Tech deals and IPOs

Ever heard of Zynga? Me neither.

Zynga makes online Facebook games like Mafia Wars and FarmVille. It made $210 million in revenue last year and expects $355 million in revenue this year.

Recent transactions in the video game world suggest Zynga could fetch as much as $1 billion in an IPO. Zynga's fat valuation is said to stem from Electronic Arts' recent acquisition of Playfish, which you can play while logged on to Facebook, MySpace, and other social networking websites. Electronic Arts is paying three to four times revenue for Playfish.

The online games market is growing rapidly. It's expected to top $2 billion by 2012. The market for games played on Xbox and Nintendo game consoles appears to be shrinking, down 12% through October this year, according to researcher NPD Group.

There's not a word anywhere about any of these online game companies making profits... which is what reminds me of 1999.

Recently, gourmet coffee seller Green Mountain Coffee Roasters appears to be winning a bidding war to buy rival Diedrich Coffee. Peet's Coffee and Tea started the war by offering $26 a share, then Green Mountain countered with $30. Then Peet's offered $30.41 in cash and stock. Now, Green Mountain seems determined to win the war by raising its bid to $32 a share.

Where will it end? Presumably someplace good for Diedrich shareholders... and more than likely, it'll end someplace bad for the winning bidder's shareholders.

That's the way most acquisitions go. It's called "The Winner's Curse." There's a whole book about this and other paradoxes in finance, by a fairly famous economist named Richard Thaler. It's a bit technical, but very enlightening.

The winner of an auction is often "cursed" because in order to win, he has to bid higher than the other auction participants. If everyone in the auction knows approximately what the prize is worth, then you can only win the auction by paying too much, i.e. instantaneously turning yourself from a winner into a loser. Peet's and Green Mountain likely know better than anyone what Diedrich is worth, since all three companies are in the same business. Yet they keep bidding higher and higher...

That's why I've been telling my readers for more than a year that corporate America is delusional. Research shows corporate managers believe their acquisitions add value around 80% of the time, but other research shows acquisitions add value less than 40% of the time. Ergo, corporate America is delusional.

Poor Green Mountain Coffee. It's bidding $265 million for a business that has yet to prove it can generate cash flow.

And how wonderful for Diedrich shareholders, whose shares traded as low as $0.21 in March and now sell for more than $33 each, around 53 times last year's earnings, possibly in anticipation of a more voracious loser stepping up to top Green Mountain's so-far winning (or is that losing) bid.

Few people know that better than Bill Ackman and his firm, Pershing Square Capital. They've made a ton of money investing in bankrupt mall owner General Growth Properties (GGP). Ackman started building his GGP position in November 2008. He spent $50 million on the stock, which sold for less than $1 a share at the time. Now, the stock is worth $560 million. Ackman also spent $100 million on unsecured debt, which is now worth $400 million.

One of the largest gold vaults in the United States lies beneath the HSBC tower on Fifth Avenue in New York City. Gold prices have soared over the past year, bullion is more popular than ever, and HSBC's vault is running out of room.

So HSBC has come up with a solution to its overcrowded vault: Kick out the retail customers in favor of the more lucrative institutional gold holders. HSBC says retail clients must move the metal themselves or prepare to have it delivered to their doorsteps.

The first thing on my mind was: Let's build a vault for small retail investors and charge a premium price. But the business is not exactly a high-margin operation. The Delaware Depository Service, located in Wilmington, is one of five major depositories in the country. It charges $6 each month for a 1,000-ounce silver bar and $12 a month for a 100-ounce gold bar.

You'd have to invest a lot of capital up front, too, to build a vault with a 27-inch-thick steel reinforced wall, surrounded by a "man trap," a series of doors that open only if the one behind you is locked.

Ferris comment: Let's set aside for another day any discussion of the likely effects of a bubble in gold, oil, or any other commodity.

Let's just focus on this: No matter what anyone tells you about stocks being good investments during times of inflation, high inflation is bad for business, and what's bad for business is ultimately bad for stocks.

Look at the 1970s. Stock valuations moved lower from the late 1960s until the big market bottom in 1982. That's because inflation makes it really difficult and risky to do just about anything in business. So buyers of businesses insist on higher rates of return in order to take on that risk. When you get to a moment like early 2000, everybody loves stocks. When you get to a moment like 1982, everybody hates them. Which moment do you think we're headed for now?

Over the next several years, valuations will move gradually lower. Today, the U.S. stock market is at 29 times earnings. At the bottom some years in the future, it'll likely be around 10 times earnings or less.

Along the way, I think we'll see $5,000 or $6,000 gold, and perhaps $150 or $200 oil. The government is dead set on inflating. It has set up an avalanche of money, and it can't be held back. Since the 2008 Stansberry Alliance meeting, I've been telling the world what John Paulson has recently been saying. The great majority of our money is created and multiplied in the banking system. If lending activity picks up again, we're in for the mother of all inflations.

Inflation isn't the solution to anything. It's a bigger risk than ever and an enormous problem. As long as our money is managed by the Federal Reserve, we'll always be on our way to the next bubble. I doubt $5,000 gold and $200 oil will solve anything in the way I think you mean it.

Regards,

Dan Ferris and Sean Goldsmith
Medford, Oregon and Baltimore, Maryland
November 24, 2009