this week, bouncing solidly off of $17.80 on Wednesday and Thursday. For now, I’m still watching.

We finally received acknowledgment of our investment thesis from an analyst. As you know, we own this company on the belief that it’s coming back strong after losing ground to its smaller rival Advanced Micro Devices (AMD), which has steadily taken market share over the past year. I like this company’s upcoming product line, and believe that the company will benefit from the broad computer buying that should come from the release of the new Windows Vista operating system in January.

On Monday, Rick Whittington of Caris & Company downgraded AMD from buy to above average, citing this company’s improved line of chips on the way. He also noted that the company will probab
ly get its 45-nanometer architecture out quickly.

What jumped out at me in Whittington’s report was his conviction that the company won’t make the same mistakes again. He said that the “organizational disconnect” between process and design, in addition to the company’s underestimation of AMD’s capabilities, led to poor execution. This is “not likely to be repeated in the period ahead.”

He thinks, however, that AMD still has a window of opportunity to get a little more market share before this company ramps up volume on its new line in Q4.

When that volume comes, though, watch out. He says the Conroe chip will firmly place this company in the leading desktop role and that AMD won’t have a strong response for some time.

Finally, somebody else on Wall Street recognizes that this company’s mistakes are behind it and that it’s working feverishly to right them. It is knuckle-cracking mad over the loss of share in the past year, capped by last week’s announcement that Dell (DELL) would offer AMD chips in its servers. It’ll be the first time in history that Dell has sold a machine without this company’s chip inside. I guarantee that nobody is more keenly aware of the company’s recent shortcomings than the company itself.

What a great time to own shares in the chip giant.

The company will make a presentation this coming Wednesday at the FBR 2006 Growth Investor Conference at the Grand Hyatt in New York City.

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Japanese Stock Market (SYMBOL, $64.51)

Mon -5.6% | Tue -1.4% | Wed +2.3% | Fri +3.3%

We bought into the Japanese stock market on Oct. 4 at $47.20. We sold one-half of our position on Feb. 17 at $64.55 for a 37% gain. The remaining half is now sitting at almost exactly that level of performance.

The rough seas of the past two weeks provided ample proof to us that we need to be out of this fund entirely before the real trouble hits in late summer. Three weeks ago on May 5, it closed at $74.75, representing a 58% gain for us. It then free-fell 19% to Tuesday’s close at $60.77. That kind of plunge in 12 trading days was a valuable lesson. I’m happy that we didn’t sell on Monday or Tuesday, but am still nervous about this fund and itching to find the right exit.

The problem is that Japan’s economy is doing too well. Consumer prices just came in higher for the sixth month in a row. That means, in a familiar refrain, that Japan’s central bank will probably raise interest rates for the first time since Aug. 2000. Some economists expect the first increase to come as soon as July.

I can tell you firsthand that prices are on the rise here. McDonald’s (MCD) is charging more on certain set meals, and Tokyo Disney Resort (DIS) is planning to hike ticket prices by some 5%, its first such increase in almost six years. It looks like the deflating Japan story is finally over.

Even the International Monetary Fund thinks so. Daniel Citrin, deputy director of the fund’s Asia and Pacific Department, said on Wednesday that “The risk of slipping back into deflation is pretty small, barring some unforeseen shock.”

As investors in the Dow (of which McDonald’s and Disney are members) and holders of Disney stock, this news is fine by us. As investors in the Japanese market ahead of interest rate increases and a tough summer, this news is worrisome.

We’re probably fine until July, but keep an eye out for a sell email nonetheless. As the last three weeks made clear, things can change quickly.

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Online Media Giant (SYMBOL, $33.02)

Mon +3.2% | Tue +1.0% | Wed +3.4% | Thu +3.6%

We bought Investments are shown only to KELLY LETTER subscribers. Click to try the letter for one cent. on Mar. 17 at $30. So far, we’re up 10%.

It was a grand week to be a shareholder in this company. The stock went up every day. Whether you should thank last weekend’s Barron’s article or my constant raving about the company in The Kelly Letter is up to you.

This week, our investment thesis was confirmed.

Google stole the internet spotlight when it went public and became a verb. “Google it” morphed into the new way to tell somebody to check it for themselves. There’s no doubt that Google’s fast, simple searches and its well-placed text ads were the right way to rocket to the top.

What I’ve always questioned is whether that’s enough. Our online media giant, I’ve pointed out, is concentrating its efforts on its many human-powered services. They are harder to beat with just improved technology, which is available to any of the leading net companies, and they’re harder to duplicate because once a person is part of something with a log-in and password and custom settings that have become familiar, it’s hard to get them to change allegiance. Let’s call these reasons to stay “non-tech sticky points.”

Because the company has already closed in on Google’s search dominance, is almost set to close in on Google’s text ad dominance, has steadily fortified its human-powered services, and is trading at a much cheaper level than Google, I’ve argued that it is the better net buy. Hence, we bought it.

This thesis received critical confirmation this week. On Monday, market research firm Hitwise reported that 80% of the traffic to Google’s network of sites including search, news, maps, video, mail, and social networking, goes to the base Google.com page. Google’s other efforts just haven’t gained any traction. It’s a one-trick pony.

What is constantly hammered on in the media is Google’s growing market share. It’s not a lie, it’s just not the whole picture. Google seems to gain a larger piece of the search pie every quarter. It happened again last month for the ninth time in a row. Google handles 43% of all U.S. searches. This company is second at 28%, followed by MSN at less than 13%. There’s no question that Google is the search leader.

That’s where its story ends.

Remember the buzz around Gmail hitting the web with gigabytes of free storage that were sure to put others out of business? Before Gmail even got started, both primary competitors simply offered similarly huge amounts of free storage. Google’s tech-delivered advantage was instantly nullified, and the above-mentioned non-tech sticky points kept people right where they’d been all along. Of the internet email market, this company commands 42%, Hotmail commands 23%, newcomer MySpace mail already commands nearly 20%, and Gmail claims just 2.5%.

It’s the same story in news. The leader is, again, this company, followed by the Weather Channel, MSNBC, and CNN.

We’ve all seen the amazingness of Google Maps and Google Earth. I remember when I first heard about Google Earth from my uncle at Newport Beach during the annual Kelly Family Summer Vacation. He said I could see my own home via satellite right at Google Earth, for free! I looked, it was cool. Those satellite overlays were even included in Google’s driving maps, making this company’s look stale by comparison.

Here again, it didn’t take the company long to buy some new computers, put some interns to work on the software, sign some data sharing contracts, and crank out its own upgraded satellite mapping service, also free.

My point is not that Google is not cutting edge and all that’s cool. It is. It’s just not unassailable and, in my opinion, is barking up the wrong tree with a focus only on what computers and software can do. The long-term winner online will be the company with the most people on the most services. It’s not just about search. It’s about human networks that have more than technology in their defense moats.

Back to maps. Who do you think is number one? The pacesetter, Google? Nope. It’s third. Mapquest is first with a 56% share, then comes this company, then Google, and finally MSN.

This company’s strategy is gradually winning the web. It ranks at or near the top of every major online destination category. Its graphical ad network is the strongest. Its pay-per-click text ad system is in beta now and coming along quickly. It should be in full force by year-end.

This company is the place to be online, and we own it.

_____________________

On Deck

Mon 5/29: U.S. markets will be closed for Memorial Day.

Tue 5/30: The Conference Board’s consumer confidence report for May will be released.

Wed 5/31: Minutes from the May 10 FOMC meeting will be released. The Chicago purchasing managers index (PMI) will be released.

Thu 6/1: The Institute for Supply Management (ISM) reports its May index. It will probably drop from April’s 57.3 to about 56, give or take 0.5. Construction spending numbers for April will also come out.

Fri 6/2: May’s job statistics will be reported. They include the average workweek, hourly earnings, nonfarm payrolls, and the unemployment rate. April’s factory orders will also be released.

That’ll do it for this week.

It’s the rainy season in Japan, and every trip out of the office requires an umbrella. Outside the window next to my desk sit four bonsai that I’ve received from friends. They’ve soaked up the rain and are a bright, pleasant green just waiting for the sun to break through. Everything goes in cycles.

More than 60 years ago, my grandfather fought against Japan in the biggest war the world has ever seen. Today, I live in a city that saw American bombers fly overhead to destroy nearby factories. America’s former enemy is now its ally, and has been a delightful host to me for four years. The people of Japan built their economy with the help of America, and it is now number-two in the world, second only to the U.S. itself. A lot of good has come from America’s military might. That good did not come cheap. The people who paid the ultimate price did so for generations of strangers to come. We are among those strangers.

Around the barbeque or in church or wherever you will celebrate this day of remembrance, do take a moment to actually remember. There’s a reason for the day off. My grandfather lived. Many others did not. The only place for them to exist in this world now is in our thoughts. Let’s make some space.

Have a wonderful Memorial Day weekend.

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