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Adobe Systems Inc.: Deutsche Bank equity analyst Tom Enrst Jr. maintained a buy rating on shares of Adobe Systems Inc. (ADBE) on Mar. 17.

In a note, Ernst said he expects the maker of the Flash video software to post “solid” first-quarter results on Mar. 23, ahead of the Wall Street consensus expectations of revenues of around $827 million and earnings per share (EPS) of 37 cents. Ernst said the improving macroeconomic environment, alongside a strong fourth-quarter deferral, more than offset depressed demand ahead of the product cycle for Creative Suite 5 — the newest iteration of the company’s flagship bundled offering — which he expects to launch in the second or third quarter of 2010. Ernst estimates first-quarter revenues of $835 million and EPS of 39 cents.

While uncertainty around the company’s October 2009 acquisition of Web analytics company Omniture has muted investor sentiment regarding Creative Suite 5, Ernst said he believes the launch of the product should help return Adobe shares “to more typical premium levels”.

The analyst hiked a price target on the shares to $46 from $44.

BlackRock Inc.: Credit Suisse equity analyst Craig Siegenthaler raised an investment rating on shares of BlackRock Inc. (BLK) to outperform from neutral on Mar. 17.

In a note, Siegenthaler said recent underperformance in BlackRock shares, and their improved valuation relative to peers, “provides an entry point” on the stock. He said he believes BlackRock is “best-positioned” to benefit from three factors that could drive growth in assets under management: ETF products, the payout market (retirees in the U.S. and Western Europe); and international distribution.

“More importantly, we expect strong EPS and [fund] flows to drive stock price outperformance over the intermediate term, Siegenthaler wrote.

The analyst raised a 2011 EPS estimate to $13.50 from $13.30, vs. the $13.22 consensus estimate of Wall Street analysts. He also lifted a price target on the shares to $280 from $270.

Discover Financial Services: William Blair & Co. equity analyst David Long maintained an outperform rating on shares of Discover Financial Services (DFS) on Mar. 17.

The credit-card lender announced on Mar. 16 a net loss for the three months ended Feb. 28 of $103.5 million, or 22 cents a share, compared with a profit of $120.4 million, or 25 cents, in the same period a year earlier. The card issuer said March 11 that it expected to report a loss of 22 cents to 23 cents a share. It also said it will pay back $1.2 billion to the Troubled Asset Relief Program, making the lender the last of the six biggest U.S. credit-card issuers to return bailout money.

Discover received regulatory approval to redeem the $1.2 billion of preferred stock that it issued to the U.S. Treasury Department under the TARP Capital Purchase Program, the company said. Discover Bank will issue $350 million of subordinated debt during the second quarter, the company said.

In a note, Long said the loss in the most recent quarter included a $305 million (34 cents per share) addition to Discover’s loan loss reserve to incorporate a new analytical process intended to enhance management’s ability to estimate incurred losses on non-delinquent accounts. The analyst said Discover indicated that net charge-offs of bad debt may have peaked in its fiscal first quarter as it recorded charge-offs of 8.51% of average loans and guided second-quarter charge-offs to be in the 8.0% to 8.5% range; additionally, delinquencies of 5.05% declined from 5.31% in its fiscal fourth quarter.

“When we consider that delinquencies seasonally increase in the first quarter from the fourth quarter, the contraction leads us to believe that Discover’s credit quality may be improving at a faster pace than we previously expected and that it will be able to begin materially releasing loan loss reserves by the third quarter,” Long wrote.

In the wake of Discover’s TARP repayment announcement, the analyst said he calculates that the company will remain “well capitalized”; its tangible common equity ratio at Feb. 28 was 8.1%.

Long reduced a fiscal 2010 (ending November) EPS estimate by 22 cents to 58 cents to incorporate the addition to reserves. He noted that “increasing the loan loss reserve in the first quarter increases the reserve release in future quarters as credit quality improves”; he raised his fiscal 2011 EPS estimate by 10 cents to $1.65.

“We expect the consensus 2011 EPS estimate to increase, driving attractive stock price appreciation, as we expect the company to continue to report improving consumer credit quality trends over the next several quarters,” Long wrote.

Greenhill & Co. Inc.: Keefe, Bruyette & Woods equity analyst Lauren Smith raised an investmnet rating on shares of Greenhill & Co. Inc. (GHL) to outperform from market perform on Mar. 17.

Greenhill, the merger advisor founded by Robert Greenhill, said on Mar. 16 it will buy Australia’s Caliburn Partnership Pty for as much as $181 million, adding a firm whose clients include Rio Tinto Group and Westpac Banking Corp. New York-based Greenhill agreed to buy the 11-year-old financial adviser with 1.1 million shares valued at $90.7 million. If Caliburn meets certain revenue targets in three and five years, Greenhill will pay out more stock worth $90.7 million, based on the latest closing price.

In a note, Smith said Greenhill’s announcement that it was acquiring Caliburn was a “game changer” for the company. Smith said that with Greenhill’s expanded geographic presence, she believes the deal will add to the company’s earnings “immediately”.

She raised her 2010 EPS estimate to $3.45 from $3.15 and her 2011 projection to $5.40 from $4.25.

The analyst also hiked her price target on the shares to $110 from $82.

A Long-Term ‘Ice Age’ for Stocks
Stocks are poised to enter a long-term “Ice Age,” according to Société Générale (SCGLY) global strategist Albert Edwards. Both the Economic Cycle Research Institute’s weekly index of leading indicators for U.S. growth and the Organization for Economic Cooperation & Development’s monthly gauge of economic measures for China have peaked, Edwards wrote in a recent report. Such high points foreshadowed the stock market sell-off that began in October 2007 and sent the MSCI (MXB) All Country World Market Index down as much as 60% in 16 months. The strategist recommends holding 35% in stocks, 50% in bonds, and 15% in cash. His report follows one by Ian Gordon, a strategist at Longwave Group in Surrey, B.C., on Feb. 9 saying the Dow Jones industrial average could fall 90% over three years as U.S. equity markets move deeper into the “winter” phase of a half-century economic cycle. Gordon said the Dow is likely to bottom in 2012 and that “winter” may last until 2020.
Deere: A Capital Expenditures Comeback?
Deere (DE) didn’t just beat expectations on Feb. 17. It slaughtered them. Net income rose to 57 cents a share, leaving analysts’ average calls of 19 cents in the dust. Its stock rose 5%, to 56.48, on news of its first-quarter profit. Deere also raised its 2010 forecast and expects equipment sales to gain 6% to 8%, compared with the 1% decline it forecast last November.

Analysts at Credit Suisse (CS), JPMorgan Chase (JOM), and Morgan Stanley (MS) say the stock could hit 65 to 70 over 12 months as demand overseas and efforts to replenish U.S. inventories spur production. “Foreign demand growth continues to be very strong, particularly from Asia, and we’re starting to see capital spending pick up,” says JPMorgan Chase economist Michael Feroli. Ways to play the trend: Vanguard’s Industrials Exchange Traded Fund (VIS), up 3% this year, and the Industrial Select Sector SPDR ETF (XLI), up 4%. The S&P 500 is down 0.3%.
What the Fed’s Rate Hike Means
The Federal Reserve’s decision on Feb. 19 to raise the discount rate, which it charges banks for loans, dampened demand for riskier assets. The Fed said the quarter-point bump, to 0.75%, will encourage financial institutions to rely more on money markets, instead of the central bank, for short-term liquidity. The move “rocked the markets,” says Crédit Agricole CIB strategist Stuart Bennett, as foreign indexes—including Brazil’s Bovespa—fell while the U.S. dollar hit a seven-month high. These moves don’t necessarily mean investors should flee to safe havens. Channel Capital Research chief investment strategist Doug Roberts says to stick with what you’ve got, “unless the Fed embarks on a massive tightening spree.” The discount rate rose from 2% to 6.25% from June 2004 to June 2006. Over that time, the S&P 500 returned 15% and the MSCI EAFE Index 37%. The Barclays Capital U.S. Aggregate bond index climbed 6%.

By
David Bogoslaw

Unlike much of the market, most of the homebuilder stocks have continued to rally this year, albeit bumpily, despite renewed concerns about the pace of economic recovery amid fear of contagion from the European sovereign debt morass. The rally is primarily due to the stronger-than-expected earnings that many of the companies have reported this season, which is giving investors some hope that these stocks will be good bets in 2010.

While new home orders have increased in recent months and the pace of housing starts is expected to accelerate, the reality is that the housing market continues to be heavily reliant on government stimulus initiatives affecting everything from mortgage rates, sales of homes to first-time home buyers, and the pace of bank foreclosures. One example: Demand for new homes dipped temporarily in late 2009, until prospective home buyers heard that a tax credit aimed at stimulating home sales had been extended into the first half of 2010.

In a Feb. 12 research note, Daniel Oppenheim, an analyst at Credit Suisse Equity Research, predicted that orders for new homes would be concentrated in the February-to-April period, with the extended tax credit creating urgency among buyers. He estimated a 21% increase in orders in the first quarter, slowing to 5% growth in the second quarter, a decline of 4% in the third quarter, and then growth of 13% in the fourth quarter. Mortgage rates will probably climb modestly after the Federal Reserve stops purchasing mortgage-backed securities at the end of March, according to his note.

Overhang of Foreclosures

Oppenheim’s biggest concern is that a recovery in the housing market will be muted by a continuing flow of foreclosure sales.

“We don’t necessarily need to see the economy worsen that much,” he says. “We just need to see more of those homes that are delinquent or in the early stages of foreclosure go fully through the foreclosure process.” Oppenheim estimates there are five million homes for which owners are either severely delinquent in mortgage payments or that are already in the foreclosure process. “The challenge is that this pent-up supply will limit pricing upside in the next several years,” he says.

Macquarie Equities Research analyst Kenneth Zener says he expects distressed home sales to be kept near the 2009 pace—1.8 million—over the next three years, because of efforts by the government and banks. But he believes government programs, such as the Federal Home Affordable Modification Program (HAMP), have only delayed and not solved issues around negative equity, which require some principal forgiveness.

Zener, in a Jan. 19 research note, reaffirmed his outperform rating on the homebuilder sector, based on his assumption that housing starts will rise off the record low in 2009, to around 900,000 by 2012. That’s likely to occur as long as a slow job recovery helps the market absorb about 5 million foreclosures over the next two years, he said. His top picks for 2010 are D.R. Horton (DHI) and Ryland Group (RYL), which he expects to post more robust earnings than their peers, largely on lower general and administrative (G&A) costs.

Telling Homebuilders Apart

Zener says he plans to use three tests to differentiate between homebuilders over the next two years: How successfully they cycle out of legacy assets, how effectively they use their surplus cash, and the extent to which increases in sales volume help them absorb G&A costs. He expects net debt levels for the group to fall from the current 33% to 26% by 2012 as modest growth rates limit capital spending. Margin growth for most builders will come from nearly equal parts gross margin and G&A absorption, his report said.

Meanwhile, Credit Suisse’s Oppenheim says he has seen a shift in strategy by homebuilders in response to the availability of home-buyer tax credits. Over the past few years, the goal of builders has been to reduce the number of homes they build on speculation—without a signed contract—to avoid price wars with competitors. But in 2009, builders that didn’t have a supply of spec homes available in October or early November saw their orders drop dramatically, because buyers needed homes that would be ready to close on by Nov. 30 in order to qualify for the tax credit, says Oppenheim.

That’s one reason for D.R. Horton’s better-than-expected earnings in the first quarter of fiscal 2010, since the company had the largest supply of spec homes, he adds.

This year, most builders are talking about erecting more spec homes in order to meet demand by buyers eager to take advantage of the extended tax credit, says Oppenheim. “Some builders don’t want to build too many spec homes, but they will build and stop at the drywall stage, so buyers can still choose the finishes they want” to personalize their homes, he says. “Homes can be finished fairly quickly.”

Most Attractive Shares

Oppenheim’s top stock picks are KB Home (KBH), Lennar (LEN), and NVR (NVR), all of which he expects to benefit disproportionately from demand from first-time home buyers spurred by the tax credit. He upgraded NVR to outperform from neutral and raised his rating on D.R. Horton to neutral from underperform on Feb. 12.

KB Home’s advantage is that roughly 80% of its customers are first-time buyers. To compete better against foreclosure sales in certain markets, the company is building smaller homes, hoping to push sales prices down close to those of foreclosures, says Oppenheim. While the tactic has generated some orders, new home construction overall is down sharply from where it was before the housing slump, due to competition from sales of existing homes, including foreclosures, he says.

Lennar has a fairly low price point, while 50% to 60% of NVR’s exposure is in the mid-Atlantic area, which is still considered strong. NVR’s market-share gains in that region will help boost its margins, he adds.

In the Phoenix metro market, one of those hardest hit by the downturn, home builders have shifted toward lower-priced homes. Builders are also making a big play to boost their market share in that market, according to Jim Belfiore, president of Belfiore Real Estate Consulting, a market research firm in Phoenix.

He sees companies such as Meritage Homes (MTH), Beazer (BZH), Lennar, Hovnanian (HOV), and KB Home aggressively buying up subdivisions now that a lot of small and midsize privately held builders have gone out of business due to bankruptcy or site foreclosures. Prices of lots in these subdivisions have been bid up aggressively in recent months, he says.

Keeping Their Names Visible

“Prices are phenomenally low. [A home buyer] can buy a $80,000 to $90,000 house brand new on the outskirts [of Phoenix]—1,000 to 1,200 square feet—and you haven’t been able to do that in a very long time,” says Belfiore.

Builders are saying they don’t expect to turn a profit on any of the homes they build in these subdivisions in the first year, but the activity keeps their names visible in the market, which is important for gaining market share once the recovery comes.

The builders are more likely to be able to sell out their homes in new subdivisions in view of the plunge in the number of active new subdivisions in the metropolitan Phoenix area. The number fell to 414 at the end of 2009, from 1,250 in early 2006, when the housing decline began, says Belfiore.

“They’re keeping their division people on board—division presidents and land acquisition personnel, the business people who run the operation,” he says.

While the economic recovery holds out hope for homebuilders, the wild card will be the rate of foreclosures. And that’s likely to become more volatile as the government withdraws its massive liquidity on signs that the economy is finding its footing again.

Bogoslaw is a reporter for Bloomberg BusinessWeek’s Finance channel.

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