Member Q&As – MSFT’s ARMH Strategy, MLNX, Swing Trading, PMCS, CREE, and NETL

Q) Would love some intelligent thoughts around Microsoft (MSFT) signing an architectural license with ARM Holdings (ARMH) today, rather than the usual sell side drivel. Bulls are reading it as a precursor to MSFT either designing its own chip (apps processor?) for a tablet, or the first step towards porting Windows 7 onto ARMH silicon. Would love your thoughts.

A) The short story is I don’t know what’s on MSFT’s mind and the better trade journals aren’t speculating either. What I do know is that MSFT and ARMH have been working together since 1997, but this agreement clearly resets the bar at a much higher notch.

To the best of my knowledge, there are only three chip vendors with ARMH Architectural licenses. These include Infineon, Marvell (MRVL) and Qualcomm (QCOM). There have been persistent rumors that Apple (AAPL) struck an agreement for an architectural license, but there is no solid agreement that it was used to develop the ARMH based A4 processor introduced in the iPad and used in the new generation of the iPhone. Evaluations of the A4 die suggest it uses a standard core, but I think the jury is still out.

Some speculation exists that MSFT is looking to develop a new processor for its Bing search engine (an enterprise application). While ARMH cores have seen some limited enterprise applications, I think this is a long-shot and, even if it part of the plan, I doubt it is MSFT’s core strategy; I think MSFT needs to and is thinking bigger picture.

If we look where MSFT sits today in the competitive landscape, we can see a company that is highly dependent on its Windows franchise, but losing ground in emerging markets. While Windows won’t be going away any time soon, we are rapidly approaching a time when many forms of computing devices won’t need it. On one side, MSFT is losing ground to AAPL and Android in both the smartphone and tablet sectors and, on the other side, we’re seeing INTC move rapidly into these and other consumer sectors with its newest Atom chip being coupled with various Linux based operating systems including Android. And, in addition to these headline topics, there are at least a half a dozen other operating systems for portable devices striving to stake a market share claim. The short story here is MSFT needs to do something to improve its value proposition and enhance its differentiation.

I believe the more likely case is that MSFT is focused on developing a processor optimized to run its portable device operating system (thinking more broadly than just the smartphone market). Beyond the potential benefits of developing either a chip or a transportable core design optimized for its operating system, MSFT could also develop chips for its various consumer products.

Bottom Line: MSFT has been out-maneuvered by both AAPL and Google (GOOG) in the emerging computing markets. While I don’t dismiss at all the thought of MSFT developing a custom ARMH chip or core capable of supporting Windows, I think MSFT is thinking beyond that. The way I see it, MSFT needs to take bold steps to define its future with a new portable device ecosystem as many computing applications move away from its core Windows ecosystem during the coming years.

*****

Q) Do you have an opinion on Mellanox (MLNX)?

A) While I think much of this carnage is due to MLNX and its customer, Oracle (ORCL), previously over-stating its position, I think the sell-off is over-done. That said, I like QLogic’s (QLGC) positioning in the sector better.

*****

Q) I listened to the conference call for PMC-Sierra (PMCS), and the call was in my opinion upbeat in tone, and even one of the analysts started his question by congratulating management for showing good results. PMCS beat on earnings and revenue, and the outlook is positive with continued growth. Cash is in good shape, yet the stock tumbled today, down as low as $7.95. Do you have any idea what is happening? I know that Morgan Stanley upgraded the stock on 7/15 when the stock was at $8.17.

A) There are two ways to look at the PMCS equation. We could fret about the orderly digestion of some inventory that was built up when lead times were longer and much less predictable or several other wiggles in the PMCS equation. We could also worry, as some analysts are, about the potential for demand weakening in emerging telecom or the enterprise storage markets that are driving sales for PMCS. In short, there are almost always a couple pimples on a report we can point to as concerns. However, as I see it, these blemishes were minimal for PMCS and strongly outweighed by the company’s momentum and progress.

Another thing to consider is the fact that PMCS, like Altera (ALTR) and several other stocks, rallied ahead of (in anticipation of) its earnings report. This is always an important thing for investors to monitor. When a stock rallies in anticipation of something positive, there is little room to move up further when the “rumor” becomes “news.” This is the basis for the old saying, “buy the rumor – sell the news.” However, I think to isolate on these factors would be to miss the bigger and more important story.

In 2008 when the price of PMCS fell below $3.00, I wrote that Wall Street simply didn’t understand the story and was viewing PMCS as being the same company it was in 2002 when its price was also pushed down to a similar level. In both cases, the stock rebounded sharply, but in this case, it has stalled at high single-digits. Ironically, PMCS is much better positioned for profitability and future growth now than it was then, yet Wall Street seems content to dismiss both current earnings and the company’s growth potential.

As I see it, there are several reasons why its different this time.

In 2003, there was significantly more confidence in the economic recovery. Tax rates and unemployment rates were heading down and optimism was high. Today, tax rates are heading up and the unemployment picture remains dismal. There is even some talk among Democrats about just letting the “Bush tax cuts” expire and not saving them for families making less than $250K per year as was promised during the Obama campaign.

National Health Care and Financial Reform legislation have both thrown considerable uncertainty into the mix and there is still a threat we’ll see some form of Energy legislation and sweeping Immigration Reform that will add to this uncertainty. It’s not that these and other aspects of our country couldn’t use improvement; there’s a lot of things we can and should improve. However, as is always the case for Washington, the legislation that has been and may still be signed into law is very poorly written and therefore may take years of court proceedings to define what is really law. This means companies and their investors face undefined risks and when risks are undefined, hiring and expansion are stymied and stock valuations are significantly compressed.

The big word in all this is “risk” and, to a great extent, risks that are undefined. Remember, the value of a stock is defined by the net present risk-adjusted value of future earnings. Today we are extremely risk averse and therefore factor the risk element in that equation much higher than usual. The result of a high risk factor is a low valuation multiple (low price to earnings multiple) and even if we discount the fact that interest rates are at very low levels, valuation multiples throughout the markets (not just for tech) are extremely low by all methods of rational measurement and historic standards. While we could argue why valuation multiples should be considerably higher until we’re blue in the face, nothing is going to change until we are in a position to better quantify risks and, thereby, able to lower the risk factor in the net present value equation.

Bottom Line: I think you can look at this one of two ways. One would be to assume things will get better and, as they do, the risk factor in the net present value equation will be lowered and, as a result, valuation multiples will move up to historic norms. The other would be to assume things will continue to degrade. While I think there are clear risks of the latter in the short term, I think over the longer term the former is the more likely outcome.

Based on this thinking and the fact that it appears my higher-than-consensus earnings estimate range of $0.76 to $0.82 still appears to be solid, I see no reason to change my longer term view on PMCS from what I shared in our State of Tech coverage. The following is excerpted from that report:

If we base our estimated fair value model on a range of earnings running from the consensus of $0.76 to the high side of my range ($0.82) times a valuation multiple ranging from 15 to 17 and then add to the results PMCS Net Current Asset Value of $1.56 (net cash including $1.12 in long-term investments is $1.83), the resulting estimated fair value range runs from $12.94 to $15.50. Even if we dropped our valuation multiple range down to 14 to 16, the range is still $12.20 to $14.68.

*****

Q) I have noticed AMD (AMD) seems to be a good oscillator and it appears one could generate $25-$30 a day simply buying 100 shares @ 9:30am and getting out about 3pm. What do you think?

A) What you’re talking about is called swing or cycle trading. It can be done as day trading or in an attempt to take advantage of longer price cycles. The short story here is it works until it doesn’t. Personally, I’ll occasionally cycle trade or use what I call a “buy – surge – write” strategy. In the latter case I’ll buy towards what I think is a cycle bottom and then sell a covered call that is somewhat in the money. That takes some of the original cash off the table and gives me an extra measure of risk abatement. However, neither strategy is without risk.

Since everyone’s situation is unique, I don’t want to suggest that swing trade profits of $20 to $30 aren’t worth your time, but I think it’s always important to consider the value of your time in the decision process.

*****

Q) I am very pleased with the call/write strategies that you suggested at the most recent peak and I took advantage of opportunities in Netlogic (NETL) and Cree (CREE).

I realize that we all are responsible for our own “call” on when to take a profit. however, I am new to hedging strategies and would like your view.

I have long since bought out the NETL calls I sold for a handsome profit. My question is that I still have contracts written for CREE $95 September calls and CREE $95 January calls.

I am comfortable at today’s closing of around $71 that the September contracts will expire worthless in 58 days. The January contracts also have a hefty profit and I am looking to your view on CREE’s potential for price appreciation through the end of the year. Another variable is that I have a much greater number of long-term option contracts that are the offset to this trade, but no actual shares.

A) Thank you for your kind words. From what you’ve written, I think you are going through emotions that are common for investors who use covered calls as a hedging strategy. That emotion is that you don’t want to miss profit potential or, said another way, the perfectly understandable human emotion of wanting to make all you can. Like most emotions, this can be a destructive emotion for investors.

The important thing in investing is to remain dispassionate. That’s easy to say, but when you’re looking at your money, very tough to put into practice. This is why so many investors mess up what could otherwise be a good strategy.

It’s not that attempts to maximize profit don’t work out – they sometimes do. However, they take energy away from what should be more important focuses and often lead to fragmented strategies and losing track of the much more important practice of risk management.

CREE and NETL are both highly volatile stocks. Since stock option prices are partly predicated on volatility, this makes them both ripe for “buy / write” strategies or for hedging risks within a long position by selling covered calls when prices surge and lead to you sitting on a higher allocation risk than appropriate. Based on what you’ve written, it sounds like you’ve done the latter.

While I’ll very seldom close out the covered call side of a buy / write play unless there is a fundamental change in my thinking and a very good opportunity to do it on broad market (not company specific) weakness, I’ve most certainly bought cover for short call positions I’ve used to hedge long positions that run above either my allocation risk parameters or beyond what I see as a fair valuation. However, when I do that I’m very careful to assess the risk expansion that comes with it and insure it doesn’t push my aggregate risk exposure above what I see as appropriate limits. These are the points I think you should consider with much greater importance than whether or not you’ll lose shares to the call contracts.

Another strategy you can employ when you have a short covered call position and the underlying stock you own is at a very low cost basis is to buy new shares to attach to the call. This can delay taxes on the lower cost shares. But again, just like buying cover for the calls, this expands risk exposure and should therefore be viewed in the larger context of your situation.

In 2009, the Next Inning portfolio was up 74% vs. 44% for the Nasdaq.

Disclosure: At the time of this publication, out of the companies discussed herein, Paul McWilliams had long positions in AAPL, INTC, QCOM, MRVL, ORCL, NETL, CREE, PMCS, and ALTR. In addition to these, he also had short positions in NETL October $37.50 calls, CREE December $70 calls, CREE January $95 calls, INTC January $25 calls, QCOM January $42.50 calls, and PMCS January $10 calls.

Tags: AAPL, ALTR, AMD, ARMH, CREE, GOOG, MLNX, MRVL, MSFT, NETL, PMCS, QCOM, QLGC