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US Bancorp’s Glass Is Half Full

By Vitaliy Katsenelson, CFA

October 19, 2006 - The Motley Fool.com

One nice thing about owning US Bancorp (NYSE: USB) is that you know you won't blow up when it reports earnings. Unlike other money-center banks such as JPMorgan Chase (NYSE: JPM) and Citigroup (NYSE: C), it won't make dumb loans to a risky country, nor will it be involved in a hedge-fund trade that went bad, nor will it grow through making large acquisitions. It is not that kind of company.

As expected, the third quarter was not exciting. It's hard to analyze the company's performance without diving into a series of glass-half-empty and glass-half-full arguments. So I'll do just that.

Half full: Earnings per share rose 6.5% over the third quarter of 2005 -- not bad, considering the stock is yielding 3.8%.

Half empty: Half of the EPS growth came from stock buybacks.

Half full: The rate of decline in net interest margin has been decelerating and likely will come to a halt if or when the Federal Reserve stops raising short-term rates.

Half empty: The net interest margin declined further, from 3.95% last year to 3.56% in the current quarter. Though loans have grown by 5.6%, average deposits shrank by 0.8%. To make things worse, non-interest-bearing deposits declined 4.8% as customers fled to accounts that paid higher interest. That further contributed to an increase in cost of capital.

Half full: This quarter demonstrated the tremendous value of the fee side of the business, which accounts for about half of the company's profitability. Fee revenues grew 15% on an organic basis -- very impressive!

So which is it?

The fee business is firing on all cylinders. But in the lending business, half is working (i.e., assets are growing) but the other half is temporarily broken (i.e., deposits are shrinking and the net interest margin is contracting).

This is where my "half-full" personality takes over. I'm not sure what could stop the deposit shrinkage, but stabilizing short-term rates should definitely help to stop the bleeding in the net interest margin. Once the contraction there stops, the net income will start growing nicely because the loan portfolio is growing. Banks have a tremendous operational leverage in that costs grow at a slower rate than revenues. Even a mild resumption of net interest income growth should help the company to substantially accelerate EPS growth.

US Bancorp is trading at about 13 times earnings, so it's not screaming "cheap." But it's not expensive, either. However, any expansion in margins, if achieved on top of growing loans, should send earnings growth into the double digits, and earnings estimates should face upward revisions.

This is one of the best-managed large-size banks, it has one of the lowest cost structures in the industry, and it has been very conservative with its lending practices. Though it does have an exposure to home equity loans -- which I believe is a riskier business than most people believe -- it is a relatively small part of its overall loan book.

One final word from the half-empty side: A significant slowdown in the economy is not good for any bank, including US Bancorp, as loan growth declines or turns negative and bad debts increase. Though I expect US Bancorp to fare better than most banks, it is not immune from troubles.

Need I say more?

Walgreens (WAG) comments on Wal-Mart (WMT) "will put them out of business strategy" on the company conference call:

• For the 291 drugs that Wal-Mart will sell for $4, the average co-pay at Walgreens is $5.30 and for Medicare Part D patients it’s only $3.18.
• Wal-Mart’s program covers less than 300 generic medications while Walgreens pharmacies’ stock has about 1800 different generics.
• Over the years, WAG's convenience, locations, and services have proven to be bigger factors for its patients than a few dollars in price difference - the point I argued in this article.

Need I say more?

Vitaliy Katsenelson : Oil, diapers and US economy

By Vitaliy Katsenelson September 22, 2006 - Financial Times Are low oil prices good for the US economy? Of course. But are they good for retail stocks? That depends on the retailer, and on the mental account that consumer spending is coming from.

A “mental account” is not a new form of a cheque or savings account. Rather, the term comes from behavioural finance – a relatively new science that tries to explain our financial decisions. Our brain uses shortcuts to process information. And it creates “mental accounts” for different financial decisions.

We will buy a nice entertainment centre with a windfall from a risky gambling excursion – it was “found” money after all. With an inheritance from a grandmother, the money goes to a more conservative type of mental account, maybe even making it into our retirement fund.

Money is a fungible commodity – $5,000 inherited from grandma buys as many Britney Spears compact discs as $5,000 won in casino gambling. But we treat this money differently, placing them into different mental accounts. We just do.

The same type of thinking applies to other aspects of life. We put a different value on money depending on the source of funds. Borrowed money usually carries less weight when it comes to spending decisions than hard-earned cash, though it should carry a higher value since we have to pay interest on it.

Almost unprecedented low interest rates created cheap money in the eyes of US consumers and fuelled the economy. After 9/11, they went on a prolonged shopping spree taking out equity from their appreciating house and buying newer, bigger, shinier must-haves.

Home equity loans are considered to be “found” money and thus put in a less valuable mental account. What many neglected to notice:

• Home equity loans do not come free – they carry an interest rate often linked to short-term rates, which have risen substantially. That chips away at discretionary spending.
• Home equity loans have to be repaid.

• Housing prices rose nationwide, thus creating no wealth. Consumer debt – the liability side of the balance sheet – has risen over the years, but so has the asset side. Unless a homeowner decided to move to Antarctica or into a smaller house, the new wealth did not increase their house buying power.

I would argue that rising housing prices have not increased homeowner’s wealth. Instead, they have increased property taxes – as our houses appraise at a higher value. They have increased the transaction cost of buying and selling houses (because agents take a percentage of the price).

And they have encouraged consumers to spend more as they counted on housing prices to rise forever.

This leads to another problem, as housing prices may face a first nationwide decline. The asset side of consumer balance sheets will be lower but the liability side, the debt, will remain the same or even rise as interest rates increase and negative amortisation loans keep adding to mortgage balances.

How does this relate to oil prices and retailers? Very simply, our spending on gasoline comes from wages – a mental account many call a pay cheque. We spend our pay cheque mental account on staples such as groceries, clothes and diapers – lower-price items. A new kitchen countertop from Home Depot or a flat-screen television from Best Buy comes from the home equity loan mental account. This account will shrink as housing prices decline.

Wal-Mart (WMT) and Target (TGT) , which sell must-haves, should benefit as the amount in their mental account will rise with lower oil prices. Companies that sell big-ticket discretionary items will not benefit much.

Lower oil prices will most help companies that make “stuff”. Take Kimberly Clark (KMB): it takes polymer (an oil byproduct) to make diapers, and it requires energy (oil) to convert plastic and paper into a Huggies diaper. Diapers do not wheel themselves into store shelves and transport costs will come down with oil prices. Kimberly Clark spent hundreds of millions of dollars on becoming more efficient, but its cost cuts could not offset increased oil costs. At least for a while, lower oil prices will let the company enjoy the fruits of its labour.

Vitaliy Katsenelson is a manager at Investment Management Associates and teaches at the University of Colorado in Denver.

Vitaliy has a position in WMT, KMB

Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Don't Hit the Panic Button Just Yet

By Vitaliy Katsenelson, CFA

September 21, 2006 - The Motley Fool

This morning, Walgreen(NYSE: WAG) and CVS(NYSE: CVS) investors found their stocks chopped up by a bit of news from Wal-Mart(NYSE: WMT). It seems the retail giant will introduce a pilot program next year to sell generic drugs for $4 a month in its Florida stores. This is opposed to the $30 a month that CVS and Walgreen charge. Should investors hit the panic sell button?

I own all three stocks. So when I turned on the TV and heard comments like "WMT will drive CVS and Walgreen out of business!" I walked to the water cooler, got a drink, sat down, and put on some opera music (loud -- it helps me think). I came to the conclusion that it's a brilliant move for Wal-Mart (way to go, Wal-Mart!) and almost a non-event for Walgreen and CVS.

Here's why:

Wal-Mart's program has the biggest impact on consumers who are paying for prescriptions out of their own pocket, which accounts for a very small portion of CVS's and Walgreen's sales. In fact, only 5.9% and 7.1% of CVS and Walgreen pharmacy sales are paid by consumers directly; the bulk is paid by third parties (insurance companies, government, and states). Out of this 5.9% and 7.1%, a portion goes to branded drugs and the rest goes to vitamins and generics. I think the impact on Walgreen's and CVS' future sales should be negligible.

The only way the news would have a meaningful impact on CVS or Walgreen is if the insurance companies and government suddenly decided that $4 is a fair price for a generic drug -- a very unlikely scenario. Both companies operate on razor-thin margins as it is. They have very large store bases and armies of loyal customers, and they're likely to join forces to fight insurances companies that would lower their compensation for generic drugs.

Wal-Mart will probably not be making money on generics, but it doesn't have to. Where pharmaceuticals represent greater than two-thirds of sales for stand-alone pharmacies, pharmacy sales are a mere rounding error on Wal-Mart's electric bill.

Wal-Mart will be subsidizing pharmacy sales by (hopefully) getting old customers into their stores more often and bringing new customers through the doors. Have you ever tried to buy just one thing at a Wal-Mart? I think it's physically and psychologically impossible -- at least, it's never happened to me. If this pilot is successful, it should offset the loss of profitability in the pharmacy by generating sales of other general merchandise and groceries. Also, Florida is a perfect testing ground for this program, as it has more "blue hair" -- the main consumers of drugs -- per capita than any other state.

This move may also help to cool off the criticism against Wal-Mart on the PR front -- the company is working to lower medical costs to U.S. consumers, after all. The brilliance of this move lies in trying to bring market forces into the fight.

I think the Wall Street reaction to the news is overblown. But the news added a level of uncertainty to pharmacy stocks, and Wall Street doesn't like uncertainty. It also raises the question, "What else does Wal-Mart have up its sleeve?" But while Wal-Mart has a competitive advantage over many other retailers, its competitive advantage against Walgreen and CVS is very limited. These companies don't try to compete on price because insurance companies are the ones most often footing the bill; insured consumer out-of-pocket expense (the copayment) for drugs is the same at any store. One doesn't go to Walgreens or CVS because they have the best prices. People shop there because of convenience -- smaller stores, quick in-and-out trips, proximity of location -- not something Wal-Mart is going, or wants, to replicate.

Before this news, Walgreen and CVS stocks were pushing all-time highs. In my estimate, CVS was approaching a fair price valuation -- it was a couple of dollars from our target sale price -- and Walgreen was trading with little margin of safety, if any. (My firm sold shares of Walgreen a couple of weeks ago on the valuation concern.)

These stocks have big tailwinds behind them. High predictable growth rates are likely to persist in the future. On top of all this, baby boomers are not getting any younger and are consuming drugs by the pound. If you loved those stocks when they were 10% higher, you must love them today; their businesses haven't changed as much as you may think.

I have position in CVS and WMT

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Brilliant!

By Vitaliy N. Katsenelson, CFA

I wrote this article on the impact that Wal-Mart's (WMT) brilliant (I think it's a stroke of genius) actions will have on CVS (CVS) and Walgreens (WAG) - which is not much, unless grocery stores will follow WMT's lead, possibly diminishing my "convenience" argument.

I failed to mention in the article that at times insurance co-pay for generic drugs will exceed $4 that Wal-Mart is offering. In my experience most copays for generic run at about $5-$10. So will consumers want to go to Wal-Mart to save from $1 to $6 on generic copay. I'd bet that a very small minority would. The brilliance of WMT's action is that neither WAG or CVS can follow its strategy otherwise they'll jeopardize reimbursement rates from the insurance companies.

Wal-Mart actions were not really focused on WAG or CVS since most of their customers have insurance, they were directed towards the uninsured consumers. A bigger question, will insurance companies try to exert pressure on pharmacy retailers to follow WMT’s pricing – they may try but I don’t believe they’ll be successful.

(see original article for position disclosure)

Russian Thievery

by Vitaliy N. Katsenelson, CFA

September 20th, 2006 - Minyanville.com

The Russian government's threat to suspend licenses for two giga-billion projects by TNK-BP, in part owned by BP (BP) and Royal Dutch Shell (RDS-A), is not uncharacteristic of Russia and its very short term thinking. The Russian government argues that it is based on environmental concerns. Nothing, I repeat nothing, in Russia gets done based on environmental concerns. The government simply wants to muscle in on a larger stake in the projects.

Russia feels like it has an upper hand in any negotiation as commodity prices and demand are on its side, plus it is becoming less dependent on the rest of the world as it is swimming in cash. This arrogance raises a political risk premium that foreign companies have to factor into their models by raising the risk premium when deciding to invest or not to invest in Russia.Since commodity prices are very high, rates of returns are high enough to cover the increased cost of capital. But commodity prices will not be scratching the sky forever.

Maybe I am just too cynical and TNK-BP really is trying to pollute poor mother-Russia... nah, if Gasprom was doing this the government would be laying a red carpet under its pipelines to make sure that its executives don't get their feet wet.

Reaction to Toll

by Vitaliy N. Katsenelson, CFA September 18th, 2006 - Minyanville.com After reading my comments on Toll Brothers (TOL), I got the following argument from a reader that I thought was interesting:

Toll builds to suit in most of its communities, thus putting itself in a position of carrying low amounts of inventory unlike virtually all other national builders. You don't have to give huge incentives to move a house that hasn't been built yet because you are giving the buyer choice!

This is an interesting observation. Let’s say the reader is right and Toll Brothers doesn’t build spec houses; all the houses are custom built to order and it faces very few cancellations. Would this practice put breaks on price declines? No! Toll Brothers competes against a small army of homebuilders that are facing cancellations of already built houses. A flood of new homes and a drop of demand caused by a cooling down of the housing market created a significant pressure on house prices. And though Toll Brothers did not cause the price declines (as the reader argues) its future to-be-built houses will be facing competition from lower priced, already built and/or to-be-built houses from struggling competitors. If other builders give incentives or lower prices to keep selling their houses, unless Toll Brothers have something very unique about their houses (i.e. premium waterfront lots, much better quality etc..) it will have to lower the prices to be competitive.

Toll Brothers may decide to abstain from selling houses at lower prices. It then will sell a lot fewer houses and its earning will still suffer. Unfortunately for Toll Brothers, industry structure is a function of actions of all competitors, not just the stronger, wiser ones (as the reader argues). Weaker, less disciplined competitors can destroy value for the whole industry, they’ve done it many times in the past and will do it again.

Mr. Toll at "It" Again

by Vitaliy N. Katsenelson, CFA September 7th, 2006 - Minyanville.com I wrote about Mr. Toll, CEO of Toll Brothers (NYSE: TOL) before. But Mr. Toll still keeps amazing me. Reader sent me the following link to Mr. Toll's latest interview.

I just love when a person who made hundreds of millions on building houses pleads ignorance. This comment insults everybody’s intelligence: “The current slowdown is 'strange' because it cannot be explained by macroeconomic factors such as interest rates or unemployment that traditionally reduce demand for houses," Toll said. "We have an apparently decent economy."

Why? Because he just told us in a previous statement: “The current downturn is mostly the result of a 'severe overhang' in supply that Toll estimated at 15 percent to 20 percent more than the market can easily absorb. That was driven by 'tremendous speculation' by home buyers who never intended to occupy seeking a quick profit from a rising market, and by builders who constructed homes before securing buyers, he said.”

I don’t have anything against Mr. Toll, in fact I don’t even follow the stock. But I find his comments are very insulting. You did not have to be a braniac to know that the housing market was going through a bubble. I am waiting until he’ll take Mr. Byrne' (from Overstock.com (Nasdaq: OSTK) tactic and will start blaming the decline in housing prices on short sellers – he is already blaming other builders. There is a unique element to the housing industry – once you build and sell a house, it starts competing with your future houses because at some point that house will make it back on the market. Mr. Toll knows about it but he pleads ignorance.

I don’t know if housing stocks are cheap enough. I am aware that one has to be able to differentiate between a good company and a good stock. There is a possibility that despite the housing market going through some very tough times, the housing stocks’ valuations reflect a scenario that is a lot worse that could possibly transpire. I know some very smart investors for whom I have a tremendous respect that made that case. I have an un-quantified hunch that they probably are not cheap enough – Toll Brothers (TOL) is still trading at above 2004 levels. I am not sure that 2004 earnings will be coming back. Looking at past earnings is a fruitless exercise as they are meaningless for the forward looking analysis – the past is unlikely to repeat for quite awhile.

China Redux

by Vitaliy N. Katsenelson, CFA

Sep 15, 2006 - Minyanville.com

Some interesting feedback... I wrote an article in July 2005 titled “China Speed -- Running Into the Great Wall”, making a case that Chinese economic slowdown will send that great country into a severe recession. Last month I updated that article adding some minor twists. I found an interesting counter point to my article on this website that I thought I should share with readers:

The post, written by Vitaliy Katsenelson, VP with Investment Management Associates and a teacher of equity analysis at the University of Colorado, entitled, "The Great Bubble of China?" posts China is "living through one of the greatest historical bubbles." Katsenelson sees China as a manufacturing country built with high interest debt. He sees China's fall occurring due to factory overcapacity, a rise in the cost of money, and/or a slowing U.S. economy.

Katsenelson even has titles for the books he sees being written after the fall: “The Chinese Conundrum” or “The Great Chinese Bubble” or “Irrational Exuberance 2.” The author's investment advice is to take your money out of commodities and to forget about investing in Chevron (CVX), Exxon Mobil (XOM), or Conoco Phillips (COP). Katsenelson equates the idea that all companies need a China strategy to the idea in the late 90s that all companies needed an internet strategy.

Call me part of the bubble, but I disagree with Katsenelson on all points. China is a manufacturing country now, but it is rapidly diversifying from that. Its consumer and service sectors are rapidly rising and even if they were not, I could see manufacturing tailing off and stabilizing, but I cannot see it crashing. If labor costs in China rise such that companies take their manufacturing elsewhere (Vietnam, Indonesia, and the Philippines come to mind), and China has no industries to replace it, labor costs will stop rising. On top of this, China's advanced physical and legal (yes, legal, at least as compared to lower cost countries like Vietnam, Indonesia and the Philippines) infrastructure creates real value for manufacturers.

I also find fault with the view that a U.S. slowdown will crush China. Firstly, there has to be a U.S. slowdown on trade with China. Secondly, the U.S., though obviously of huge importance to China, is not everything. Thirdly, though I do believe there will be a slowdown at some point (there has to be!), a slowdown is not a crash. It is interesting to note that in this post from June, 2005, entitled, China Speed -- Running Into the Great Wall," Mr. Katsenelson said pretty much the same thing he is saying now. So when is this bubble going to pop and why did it not pop in the last year when all of these same bubble poppers were purportedly in place?"

I was glad to see interest in the article and it got me thinking more about the discussion. Let me try to reply to every point made:

"China is a manufacturing country now, but it is rapidly diversifying from that. Its consumer and service sectors are rapidly rising... "

I actually agree with this statement, at least in part. China is likely to transform to a broader economy over the years, but it will take time. And with manufacturing making up such a large sector of the economy, it will take awhile (decades) before the services sector will be able to make meaningful contributions to the economy.

"I could see manufacturing tailing off and stabilizing, but I cannot see it crashing."

The operational and financial leverages are likely to prevent a normal slowdown, as revenues fall the costs will not fall as fast (by definition of leverage) and thus profitability will suffer.

"If labor costs in China rise such that companies take their manufacturing elsewhere (Vietnam, Indonesia, and the Philippines come to mind), and China has no industries to replace it, labor costs will stop rising."

Business Week had a small article last year making the case that China saw some double digit wages in inflation, but I think this is not true for the whole economy, but more common in specific industries. If the Chinese economy implodes, I don’t think the wages will be rising, the implosion will be deflationary for China and the rest of the world. I agree that if labor costs in China become high enough, companies will start looking for a cheaper alternative.

"China's advanced physical and legal (yes, legal, at least as compared to lower cost countries like Vietnam, Indonesia and the Philippines) infrastructure creates real value for manufacturers."

I agree.

"I also find fault with the view that a U.S. slowdown will crush China. Firstly, there has to be a U.S. slowdown on trade with China."

This comes back to my point of leverage - China has plenty of that. A U.S. slowdown will decrease incremental demand and depending on the amount of the U.S. slowdown it may be enough to decrease incremental demand to send many Chinese producers into red. Also, something I did not mention in the article is the bad loans are a real issue in China, a number I saw was 40% of GDP. Once the economy slows down they’ll come to the surface.

"It is interesting to note that in this post from June, 2005, entitled, China Speed -- Running Into the Great Wall," Mr. Katsenelson said pretty much the same thing he is saying now. So when is this bubble going to pop and why did it not pop in the last year when all of these same bubble poppers were purportedly in place?"

As I mentioned in my article “But, as with any bubble timing, the pop is very difficult, Bears are usually too early to call it and Bulls are usually too late to see it.” I really have no idea when it will take place. The Chinese government plays a very large and important role in China's economy, thus it may postpone the crash by intervening. But the longer it intervenes the great the decline will be. I have no idea when it will happen, but I am aware of the risk and thus we structure our firms portfolios accordingly, trying to minimize our exposure to a slow down in the Chinese economy.

The Best of: Dell, Not Yet?

Since there are lot of new visitors to this site, I am reposting some of my older articles that I believe are still relevant today.

July 14, 2006 - The Motley Fool By Vitaliy Katsenelson, CFA

Dell (Nasdaq: DELL) is hitting multi-year lows and, at 16 times trailing earnings, is attracting value investors that have coveted the stock from afar for years. Some of this latest decline can be traced to the company's recent downward revision of earnings estimates. And this is precisely the noise that a contrarian investor looks to capitalize on.

But are Dell's problems short-term in nature? Though the valuation appears alluring on the surface, I don't yet own the stock. Here's why.

Almost no recurring revenues With the exception of small service and printer cartridges businesses, Dell has no recurring revenues -- none! To grow a computer business 10% year over year, it has to sell as many computers as it sold last year, plus 10% more -- not an easy task with computer prices on a steady decline.

The upgrade cycle It is the last inning of the usual four-year PC upgrade cycle, and that's not great news. However, Microsoft's (Nasdaq: MSFT) Vista is likely to provide a new engine of growth for computer makers. It shifts a lot of processing from the CPU to the video and network cards, which will -- in theory -- improve the computer's performance. To reap the benefits of improved functionality, users will need to upgrade to brand new, redesigned computers -- great news for Dell. But will consumers and corporations looking to upgrade take a wait-and-see approach to Vista? Or will they install Vista on top of their existing, relatively new PC?

Laptops are still hot Laptops are a bright light in the Dell story for several reasons. First of all, as more and more people switch to laptops from PCs, the upgrade cycle will get shorter -- since a laptop's useful life is about half that of a PC's -- good news for all PC manufacturers. Second, laptops are a less commoditized product. While PCs have been mostly impersonal commodities bought mainly on price or availability, laptops are a more personal product, with features that vary from one manufacturer to another. Dell got the laptops right. And as Wi-Fi becomes more of an everyday staple throughout the world (I assume), laptops could overtake PCs.

Eroding advantage? Dell's competitive advantage as a low-cost producer, which helped the company become what it is today, has been shrinking. But it is still there; Hewlett-Packard(NYSE: HPQ) and its competitors have been squeezing suppliers, becoming much more competitive on price. In Dell's defense, it still has a distribution advantage, since it sells its computers directly to customers, allowing the company to capture extra margin instead of sharing it with distributors and retailers. And it maintains much lower inventories, a very important competitive advantage. Dell is still the only manufacturer with a negative cash conversion cycle -- it sells a computer and doesn't need to pay for the components for more than a month, resulting in great free cash flows.

Converging prices Back when a decent computer would cost a couple thousand dollars (seems like decades ago, doesn't it?), price was a very important factor. But the prices of computers have declined so much that a $30-$50 price difference is not a very persuasive argument to go with Dell versus HP or another respected manufacturer. However, this may be a very U.S.-centric perspective. For consumers and corporations in developing countries -- Dell's source of future growth -- $40-$50 is still a meaningful amount.

New products Life beyond computers is uncertain. Dell has done a decent job of expanding beyond computers to printers and ... really nothing else, at least not yet. It is an extremely efficient manufacturer, but not an innovator. It is too early in the game to determine if Dell will succeed or not, but the deck is stacked against it, insofar as it is competing against a new breed of innovative companies like Sony(NYSE: SNE) and Toshiba.

Poor customer service To cut costs, Dell has dropped the ball on customer service. I've talked to many people who've had a terrible customer service experience. While I give management credit for realizing the problem and announcing plans to hire more customer service people in the United States, I wonder how this will affect the company's margins. Is the damage irreparable? Not likely. Will it have to spend more money on advertising (further affecting thin margins) to convince consumers that things have changed? We'll see.

Financials are still strong Dell has a 58% return on capital, about 15% of its market capitalization is in cash, and its free cash flows are to die for. However, its core earnings, as calculated by Standard & Poor's, stand about 30% lower than reported, thanks to significant stock option expenses.

Tempting, but will you regret it in the morning? After reading this, the reader may find that the positives and negatives are pretty close. But two negatives in particular prevent me from buying Dell (at least at this price): lack of reoccurring revenues and a good possibility that the growth of PCs will slow down and laptop growth will not be able to make up the difference.

Glancing at the P/E, the stock appears to be inexpensive, especially in relation to its historical P/E. However, based on my discounted cash flow model, a GDP-like 4%-5% sales growth is priced into the stock. And at today's price, I think that provides little margin of safety if the above scenario plays out for at least couple years. This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Jos. A. Bank: You Betcha!

By Vitaliy Katsenelson, CFA September 12, 2006 - The Motley Fool Jos. A. Bank (Nasdaq: JOSB) has reported its second-quarter numbers, and they aren't good -- they're great! To start with, sales were up 20.8%, and gross and operating margins improved, mainly driven by maturation of the company's fairly new store base. But the Jos. A. Bank story is not about growth -- it always had plenty of that. It is about inventories, and they were the bright, shining star of this quarter. Specifically, inventories increased only 11.7% over the second quarter last year. So why is that great news? To answer that question, it's necessary to understand the issues surrounding Jos. A. Bank. First, it has double the inventory days (a measure of how long it takes to convert inventory into sales) of its closest competitor, Men's Wearhouse (NYSE: MW), and second, it had a terrible first quarter due to too much seasonal inventory. I have written two long articles on the first issue, so let me address the second issue here. At the end of last year, Jos. A. Bank had some incredible, blockbuster same-store sales numbers. As the company prepared for future sales growth, it continued to stock up on winter inventory. However, the winter was warmer than expected, and demand did not materialize. The company launched an aggressive fire-sale campaign to move that entire seasonal inventory, and the stock was slaughtered as margins crashed and earnings estimates were missed. Wall Street was concerned that Jos. A. Bank's "let's have a year of inventory" strategy was falling on its face. Last quarter, the company's management said it had been too aggressive with price cutting -- the benefit of hindsight showed that prices didn't need to be cut so much. Management also said it will not be cutting prices for winter merchandise in the second quarter. Declined inventory on a per-store basis and improved margins suggest that management kept its word. In fact, margins improved on an overall basis. The only cost that was rising (slightly) faster than sales was sales and marketing, which makes sense as the company has been spending more money on TV advertising. Though inventories increased, they have grown at a much slower pace than sales -- a very important nugget of information. I expect inventories will still be growing in the future, but probably slower than sales, as inventories in established stores will not be rising. This is great news on many fronts. First, the company's free cash flows will start outpacing net income growth, and second, the management that took an unorthodox strategy will gain credibility with the Street -- and the company's stock will reflect that. Let's quickly take a look at three important components of any investment: quality, valuation, and growth. Quality:

• Balance sheet: With the exception of leases, the company has almost no debt.
• Return on capital: This number has improved on a consistent basis since 2000 (despite rising inventories per store).
• Sustainable competitive advantage: JOSB is not a Wal-Mart (NYSE: WMT), but it has a product and a distinct brand that men want and it provides a better, more personal shopping experience than Men's Wearhouse.
• Free cash flow: On average, operating cash flows have consistently grown in line with net income -- a good sign in itself. As inventory growth decelerates, free cash flows will follow.
• Management: So far, it's done everything it said it would do. It made mistakes along the way (i.e., the first-quarter mishap), but nothing that would make me doubt its unorthodox strategy.

Valuation: The stock is cheap! It is trading at 13 times next-year numbers and at 5.4 times my $5 estimates for 2009 (yes, I do look that far). Growth: The company is set to open about 150 stores over the next three years to bring its total store count to 500 by 2009. As its fairly young store base (more than half of its stores are less than three years old) matures, its margins will increase, driving earnings growth in excess of sales growth.

Owning Jos. A. Bank requires one to think independently from the rest of the pack. Analysts don't get fired for owning conventional stocks like IBM or Colgate, but they do get fired for owning a company that has double the inventory days of a close competitor. Investing in JOSB requires a strong stomach for high short-term volatility and a conviction that can only be achieved from one's own in-depth research.

Vitaliy N. Katsenelson, CFA

Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He and his company own shares of Jos. A. Bank and Wal-Mart. The Motley Fool has a disclosure policy.

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

China stuck in overdrive

By Vitaliy N. Katsenelson

Denver Post Al Lewis's Blog - August 16th, 2006

The Chinese economy reminds me of the movie “Speed”, where Dennis Hopper wires a bus with explosives and sets them to blow if the bus goes slower than 50 miles per hour.

• The Chinese economy has 1.2 billion unsuspecting people on board. It could all blow if economic growth drops below its current pace of more than 8 percent. Even a small, otherwise harmless speed bump is likely to send this gigantic economy into a severe recession. Here are the reasons why: China has become a de facto manufacturer for the world. With exception of food products, it is difficult finding a product that was not, at least in part, manufactured in China. Industrial production accounts for 53 percent of its Gross National Product (according to CIA Handbook), double the rate of most developed nations. Industrial production for the United States is 19.7 percent of GDP, UK 26.3 percent, Japan 24.7 percent. Chinese economic growth is largely driven by the manufacturing sector, as its industrial production growing at the double rate of GDP.
• The manufacturing industry is very capital intensive. Building factories requires a large upfront investment. To make things worse, with commodity costs rising, the required investment has increased. Once it’s built there is a fixed cost associated with running a factory that is to some degree independent of utilization level – a classical definition of operational leverage. Laying-off workers is a politically sensitive process thus creating another layer of fixed costs.
• Debt is an instrument of choice in China. Due to a lack of equity-fund- raising alternatives, bank debt and underground finance companies that charge very high interest rates are the predominate sources of capital in China – financial leverage. Large piles of debt (financial leverage) combined with high fixed costs (operational leverage) create a very high total operational leverage. Total operational leverage in China is elevated further as factories are built to accommodate a future demand, and since it has been rising in the past automatically projected to climb in the future. This greatly leveraged growth works fine as long as the economy continues to grow at fast pace. As sales are growing, costs are not growing as fast as they are largely fixed (thanks to operational leverage) leading to operating margins expansion - the beauty of leverage. Unfortunately leverage works both ways, as sales growth slows down the opposite takes place.

There are many factors that could cause the fatal slow down in Chinese economic growth:

• Slow down of China’s largest trading ‘partner’ - the U.S. economy: China is financing its biggest customer – the U.S. consumer. Similar to Lucent Technologies trying to induce sales growth by financing its dot.com customers, China is in part financing U.S. consumers by buying U.S. Treasuries, thus keeping the U.S. interest rates at very low levels and creating what Mr. Greenspan called a ‘conundrum’.
• Higher short-term rates coupled with debt levered balance sheets, doubling of credit card minimum payments (coming to consumer door steps in January 2006), high gasoline prices topped with a sprinkle of significantly higher heating costs may push consumer off the shopping train - lowering demand for Chinese produced goods.
• An ever rising pile of politically motivated bad loans may bring the Chinese banking system to a halt (similar to Japan’s of late 80s). Though China is trying to Westernize its lending practices, a dangerous combination of semi-market economy and a in most part government controlled banks is very dangerous. In this environment loans are often made not on the merit of investment but based on political connection – a recipe for disaster.
• Overcapacity - It is a human tendency to draw straight lines and thus making linear projections from past into the future. During the fast growth period the angle of the straight lines is usually tilted upward, causing over investment in fixed assets, as inability to keep up with demand may cause manufacturers to lose valuable customers. However, overcapacity is a death sentence in the manufacturing (fixed costs) world. As companies face overcapacity or slowdown in demand, they try to stimulate sales by cutting prices, which in part lead to price wars (similar to what we observed in the U.S. between Sprint, MCI and AT&T (NYSE: T) in long distance business in mid 90s) and to a fatal deflation.

Currently companies emphasize their China strategy on their conference calls, in a similar fashion as companies were emphasizing their internet strategies in the late 90s. Though did not start re-naming themselves to incorporate China into their names -a common practice in late stages of internet bubble; It is very apparent that many are making large investments in China. As it usually happens after the bubble pops, the past assets turn into today’s liabilities. Thus, a highly touted exposure to China that was looked upon as an important asset lead to a written-off investment, leaving nothing but a trail of liabilities behind.

Though a pop in Chinese bubble is unimaginable to many, the same way as collapse of Japan and fifteen year recession that followed was unimaginable in late 80s. It is not a question of ‘if’ but more of a question of ‘when’ the Chinese economy will cross that metaphorical 50 miles per hour mark and falling into the deep abyss of prolonged recession and very possible deflation.

China is living through one of the greatest historical bubbles. Books will likely be written to describing its ‘ridiculousness’, but as always, they’ll be written after the fact. Here are some suggestions for the book titles: “The Chinese Conundrum” or “The Great Chinese Bubble” or “Irrational Exuberance 2”.

But, as with any bubble timing, the pop is very difficult. Bears are usually too early to call it and bulls are usually too late to see it.

As government published numbers of economic growth cannot be trusted, investors should look for anecdotal clues for the inflection point. Conference calls of U.S. companies doing business in China are probably the best source of information.

The risk of the Chinese bubble is real, thus it may be wise to prepare by immunizing portfolios from that risk. Though being completely rid of the China risk is impossible and impractical, it is very important to stress-test a portfolio against that risk, one stock at a time. Industrial commodities and companies that produce them are likely to be the first casualties of the bubble bursting. Oil stocks like Chevron (CVX), Exxon Mobil (XOM), Conoco Phillips (COP) and many others were great performers in 2005, up in double digits. Their run is likely to end when Chinese economy goes into a tail spin.

Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches equity analysis at the University of Colorado at Denver’s Graduate School of Business. He also writes for the Financial Times, The Motley Fool and Minyanville.com. More of Vitaliy’s articles could be found at www.ContrarianEdge.com

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Jos. A Bank Is a Patient Joe

By Vitaliy Katsenelson, CFA

August 31st, 2006 - The Motley Fool

Investing isn't for the faint of heart. A Foolish investor must be strong enough to change his or her mind when a stock's underlying facts change -- or hang on tight, even in the face of a share-price decline, when they don't. I wrote a very favorable article about Jos. A. Bank (Nasdaq: JOSB) about a month ago, and I wouldn't change a single line in that article, despite news that the retailer's same-store sales for August fell 6.1%.

Monthly same-store sales numbers are just too random to make good predictors of future results. And Jos. A Bank's most recent sales faced numerous obstacles:

• They had to top last month's 15.9% same-store sales increase. The company's average July/August sales are still up 4.9%, and year-to-date same-store sales are still running at a very impressive 5.7% clip. Note that catalog and Internet sales (about 10% of total sales ) were up 17.4% in August.
• They faced similarly tough comparisons with the year-ago quarter's 12.9% same-store sales increase.
• Finally, they relied upon uneven promotional activity. Jos. A. Bank's same-store sales were always volatile, largely because of its legacy marketing positioning. Under previous management, the company mailed promotional coupons to target male shoppers; store prices were inflated to compensate for these coupons. This kind of of promotion-driven marketing causes same-store sales to ebb and flow.

The current management team is gradually trying to steer the company away from coupons and toward brand-building via TV advertising instead. But old habits die hard; male shoppers in established Jos. A. Bank markets have grown accustomed to waiting for coupons before shopping at the store, so the company must still rely heavily upon coupons to bring them in.

Invasion of the increasing inventoryWhile all these points may help explain Jos. A. Bank's recent difficulty with same-store sales, they're irrelevant to any analysis of the overall company. This is not a sales story; the company has demonstrated a healthy ability to grow sales. This isn't even really a profit-margin story; with the exception of last quarter, the company's profit margins have been rising since 2001.

No, Jos. A. Bank is an inventory story. The stock has fallen from its mid-$40s highs because Wall Street doesn't trust a retailer whose inventory has been on the rise for the last five years. The distrust makes a lot of sense to me, since retailers live and die by inventory -- but not all inventory increases are created equal. If inventory days were to rise for American Eagle Outfitters (Nasdaq: AEOS) or Abercrombie & Fitch (NYSE: ANF), I'd be very concerned, since teenagers' love affair with hole-filled jeans fluctuates as quickly as the fashion trends spotted on YouTube or MTV. But casual and not-so-casual men's fashions move at a more glacial pace. White and pinstripe shirts have been in fashion since ... frankly, I can't count that far back.

Out-of-control inventory increases are simply scary, an indication that customers don't want to buy the company's merchandise. But again, that's not the case here. In conference call after conference call, Jos. A. Bank management has stated its intent to increase inventories at its stores. Why? The company found it was turning customers away because it didn't have enough of the right sizes. By increasing size selection in its stores, Jos. A. Bank was able to generate higher sales. It's just that simple.

Rising inventories are a cash flow hog, but Jos. A. Bank still has enough cash left over to fully cover its explosive growth. Despite rising inventories, its return on capital has been increasing since 2001, exceeding the return on capital of Men's Warehouse (NYSE: MW). The higher-inventory strategy has worked for Jos. A. Bank, and I believe it will keep working.

Tailored for successHow much inventory is enough? Management has indicated that the end of inventory increases is in sight. Once the market becomes comfortable with Jos. A. Bank's inventories once more, the stock should find a renewed Wall Street following. In my analysis, Jos. A. Bank should earn about $5 a share in 2009 -- perhaps a dollar or so less if the economy slows down. At today's price, I've got more than enough of a margin of safety to remain patient about this stock.

Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He and his company own shares of Jos. A. Bank. The Motley Fool has a disclosure policy.Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Random Thoughts: Toll's Bias; Housing Market; Russian Oil Production

August 25-26th, 2006 - Minyanville.com

Toll's Bias

There was an interesting article in the NY Times on the housing market. But what really struck me is Robert Toll’s (CEO of Toll Brothers (TOL)) denial of what is taking place in the housing industry until recently:

Here is a sample of his comments from a year ago: “We’ve got the supply, and the market has got the demand. So it’s a match made in heaven.” This is from last October: “Why can’t real estate just have a boom like every other industry?” he asked. “Why do we have to have a bubble and then a pop?”

Now, after the market turned ugly: “... is unlike anything he’s seen: sales are slumping despite the absence of any 'macroeconomic nasty condition' taking housing down along with the rest of the economy." He suggests that "unease about the direction of the country and the war in Iraq is undermining confidence. All I have to say is: pop!”

What bothers me about this is that I am sure Mr. Toll is a very smart person, he has built a multibillion dollar company after all – he's not a dummy. I have two theories on why he made the previous comments:

He convinced himself that the housing market is going through a normal boom and rejected every other rational argument that almost any other rational person would see without a magnifying glass. He had so much at stake for this to be true that he had an inherent interest to reject the bubble argument. The sad part about it is that he may not have been lying when he made his “not a bubble” argument, as he truly convinced himself to believe it.

The second theory: He just lied. His whole sales organization’s job was to convince potential buyers to buy bigger, better houses. Toll Brothers sales people had to answer the “are we in the housing bubble?” question from potential buyers on a constant basis. You don’t sell houses by telling buyers that they are purchasing a bubbly asset. Also, even if his sales people would never read his comments in the Wall Street Journal, these comments for sure would send the stock down and thus his net worth.

I tend buy into the second theory for one reason: Mr. Toll was selling Toll Brothers stock as it was going out of fashion. This is a very transparent and important lesson to learn: management’s comments always have to be looked at with a healthy dose of skepticism. The car salesman may be telling you the truth about the car, but you still don’t take him at his word as he has an inherent bias to sell you a car. He is not a bad person, but he has a nagging wife, his kids need to go to “better” schools and they need braces. What would you expect? Corporate executives arguably have a higher standard on “truth” than a car salesman, but they still have a bias as they need to sell stock. More thoughts on the housing market:

I don't know if other states have "charity programs" that help consumers to buy houses, but I think in part these "charity programs" were in part (emphasize: in part) responsible for what is taking place in Colorado. As I understand it, according to law, a seller cannot provide a down payment to help a buyer to buy a house. But there is a loophole in the law - the charity can "help" a buyer with a down payment. The game that was very often played in Denver was as follows: Let's say a house is on the market for $300,000. A buyer needs to bring $15,000 down payment to the closing, the buyer doesn't have it. So the following would take place: The seller agrees to donate $16,000 to a "charity." The "charity" in turn would "donate" $15,000 to the buyer for the down payment. The seller in turn would raise the price of the house from $300,000 to $316,000 and charity would keep $1,000 as a processing fee. Everybody happy? Well, yes, with exception that the entity that has arguably created zero economic value, just increased the transaction cost by $1,000 and comparative housing prices just registered a 5.3% ($16,000) jump.

Russian oil production:

Paint me a skeptic or perhaps it's just from being born in Russia, but I think Russian oil production is very likely to decline in the future. Why? Simple, over last couple of years Russian Government has de-privatized a big chunk of oil companies.As we know government is not as effective at managing resources as private enterprise. Don't believe me? Just take a look how Fed Ex (FDX) and UPS have taken share from the US Postal Service - a government run legal monopoly.

Vitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Random Thoughts

Minyanville - August 16th, 2006

I'll pose these questions for readers:

Let's say the scenario that I described in this article plays out, the Chinese economy slows down, its massive operational and financial leverages create deflationary pressure on the companies forcing them to lower prices in an attempt to stimulate sales growth, starting a price war which would in turn lead to even lower profitability, driving many companies into red. A sudden loss of profitability would lead the bad loans, which are estimated to be around $900 billion (40% of GDP), to become a real problem.

Let's say government decides to take a hands off approach and not take the Japanese route by creating a zombie economy and would let the market forces play out (I know I am stretching here). If (actually in my mind it is a question of when, not if) all that takes place, what would happen to:

1. The U.S. dollar reserves, would Chinese companies have to pull the money out of U.S. Treasuries? What would happen to the U.S. interest rates? Long term and short term?

2. What would happen to the Chinese/U.S. Exchange rate?

3. Would the Chinese exported deflation throughout the world be a net positive? Or we may see an Asian contagion spreading throughout the world?

We have nothing to fear but Google itself

Let's say written in the past, though Dell (DELL) appears to be cheap relative to its past valuations, I believe it is not cheap on an absolute basis, which is more important for range bound markets.If Dell decides to take a recommendation from Barron's and start opening new stores, it will be a kiss of death as it will give up on its last competitive advantage. Just take a look at Gateway (GTW).

I believe Microsoft (MSFT) is a much easier play on the computer sector. Its valuation is very attractive, 14x earnings (excluding cash that is going back to shareholders through stock buy backs and rising dividends). It also has a Google-will-take-over-the-world discount built into it, which I believe will dissapear a lot sooner than later.

Another stock that becoming more and more appealing through valuation (though not there yet) due to Google (GOOG) fears is Ebay (EBAY).

More on Dell, Intel, HP and AMD

Professor Gilmartin and I were exchanging thoughts on Dell's (DELL) valuations. Trying to figure out what is the appropriate buy valuation for the stock that would have an appropriate margin of safety.One thing I have found is that relative valuation (i.e. today's P/E vs. where it was in the past) is skewing many fundamental folks' view on Dell's attractiveness. But I believe it is very important to attempt to come up with the appropriate absolute valuation for the company first and only then look at the past valuations. If one does that, then today's P/E or P/CF may not appear to be as attractive. I am not in love with Dell (DELL) at today's price, falling in love with Hewlett-Packard (HPQ) looks like a mistake to me. Just scanning through Dell's conference call (albeit between the lines) it is fairly clear that Dell will not let HP prosper at Dell's expense.

Also, aside from offering customers "variety," I gather from reading the transcript that Advanced Micro Devices (AMD) is likely to be undercutting Intel (INTC) on price. Maybe that is their way to get into Dell's computers and get the scale needed to compete with Intel? But that is a risker strategy. Just compare Intel and AMD's operating margins.

Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Random Thoughts

I wrote these short comments on Minyanville.com between August 14-16.

It's what good managers do to win ball games

At MIM2 (Minyanville in the Mountains 2) Jeff Macke and I discussed how being a public company impacts management's decisions, where management may do things that are not necessarily good for the long run of the business to please the short-term, result hungry Wall Street.

This excerpt from Lion's Gate Entertainment (LGF) is a good example of that.

Analyst: There does appear to be a move towards really squeezing those windows closer together. I am wondering what the pros and cons of that are.

Jon Feltheimer (CEO): We think 16 weeks is still about the right amount between windows. I do not think we see really compressing them much more than that. I think there are times, particularly as a public company, when you are trying to get certain revenues within your fiscal year, and you move a movie a couple of weeks, so maybe the window changes a little. Life Sentence

A WSJ article highlights how dysfunctional French labor laws are. Two-thirds of France Telecom's employees, for instance, have civil-servant status - a job for life guarantee. This is shocking, since this is a company that is fighting for its existence in the fast changing world of telecommunications. The majority of its workforce have little incentive to work. The article highlights the hoops the company has to jump through to convince its workers to voluntarily retire.

The employment for life mentality only works when there is no competition or when you compete with other employment for life entities. Meanwhile, employment-for-life Europe is competing with the rest of the world which operates under capitalistic conditions (employed until you create value), or even worse - sweatshop-like conditions, 20 hours a day, no-lunch labor laws.I don't know how Europe can remain competitive when it is still stuck in the 20th Century pre-flat world.

Danger of Cheap Stocks

By definition, a value investor is enticed by “cheap” stocks. However, quite often “cheap” stocks are cheap for the right reasons: fundamentals deteriorate or expected growth rates don’t materialize - welcome to the value trap, the value investor’s hell. I wish there was a silver bullet that would keep the investor out of value traps, but there isn't. Investors might want to do an un-American thing – assume a cheap stock is guilty of been cheap for the right reason until proven otherwise. The burden of proof should be on NOT buying the stock.

Though I don't short stocks – I run long only accounts, I believe an ability to short stocks may make investor more objective. A long only manager often lacks the dark (short) side’s perspective. The ability to walk on the dark side forces investors to look at the negative more objectively.

I’d love to spend as much time in value investor’s hell as the next guy. I’ve stepped in my fair share of value traps and (publically) avoided a few (here and here).

Recently I looked at Cedar Fair (FUN) which attracted me with its 7.6% dividend yield, however, as you’ll see from this article, I found that the risk profile of the company has increased exponentially after it bought Paramount Parks from CBS and dramatically leveraged its balance sheet. Though Cedar Fair may be able to maintain its dividend over the years (it will unlikely be able to raise it by meaningful amount), an economic slowdown or bad weather or any other unforeseen event (earthquake, hurricane, flood etc...) will put the company’s ability to pay its dividend in jeopardy.

Large and In Charge

A couple of weeks ago I wrote an article for the FT which also FT, making a case that quite a few large cap growth stocks like Microsoft (MSFT), Wal-Mart (WMT), Johnson & Johnson (JNJ) are trading at very attractive valuations. Their earnings more than doubled or tripled since the late 90s but the stocks have not gone anywhere, for the right reasons I might add - they were overpriced.

I believe the investors in these stocks that bought them in the early 2000s fell into what I call a "relative valuation trap" as they appeared cheap relative to the end of the bull market valuation. I believe today they are cheap on a more important absolute basis. However, after I wrote the article, I received several dozen "right on" emails and only one "you are out of you mind emails," this tells me I am probably too early as too many people agree with me.

Vitaliy N. Katsenelson, CFA

Dividends on the Ride Down

August 11, 2006 - The Motley Fool

By Vitaliy Katsenelson, CFA

As I began analyzing amusement-park operator Cedar Fair (NYSE: FUN), it reminded me of a computer game that I used to play called Rollercoaster Tycoon, because I felt like I was on a roller coaster when debating whether to open a position in this company.

Cedar Fair is known as a pure-play, profitable, well-managed company that has paid and raised dividends every year for the past 19 years. Though competitor Six Flags (NYSE: SIX) is a pure-play amusement-park operator as well, it lacks all of the other qualities that Cedar Fair brings to the table -- it is buried in debt, and its cash flow reminds me of its wilder coaster rides.

Then, several months ago, Cedar Fair revealed its plans to purchase all six Paramount Parks from CBS for a tidy $1.25 billion. That announcement shocked investors, who were attracted to Cedar Fair for its reputation as a relatively low-risk and stable dividend-payer. The stock fell from the low $30s to the mid-$20s, while the dividend yield rose from 6% to 7.6%. Being a sucker for a dividend, I decided to take a peek at the stock. I wanted to find out whether the sell-off was warranted.

The upside of the roller coasterI also knew that Cedar Fair is run by a good, seasoned management team, and that its EBITDA (earnings before interest, taxes, depreciation, and amortization) margins and return on capital are the best in the industry, even exceeding those of the almighty Disney (NYSE: DIS) theme parks.

I like the general stability of the theme-park business. It's not immune to economic downturns, but a trip to a theme park is still one of the cheaper ways for a family to spend time together in the summer, which makes the industry somewhat resistant to rough patches. At the same time, a weaker dollar makes international travel more expensive, so U.S. citizens are more likely to vacation stateside in the first place. Cedar Fair's theme parks usually serve customers who live within a 150-mile radius, so high gasoline prices are unlikely to have a significant impact.

The Paramount purchase has doubled Cedar Fair's revenues and diversified the company's revenue base. It exposed the company to more robust local U.S. economies and even provided foreign exposure, since one of the largest Paramount theme parks is located in Canada. The steep descentAnd then there's the downside. At the right price, the Paramount acquisition would have made sense. But at the price Cedar Fair paid -- 10.7 times EBITDA -- the company's risk profile increased substantially, and the steep price may have limited its ability to further raise dividends for a while. Let's look more closely at why I think Cedar Fair paid too much.

1. Increased debtRight around the time of the purchase, Cedar Fair's $470 million in debt came due for refinancing. Banks, being aware of the company's increased risk profile after the acquisition, required a higher interest rate from the company for both old and new debt, which significantly raised Cedar Fair's borrowing costs. The company says it would like to raise $250 million in equity to pay for the acquisition, but it's not willing to do so at today's stock price. It may not have a choice, however.

Management said that it can increase merchandise and food sales at the existing parks. If so, that should help increase spending per visitor and raise the new parks' margins by about 3%-4% over the next several years. If anybody can do it, this management team can, but doing so could prove more difficult than expected.

Assuming the company will be able to refinance a $1.25 billion bridge loan from Bear Stearns and $470 million of its existing debt at 8% -- a rate the company says it can get -- management will still need to grow food and merchandise sales in Paramount Parks in the low-teen percentages for the acquisition to become accretive in three to four years. It will barely swing by in making its dividend payments, and it will have to make a heroic improvement in the Paramount parks' performance to be able to raise that dividend.

2. Potential for underinvestment in the parksIn the past, Cedar Fair prided itself for spending about $55 million a year on capital expenditures -- maintaining the parks, improving the rides, and so on. Paramount Parks, meanwhile, spent around $45 million a year. Next year, the company expects to spend $80 million on capital expenditures for Paramount and Cedar Fair parks combined. Part of that expense will go toward adding amenities such as restaurants and shops for the Paramount parks.

Is the new, much higher debt constraining Cedar Fair's capital expenditures? It's hard to say. But if so, underinvestment in its theme parks may increase the risk that it will share Six Flags' financial fate.

Although the Paramount parks are in better shape than Cedar Fair's previous acquisitions were, management was also very shrewd with its past purchases. They were much smaller and cheaper, and the management team focused on turning around mismanaged theme parks. That's arguably less difficult than converting a good, above-average group of theme parks like Paramount's into a great one.

3. Limited financial flexibilityBefore the acquisition -- with the exception of the past two years, when it built a water park and converted a Sea World into a water park -- Cedar Fair had a nice margin between its free cash flow and the dividend it paid. But the Paramount acquisition has put the company's ability to pay a dividend, much less raise one, at grave risk. If management is successful at improving the Paramount parks, this acquisition will become accretive in a few years. But if it fails, or if anything really unexpected happens, the company may become forced to do one of three things:

• Borrow money to pay the dividend, which would further increase its future financial burden.
• Cut capital expenditures, which it would pay for in years to come by way of lower attendance.
• Lower the dividend, which investors would not welcome.

The debt Cedar Fair amassed from the Paramount acquisition has made the potential cost of being wrong tremendous. There is little room among the operating cash flows, interest expense, and the dividend payment to soften the blow. The future ain't what it used to beIt's easy to say this management team has created a lot of shareholder value, made successful acquisitions in the past, and increased dividends for almost two decades. But investing is a forward-looking activity. Though I'd give the management team the benefit of the doubt, the recent numbers speak for themselves. Cedar Fair's interest coverage ratio for 2006 (in this case, computed EBITDA divided by interest expense) will have declined from about 7 before the Paramount acquisition to a meager 2.5 or so, assuming the company can obtain the 8% debt financing it says it can. With its 7.7% dividend yield, the stock looks very attractive on the surface. But there's no such thing as a free lunch. An increased dividend yield (caused by the price decline) has come at a much higher risk. Put simply, Cedar Fair is not the company it was three months ago. I believe that management made a mistake when it hurried to buy Paramount. I suppose I have an excuse now to play Rollercoaster Tycoon, but because of the Paramount acquisition, I won't be buying Cedar Fair's stock anytime soon. Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates. He and his company have no positions in the companies mentioned. The Motley Fool has a disclosure policy.

Vitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Fall in love again with a bellwether friend

August 4th, 2006 - Financial Times By Vitaliy Katsenelson

Published: August 4 2006 19:42 Last updated: August 4 2006 19:42

Love was in the air, birds were singing, price/earnings ratios were growing and the stock prices of large-cap, bellwether companies such as Microsoft, Wal-Mart and Johnson & Johnson were rising as if dotcom had become their middle name. Investors could not get enough of these great companies that had created substantial wealth for shareholders in the preceding decades. But they were in for a surprise.

Late 1999 and early 2000 marked the end of the renaissance era for large-cap growth stocks. Most of them either have gone down or drifted sideways since. And this should not have been surprising. In the ecstasy of market excitement, investors had confused great companies with great stocks. And those great companies stopped being great stocks once their p/es reached unprecedented highs.

The birds stopped singing. Seeing their money going nowhere during the past six years, investors’ excitement has gradually turned into indifference and then disappointment. The cold reality of miserable stock performance leaves no room for argument: these stocks were grossly overpriced.

But time is the great healer, especially when earnings are growing. These companies have more than doubled their earnings since the late 1990s. Those higher earnings have combined with lacklustre stock performance to create very attractive valuations.

Microsoft stock has declined substantially from its 1999 highs when it traded at more than 50 times earnings. Since then its profits have doubled. Adjusting its price for a cash pile (that is soon to make its way back to shareholders’ pockets through a $20bn share buyback and constantly rising dividends) it trades at an unbelievable 13 times earnings. Yes, this is not a typo. One of the few legal monopolies – which has a return on capital of 28 per cent, scores profit margins of 30 per cent and is increasing revenues at a double-digit rate – is trading at a below-market p/e. To top all of that, this downward valuation has taken place when it is about to come out with two huge new product releases, Windows Vista and Office 2007.

Wal-Mart in 1999 sported a p/e of 39 and earned $1.28 a share. Six years later it is expected to earn $2.95 for 2006. Yet its stock price is at the same level as it was in 1999. Its p/e is at a level that has not been seen in more than 20 years: 15 times forward earnings. That is very cheap for a company that is likely consistently to increase earnings in the low teens for years to come, and has a moat the size of Lake Michigan around its business.

Johnson & Johnson is trading several dollars above its 1999 level in spite of its large size. Its earnings have grown at a very impressive 15 per cent a year at the same time as its p/e has been cut in half from 32 times in 1999 to 16 times 2006 earnings today. How often do we get an opportunity to buy one of the best and most diversified pharmaceutical and consumer companies that pays a 2.5 per cent dividend yield at this valuation? It happened a couple of times in the early 1990s, and Johnson & Johnson’s stock has more than quadrupled since then (although I am not saying I expect it to do that this time around). Did I mention it has $15bn of net cash (cash less debt) in the bank?

Six years of subpar stock performance for large-cap growth stocks has led many to believe there is something wrong with the underlying companies. That assumption could not be more wrong. The stocks have disappointed investors’ linear expectations because they were overpriced in the late 1990s and it took six long and dreadful years for the valuations – the p/es – to catch up with fundamentals. They have finally done so. What these companies usually share is that they have strong moats around their business, a long track record of success, above average dividend yields, strong brands, great return on capital, a bright future of growth ahead and very attractive valuations. They are considered to be bellwethers for a reason. Their defensive qualities make them less risky stocks, performing better than the rest of the market at times of uncertainty – and we have plenty of uncertainty to go round.

The laundry list of the large-cap growth stocks that have not gone anywhere in a long time and are hitting attractive valuations is very long. Also look at McDonald’s, Abbot Labs, Berkshire Hathaway and General Electric. They have not been this cheap in a very long time. When quality, defensive growth becomes value who can say no to that?

Vitaliy Katsenelson is a portfolio manager at Investment Management Associates and teaches at the University of Colorado in DenverVitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Being Contrarian With Jos. A. Bank

August 3th, 2006 - Minyanville.com Vitaliy Katsenelson, CFA Jos. A. Bank (JOSB) is up close to 6% after reporting truly unbelievable sales numbers for July: same store sales were up 16% and total sales were up 28%. July's performance has validated my view on the stock that you are about to read.

What does it really mean “being contrarian?” Doing the opposite of what everybody else is doing, all the time? What if you agree with what everybody else is doing? Should you disagree for the sake of being contrarian?

“Being contrarian” means being able to think and act independently of the crowd and not be swayed by the crowd thinking. It means to stay on your own autonomous thinking track, independently of the direction the crowd is taking, even if it requires going against the crowd. It means not accepting (though respecting) the market’s wisdom unconditionally, but attempting to develop an opinion of your own.

Yogi Berra’s saying “In theory there is no difference between theory and practice. In practice there is,” could not be more true when it comes to contrarian investing. In theory it is easy to be able to think and act independently; however, in practice it becomes a very lonely and trying experience. Emotions that we don’t experience in the theoretical state overcome us in "the in-the-practice-state."

Investing in Jos. A. Banks requires the investor to be a contrarian. Wall Street hates the stock for sending share price from the mid 40s in April 2006 to the mid 20s. The stock is trading at a pitiful 12 times forward earnings. The stock has been slaughtered as Wall Street did not care for the earnings miss in the first quarter coupled with higher inventories.

At this price, the market expects no growth from the company, but the market could not be more wrong. Here is why:

In December of 2005, JOSB delivered 20% same store sales; management has likely expected this trend to continue and has built up a significant amount of fall inventory. However, weather was not on the company’s side, the spring ended up being warmer. The 20% same store sales comps of December did not come through in the following months and that, coupled with warmer springs, sent management on a fall close discounting spree. Management admitted that it was too aggressive in discounting fall merchandise, with the benefit of hindsight it did not have to do that.

It is hard to tell what the next quarter will look like, but that would be focusing on the trees in the forest and not on the forest. However, the future (the forest) appears to be bright for this company. I recognize that managing business involves making decisions under uncertainty. In the first quarter, management made a mistake, I believe that mistake will have little consequence in the long-term fundamental picture of JOSB.

Inventory is Not An Issue Retailers live and die by their inventory; it is the lifeblood of their retailing business. Too little inventory means the company doesn’t have enough goods to sell, too much inventory means the company has to heavily discount merchandise in order to clear the inventory. So here is the perceived bad news about JOSB – its inventory days have almost doubled over the last six years from 173 days to 334 days. It is twice the amount of its most comparable competitor, Men’s Warehouse (MW) whose inventory days have stayed in a very stable range of 153-169 days over the same time frame. That is just bad, isn’t it? On the surface, inventory numbers look terrible.

Over the last six years since the new management team has taken the reins of Joseph A. Banks, it has intentionally increased inventories per store. Why am I not worried about high inventory levels? Not all inventories are created equal. Inventory increases at a grocery retailer, like Kroger (KG) may lead to higher spoilage and thus lower profitability. Teen apparel retailers, like American Eagle Outfitters (AEOS) and Abercrombie and Fitch (ANF) need to have a fairly high inventory turnover, as teen preferences for the size and location of holes in their jeans could change with Britney Spears' new CD. However, when it comes to men’s apparel, the men’s tastes rivals the speed of the ice age. Blue shirts and stripe suits have been in fashion as long as...well, forever.

Instead of looking at JOSB's inventory as a risky, unstable assets which may have to be discounted by the retailer to clear the shelves (which is usually is the case for other retailers), one should look at it as an investment in long term assets, not unlike investment in store improvements. Though increasing inventory per store is counter intuitive for retailers that strive to achieve Wal-Mart (WMT)-like inventory efficiency, JOSB customers come to the stores only once or twice a year. The company wants to make sure that the customer finds everything he desires in the right sizes, knowing they won’t be back for a long time. The inventory increase was mostly done on the availability of more sizes, not in greater variety. As customers found the merchandise they liked and the sizes that fit – they bought more, driving same store sales and operating margins at the same time. Also, reading the transcripts of the conference calls from 2004, management has been constantly saying that raising inventory is a part of the company’s strategy.

This strategy has paid off handsomely since it has been implemented; earnings and sales have grown in double digits, margins expanded due to increased same store sales and most importantly, returns on assets (despite higher asset base due to increased inventories) have more than doubled. JOSB has beat Men’s Warehouse hands down on every aforementioned measure! Despite substantial increases of inventories per store, JOSB more than doubled its store base and achieved that mostly from its free cash flows.

The good news is that JOSB is in the last inning of inventory increases. Although the inventory of new stores will still be climbing as they will be brought to company’s average level, management indicated that they are happy with the inventory levels at the matured stores.

Pristine Balance Sheet JOSB is allergic to interest bearing debt as it was a byproduct of a leveraged buyout, though it does compare to most retailers' operating leases. The company has almost no interest bearing debt and has an available credit line of $125 million that is used to finance seasonal capital needs. Growth Management has stated that they plan to bring the store count from 329 today to 500 in 2009, which will be financed by internal free cash flows. But it has been mute about the plans beyond that. Logically, the United States should be able to support more than 500 stores, which are only about 4,500 square feet. There is also life beyond the United States, though it's riddled with more unknowns.

Economic Uncertainty This is probably the biggest risk facing this stock. Economic slowdown, deflation of the housing bubble and a weaker stock market are all risks that could create the headwinds for consumer spending and thus for the stock.

Though not immune to economic slowdown, the majority of JOSB customers make over $100-125 thousand a year and are less sensitive to an economic slowdown. Business suit or slacks purchase decisions could be postponed if one is not certain of what the future holds, however, clothes rip, coffee gets spilled and new ones need to be bought.

One way to gauge how the JOSB customers will behave during a recession is to look at their behavior in the last recession – average same store sales in 2002 were 6.6%, not bad for any environment.

The Hidden Asset JOSB has a hidden asset which is not apparent to most investors looking at the company’s operations on the surface, half of JOSB stores are less than three years old. “So what?” - You’d ask. It takes close to five years for a store to reach companywide average sales and operating margins of 23%. A store that is less than three years old has a profitability of 10% below company average. This makes sense, as a very large portion of the costs of running a store (rent, salaries, utilities etc...) are fixed. These costs are more or less the same, either sales are at $0.9 million approximate average sales of a new store, or they are at $1.6 million approximate average sales of a relatively mature store. As new stores mature, sharply rising same store sales arrive with much higher margins. Today, company’s margins are depressed with half of its stores being relatively new, but as they mature, margins will rise and earnings and free cash flows will go through the roof.

I estimate the company’s net margins will rise by about 3-4% and the company will earn somewhere around $5 in 2009. Slapping a 10 times P/E (no growth) multiple we get a $50 stock. There is plenty margin of safety in this stock.

Vitaliy N. Katsenelson, CFA

Positions WMT, JOSB

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Dell? Not Yet

July 14, 2006 - The Motley Fool By Vitaliy Katsenelson, CFA

Dell (Nasdaq: DELL) is hitting multi-year lows and, at 16 times trailing earnings, is attracting value investors that have coveted the stock from afar for years. Some of this latest decline can be traced to the company's recent downward revision of earnings estimates. And this is precisely the noise that a contrarian investor looks to capitalize on.

But are Dell's problems short-term in nature? Though the valuation appears alluring on the surface, I don't yet own the stock. Here's why.

Almost no recurring revenues With the exception of small service and printer cartridges businesses, Dell has no recurring revenues -- none! To grow a computer business 10% year over year, it has to sell as many computers as it sold last year, plus 10% more -- not an easy task with computer prices on a steady decline.

The upgrade cycle It is the last inning of the usual four-year PC upgrade cycle, and that's not great news. However, Microsoft's (Nasdaq: MSFT) Vista is likely to provide a new engine of growth for computer makers. It shifts a lot of processing from the CPU to the video and network cards, which will -- in theory -- improve the computer's performance. To reap the benefits of improved functionality, users will need to upgrade to brand new, redesigned computers -- great news for Dell. But will consumers and corporations looking to upgrade take a wait-and-see approach to Vista? Or will they install Vista on top of their existing, relatively new PC?

Laptops are still hot Laptops are a bright light in the Dell story for several reasons. First of all, as more and more people switch to laptops from PCs, the upgrade cycle will get shorter -- since a laptop's useful life is about half that of a PC's -- good news for all PC manufacturers. Second, laptops are a less commoditized product. While PCs have been mostly impersonal commodities bought mainly on price or availability, laptops are a more personal product, with features that vary from one manufacturer to another. Dell got the laptops right. And as Wi-Fi becomes more of an everyday staple throughout the world (I assume), laptops could overtake PCs.

Eroding advantage? Dell's competitive advantage as a low-cost producer, which helped the company become what it is today, has been shrinking. But it is still there; Hewlett-Packard(NYSE: HPQ) and its competitors have been squeezing suppliers, becoming much more competitive on price. In Dell's defense, it still has a distribution advantage, since it sells its computers directly to customers, allowing the company to capture extra margin instead of sharing it with distributors and retailers. And it maintains much lower inventories, a very important competitive advantage. Dell is still the only manufacturer with a negative cash conversion cycle -- it sells a computer and doesn't need to pay for the components for more than a month, resulting in great free cash flows.

Converging prices Back when a decent computer would cost a couple thousand dollars (seems like decades ago, doesn't it?), price was a very important factor. But the prices of computers have declined so much that a $30-$50 price difference is not a very persuasive argument to go with Dell versus HP or another respected manufacturer. However, this may be a very U.S.-centric perspective. For consumers and corporations in developing countries -- Dell's source of future growth -- $40-$50 is still a meaningful amount. New products Life beyond computers is uncertain. Dell has done a decent job of expanding beyond computers to printers and ... really nothing else, at least not yet. It is an extremely efficient manufacturer, but not an innovator. It is too early in the game to determine if Dell will succeed or not, but the deck is stacked against it, insofar as it is competing against a new breed of innovative companies like Sony(NYSE: SNE) and Toshiba. Poor customer service To cut costs, Dell has dropped the ball on customer service. I've talked to many people who've had a terrible customer service experience. While I give management credit for realizing the problem and announcing plans to hire more customer service people in the United States, I wonder how this will affect the company's margins. Is the damage irreparable? Not likely. Will it have to spend more money on advertising (further affecting thin margins) to convince consumers that things have changed? We'll see. Financials are still strong Dell has a 58% return on capital, about 15% of its market capitalization is in cash, and its free cash flows are to die for. However, its core earnings, as calculated by Standard & Poor's, stand about 30% lower than reported, thanks to significant stock option expenses. Tempting, but will you regret it in the morning? After reading this, the reader may find that the positives and negatives are pretty close. But two negatives in particular prevent me from buying Dell (at least at this price): lack of reoccurring revenues and a good possibility that the growth of PCs will slow down and laptop growth will not be able to make up the difference. Glancing at the P/E, the stock appears to be inexpensive, especially in relation to its historical P/E. However, based on my discounted cash flow model, a GDP-like 4%-5% sales growth is priced into the stock. And at today's price, I think that provides little margin of safety if the above scenario plays out for at least couple years. This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Telecom New Zealand: Bull or Bear?

Friday June 30, 1:14 pm ET

By Vitaliy Katsenelson, CFA

Every trade has a buyer and seller taking opposite sides. They often have different risk tolerances, time horizons, and beliefs about the direction of a stock. And before purchasing any stock, investors should build a good bull case that refutes the bear case. In that spirit, I'll spend the next few paragraphs making both a bullish and a bearish case for Telecom New Zealand (NYSE: NZT - News), and I'll let the reader decide which argument is more convincing.

Bull case In the past couple of days, Motley Fool Income Investor recommendation Telecom New Zealand announced that it will voluntarily separate its operations into retail and wholesale units.

The company will have two independent units. Wholesale would still be a regulated monopoly, not unlike Telecom New Zealand today, selling retail providers access to its network. Telecom's retail operation would be one of the providers (likely an unregulated one) buying services for the same price as the rest of the retail competition from the wholesale division. This is a very logical route for the company to take.

I have to hand it to Telecom's management. This is a brilliant move on many fronts, and here is why:

• It will preemptively get the New Zealand government off its tail. It is hard to go medieval on a company that is trying to promote competition and become friendly.
• This separation of wholesale and retail operations was a very likely outcome of the Kiwi government's future actions. Now it will be done on mostly Telecom New Zealand's terms, not the government's. Similar to a child that eats a forbidden cookie, as a parent you would not punish the child as hard if he or she comes to you first and suggests a punishment. Telecom New Zealand did just that.
• Once the telecom market was opened to competition, a new type of strategy was needed to effectively compete in the "new" marketplace. Separating and managing retail and wholesale operations will allow the company to manage each division appropriately: Wholesale operations will likely be managed for asset and free cash flow maximization -- attempting to get as much as possible from the existing assets. It is still a regulated monopoly with somewhat limited revenue upside, after all. And since competition instead of government will be breathing down the neck of its retail operations, a relatively new development for this company that has operated (at least on the wired side) in a competition-free vacuum, the retail operations will require a very different approach -- a marketing touch.

Other considerationsThe threat of competition may be overblown. If the deregulation happened in any other place, new competition would likely bring down the prices and compete away "the monopolistic profits" from the incumbent. However, New Zealand is not the rest of the world. The country's unique geography -- two mountainous islands in the middle of the South Pacific and a relatively small population of 4 million people -- is likely to prohibit new entrants from achieving a much-needed scale to become formidable competition.

The relatively small market size will very unlikely invite the big fish. Telstra (NYSE: TLS - News) is busy with its problems in Australia, and Vodafone (NYSE: VOD - News), a wireless competitor in New Zealand, doesn't have wired business outside Germany, though this could change, and it is a viable risk. (I discussed this issue in a previous article.) The smaller competitors will likely play a similar role that Apple (Nasdaq: AAPL - News) played so well for Microsoft (Nasdaq: MSFT - News) for a long period of time -- its existence and small market share in the desktop market has kept the government (mostly) off Microsoft's back.

The government has absolutely no intention of destroying Telecom New Zealand it is one of the country's largest employers, and the stock represents close to 25% of its stock market's entire market capitalization. The government wanted to introduce some competition into the marketplace and lower the broadband prices, and it has achieved that. Politicians can safely declare a victory and move to the next page on their agenda.

The separation will not change company's cost structure. However, it probably will incur some upfront costs going through the separation, which will amount to tens of millions -- a drop in the bucket for this giant. The business will not really change that much, as wholesale and retail divisions are already operating on quasi-separated basis.

Bull conclusion Telecom New Zealand will likely come out of this debacle stronger than it came into it. The appearance of competition will keep politicians off its back, and it will have two operating companies that appropriately will have two different sets of managements and very different competitive strategies.

Most importantly, the dividend should be intact. In the worst case, the reduction to the dividend will be very small. Telecom's dividend is set to be 85% of its net income. The net-income figure used in the dividend calculation is a somewhat subjective measure as one-time charges and noncash items are added back in it. Despite all of the negativity surrounding this company, it still generates (and will likely to continue to do so) an enormous amount of free cash flow, it has a strong balance sheet, and it is underleveraged.

Even after the company pays for capital expenditures and its enormous dividend (yielding nearly 10% at today's price), it still has several hundred million dollars of discretionary cash flows. Therefore, even if the company is faced with unplanned expenses that come with separation, its abundant and very stable cash flow should cover them without needing to dip into the dividend. The next couple of years will be bumpy for Telecom New Zealand, but the current stock price appears to appropriately discount the drop-off in profitability.

Now, the bear case New Zealand government has so far shown complete disregard to what will happen to Telecom New Zealand. Even though it is the largest employer and the largest company on the New Zealand stock exchange, the government's core focus has been to reignite economic growth (assuming that lowering the prices for telecommunications services would accomplish that), even if it meant driving Telecom New Zealand stock into the ground.

The actions of the New Zealand government have been fairly draconian to date -- the latest ruling allowing Vodafone wireless customers free calls to Telecom New Zealand customers speaks volumes to that effect. It was hard to see the light at the end of this tunnel, and with uncertainty written all over the stock, it is hard to know what other bad news will emerge. And since the latest news from New Zealand only got worse with time, investors naturally expect more bad news.

Before this latest ruling in its favor, Vodafone was just a bystander competing with the incumbent in the wireless segment, happily enjoying its cozy duopoly in the New Zealand wireless market. This latest news is another piece of the puzzle explaining the Telecom New Zealand stock's precipitous decline. Though the small competitors are unlikely to have a significant impact on Telecom's market share, Vodafone's existing significant market presence in the New Zealand wireless market may provide the needed scale to compete with Telecom in the soon-to-be-unbundled land line and DSL businesses. Vodafone could start by bundling a DSL and voice over Internet protocol (VoIP) products with a wireless service plan.

However, Telecom New Zealand is likely to make it a very difficult task for Vodafone. Since it will take about 18 months to two years for the laws to be passed and all regulatory kinks to be worked out, Telecom New Zealand will use this window of opportunity to roll out a very aggressive marketing campaign in an attempt to capture as much market share in DSL, and switch customers to a feature reach VoIP product.

Once it captures a very large market share in the DSL and VoIP markets, it will take a very sweet offer from competitors for customers to leave Telecom New Zealand. This will be a smart move on Telecom's part; however, it is also likely to put additional pressure on earnings, at least over the next two years as marketing (i.e. TV, radio, and print advertising) doesn't come cheap. There is still an issue of land-line customers dropping that service for the soon-to-be much cheaper wireless service. The cellular service is not an optimal substitute for a landline service for the majority of customers; for a household with several family members, every person would need to have a cell phone otherwise, if someone leaves the house and takes the cell phone, the rest of the family will be phoneless. We are likely to see the highest migration to the cell-phone service among college students, singles, and families without children. Satellite-TV subscribers and customers that have a security system will still require a landline, though it doesn't necessarily have to be a Telecom New Zealand line. In addition, phone calls outside the local area should still be expensive, unless the government changes pricing structure there as well.

The separation of regulated wholesale business and unregulated retail business may work out well for the company. However, success or failure lies in a small but very important detail: the price the government will allow the wholesale division to charge for its services. If the price is high enough, then even if the company loses market share in the retail space, it will still be able to be a very profitable business on a combined basis (retail and wholesale). So far, the government has not shown its kind side to Telecom New Zealand. A sliver of bright light is that the pricing will be decided not by politicians but by a regulator that doesn't (at least in theory) have a political agenda. Bear conclusion Neither American nor New Zealand investors like uncertainty, and the uncertainty over the company's future profitability has driven this stock off the cliff. Future regulation, the state of future competition, company profitability, and the dividend are uncertain at this point. The government's behavior to date has surprised most investors, including myself. Will the government go even more draconian on the company? Though logic tells me "no," logic was not a very useful tool in predicting the New Zealand government's actions over the past couple of months. I ask myself: what did I miss? Why didn't I foresee the large stock decline? The answer (not an excuse, but a mere observation) has to do with the timing of the news cycle. On a standalone basis, the events that transpired over last couple of months are not earth-shattering, considering the unique natures of New Zealand's geography and industry structure. However, once all of these events are put together, their impact on the company's future profitability could be very significant.

Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. Vitaliy and his company own shares of Telecom New Zealand and Microsoft. The Fool has an ironclad disclosure policy. This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Copyright The Motley Fool

Minyanville's New Blog

One of the sites I contribute to, minyanville.com, offers great investment analysis and they have just launched their New and Improved Buzz and Banter, an exclusive resource for investors. It supplies the most current market insight and innovative idea generation to your desktop, with some useful new features. Recently they have created a blog, minyanville.blogspot.com, providing some of the best info from their site and some witty humor. It’s worth a look. Vitaliy Katsenelson, CFA

Don’t be downbeat about Wal-Mart

Don’t be downbeat about Wal-Mart

May 12 2006 - Financial Times

The greatest investment opportunities are seeded not by warm sunshine but by chilling rain. It has been freezing and pouring in Wal-Mart’s neck of the woods. To say Wal-Mart is not loved is a serious understatement. It has been convicted and fined $172m for refusing employees in California rightful overtime breaks, it has been criticised for paying low wages and being stingy with health benefits, its older stores are so shabby they could easily be confused with K-Mart stores in the 1990s.

To add fuel to the fire, its stock has been drifting down since 1999. The public perception has grown so negative that after buying stock for my firm I got a note from a client asking me not to tell his children he now owns Wal-Mart stock.

All this negativity surrounding the largest retailer in the world has created a great buying opportunity.

Its future is still bright. Wal-Mart’s biggest competitor is Wal-Mart itself. It has an enormous presence in the US. It is very hard for the company to open new stores without having a effect on sales at its existing stores. But in spite of its great geographic presence Wal-Mart currently appeals mostly to lower income demographics, and this is where things will change the most. Wal-Mart has three broad groups of shoppers: loyalists, who do most of their household shopping at Wal-Mart; selective shoppers, who buy most of their grocery and staples at Wal-Mart but don’t cross the aisle to the higher margin merchandise such as apparel and electronics; and the sceptics, who visited stores and were disappointed by the lack of cleanliness and appealing merchandise.

With its gigantic store base, it will only get harder to increase sales from new store openings. Instead, Wal-Mart is trying to widen its customer base and boost sales growth at existing stores – the cheaper, high return on capital source of growth.

In the past all its stores were indifferent to the demographics (defined by level of affluence, ethnicity, and so on) that they served. All stores carried the same lower quality merchandise at the best possible price. Although Wal-Mart’s core base of less affluent customers wanted the lowest price, the more affluent middle class – selective shoppers and sceptics – were looking for a value proposition: quality merchandise at great prices.

Things are now about to change. Over the next 18 months Wal-Mart will spend billions of dollars on remodelling 1,800 stores – almost half its US store base. No more K-Mart-like stores, it will focus on selective shoppers and sceptics by stocking stores to fit the demographics. This may hinder some of Wal-Mart’s hallmark efficiency but it should bring new, higher margin same-store sales. Cleaner, better, more appropriately merchandised stores will attract new customers – the sceptics – and encourage shoppers to cross the food aisle and spend more.

As initiatives take effect and the shopping experience improves, Wal-Mart will be taking market share from upper scale retailers, the same way it stole market share from Toys-R-Us in toys.

This remains a quality investment. Wal-Mart’s distribution efficiency and sheer size provide an incredible competitive advantage making it the lowest cost producer. Despite all the negative publicity Wal-Mart is still perceived to be a high quality company, with strong balance sheet and high return on capital.

The stock looks like value for money. It has been drifting down since 1999, not because company did not do well – earnings more than doubled in six years – but because in 1999 the stock was loved to death by Wall Street, sending its valuation 54 times earnings. It took six years and a lot of earnings growth to bring its p/e to 16 times its 2006 earnings – its lowest level in 20 years!

International markets, which represent close to 20 per cent of Wal-Mart’s sales, will be another very important growth engine. International sales, at $60bn, have almost doubled in the last five years. Although margins overseas are lower than in the US, they have been rising as higher sales bring improved operating efficiency.

Wal-Mart can deliver 10-14 per cent earnings growth, depending on the degree of success of its new initiatives. The Street expects 14 per cent. Of this, 5-8 per cent would come from opening new stores domestically and internationally, 3-6 per cent from same-store sales and another 1-2 per cent from share buybacks. In addition Wal-Mart pays a 1.5 per cent dividend yield, which has been on the rise in line with earnings growth.

Finally, this is a defensive stock. In economic uncertainty, Wal-Mart’s customer base should balloon as budget-conscious consumers flee there in a quest for savings. A similar fate will await investors, as the defensive characteristics of the stock and a very appealing valuation will attract investors if there is a correction in the overall market.

Vitaliy Katsenelson is a portfolio manager at Investment Management Associates and teaches at the University of Colorado in Denver This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Government Goes Medieval on Telecom New Zealand

By Vitaliy Katsenelson, CFA

May 5, 2006 - The Motley Fool

A political risk is present in shares of any government-regulated company, but it came to fruition for Telecom New Zealand (NYSE: NZT) when the New Zealand government unbundled the local loop. Unbundling a local loop is a fancy phrase for requiring an incumbent telecom provider to open its networks to competition at cost. But maybe, just maybe, it created a very unique buying opportunity for Telecom New Zealand's shares.

The competitive telecom landscape in New Zealand is very different from the rest of the world. Let's review.

New Zealand is a very small country with a population of four million people. Hidden on two mountainous islands in the South Pacific, its geography has created a very unique competitive environment for the telecom services. Cable competition -- which has been gradually eating away at American counterparts Verizon (NYSE: VZ) and AT&T (NYSE: T) -- is virtually nonexistent in New Zealand, since cable proved to be an uneconomical route because of the relatively small market size and large, rough terrain. For the same reasons, Telecom New Zealand has only one competitor on the wireless side -- Vodafone, where both companies split the wireless market share in half.

The telecommunication business is not much different from a cargo plane trying to take off on the runway. The heavier the cargo that the plane carries (the fixed costs) the longer the runway (number of customers) required for the plane's successful takeoff. Scale is a must in the telecom business, and ability to achieve the scale is tremendously limited by the relatively small market size. There is only space for one runway in New Zealand's telecom landscape. And the size of any new runways is limited by the success of the existing players.

Over the last couple years, Telecom New Zealand has been cutting prices on DSL services, which fueled DSL subscriber growth exceeding 100% a year. In March, Telecom New Zealand cut DSL prices to the point that it rivals much inferior dial-up. This move should only accelerate DSL subscriber growth over the next couple years, since dropping dial-up for DSL becomes a no-brainer decision.

Despite the apparent urgency of the government's action, it will take several years for the decision to come into effect, since a lot of details have to be ironed out. This will give Telecom New Zealand plenty of time to increase its DSL penetration to at least 50% of the consumer market -- from today's 20% or probably even higher -- since Telecom New Zealand will try to capitalize on this window of opportunity and step up its DSL marketing efforts.

Any new entrant going after the DSL or voice market will have to spend a considerable amount of money to put its equipment in Telecom New Zealand's network operating center, and then it will have to try capture a significant market share of a relatively small market (where incumbent Telecom New Zealand already has a large market share) to recoup that cost. In reality, very few players are willing to take such risks. Telstra -- an Australian counterpart -- already has operations in New Zealand and is speculated to enter the market once it is deregulated. However, it appears that it has its hands full with its core Australian operations. Smaller players are likely to make some waves, but their success will be very limited, since they lack the scale to compete with Telecom New Zealand.

NZT shows resilienceThe decision to unbundle the local loop made little sense, though it was expected by many (including the company). What was not expected is the decision to force Telecom New Zealand to provide naked DSL. Naked DSL means that Telecom New Zealand is obligated to offer DSL services even to the customers that don't subscribe to the dial tone and pay for line rental. This means that competitors will be able to offer VOIP service over the company's phone lines. However, things may not be as bad as they seem:

• Telecom New Zealand is working on its own VOIP solution, and it will have a several-year head start to sell it to its customers before competition enters the market.
• As soon as the call comes off the Internet on Telecom New Zealand's last mile (which Telecom New Zealand owns) a competitor VOIP provider has to pay for it.
• In France, a year and a half after Naked DSL was introduced, only 8% of the customers have taken the offer and canceled their phone line.

Though it appears that Telecom New Zealand is powerless to fight the government on this ruling, it holds a lot of political leverage:

• As the largest company in New Zealand, it accounts for close to a quarter of the New Zealand stock market's capitalization. A significant drop of Telecom New Zealand shares over the last couple days had a tremendous impact on the NZ stock market.
• It is the largest employer in New Zealand. The new law may force the company to cut costs -- and potentially start some unpopular layoffs. I believe Telecom New Zealand will have no problems with blaming politicians for the layoffs.
• The company has made it clear that if the new laws are instituted it will stop investing in New Zealand, since it won't be to recoup its investment with the new laws. It will not invest in a new fiber-to-home network -- the future of telecom. And if a regulated incumbent abstains from making this multibillion dollar investment, nobody else will. This will derail the increase in available broadband speed in New Zealand, which is, ironically, the outcome politicians are trying to accomplish.

Future still looks brightIn spite of apparent certainty that the new ruling brings, investors just had a small peek at the worst possible outcome of proposed regulation. But it's always darkest before the dawn, and I believe the news flow will not get any darker. Today's valuation factors in a very high market share loss, which is very unlikely.

The stock success is largely driven by its super-sized dividend. The core ($1.93) dividend appears to be secure. If Telecom New Zealand decides to rollout the next-generation network, it can finance it from existing cash flows (after paying for capital expenditures and core dividends it still has a couple hundred million in U.S. dollars leftover), cost cutting, and possibly from lowering or cutting the special dividend of about $0.27 a share. (Since the special dividend was an added bonus, I never counted it in my analysis.)

Once the political landscape softens, which I believe it will, Telecom New Zealand will be making an investment into a next-generation fiber network, which has a hidden kicker -- it will allow the company to bring television services to New Zealand customers. This may extend top line growth for Telecom New Zealand for years to come.

All that said, politicians are infamous for making decisions that improve their chances of being reelected, but hurt the general public in process. Let's hope the consequences of this political decision won't be hurting consumers years later -- when today's politicians are likely to be out of office, sipping margaritas on the beach.

Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He also writes for the Financial Times and Minyanville.com. Both he and his firm own shares of Telecom New Zealand. The Motley Fool has a disclosure policy.

Vitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Nokia: Slim Phones, Fatter Margins

By Vitaliy Katsenelson, CFA

April 11, 2006 - The Motley Fool

Nokia (NYSE: NOK) announced that its average selling price (ASP) has increased in the first quarter from a projected 98 euros to 103 euros. This is great news for the company. Over the last several quarters, Nokia has demonstrated very high revenue growth, but its margins have taken a hit as lower-priced introductory cell phones in China and India reduced ASP and margins.

If higher ASP is the start of a new trend -- and I believe it is -- net income will likely jump as operational leverage kicks into a higher gear. In addition, Nokia's media phone division (consisting of higher-end consumer phones) stopped bleeding money over the last couple quarters and went solidly into the green. The division's operating profit margins of 14% still have plenty of growth ahead of them, since they are much lower than the mobile group's 17% operating margins.

Even the U.S. market, which Nokia mostly lost a couple years ago to Motorola's (NYSE: MOT) superior U.S. phones and other competitors' clamshell designs, seems to be doing better, with more new phones becoming available for the U.S. consumers. However, the United States isn't crucial for Nokia's success; it only represents about 8% of Nokia's sales, and the company's market-share position in the U.S. has stabilized in 2005. As long as its market share doesn't take a drastic dive, the rest of the world should carry a growth torch for Nokia.

At today's valuation of about 18 times 2006 estimates, Nokia is no longer a value manager's dream per se. But as earnings estimates start climbing, it is likely to turn into the growth and momentum managers' paradise.

Westwood One to Avoid

By Vitaliy Katsenelson, CFA April 6, 2006 - The Motley Fool

The value guy in me always awakens when I see a stock scratching at multi-year lows, and Westwood One (NYSE: WON) piqued my interest a couple weeks ago. It declined from more than $30 two years ago to around $11 today, trading at about 11 times 2006 earnings. That's cheap -- but is it cheap enough? At first, the company seemed very appealing: It pays a nice 3.7% dividend, and its small capital expenditures help it generate a lot of free cash flow. In addition, Sirius (Nasdaq: SIRI) and XM Satellite Radio (Nasdaq: XMSR) are its friends, not foes. Westwood One doesn't own radio stations; it creates content like traffic updates and Jim Cramer's radio show, selling those shows to both terrestrial and satellite radio stations. However, a deeper look at the company makes me think that it may be cheap for two good reasons: 1. Westwood One has showed little revenue growth over the last five years. Actually, "little" doesn't do it justice -- there's been zero revenue growth since 2002. In real terms (after inflation), revenues actually declined. 2. Instead of reinvesting money and growing the business, Westwood One bought back stock as if it was going out of style. Unfortunately, the stock itself has been going out of style over the last five years, declining from more than 35 times earnings in 2002 to today's P/E of 11. Sadly, the company was buying the stock all the way from the top to bottom, paying an incredibly high P/E multiple in the process. A vexing valuation I can understand when a company buys back undervalued stock and it subsequently gets cheaper; timing those things is very difficult. However, buying back stock that's trading at a very high valuation -- and I'd argue that 25-35 times earnings is high, especially for a company that isn't growing revenues -- and leveraging its balance sheet to support those purchases shows management's disregard for shareholders. All earnings-per-share growth since 2002 came from share buybacks -- none of it was organic. I cannot fault management for this no-growth company's ridiculous prior valuation; investors had everything to do with that. But I can fault management for buying back stock at very high valuations, instead of reinvesting earnings to grow its core business, or paying a nice fat dividend. (The company only started to pay a dividend in 2005.) How much do you pay for this kind of business? Today's valuation assumes absolutely no growth of cash flows -- none! However, in the last quarter, revenue declined 3%. Management has blamed many external factors for stealing advertising dollars and audiences' interest. That's the favorite song management sings when it doesn't want to take responsibility for its actions (or lack thereof). In addition, Westwood One executives noted that the absence of political advertising in the last quarter created tough comparisons with the presidential election year of 2004 – the Super Bowl of radio advertising. Judging by historical revenue performance, revenue does decline in odd (non-election) years between 2%-8%, at least partly supporting management's claim. Management also mentioned that it is investing in new shows that have not yet reached the economy of scale necessary to boost revenues. Will the growth come back? The good news for Westwood One -- and bad news for the rest of us -- is that political advertising will make a comeback with the 2006 midterm elections. But it will only bring revenues up to par, rather than driving long-term growth. Advertising adversity Westwood One's cousins in the newspaper business are facing similar troubles. Despite a readership that was slowly vanishing into the abyss of the Internet, firms like Gannett (NYSE: GCI) and Knight Ridder (NYSE: KRI) were previously able to raise advertising prices. Revenue growth from those higher ad rates helped to mask the gradual deterioration in the underlying business, as advertisers gradually paid more for fewer readers. Westwood One was not so lucky; radio is a more competitive market, especially in national advertising, where Westwood One has a large presence. That limited the company's pricing flexibility. The old joke in the advertising industry is that half of the money spent on advertising is wasted -- but nobody knows which half. Unfortunately for media companies, corporate America is enjoying all-time high profit margins, and they want to hold onto them as long as possible. Companies are desperately trying to figure out which half of their advertising spending is wasted. Procter & Gamble's (NYSE: PG) plans to cut its TV advertising budget speak volumes; P&G one of the United States' savviest marketing companies, and other corporations will likely follow its lead and rationalize their ad spending. The advertising pie's growth is slowing down, even as it's being sliced into smaller pieces by a relatively new breed of competition: Google (Nasdaq: GOOG), Yahoo! (Nasdaq: YHOO), and a small army of Internet portals and search engines, most of which didn't even exist a decade ago. Google's revenues went from $439 million in 2002 to $6.1 billion in 2005; if not for Google or Yahoo!, most of this money would have flown to Westwood One, Gannett, and the rest of the media pack. The story only gets worse. Though we have two ears but can only listen to one thing at a time, in the future, we will be listening to more prerecorded podcasts from the Internet, ad-free satellite radio, and tunes stored on media players like Apple's iPod. None of these will help the growth of the radio-advertising pie. Foolish bottom line Westwood One's revenues may receive a short-term boost from political advertising, the speculation of a takeover may spark interest in the stock, or a hedge fund may try to right this ship by taking it private. Nonetheless, long-term revenue growth is suspect at this point. The company believes that new radio shows should fuel its growth, but history and recent events aren't on its side. I believe long-term revenue growth is very unlikely. Management should admit to shareholders and itself that growth has left the building, and focus instead on creating shareholder value by increasing the dividend, cutting costs, and managing the company as a cash cow. The new CEO appointed in December 2005 may shake things up, but I'll believe it when I see it. Westwood One may appear to be cheap, but it's cheap for the right reasons. Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He also writes for the Financial Times and Minyanville.com. He and his firm have no positions in the companies mentioned. The Motley Fool has a disclosure policy.

Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Chicken Run: Value Manager's Dream?

By Vitaliy Katsenelson, CFA

March 20th, 2006 - The Motley Fool On the surface, chicken stocks like Sanderson Farms(Nasdaq: SAFM), Gold Kist(Nasdaq: GKIS), and Pilgrim's Pride(NYSE: PPC) are a value manager's dream. Most of them are not very leveraged, they generate a decent return on capital, and best of all, they trade at single-digit P/E based on last year's earnings. So, are chicken stocks the value manager's dream, or are they a value trap in the making? I think the answer is a little bit of both, depending on an investor's time horizon. A bird's-eye view Although it appears that chicken stocks are inexpensive, their cheapness is measured against last year's earnings when poultry prices were through the roof. The forward earnings have been sharply revised down, but even based on revised earnings guidance, chicken stocks appear to be relatively inexpensive. When analyzing companies that sell commodities, it's important to look at commodity prices. All right, industrial commodities are scarce, as it takes millions of years for them to form, whereas it takes six to eight weeks to raise a chicken. And yes, chicken does taste better than the usual industrial commodities. But chicken is chicken, and price is the most important differentiating factor. The cost of raising chickens is fairly fixed with the exception of feed prices (accounting for roughly 30%-40% of cost of goods sold), which may fluctuate. Thus, the market chicken price separates profitability from loss. The poultry prices trade at the historical average in nominal terms, or slightly below average in real terms. Although chicken leg prices declined by almost half over the past several months, a very large portion of chicken legs produced in the United States are exported, and legs are a relatively small (lower commodity price per pound) market compared to the white meat. Interestingly, only 15% of the chicken produced in the U.S. is exported, and 75% of these exports go to Russia. And Russia is one of the largest consumers of the dark meat. None, zero, zilch of American chicken exports go to Europe, as our American chicken doesn't meet European standards. (Another interesting factoid: Chicken legs imported from the United States are called Bush legs in Russia, after George H.W. Bush, on whose watch Russia started importing chicken legs from the United States.) Avian flu worries If an investor has a long-term horizon (let's say five years) and has a very strong stomach to see chicken stocks get halved or quartered on avian flu scare, today is as good a time as any to buy chicken stocks. However, at today's prices, chicken stocks don't fully discount the avian flu coming to the United States. If the avian flu does come to the U.S., which is a very high probability scenario, we'll get a chance to buy these stocks at much lower prices. I put very little value on forward Street earnings estimates, because avian flu could change these forecasts on a dime. According to the Department of Homeland Security, the migration of birds is likely to bring avian flu to the United States -- it's just a matter of time. And when avian flu comes to America, chicken stocks will share the fate of the chickens -- they'll get slaughtered, as their profitability will dissipate overnight. Demand for chickens will likely drop off disproportionately to the actual threat, similar to what happened in European countries when they got their first cases of avian flu. However, the drop will not be permanent. Once the real threat passes, consumers will get tired of steak, pork, and Tofurky, and they'll want real white-meat chicken. So far, that's how avian flu has played out in Europe: an immediate decline in demand followed by gradual recovery. If the infected birds flying from Asia take a different route and spare the United States from the avian flu, the chicken prices and stocks may rebound from today's lows very rapidly because they're heavily shorted. Surprisingly, Sanderson Farms -- the only one of the bunch that pays a meaningful dividend -- appears to be the most shorted one, with 23% of it float shorted, which is at least twice the short interest of other chicken producers. Importance of a strong balance sheet The avian flu will pass, but financial strength will be extremely crucial for chicken stocks, as it will provide staying power. Chicken producers will be losing money for some time. Thus, their balance sheets will be their life sources. Chicken producers are in very good financial shape: Gold Kist has $145 million of cash and approximately as much debt. However, the bulk of debt will not mature until 2014. Pilgrim's Pride has $500 million of debt (about 20% of its assets), and close to 40% of its debt is due within a couple of years. It does have $170 million of cash and reserves to get it through the tough times. Both Pilgrim's Pride and Gold Kist have more than a $100 million line of credit available to them. Sanderson Farms -- the smallest of the bunch -- has very little debt, but it has little cash. However, it does have access to a $200 million line of credit, which is plenty of liquidity to guide it through these trying times. One important caveat on credit lines -- banks love to provide them when companies don't need them and may withdraw them if a company starts losing money. However, Sanderson Farms' bank covenants are dependent on the balance sheet, not profitability. The covenants restrict the debt-to-assets ratio from exceeding 55%. It's currently around 4% today. Foolish bottom line Sanderson Farms and Gold Kist both had respectable return on assets over the years, higher than Pilgrims Pride's, which has been moving to more stable and lower return on asset business of prepared foods. However, I favor Sanderson Farms over other chicken stocks for the following reasons: * Leveraged to chicken prices. Sanderson doesn't focus on the fast-food (small chicken) market, where most of the agreements are cost-plus type of arrangements. Therefore, its sales will be more sensitive to market prices. If you believe that in the long run, chicken prices will go up (after the initial decline), then Sanderson Farms is a way to go, since higher prices will generate a better return on assets. * Lack of debt. Sanderson Farms has chosen the higher volatility of cash flow and higher return on assets route. Thus, a conservative balance sheet offsets the risk inherent in more volatile operating cash flows. * Dividend yield of 2.2%. Yes, this stock can go up or down by more than 2.2% in a given day. However, the commitment to a dividend is an indication of management creating shareholder value. * High short interest. On a sliver of any good news, short sellers will have to start buying back the stock to cover their short positions. That means that Sanderson Farms will bounce back at a faster pace than the rest of the flock. Of course, there's Tyson Foods(NYSE: TSN) as well. However, Tyson is not a pure play on chicken, as it's diversified into pork and beef. I've been asked many times whether there are any non-chicken plays on avian flu. Yes, in fact, there are. Aside from vaccine stocks such as Chiron(Nasdaq: CHIR), Baxtor International, and Invitrogen, there's also pork play Hormel(NYSE: HRL), which is one of the biggest producers of the other white meat. Of course, there's also Clorox(NYSE: CLX) -- maker of disinfecting products. Avian flu is passed through uncooked chicken, so Clorox wipes and the rest of the disinfecting arsenal will come in handy to fight the flu on the kitchen front. Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates. He teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He also writes for The Financial Times and Minyanville.com. He and his company have no positions in the companies mentioned. The Motley Fool has a disclosure policy. Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Lloyds: Prime for Takeover

February 1, 2006 - The Motley Fool

By Vitaliy Katsenelson, CFA

Lloyds TSB (NYSE: LYG) is up more than 5% at Wednesday's open, on the speculation that it will be bought out by Spanish bank BBVA. It's hard to tell whether this speculation has any substance, since rumors of a Lloyds takeover surface every couple months or so. However, Lloyds is a prime candidate for acquisition for several reasons:

• Lloyds provides a clean exposure to the U.K. market. It's a very well-managed company and provides quick entry into the European Union's best economy.
• The Lloyds brand is valuable. As one of the highest-rated banks in the world, Lloyds TSB carries a very old and well-respected brand. Wells Fargo (NYSE: WFC) is the only other non-government-sponsored bank rated AAA by Moody's.
• The acquirer will be able to leverage Lloyds' AAA-rated balance sheet. I've seen this happen before when Lincoln National (NYSE: LNC) bought Jefferson-Pilot (NYSE: JP). Lincoln Financial's debt rating was several notches below the very highly rated Jefferson Pilot's. By bringing Jefferson Pilot's debt rating to Lincoln Financial's level, it was able to extract several hundred million from Jefferson Pilot's equity, thus reducing the ultimate cost of the acquisition.
• Say goodbye to the high dividend. Lloyds has one of the highest dividend yields in its industry, 6.6%. The acquirer will be able to cut the dividend, bringing it to the industry's level and freeing up additional cash.
• Lloyds is still a bargain, trading at about 12 times 2006 estimates. Banks usually trade at lower P/Es to the market, due to the limited growth opportunities in this mature industry. Thus, at current valuation, Lloyds does not appear to be a bargain-basement stock. However, after leveraging Lloyds' balance sheet, the company may, in fact, be a bargain.

Despite its 80% dividend payout ratio, Lloyds is growing earnings by mid-to-high single digits. Since the company has plenty of room left for organic growth, it's not building a war chest to make acquisitions.

Foolish bottom lineI have to confess, I don't want Lloyds TSB to be acquired. Yes, I could make a couple more dollars in the short run, but I'm loath to part with Lloyds for several reasons. First, management showed that it is very shareholder-friendly by paying a superb dividend. Second, the company doesn't have any plans to do something foolish, like buy a minority interest in a risky foreign bank that will turn into a liability in a few years. (Remember Argentina?) Lastly, Lloyds doesn't have trading operations that help it meet quarterly earnings -- until it loses billions of dollars on a good trade gone bad. You can pass this stock along to your grandkids, secure in the knowledge that it'll still be around in 30 years.

Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He and his company own shares of Lloyds TSB. The Motley Fool has a disclosure policy.

Vitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Expect the Unexpected

February 23rd, 2006 - The Motley Fool

By Vitaliy Katsenelson, CFA

After reading Jeremy Siegel's book Stocks for the Long Run, one gets a strong sense of security about investing in the stock market. Over long periods, the market overcame catastrophes like a global influenza pandemic, the Great Depression, the Cold War, two Gulf wars, two world wars, terrorist attacks, natural disasters, and much more. All of those events look like small potholes on the long road to prosperity when you put it into historical perspective.

I use Siegel's excellent book in my graduate investment class because it provides a very good historical overview of financial markets. However, students often ask me after looking at the well-defined upward slope of the stock market line on a 200-year chart, "Why bother tinkering with stock picking? Just buy an index fund and forget about all your worries."

Should investors buy an index fund in any market environment, regardless of the market's valuation? Does market valuation matter? After all, over the long term, stocks have produced a very respectable rate of return.

Unexpected Returns, the very insightful book by Crestmont Research's Ed Easterling, provides an answer to that and many other questions.

"Soar into space, and the earth loses its distinctive features: the Himalayas flatten; the Grand Canyon appears no deeper than a ditch ... but it gives few, if any, clues to the harsh geographical and financial realities that you should face walking across the earth's surface. ... If you take a long-term view on the stock market, perhaps fifty or seventy-five years, it becomes a beautiful blue chip market. But the long-term rise in the market obscures the realities that affect almost every investor."

What does Easterling mean by that, exactly? Here are a few of his key points:

Market valuation matters When buying an individual stock, investors must make the distinction between a good company and a good stock -- they're not always the same thing. For example, Wal-Mart(NYSE: WMT) is arguably a great company. It has a great balance sheet, a respectable return on capital, and a solid moat around its business. But the investor who purchased the stock in 1999 at 39 times earnings received no returns from the stock, with the exception of collecting a skimpy dividend. Although Wal-Mart has grown earnings more than 15% since, its excessive valuation has deterred the stock from rising (the valuation has since dropped to 17 times earnings). The same is true for other blue chips like Johnson & Johnson(NYSE: JNJ), First Data(NYSE: FDC), Microsoft(NYSE: MSFT), and Coca-Cola(NYSE: KO), to name a few.

This distinction often fails to translate when investors are talking about the stock market. Even when the stock market approaches a very high valuation, a buy-and-hold strategy is encouraged and investors expect to receive "average" returns. But average returns rarely happen. Returns that investors receive are a function, to a large degree, of a starting P/E. That makes a lot of intuitive sense. Returns from stocks are comprised of stock appreciation and dividends. Stock appreciation consists of P/E expansion and earning growth.

"Periods that start with above-average P/Es produce below-average returns, and periods that start with below-average P/Es produce above-average returns." Easterling proves this point time and again with numerous tables and charts.

The market is expensive Today's valuation is still above average as we're coming out of one of the biggest bull markets of 20th century. The S&P 500 is trading at 17 times trailing earnings, compared with the historical average of around 15.

Still, some would argue that the S&P's forward P/E of 15 is about average. The problem with this argument is that the historical averages are calculated based on trailing, not forward, earnings. Thus, the forward P/E is not useful for gauging today's market valuation because we're comparing apples to oranges.

Also, the current dividend yield of 1.7% is far below the historical 100-year average of 4.4% -- another confirmation of relatively high market valuation. Easterling argues that dividend yield is arguably a better yardstick of market valuation than P/E. P/E can be distorted during recessions (and economic booms), when dividends are more stable and unaffected by earnings adjustments.

Easterling makes another very interesting observation. Investors often associate bear markets with subpar or declining earnings growth and associate bull markets with above-average earnings growth. Nothing could be further from the truth. During the bear markets that took place in the 20th century (with the exception of the Great Depression), when stocks declined 4.3% on average per year, nominal GDP grew 6.9% -- in fact exceeding the nominal GDP growth of 6.3% experienced during the bull markets, when stocks rose 14.6% a year on average.

Foolish bottom line Unexpected Returns raises many very important questions. It doesn't-- nor does it claim to -- provide specific investment solutions. However, it does provide important investment insights. Easterling makes a very compelling case for active, more "hands-on" investment strategies in today's investment environment. The sense of security about stocks the book fosters goes away pretty quickly after putting it down. Yes, buying an index fund and forgetting may work if one's investment horizon is 50 years or longer, but that's not the case for the rest of us. As economist John Maynard Keynes said, "In the long run, we are all dead."

It would be just plain wrong to leave the reader on this less-than-optimistic note. In future articles and in my upcoming book, I'll discuss an investment strategy that will work in today's market environment.

Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He and his company own shares of First Data. His company also owns Johnson & Johnson. The Motley Fool has a disclosure policy.

Vitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Copyright The Motley Fool

The Profit Margin Paradigm?

March 1st, 2006 - The Motley Fool

By Vitaliy Katsenelson, CFA

"Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly." -- Jeremy Grantham

Many investors (including the author) were caught off guard by the economy's surprising earnings growth over the last several years. Earnings of S&P 500 companies have grown more than 20% during the last two years, and they are expected to climb another 8% in 2006. This astonishing growth has exceeded the Gross Domestic Product (GDP), which topped out at 4.6% in 2004 and has grown at a slower rate since. Contrary to common perceptions, corporate earnings growth historically stays in line with GDP growth.

The source of this earnings growth was profit margin expansion (here we define profit margins as corporate profits / GDP), from 7.0% at the end of the third quarter 2001 to a whopping 10.3% in the latest quarter. As profit margins rise, corporations get to keep more of their sales, leading to improved profitability. To put things in perspective, the average profit margin for corporate America over last 25 years was approximately 8.3%, 200 basis points less than today.

The question comes to mind: Are the billions of dollars dedicated to productivity enhancements over last decade finally paying off? Did the new era of technology-induced corporate efficiency descend upon us? Are we in a "new"-economy, higher-profit margin paradigm? (OK, three questions). The answer is no, no, and definitely no.

Fallacy of composition Corporate America's enormous investment in technology did not go to waste. It made companies more efficient, helping them to produce more with less -- the definition of productivity. That's the good news. The bad news is that technology improvements were available to everyone. Oracle(Nasdaq: ORCL) will sell its software to any company that can spell "Oracle" on a multi-million dollar check. This is where the economic concept fallacy of composition (what is true for part may not be true for the whole) kicks into high gear. Though technological investment may help the first adapter to cut costs and get a leg up on the competition, competitors won't watch their economic pie being eaten by a more efficient company. Those who do sit still will be driven out of business. The others will adapt by writing a big fat check to Oracle, SAP(NYSE: SAP), or Microsoft(Nasdaq: MSFT), eventually catching up and competing the higher margins away. Thus, what was true for one company is not true for the industry.

As much as we would love to believe that productivity improvements brought to us by technological innovations will transform into corporate profitability, historically that has not been the case. Wal-Mart(NYSE: WMT) has changed the retail landscape by installing the most (at the time) revolutionary inventory management and distribution systems, passing the cost savings to the consumer, and driving less efficient competitors out of business.

However, Wal-Mart-like technology is available off the shelf to any retailer aspiring to coexist in today's competitive landscape. Even companies like Dollar General(NYSE: DG), with stores the size of several Wal-Mart bathrooms put together, wrote sizable checks to Manhattan Associates(Nasdaq: MANH) and installed perpetual inventory and automatic reordering systems. This investment will keep Dollar General in the game by helping it survive in the new competitive environment, but is unlikely to send its margins much higher from today's level.

Should all-time high corporate margins worry investors? Today's stock market valuation is higher than it may appear. As margins revert to the historical average (and they always do), corporate earnings growth will either decelerate -- disappointing Wall Street expectations of 8% earnings growth (according to First Call) for the S&P 500 over next five years -- or decline, driving earnings, the "E" in the P/E equation, down. The broad market index fund investor may be in a pickle when a cheap market suddenly becomes more expensive. If today's corporate profitability reverts to the mean profit margins observed over the last 25 years, corporate profits would decline almost 19%.

Putting macro-shmacro stuff aside, why does this all matter to investors holding individual stocks? Companies that don't have a sustainable competitive advantage (a metaphorical moat around their business) will not get to keep the benefits from the increased productivity. These benefits will get competed away, and their margins will decline. Do you own one of those companies? I strongly recommend you take a look at the companies whose margins are hitting an all-time high, and examine their competitive landscape and their business for sustainable competitive advantage.

Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. His firm own shares of Oracle and Microsoft. The Motley Fool has a disclosure policy.

Vitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Copyright fool.com

Protection Against a Dangerous Enemy

By Vitaliy Katsenelson, CFA

February 15, 2005 – Motley Fool

A few nights ago I was awakened by my two and a half year old son Jonah at two o'clock in the morning. He was whimpering and crying out for us to pick him up and bring him into our bed. We succumbed.

For the next couple of hours my dear wife and I would receive the occasional kick in the stomach, or elbow to our eyes, ears, and other vital body parts. Oddly enough, this experience made me realize that investing is often not very different from parenting.

Let me explain. As tired, sleep-deprived parents, my wife and I made an emotional decision about a year and a half ago. We gave into Jonah's cries and acted on our emotions by bringing him into our bed in the middle of the night. The harder, more logical route would have been to calm him down and let him fall asleep on his own, in his own bed. If we had done that, we would have been enjoying eight hours of uninterrupted sleep for the last 18 months, and Jonah would've gained the security to sleep on his own.

Clearly, emotions are a large part of both parenting and investing. Unfortunately, emotions often cloud our judgment and steer us toward making erroneous and irrational decisions. Emotions are a far more dangerous enemy to investors than anything Elliot Spitzer has unearthed. Emotional decisions are worrisome because they are usually made to satisfy an emotion that is short-term in nature. In the absence of emotions, the decision often would have taken into account the long-term consequences and therefore, would have been different.

For example, emotions were responsible for investors suddenly waking up after the tech meltdown, and finding that "boring" blue-chip stocks like Wal-Mart(NYSE: WMT) and Coca-Cola(NYSE: KO) had been replaced by exciting, but now considerably less valuable stocks like Sun Microsystems(Nasdaq: SUNW) and JDS Uniphase(Nasdaq: JDSU). As recent history instructs, emotions lead us to buy stocks like there is no tomorrow during a bull market and dump them during a market decline; these are not the actions of a rational investor.

A very effective way to maintain rationality and fight off the desire to act on emotions is to create rules of engagement for your portfolio: an investment policy. An investment policy doesn't need to be very formal, but it helps to have it written down, since it is easy to forget your plans from even a week ago, let alone a year or two ago. An investment policy should be created at a time of emotional tranquility. It should spell out your investment goals and specifically define the strategy for achieving them. Asking the following questions can help you create a simple investment policy:

• What is the purpose of investing (retirement, college, larger boat)?
• How much money is needed to achieve these desired goals?
• What rate return will be required to achieve these desired goals?
• What is a tolerable level of risk?
• What asset allocation will produce a required rate of return and still fall into the comfort zone of risk tolerance?
• How often will the portfolio be reviewed and rebalanced? (It should not be more than twice a year.)

Once an investment policy is created, it should be looked at as an investment constitution. Not unlike the Constitution of the United States, amendments should not be made on a whim and should require considerable deliberation and the input of trusted and involved advisors, friends, or relatives.

An investment policy is the unemotional "you," made at a time when you were thinking clearly and rationally. An investment policy will provide you peace of mind. No matter how volatile markets become, you will have a lucid strategy for rational decision-making.

Being emotional is part of being human. Finding a way to make rational decisions under emotional pressure is what makes us good parents and successful investors.

Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He owns no shares of any stocks mentioned above. The Motley Fool has a disclosure policy.Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

The Future of Corporate Profits

 

Why Are Bank P/Es So Low?

February 10, 2006 - Motley Fool

By Vitaliy Katsenelson, CFA

Investing in the stock market is a never-ending learning experience. That's what makes it so appealing and intellectually stimulating. And I inadvertently had one of those live-and-learn experiences just the other day.

In my piece on Lloyds TSB(NYSE: LYG), I wrote that banks usually trade at lower price-to-earnings ratios to the market because they are considered riskier investments as a result of their high use of debt. That line caught the eye of Foolish financial editor Joey Khattab, who asked writers Stephen Simpson and Nate Parmelee whether they agreed with my logic. Both disagreed. They argued that larger banks have lower P/Es generally because they are perceived to have a slower or more limited growth potential.

At first, I thought there might be a conspiracy of Fools at work against me! So I asked several investment professionals for their opinion. And to my amazement, they all agreed with the Fools.

So I looked at some larger banks to see whether they had been slozw growers in the past, and I couldn't reach that conclusion. Many of these banks, in fact, had achieved very respectable earnings growth and paid above-average dividends in the process. I then looked at expectations for future earnings growth, and they appeared not to be below average, either. With the exception of Fifth Third(Nasdaq: FITB), which Wall Street once loved to love and now loves to hate, the rest of the pack was trading at a substantial discount to the market and still are.

(to see table please click here)

The answer must be more complex than just the growth rates. I believe the answer to banks' lower P/Es lies in the following four factors.

1. Cyclicality The banking business is closely tied to the health of the economy. As the economy expands, demand for loans increases and bad debt declines -- a combination that improves banks' profitability. In a contracting economy, of course, the reverse takes place.

Because investors pay up for predictability, they rarely pay a full market multiple for the volatility that comes with cyclical companies. Cyclical heavy-industrial companies like Caterpillar and Ingersoll Rand, for example, usually trade below the market P/E just as a many banks do.

2. Financial leverage We have not had a bank crisis in the U.S. for a while, so most investors have forgotten just how risky banks can be. But as Warren Buffett has said, by the time you find out a bank has a problem, it will be too late. The equity at most banks stands at meager 6%-10% of total assets, so when a bank does make a mistake, its high leverage amplifies the problem.

3. Interest rate volatility Banks are subject to the risks that come with changing interest rates. They prosper when the difference between long-term and short-term rates -- in other words, the interest rate spread -- is high. However, when that spread narrows, it becomes increasingly difficult for banks to make any money. Many banks have addressed the problem by boosting their fee businesses. For example, fees account for a full 46% of U.S. Bancorp's income, thereby making the company less susceptible to swings in interest rates.

4. Complexity of financials I could teach my 4-year-old son to analyze retailers' financials in about 20 minutes, if I could get him to sit and concentrate for that long. OK, maybe I'll have to wait a couple of years. But the point is, retailers' financials are very easy to understand. A quick look at the income statement and a glance at the balance sheet (especially the part that focuses on inventories) will very quickly tell you what happened during a retailer's quarter.

Banks and insurance companies, on the other hand, are very different animals. Where analyzing a retailer is like playing checkers, analyzing a bank is akin playing two-dimensional chess. (I'll save the 3-D chess analogy for insurance companies; their financials are even more complex than banks' are.) Investors need to look at financial statements and at dozens of other sources to assess a bank's true performance. And that's a problem, since investors tend to embrace simplicity and shy away from complexity.

To make things even worse, banks' financials are riddled with assumptions. Although all companies have to make some amount of assumptions in their financials, the complexity and magnitude of those assumptions increase exponentially with banks. Consider, for example, that it's not uncommon for a high-growth bank to have its expected credit losses understated because of the immaturity of its portfolio (in other words, new loans have not matured yet). However, as growth decelerates and large portion of the loans matures, credit losses may skyrocket beyond the estimated provisions.

The quality of growth The very size of large banks often gets in the way of their ability to continue producing high-percentage growth. Instead, the bulk of growth for large banks comes from acquisitions. An acquirer is able to fold most of the acquired bank's operations into its existing infrastructure, which, in turn, results in huge cost savings and, of course, higher earnings.

That sounds great on paper. However, acquisitions come with risks, including integration challenges. Bank One (now part of JP Morgan Chase) learned about that problem firsthand when it acquired First USA. Soon after the acquisition, Bank One ran into huge problems with the incompatibility of the combined companies' computer systems, and the stock tumbled as a result. Regions Financial had similar integration problems after making successful acquisitions for a long time. To sustain its growth, it eventually had to start marking larger and larger acquisitions, and that's when the problems began.

In addition to the integration risks, bank executives' egos and their attendant desires to manage bigger and bigger (though not necessarily better) empires often get in the way of common sense. Ultimately, the acquirer overpays for the acquired.

Still, despite all of the potential pitfalls, acquisitions have been the main source of EPS growth for most large banks. In fact, I can't think of a large bank that became large by way of organic growth. Not one!

Bottom line Growth by acquisition is much riskier and usually more expensive than organic growth is. Investors recognize that risk, and thus they put a lot less value on large banks' growth. So, to a large degree, Joey, Stephen, and Nate were right: Slow organic growth is, in part, responsible for banks' below-market valuations. However, I believe that higher risk caused by cyclicality, high financial leverage, and the complexity of financials contributes to the lower P/E as well.

Motley Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He owns shares of Lloyds TSB, and his company has positions in U.S. Bancorp, Lloyds TSB, Wells Fargo, Citigroup, Bank of America, Amsouth, Regions, and JPMorgan. The Motley Fool has a disclosure policy.

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Copyright Motley Fool

The China Bubble

December 20th, 2006 - Motley Fool

In the late 1980's and early 1990's, the world witnessed a bubble economy in Japan. Soon after, we experienced the tech bubble here in the U.S. Now people are wondering if there is a real estate bubble. I hate to be the bearer of more bad news on the bubble front, but there's yet another one on the horizon. The ever-growing Chinese market, a topic which dominated the financial press in 2005, has become overheated, and the consequences could be dire for the global economy.

Back in June 2005, I warned investors that even a mild slowdown in the U.S. economy could send the Chinese economy into a tailspin, possibly throwing one of the world's largest and fastest-growing economies into a Japan-like deflation.

Why should we care about what happens to China? As New York Times columnist Thomas Friedman put it in his book, the world is now flat. The amusing saying, "What happens in Vegas, stays in Vegas," doesn't apply to world economics, especially when it comes to fungible (that is, exchangeable or substitutable) commodities like oil. What happens in China now impacts the rest of the world. Metternich's old line about Paris sneezing and Europe catching the flu has come true on a global scale.

Unlike the oil crisis of 1970s, the rise in the price of oil to $60 per barrel was caused not by a shortage of supplies, but by increased demand, especially from the fast-growing Chinese economy. According to the Energy Information Administration, in 2004 China became the second-largest consumer of oil after the United States. It was the source of around 40% of the world's oil demand growth over the past four years, with year-over-year growth of 1 million barrels a day in 2004.

However, the pendulum swings both ways. Just as an increase in demand drove oil prices to all-time highs, its decrease (driven by a slowdown in the Chinese economy) is likely to deflate oil prices below conventionally expected levels. Oil stocks like Chevron(NYSE: CVX), ExxonMobil(NYSE: XOM), ConocoPhillips(NYSE: COP) and many others that were great performers in 2005 are likely to be the first casualties of the bubble pop. Many of the big oil companies are struggling to increase their production, and the price of oil is the wild card that drives their earnings growth.

Most observers can't imagine a pop in the Chinese bubble -- but they felt the same way back in the late 1980s about Japan. Its ultimate collapse led to a fifteen-year recession. Alas, the Chinese government's close involvement in running its economy complicates matters even further, as it may try to sustain the rapid growth for as long as possible. History (and Japan's own case) show that the longer the government tries to support ailing companies, the more painful the economic reckoning will be.

The possible deflation in China has serious ramifications for other industrial commodities, including copper and steel, but it goes a lot further than just that. China has become a de facto manufacturer for the world. Industrial production accounts for 53% of its GDP, according to the CIA World Factbook. That's double the rate of most developed nations. The following chart shows how China compares with the U.S., U.K. and Japan.

(Please follow this link to see the chart)

Chinese economic growth is largely driven by the manufacturing sector; its industrial production is growing at double the rate of GDP. Any company that competes with Chinese rivals in manufacturing will face even greater competition once China is thrown into a deflationary environment, since the incentives to lower prices when fixed costs are high are too great to resist.

China will likely continue to dominate the business pages in the near future. Unfortunately, the stories may not all be so positive.

Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He also writes for the Financial Times and Minyanville.com. His firm has a position in Exxon Mobil. The Motley Fool has a disclosure policy.

Vitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Natural disasters may herald a 'hard' market

January 4th, 2005 - Financial Times

Last year's rendezvous of three witches (Rita, Katrina and Wilma) on the Gulf coast caused destruction and sucked out capital from the property and casualty insurance industry.

The bad news is: insurance companies lost a lot of money. But the good news is: insurance companies lost a lot of money. Thus we are likely facing a new "hard" market, of increasing prices. If you are an investor in the sector, rather than a buyer of insurance, that is good news - provided the likes of the three witches don't pay the US another visit next year, or the small earthquake California felt in December was not a prelude for a larger one.

There is, however, a good way to participate in the upside of the rising insurance premiums without bearing the risk of a natural disaster - insurance brokers. They are hired by companies (from mom and pops to Fortune 100 companies) to find an appropriate insurance coverage at the best price. Insurance brokers are transaction facilitators, enjoying the upside of rising premiums since their commissions rise with premiums, but at the same time they are not risking their balance sheets, which is the insurance companies' job.

AJ Gallagher (AJG) is the best play in the broker industry: it has the highest dividend yield (3.6 per cent), one of the lowest valuations, virtually no debt, a very respectable 20 per cent return on capital and it is trading at 16 times 2006 earnings, which are likely to be revised upwards as the market hardens. It has a good management team, headed by Pat Gallagher - the third Gallagher to run the company since it started in the suburbs of Chicago 77 years ago - which has shown a commitment to long-term growth even if it means making sacrifices to short-term profitability. This is a rare quality in today's often short-sighted corporate environment.

In the past decade AJG has grown earnings per share at about 14 per cent a year. Long term growth is likely to be somewhat in line with the past, with 7-8 per cent coming from organic growth and the rest from acquisitions, though I expect sales growth over next couple years to be higher, driven by firming (hardening) of the insurance market. I am usually not a big fan of acquisitions as they introduce an execution risk to the business and are often done to build corporate empires, not for the benefit of shareholders. However, that is not the case with AJ Gallagher. It has perfected the art of making small acquisitions that effectively involve hiring an office of insurance agents (usually 10 to 20) that share a similar culture and goals.

A grey cloud in the person of Eliot Spitzer is hovering over insurance brokerage stocks, but that could dissipate soon. All top insurance brokers, including AJ Gallagher, stopped taking contingent commissions (which according to Mr. Spitzer created a conflict of interest for insurance brokers) and paid fines. To offset loss of contingent commissions, insurance brokers are negotiating with insurance companies to raise their normal commission thus making their compensation transparent to their clients.

AJ Gallagher has shown a remarkable ability to create shareholder value, and grow earnings and cash flows in any market environment (hard or soft). Using Warren Buffett's analogy: it is one of those rare stocks that I would feel comfortable holding even if the stock market were closed for the next ten years and I could not sell it.

Vitaliy Katsenelson is a portfolio manager at Investment Management Associates and teaches at the University of Colorado in Denver. His funds hold AJ Gallagher stock

Vitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Mailbag: The Trouble With Timocracies

December 27, 2005 - Minyanville.com

Vitaliy, Can you believe this? I mean, really, what is with these people working at Wal-Mart (WMT)? If they wanted to have a lunch break, they should have gone to college (like you and I), don't you think? The next thing you know they'll want to be paid for overtime. Oh, I forgot Wal-Mart has already been busted for that one. In any event, these ungrateful, under achieving employees will come up with some other scam to steal money from St. Wal-Mart. There ought to be a law! Merry Xmas. Michael Michael, Now I know how Michael Carleone felt when he said, “Just when I thought that I was out they pull me back in.” I thought I put the Wal-Mart issue to rest, but it keeps coming back. So let’s clarify couple things: neither I nor my firm own shares of Wal-Mart. I like the company - it has a nice moat around its business. However, I think its future sales growth rate will be a bit slower than the market expects, as a very large portion of it will come from the cannibalization of the existing store base. I believe current valuation, which looks attractive from relative to past perspective, still doesn’t reflect slower growth ahead. Thus, the stock is not cheap enough for me to step up to the plate. Also I am not a secret member of the “defend the Wal-Mart club.” It doesn’t need my defense; it has its own PR firm, which is doing a terrible job explaining how capitalism works to the public. My interest in Wal-Mart only extends as far as it represents capitalism at its worst and its best. The lost lawsuit – halleluiah! Wal-Mart broke the law, and paid $172 million for it. This is how capitalism works. Our legal system creates boundaries of acceptable behavior – laws. You break the law, you pay. I challenge you to find a Fortune 500 company that doesn’t have a lawsuit on its hands; lawsuits are just the cost of doing business in our very litigious society. Wal-Mart (or any other company) will think twice the next time it decides to deny overtime to its employees or cut their lunch break. To your comments, Wal-Mart is not breaking the law by paying what it pays to its employees (unless it pays less than minimum wage, which it is not, but then again you never know). If a person doesn’t want to take a job at Wal-Mart that pays $8 an hour, he/she can go get a union job at a local Albertson's (ABS) or Safeway (SWY) store. Oh wait a minute, those inefficient, bureaucratic, timocracies (employees paid and promoted based on time served, not based merit or skills) are losing market share and closing stores due to competition from the more efficient meritocracies such as Wal-Mart, Target (TGT), Costco (COST), BJ’s (BJ) and Whole Foods (WFMI). Timocracies don’t work well because there are no incentives in place for skills advancement and development. Capitalism is a merit system with some dose of randomness injected into it. Not everyone succeeds, but for the system to work everyone cannot succeed. Japan learned that lesson in a very prolonged and painful way, when it did not allow failed companies to fail and companies that were supposed to be dead were artificially kept on life support. This resulted in the 15-year zombie economy. There should be a healthy dose of hunger injected into system. Not hunger for food, but hunger for advancement in social status, hunger for material things (bigger cars and houses, the latest “must haves,” etc.). As I mentioned before, the social nets that are so intertwined into the diluted American version of capitalism protect the less fortunate from hunger. My friend from the Windy City, Brian Gilmartin, wrote the following: Here is an excerpt from a Stephen B. Oates book on Abraham Lincoln entitled, "With Malice Toward None." In this passage on p. 166, Lincoln is addressing or giving a graphic defense of the "Northern free-labor system" and attempting to refute slavery defenders. Slavery is an emotional topic (quite obviously), and I’m not trying to compare slavery and union membership, but as I read the following quote in the book, I couldn't help but think of your Wal-Mart piece. You tell me if what Lincoln says here doesn't apply to your Wal-Mart and anti-union argument. "Southerners he observed maintained that their slaves were better off than the hired worker in Northern society. Apparently they thought that Northern laborers were fatally fixed in their position for life, but how little they know !. For that was the basic error in Southern thought from which flowed all other mistaken attitudes. In fact it was the genius of the free-labor system that there was no permanent class of hired workers. Northerners were free to move up, progress and enjoy social and economic mobility. "I was a hired laborer", Lincoln recalled, working for $12 a month. Yet the system gave him the opportunity to improve himself to rise above his humble origins and become a self-made professional man. So in the free labor system, "the hired laborer of yesterday labors on his own account to-day; and will hire others to labor for him tomorrow." Lincoln described in story form how the system operated: "the prudent penniless beginner in the world" leaves home with his capital - two strong hands and a willingness to work - and chooses his employer and mode of labor. His employer pays him "a fair day's pay for a fair day's work" (which) he saves frugally for years, buys land on his own hook or goes into business for himself, marries, has sons and daughters, and in time has enough capital to hire his own beginner. And this free-labor system, this "progress by which the poor, honest, industrious, and resolute man raises himself" - as Lincoln had raised himself - is the "great principle" Republicans intend to take into territories.... For the free-labor system opens the way for all, gives hope to all, and energy, and progress, and improvement of condition to all. And those who remain as workers - and he conceded that many did - cannot fault the system for their condition. They remain as workers either because they have dependent natures or because of improvidence, folly, or misfortune. For the doors are always open for them to better themselves. The hope for self-improvement is always there." What surprises me is that union members don't realize that by agreeing to collective bargaining, they give up all rights to self-advancement. In effect, without regard to personal ability, they become part of a caste system. Wal-Mart workers are free to work elsewhere if they are unhappy with Wal-Mart as an employer. Got to run; my wife is about to have a baby. VitaliyVitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

National Grid's Boring Little Secret

December 21, 2005 - Motley Fool

By Vitaliy Katsenelson, CFA

If you need words to describe National Grid (NYSE: NGG), "stable," "predictable," and "unexciting" spring to mind. Reading its financials stirs so little excitement that if you can't sleep, you might want to leave a copy of its 20-F (a 10-K equivalent filed by ADRs) on the nightstand. In the competition for boredom, in fact, National Grid is likely to place second only to Service Corp. (NYSE: SCI) -- yes, the funeral home company. Even so, its stock definitely deserves to make up a core holding of your portfolio -- though at a lower price than what it now sports.

National Grid runs tollbooth-like businesses -- it collects money for allowing gas and electricity to travel along its vast network of power lines and pipelines. To make things even better, the company is the only game in town -- at least in the United Kingdom, where it is a legal monopoly. And that's the very best kind. It's the only operator of electricity transmission in Great Britain and owns four of the eight largest gas-distribution networks in the U.K., having sold the other four in 2005.

A powerhouse in the U.K.The gas-distribution business in the U.K. is a bit different from the American system, in that National Grid doesn't bill end consumers. Instead, it bills gas shippers (which are unrelated to National Grid) that have contracts with gas suppliers. The gas suppliers, in turn, bill the consumers. Also different is that the prices National Grid charges gas shippers for using its distribution network are regulated by Ofgem (the U.K.'s utility-regulating body) and not by competitive pressures. But even though the company does not have to take on any consumer credit risk, it does face a very remote risk of a shipper default. Fortunately, a lot of things have to go wrong for that to happen.

In the electricity transmission business, it doesn't own the electricity-distribution networks to the end customer, though the segment is the company's largest source of profitability.

What's more, the gas and electricity businesses are highly regulated. The company is allowed to receive a 6.25% pre-tax real return, after inflation, on regulated asset value. That's a low rate. However, combined with 55% debt financing, it results in a 9.8% return on equity, after tax. Though I usually like to see a higher return on equity from the companies in my portfolio, this is adequate when you consider the incredibly low-risk nature of this business.

Stable cash flowsThe beauty of transmission and distribution businesses like this is that their cash flows are insensitive to the volatile price swings in the commodities they transport. If revenues fall short of the projections because of a decline in demand, National Grid is allowed to recoup the shortfall via price increases the following year.

The transmission business, though, is not a high-growth sector by any stretch of the imagination. Its growth is tied mostly to inflation and to growth in the gross domestic product. There is, however, a unique opportunity knocking on the growth door for the electricity transmission segment in the U.K.: the replacement of aged power lines. The majority of Great Britain's power line infrastructure was built in the 1950s and 1960s and is in the very late stages of its useful life. That creates a growth opportunity for National Grid, as capital outlays to replace it will double next year, thus increasing its billable asset base and stimulating bottom-line growth.

National Grid's future growth will also be spiced up by its wireless and broadcast TV transmission businesses in the U.K. With the demand for wireless towers growing at a very fast clip, and with more equipment being added to existing towers, these businesses should generate double-digit profits for National Grid and make incremental sales extremely profitable. National Grid has only an 11% share of this market, however, and the opportunity for profit will depend on the wireless companies' willingness to part with their towers -- they currently own approximately 80% of the nation's towers.

The company's management, meanwhile, has done a terrific job of cutting its costs in the U.K. That was especially evident in National Grid's first-half 2005 numbers: Operating profit in the U.K. gas distribution business was up 21%, with costs declining 4% since March 2005. Cost-cutting should continue into 2007, but the bulk of it is already behind the company.

It makes sense, then, that the electricity-transmission business is not a primary political target. According to Ofgem, transmission charges account for only 3% of consumers' final bills, and that makes it very hard for politicians to score points by pointing fingers at the likes of National Grid. From a diversification standpoint, the company generates about one-third of its revenue from its gas and power transmission and distribution businesses in the northeastern United States, where it enjoys regulated-monopoly status.

As for the U.K. gas business, National Grid is taking steps to prepare itself as the nation turns into a net importer of natural gas. It's expanding its network to connect to new suppliers, and it has built a new liquefied-natural-gas (LNG) importation facility that should generate returns above regulatory set limits -- providing yet another source of incremental asset growth.

QVGLet's look at National Grid's stock from a "QVG" perspective -- quality, value, and growth. First of all, this company is not shy about using debt, which now stands at about 58% of total assets -- a normal level for a very capital-intensive, regulated industry with a low return on assets.

Furthermore, National Grid is a monopoly. Frankly, I wish every company in my portfolio was a monopoly. By definition, monopolies have a very strong moat around their business, and that guarantees continuity of cash flows. As a regulated monopoly, though, National Grid will not have Microsoft-like profit margins, nor will it generate Google-like growth. But it should maintain its very stable 10%-11% net margins and deliver sustainable and predictable growth in earnings per share. Standard & Poor's has provided its own stamp of approval on the company's debt with an "A" credit rating.

Mid-single-digit growth in earnings should come from revenue growth and cost-cutting. Even without going after new projects, National Grid is capable of growing earnings at 2%-3% a year as a function of U.S. and U.K. economic growth. Investments in new assets such as the LNG facility, modernization of power lines in U.K., and margin improvements from cost-cutting should spice up earnings growth further by a couple of percentage points.

Thus, without taking a lot of risk, this company can deliver a very predictable 5%-7% EPS growth depending on the progress of cost-cutting and asset growth. Any growth coming from the wireless and TV transmission business would be icing on the growth cake. Combining 5%-7% EPS growth with a 4.6% dividend yield results in roughly a 9%-11% total return. That doesn't sound boring to me!

And it gets betterThe company has also stated that it will grow its dividend 7% per year over next three years. National Grid comes with a hidden bonus, too: The stock works as a great hedge against a declining dollar. With the dividend paid in pounds and converted into U.S. dollars, it becomes even more valuable to U.S. investors if the dollar declines -- a bet I am willing to make in the current environment. (An appreciating dollar, of course, would have the opposite effect.) In addition, a high dividend yield creates a solid support for this stock, as it is a big attraction for income-hungry investors.

ValuationShares are trading at 14 times March 2006 projected earnings -- which is basically a slight discount to its U.S. counterparts such as Exelon (NYSE: EXC), NStar (NYSE: NST), and Consolidated Edison (NYSE: ED).

There is one weak link in this story, however. The stock has little, if any, margin of safety. Though I don't foresee investors losing a bundle in these shares, the lack of margin of safety (discount to fair value) in its price-to-earnings ratio is a concern. Since this stock won't punch anyone's lights out, even with its healthy dividends and modest earnings growth, buying in at the right price is important.

This is where discipline comes in. An investor must be able to differentiate between a good company and a good stock -- two often confused but different ideas. National Grid is a good company -- no question about it. But the stock is fully valued at the current price. I'll therefore put National Grid on my watch list, and if its stock revisits the $42-$43 (12 times earnings) level, I'll be buying it with both hands.

Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business.

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Lloyds Weathers the Storm

December 13, 2005 - Motley Fool

Lloyds TSB's (NYSE: LYG) recent announcement that it experienced slower growth in consumer lending and higher defaults in its consumer segment did not come as a surprise, and its stock actually went up on the news. One reason for that is that the company says its dividend will not suffer, even despite the uneasy economic situation in the United Kingdom.

Consumer lending represents about a third of Lloyds' profitability. The rest comes from wholesale banking (corporate) and life insurance. Both of those businesses are firing on all cylinders. In first half of 2005, the wholesale banking business saw a decrease in bad debt as corporations in the U.K., like their counterparts in the United States, are swimming in cash. The life insurance business was a very solid performer over this period as well. I am not particularly worried about Lloyds weathering the consumer storm that is currently raging in the U.K., since the company is more than sufficiently capitalized and very well managed and diversified. I am far more concerned that we are seeing a "Mini-Me" version of a massive financial hurricane that will soon hit the U.S. It appears that the U.K. is about one economic cycle ahead of the U.S.: The former's housing market has been cooling for a while, its central bank was lowering rates until recently, and its consumer spending was slowing while consumer defaults were rising. And consider this: U.K. consumers are not nearly as leveraged as their U.S. cousins.

The decline in housing prices in the U.S., coupled with higher short-term interest rates and rising energy prices (heating bills alone are expected to be 70% higher than last year), should be a cause for alarm. To throw gasoline on the fire, minimum credit card payments will double in January. The combination of these factors is likely to have a significant impact on the highly leveraged U.S. consumer, putting a great squeeze on consumer discretionary income and, thus, spending.

Lowe's (NYSE: LOW), Home Depot(NYSE: HD), Best Buy(NYSE: BBY), and a myriad of others that are closely tied to consumer discretionary spending and home equity borrowing are likely to be the first casualties when a much larger version of the U.K. financial storm hits the U.S. coast. Financial institutions that rely heavily on consumer lending, such as Capital One(NYSE: COF) and MBNA(NYSE: KRB) -- soon to be bought by Bank of America(NYSE: BAC) -- are likely to be not far behind them.

As for Lloyds, its monster 7.3% dividend will not be negatively affected by the consumer weakness in the U.K. The press release was firm about that. And that is one reason why the stock went up on bad but expected news.

As Lloyds' executives have stated many times before (and I believe them), there are only two reasons to cut a dividend: There is not enough capital, or the capital is needed to grow the business. Neither is an issue here. The company is well-capitalized, and it has excess capital for a rainy day. Nor it is not planning to make large acquisitions, so there is no reason to build up a war chest.

Lloyds TSB is one of only two non-government-backed banks that command a triple-A rating from Moody's (the other one is Wells Fargo). The company remains on very solid ground and if anybody can weather the storm -- while continuing to pay a dividend -- Lloyds certainly can. Home Depot and Lloyds areMotley Fool Inside Valuerecommendations. Best Buy is aMotley Fool Stock Advisorselection, and Bank of America was recommended byMotley Fool Income Investor.

Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He owns shares of both Lloyds and MBNA.

Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Sporadic Thoughts: A quick look at Symantec

December 9, 2005 - Minyanville.com

Symantec (SYMC) looks somewhat alluring on the surface: it is trading at 18 times next year’s earnings. It looks even more appealing if you factor in a $4 billion cash pile, which accounts roughly for 20% of the company’s market capitalization. However, a look at company stock options expense kills the appetite for the stock, as stock options wipe out 20% of the earnings. Though the company has lowered stock options issuance, curbing it down 2%, the stock options that were issued awhile back are coming to haunt the company as they have a ten year exercise period.

Oh did I mention Microsoft (MSFT) is wanting to wet its beak in the security software market? Vitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Mailbag: Corporate Citizen

December 9, 2005 - Minyanville.com

Vitaliy,

With regard to your Wal-Mart (WMT) piece. You should be ashamed of yourself. The idea of exploiting those less fortunate is not the type of thing I have come to expect out of the Minyanville. I would think your typical long term Wal-Mart employee fits the bill of those that haven't made the cut. Happy Holidays, Michael

Michael,

This is a very late response to your comment, but better late than never. It is a very holiday-like thought: let’s help the less fortunate ones. There’s nothing wrong with that in my book. However, how would you expect Wal-Mart to accomplish it? By paying higher wages? Ok, instead of paying $8 an hour (which is above minimum wage by the way), they'll start paying $10. This insignificant two-dollar increase in wages is not enough to solve the problem of the un-affordability of health care coverage or the higher cost of living in the U.S.

So, let's say Wal-Mart becomes "a responsible corporate citizen" and starts paying $16 an hour instead. Wouldn’t that be great? Now a person without any hard-earned skills or any investment of time and money into education will be making $32,000 a year - a starting salary of a college graduate.

Would anybody want to make the investment of spending four years of their life going to college and being indebted with college loans if a relatively skill-less job at Wal-Mart would pay a similar wage? You have to realize that getting an education is an investment; one makes sacrifices at the present (i.e. time from family, forgone income, cost of tuition, etc.) for higher future income.

Some people will still choose college, no question about it. There is more to life than money; it’s hard to put a price tag on thirst for knowledge. In Russia, the "working class" made more money than college educated engineers. Yet Russia is one of the most highly educated countries.

Russia figured a way to deal with this problem in a "Russian-like" way: College graduates did not have to serve in the Russian Army. That was a form of compensation for going to college. Please don't confuse the Russian no pay, three years of hell, high security prison-like Army with a civilized (if any army can be civilized) American army.

Supply and demand is at the core of capitalism, and it regulates the wages that employees receive for their skills. On Monday, when I was wheeling out the trash bin for Waste Management to pick up, I thought, “That must be a very unpleasant job; riding around in the garbage truck in this weather," (it was -5F in Denver at the time).

However, then I thought that the supply of labor that can do that job is virtually unlimited (similar to Wal-Mart’s employees). There are plenty of people that possess a single skill: a strong back.

If for some reason, like unwillingness to deal with other people's garbage and enduring unpleasant smells, Waste Management could not find enough people to do the job, they'd have to raise wages to attract the talent. It comes down to supply and demand every time. Should garbage men make less money than college graduates? I have no idea, I know I would go to college so I didn’t have to be a garbage man (or work in Wal-Mart), but that is just me. Supply and demand will sort it out – it always does.

If Wal-Mart started to pay wages that were equivalent to college graduates, the economic impact would be enormous. We'd be going back to Stone Age; we'd be rolling back the clock on progress. Disincentives to receive education would be enormous. Allowing capitalism to go wild and being capitalists sets the great U.S. of A apart from other developed “socialized” countries. We let (most of the time) market forces sort things out. Yes, supply and demand is cold, but it is the only way to allocate resources efficiently.

Should we help the less fortunate? Yes, we should and we already do. The government sponsors scholarship grants - I was a recipient of one when I started going to college. That is how you help people, teaching the man how to fish, as opposed to being “compassionate” and giving him a fish.

Let’s touch on the health care issue just a little. If one is sick in the U.S., no matter that person's income and health coverage, that person will receive medical care – it is that simple. It may be the neighborhood's general hospital (which is still better than most hospital facilities in emerging and already emerged countries) that will provide Medicaid, Medicare or free clinics. If one makes it into the emergency room of a local hospital, the hospital will NOT turn a patient down for inability to pay. In fact, they'll spend tens of thousands of dollars on his/her care and then charge it off as charity if one’s income is below a certain level. It’s another form of the rich paying for poor, but I'll leave it for a later discussion. Take a look at hospital stocks; that is the number one issue that is impacting their performance.

I believe in helping the less fortunate, no question about it, but let’s not confuse paying higher than market unwarranted wages and helping the less fortunate. They are two different things.

Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Sporadic Thoughts: Retail, Consumer and First Data

October 28, 2005 - Minyanville Retail swell?

This weekend when I heard about the 22% increase in shopping activity over last year, I could not help but wonder - have I seen this movie before? After all, auto companies tried to stimulate their demand by cutting prices, and we know how that story ended. It seems what attracted consumers to the stores were the great discounts, not the increase in their real income. Are retailers stilling their future holiday sales with early deep discounts? Time will tell.

Rushin' promotion roulette?

On the BJ Wholesale (BJ) conference call, management made a very interesting comment that may explain the Black Friday rush to buy the latest must-haves: "There are a lot of earlier promotions and everybody is trying to pull in these sales before the first heating bill arrives in consumers' mailboxes. " Need I say more?

Wish you were here

First Data Corp's (FDC) stock was up $2 on the news of its CEO Charlie Fote leaving for personal reasons. I never looked at Charlie as a liability at FDC, thus I am surprised by today's price action. Several months ago when I met Charlie at FDC investor day, he said that he was dissatisfied with FDC's price and that he'll have to do something within a couple of months if the price doesn't move - well, I never thought this would be his solution to the problem.

Positions: BJ, FDC

Vitaliy N. Katsenelson, CFA Copyright Minyanville.com This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Newspapers look flimsy in a digital world

November 29th 2005 - Financial Times

This article was published Financial Times on page 14. Ironically I originally wrote this article about six months ago, but it was pushed back by my other pieces. It was a product of my research on Gannett (GCI), which we decided not to buy--the stock has declined almost 30% since. Google’s (GOOG) incredible top-line growth which is approaching GCI’s very quickly is a sign that there is more pain for newspapers to come. Newspaper stocks are way down from last year's highs, looking cheaper than lowest grade dirt relative to their past premium to the market valuations. Gannett, Knight Ridder and Tribune are trading at a 10-20 per cent discount to the market PE. But "brand" name newspaper stocks - Dow Jones, Washington Post and New York Times - are still trading at a premium PE in spite of their declines. This might look tempting to value investors. But the situation is more dangerous than it appears. Newspaper stocks at the moment represent a "value trap". If the direst predictions are fulfilled and newspapers turn into payphones in a cellphone world, current share prices do not look good. There are several short-term reasons why newspaper stocks are down. First, they are facing tough comparisons with last year's numbers that were bloated by political advertising. Second, although employment advertisements have rebounded, car ads took a plunge because of tough comparisons with last year's numbers and a general decline in spending by car dealers. Finally, circulation has continued a decline that began in the mid 1990s. Much of this will soon reverse. Unfortunately for the rest of us, and fortunately for the newspapers, political advertising will be back next year. And, in the absence of making good cars, US carmakers will have to lure consumers with increased advertising. Thus the softness observed over the last several months should be short-lived. But the news is not that good for circulation, where decline may prove to be a long-lived, secular phenomenon. The internet is changing the way we read. Old habits die hard, and thus the decline in circulation has been in very low single digits. It has not fallen off a cliff. But the decline has taken place when population and gross domestic product have been growing. The internet is a perfect vehicle to deliver news and editorials to consumers. The incremental cost of delivery is virtually free and delivery is instantaneous, benefits not shared by "pulp-made" newspapers. The internet has commoditized news, through services such as Google News, subsequently driving the price of that commodity to zero. Only a handful of newspapers are able to charge for online content and readers are not paying for the "news" content, as there are plenty of free sources of news on the internet. They are generally paying for interpretation and editorials. Local newspapers, once considered a sweet spot in newspaper business as they traditionally had a quasi-monopoly on local print advertising, are still charging advertisers a fat premium over national newspapers. But things are about to change. Google is already luring dollars away from traditional forms of advertising. It is likely to take things a step further by localizing and customizing search technology - a direct threat to the fat profit margins of local newspapers. The recent rush of large newspaper organizations to throw huge sums of money at online properties is an indication of confusion and panic rather than a clear strategy. In Rupert Murdoch's speech to the American Society of Newspaper Editors he indicated that newspapers have not worked out how to embrace the internet and are rapidly losing younger readers. The New York Times' web traffic fell 23 per cent in the last year, according to Mr Murdoch, not a figure you would want to see in a world where online advertising is growing in double digits. It must have been unwelcome data on the eve of the Times' attempt to start charging for some content. Newspapers are not going away. Century-old habits will keep consumers reading them for quite a while. But this doesn't necessarily make newspapers a good investment; the internet creates an unwelcome headwind, and earnings growth is uncertain. Until now, the industry has masked the declining circulation by raising advertising prices. Advertisers are a number crunching bunch and at some point they will realise they are forced to pay more for less every year. Thus increases in advertising rates are not sustainable. Given the new competition from the internet, that trend is likely to reverse. In the short run ad revenues may get a boost from the resumption of car and political advertisements, and acquisition chatter - as has already been seen in Knight Ridder - may lift an interest in newspaper stocks. However, the long-run prospects are a lot less certain, setting a likely value trap for bargain hunting investors. Will newspapers become payphones in a cellphone world? This possibility is already discounted to some degree in the shares of Gannett, Knight Ridder and Tribune. But the "brand" papers' valuations still don't reflect that plausible outcome. Vitaliy Katsenelson is a portfolio manager at Investment Management Associates and teaches at the University of Colorado in Denver. Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Wal-Mart's Double Standard & Sin Stocks

November 17-18, 2005 - Minyanville.com

Wal-Mart's Double Standard

I talked to two friends of mine, both are money managers. Their firms will not buy Wal-Mart (WMT) because they’re afraid clients will be upset with them. One of the firms is located in Boulder – so that unwillingness to own WMT makes sense, as Boulder is a socialistic Californian city disguised by the Rocky Mountains (did I just call Californians socialists?). But the other manager’s firm manages north of four billion dollars and has several mutual funds. This leads me to believe that the headline noise about Wal-Mart’s immorality may force it into the “immoral investment class,” where money managers may be dropping the name from their portfolios due to client pressure, thus creating a buying opportunity in the shares.

I also had a client call me asking if I really believed in what I wrote about WMT, referring to the Wal-Mart – “Capitalist Pig” article. He could not believe that I meant every word; he thought I was just being “provocative.”

I really do believe that Wal-Mart is an incredible company and I don’t feel that it is committing any immoral acts. It is a retailer that is very good at what it does. Its only fault is that it is extremely successful; becoming the largest retailer in the U.S. and in the world. Its sheer size attracts the criticism, which has nothing to do with Wal-Mart but has to do with realities of capitalism, i.e. poverty of the lower classes, high medical costs and inability to afford health insurance etc… We don’t hear anybody discuss smaller retailers, i.e. Dollar General (DG), Family Dollar (FDO) and other businesses that pay minimum wage to their employees (Wal-Mart actually pays almost double the minimum wage) and don’t provide health insurance. It seems that there is a double standard by which Wal-Mart is judged upon.

Investors that have a social investing gene in them would be more upset about owning WMT than about owning a liquor (or any other sin) company. My view on social investing is very simple: it is an oxymoron. Investing is done to make money. Any company scrutinized enough won’t pass the “social” test. It is hard enough finding good investments, adding another very subjective criteria to the mix only makes it more difficult.

This is what Larry the Liquidator said about social investing: “Take the money. Invest it somewhere else. Maybe, maybe you'll get lucky and it'll be used productively. And if it is, you'll create new jobs and provide a service for the economy and, God forbid, even make a few bucks for yourselves. And if anybody asks, tell 'em ya gave at the plant.” Mailbag: Sin Stocks

Vitaliy,

I live in Colorado Springs….and if you don’t like living in Boulder I’ll trade places with you anytime. I think you’d find that living with the ‘socialists’ in Boulder is more tolerable (and more fun) than living with the ‘Focus-on-the-Family’ fundamentalists here in the Springs. But seriously, I don’t think screening out the biggest social culprits is that big of a hurdle. I find that most of our investors prefer not to invest in alcohol, tobacco, gambling, or military contractors. Actually, we’ve done several points better than the S&P 500 over the years without investing in those industries. So, the hurdle really isn’t that great. True, some social screens are much tighter than that, but then again, so are other fund screens based on market cap, value, growth, etc. I don’t hear Jim Awad complaining that he can only invest in small caps.

Respectfully,

William William,

I live in Denver but probably would not mind living in Boulder. Though I've been told by my friends who live in Boulder that the liberal brush I’ve painted of the city may not apply to it any longer.

Avoiding sin stocks (i.e. defense, tobacco, gambling and alcohol) doesn’t severely limit an investor’s stock universe and is not very taxing on time and effort, as sin stocks are easily identifiable. That is not something I would do, it is an issue of personal values. As you mentioned, and I agree, following that strategy should not have significant consequences on the return achieved in the portfolio. However, social investing could be taken to an extreme if one decides to do so:

• Political donations – A company is giving money to the wrong (another very subjective criteria, unless it is something black and white like Al Qaeda) cause or party.
• Treatment of employees (very subjective) - Does Wal-Mart (WMT) treat their employees fairly? Do you start looking at employee compensation of every company you invest in?
• Labor practices (use of child labor) - Do you avoid companies that use parts made in China or manufactured in China?
• Environmental citizenship – Do you avoid oil companies and refineries? What about auto companies who make gas guzzling SUVs?

I probably missed a dozen categories, but you get the idea. When social investing is taken to the extreme it turns into a very taxing exercise and substantially limits the ‘investable’ universe. Best regards, Vitaliy Vitaliy N. Katsenelson, CFA

Copyright Minyanville.com

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Cendant: The Anatomy of Sell and More

Minyanville.com - October 28, 2005

The Anatomy of Sell Buying stocks is easy, selling them less so. Therefore, in light of the Cendant (CD) news today, I thought it might be helpful to briefly look at the reasons we sold Cendant stock awhile back. Perhaps this short exercise can help illustrate the fundamental discipline involved in making sell decisions.We sold Cendant stock awhile back for the following reasons:

Wall Street did not care about company’s business model. The company was going through its “simplification” phase as it was shedding the uncomplimentary businesses, PHH and Wright Express, thus we were willing to wait. However, when CD sold its marketing business – the last “uncomplimentary” business, and Wall Street did not care (the stock did not budge) – that was a sign that Wall Street did not like CD’s business model, thus it will not price it at a higher multiple.

One of the premises for buying CD was P/E expansion – we did not feel that would happen. (I think this is in part what motivated CD’s management to break up the company... realization that the stock will be “cheap” forever as Wall Street doesn’t care for its business model. We did not like real estate business.

We never saw a synergy between the real estate business and the rest of the company. How does real estate relate to car rentals, travel and hospitality? Also, in the last quarter all growth in sales in the real estate franchise came from higher housing prices with no volume (number of houses sold) growth. Thus a decline in housing prices, something we expect a lot sooner than later, would cause a disproportionate decline in earnings due to operational leverage; remember leverage works both ways.

Reducing our exposure to discretionary spending. After stress testing our portfolio to the risk of a discretionary spending slow down, CD came out on top of the list as its travel and hospitality businesses have a very large discretionary spending component.

Minyanville.com - November 10th, 2005

Mailbag: The Spin on Cendant

Vitaliy,

I read the note that you wrote about why you sold Cendant (CD) prior to the announced break up. Now that the company is going to split into four parts and since you previously believed the company was grossly undervalued, have you thought about wading back in? I've come across some sum-of-the-parts valuations which place a value of $22 - $27 per share on the company and at its current price that would be a discount of roughly 20 to 35 percent. I believe it is undervalued; however, I worry about the combination of being at the peak of the business cycle, pricing pressure, and slackening demand in all of their businesses. Any general thoughts that you may have would be welcome.

Thanks, - Chandler

Dear Chandler,

You are exactly right. I can see how CD could work out - absolutely. However, I share the same concerns and I believe that time is CD's biggest enemy. Given enough time, the housing market may decline (arguably not far around the corner), thus creating more uncertainty about the price it'll get for its real estate business.

Economic slowdown, caused by weakening consumers, is likely to impact the travel business and the multiple it will receive when sold. The stock would not worry me that much at this level (not advice) but the upside you mentioned may or may not be there. Looking briefly at discounted cash flows, the stock does look very cheap, but my level of confidence about cash flows is not very high.

- Vitaliy N. Katsenelson, CFA

Copyright Minyanville.com

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Mailbag: Buybacks and Dividends

October 11, 2005 - Minyanville.com This mailbag is in response to my Nov. 4 article on Buybacks and Dividends.

Vitaliy,

Good stuff as always!... A minor point... near the end you say you object to a company leveraging its balance sheet to do buybacks. But technically, isn't paying out cash for a buyback changing (negatively) the balance sheet even if no borrowing is involved? In other words, you buy back stock and cash becomes a smaller part of total assets and overall shareholder equity shrinks. The enterprise now IS at more risk (smaller and less cash) than before, although admittedly not as seriously as one that takes on debt to buy back stock. Isn't it just a matter of degree, rather than a sharp difference?? Fully agree that buybacks are better and healthy dividends are second best, since management definitely does have their flights of egoistic fantasy and do some really dumb things in the name of growth. - Don

Don, great point! So let me clarify that: Buying back stock is leveraging anyway you look at it, because it lowers equity (cash balance declines – lowers equity and thus debt to total assets ratios rises) – it's hard to argue with that. Also, with this logic, paying a dividend is leveraging as well, as it forces cash balances to decline. However, the distinction I am making is that when a company increases debt (HIGH leverage scenario) – in absolute terms, by issuing debt to buy back stock, a company can only do so much of that because it has a finite borrowing capacity. Thus the growth of earnings that comes from issuing debt and buying back stock is not sustainable. Where stock buybacks that are sourced from free cash flows (LOWER debt scenario) result in a more sustainable earnings growth and arguably less risky (everything held constant), as they don’t raise the absolute levels of debt. As long as free cash flows keep rolling, a company can keep buying stock. From a credit analysis perspective, HIGH leverage scenario case does the following: raises debt to assets ratio and lowers interest coverage ratios; LOWER leverage scenario case does the following: raises debt to assets (but by lower degree than in first case) and has no impact on interest coverage ratios (alright, it has a very small negative impact as cash paid out earns interest). Best regards, - Vitaliy

Vitaliy,

Good points; all agreed and understood... but even if the buybacks come from free cash flow (definitely the preferred scenario) they by nature reduce the financial robustness of the company from what it WOULD have been in their absence. - Don

Don,

Agree, but at a certain point cash sitting on balance sheet just takes away value (i.e. MSFT) – but your point is well taken.

-Vitaliy

Vitaliy,

Wouldn't you rather see management apply a very strict value standard to any share buybacks? Something along the line of Ben Graham's 30% below book? As a small investor I'll take a dividend over share buybacks any day. -Alex

Dear Alex,

As I mentioned before, I prefer dividends versus share buybacks. Your question raises a different issue: is management a good investor? More often than not, it isn't. Management has a bias - it is usually in love with its company. They spend an enormous amount of time to increase the company's profitability, to build a stronger franchise. This investment of time creates an attachment to its company leading to a loss of objectivity. The same way a parent loses objectivity of his child's drawing skills - I believe everything my four-year-old son draws is a masterpiece (it really is, LOL) - management believes that its company is extra special, thus usually overestimating its value and overpaying for the stock. In other cases management is aware that its stock is overvalued, but it still overpays for it to make their earnings numbers. I do favor dividends to share buybacks, the same way I favor Lloyds TSB (LYG) 7.7% dividend to US Bank Corp's (USB) 4% dividend at 3%+ a year share buyback - both banks have the same payout ratio (dividend plus share buyback) of 80%. Ben Graham lived in a different time, though his principles are still alive; 30% below book value means very little in most cases as the concept of book value is becoming more and more distorted (to a lesser degree for banks and insurance companies) by gigantic write offs, spin offs and share buybacks (mixture of cost accounting and market prices, take a look at Colgate's capital structure). Yes, management should only buy back shares when the stock is undervalued, they'll always argue that their stock is cheap, you should be the judge.

-Vitaliy

Vitaliy N. Katsenelson, CFA

Positions: USB, LYG Copyright Minyanville.com

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Sporadic Thoughts: Aroung the Eearnings Block and Bargain Basement?

October 3-7 2005 - Minyanville.com

Around the earnings block... Becton Dickenson (BDX) is another darling of mine that reported 3rd quarter numbers today. Revenues grew 8% (excluding currency benefit) and performance was very solid across all segments - a sign of business quality. BDX's business lends itself to fairly good operational leverage, which was apparent in this quarter's performance as margins expanded, driving 20% EPS growth, INCLUDING stock based compensation EPS up 11.7% - still great performance. As I mentioned before, BDX is a good way to participate in rising healthcare spending without the risks and volatility that come with owning drug stocks. On a less upbeat note, BJ Wholesale (BJ) reported mediocre (to say the least) 2.9% same store sales for October; the Street was expecting 5.1%. The company blamed results on a shift of Halloween into its November reporting period and Hurricane Wilma in Florida. Interestingly, Halloween and Wilma did not have the same impact on Costco (COST), which saw its same store sales up over 8% in the quarter. Were BJ's customers the only ones that shifted their shopping into November? Though the company did not change its guidance and one month does not set a trend, I am putting BJ's on a double secret probation. Bargain basement? Not yet According to the Financial Times, 48% of VNU shareholders oppose the VNU / IMS Health (RX) deal - Halellujah! As I mentioned in this article, we sold RX on the merger announcement, as merger of these loosely-related businesses made absolutely no sense. Though I am happy that deal is unlikely to be consummated, I'll not be jumping into RX shares... unless RX visits a bargain basement price, and I have not determined what that may be yet. RX's management lost a lot of credibility in my eyes and, more importantly, in the eyes of investors.

Vitaliy N. Katsenelson, CFA

Positions: BDX, BJ

Copyright Minyanville.com

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Dividends and Share Buybacks

November 4, 2005 - Minyanville.com /Bloomberg

Before the 1982-1998 bull market, dividends accounted for a very large portion of stock market returns. In fact, in the 1966-1982 bear market, they were the returns investors received while watching P/E compress under the market.

On a theoretical level, dividends are just a transfer from a company’s corporate account (an account partly owned by a shareholder but which he/she has no control over) to a shareholder’s brokerage account (an account which a shareholder has full control over.) Thus there is a transfer of “hypothetical” wealth to real wealth. Owning 0.0000005% of the $10 billion residing in the company's account is hypothetical wealth since it is NOT spendable; whereas $5000 in the shareholder’s brokerage account is real wealth as it is spendable wealth.

Since it was the shareholder's money to begin with, stocks usually drop by the amount of dividend paid, thus no value is created. That is exactly what happened to Microsoft (MSFT) when it paid its $30 billion dividend; though don’t forget the stock ran up substantially on the dividend announcement.

Interestingly, stocks have very little memory of the dividends which were paid out, thus the immediate decline is usually erased from investor memory in a NY minute.

This is where the theory and reality diverge: The majority of companies that don’t pay out a significant portion of cash flows in dividends (or stock buybacks, though I place more value on dividends, as stock buybacks could be postponed) more often than not end up destroying shareholder wealth in empire-building acquisitions or marginal capital investments (if they had better investments to begin with they would spend cash right away).

I’ve seen a study (I think it was presented by Cliff Asness at a CFA Institute conference, though I'm not 100% sure) which showed that there is very little correlation with dividend payout and a company’s growth rate. This goes against theory as theory doesn’t factor in destruction of capital by corporate management. A company that has a high dividend payout operates in a very different environment than the one that is swimming in shareholder cash, as rigid dividend payouts force management to maximize the value of every dollar retained.

Lloyds TSB (LYG) for example has a dividend payout of 80% - very few banks have that kind of payout. How is LYG different from other banks? It is not building a war chest to make an acquisition that will likely just raise the risk profile of the company and make management feel better about their ever-growing empire. LYG is looking for internal growth. It is focusing to better its relationship with its customers--a cheaper, higher-return-on-capital type of growth.

Cash that has not been paid out is often destroyed by management, thus making dividends a very important source of value creation. Microsoft’s large cash position did not create much shareholder value as it created incentive for MSFT to waste billions of dollars on “strategic” investments; a $5 billion investment in AT&T comes to mind. Or Mobil buying Montgomery Wards to “diversify its cash flows”--this qualifies as the dumbest waste of shareholder capital ever.

We are getting 8% dividend to wait for LYG stock to come back to “correct” (in our opinion) valuation. In the case of LYG, its super-sized dividend (as long as it is maintained) creates a floor under the stock, thus arguably reducing downside volatility in LYG shares. So I don’t see any problem with getting paid a dividend to wait.

My partner Michael Conn and I were discussing the issue of dividends and both came to one conclusion: A company that has a higher portion of total return coming from a dividend (everything else is constant) should trade at a higher multiple. Here is an example:

Company D (dividend) is growing earnings at 0% and pays a 10% dividend. Company G (growth) is growing earnings at 10% and pays no dividend, everything else is constant. Return from company G will be riskier relative to company D (read: lower P/E) as all of its return is expected to come from the market placing appropriate P/E (driven by a collection of external factors) on its growing earnings. Whereas all of company D’s return comes in the form of dividends--though its price is subject to the same whims as company G’s--its 10% dividend will produce a stable return in the interim. Thus company D is a less risky investment than company G.

Share buybacks are a trickier issue. I usually welcome share buybacks when a stock is undervalued. However, companies will often do anything to stimulate their EPS growth, even it means destroying shareholder wealth through share buybacks. For example, Colgate (CL) was buying back stock when it traded at 34 times earnings--that deed alone should have gotten its management and board fired.

Share buybacks when a stock is undervalued make sense as they help EPS growth and raise dividend yield at the same time. As the buyback lowers denominator, fewer shareholders own the same piece of pie. What is not to love?

Companies that have high return on capital and don’t have a very capital intensive business--our kind of companies--usually will have substantial free cash flows, which allows them to grow earnings organically, pay a dividend and buy back stock. I do not advocate leveraging the company to buy back stock for two reasons: First, higher return comes with higher risk, thus possibly putting downward pressure on a company’s P/E and offsetting any benefits from a share buyback. Second, leveraging a company’s balance sheet has finite limitations; the company can only take on so much debt. Whereas share buybacks from free (discretionary) cash flows are only limited by shares outstanding--a nice problem to have.

In addition, share buybacks (if done at appropriate valuation) and nice, fat dividends create shareholder value on another level as they reduce the risk the company has to take to produce a total return for shareholders. Share buybacks are not a substitute for organic growth, but are often an under-appreciated bonus.

Vitaliy N. Katsenelson, CFA Positions: LYG, MSFT This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Sporadic Thoughts: Consumer, Airlines Pricing Power and Google

October 21-28, 2005 - Minyanville.com

This Quarter's Theme: Consumer Weakening I am getting the feeling that this holiday season is going to be ugly, or at least disappointing. Listening to earnings calls of companies I follow (don't necessarily own their stock) I keep hearing this "consumer weakening" justification to their poor results. Arguably, their management may be hiding their poor execution behind the "weakening consumer" theme, but I am getting the sense that this theme is less an excuse and more a reality. C is for cookie, that's good enough for me This Q&A (below) from Bemis’s (BMS) 3rd Quarter conference call is fairly explanatory. Bemis makes packaging for snacks, luncheables, cookies, cheese, meat etc… : Good morning. Jeff, the last few quarters, volumes have been rather flat. Can you talk about what you think, looking through the various pieces of the business by end market, what you think are realistic growth patterns for the next few quarters in longer term. Particularly, meat and cheese was flat in the quarter. I think last quarter it was up a few ticks. Personal care has been very good, this quarter was flat. Can you give us a little sense as to where or what's happening that has sort of changed the recent trajectory of growth? Well, Chris, I think there's been some effect which we don't have perfect data on, of the high cost of energy, affecting people's buying habits. A lot of our product, a lot of food now, is bought in convenient stores and the price of gasoline is leaving less money in people's pockets as they check out of the convenient store. They don't pick up the extra candy bars or snack foods or water or meat products. So I think there's been some effect on a consumer behavior there. Source: CallStreet.com We may be seeing the first signs on consumers slowly giving in to higher gas prices, and there may be more bad news coming with higher heating costs this winter, higher interest costs on home equity loans and mortgages (that were linked to short-term rates). Pricing power A quick food for thought about airline industry: yesterday, American Express (AXP) disclosed that its booking air travel revenues were up 12%, where average ticket price was down 1%. Air travel increased - good thing for airlines. Prices declined in spite of much higher oil prices - one of the highest costs for airlines. There is very little pricing power in this industry. Anything you can do, GOOG can do better? Says who? Every day, including today, I hear blips about how Google (GOOG) may do this (start its auction site; offer web word processing, etc.) or that (start its PayPal-like service, etc.) threatening to undermine companies that have dominated those particular segments for a long time. This raises a series of questions: what does Google have that other well capitalized companies don’t? Going after eBay? Yahoo has struggled to create a viable auction site in the US for as long as I remember. Does Google have a secret sauce that Yahoo doesn’t? Big banks (talking about well capitalized companies) tried to bring out their own versions of PayPal for a long time, yet I still don’t see anything. Does Google know the money transaction business better than banks? Is Google an incredible company? – Yes. Does it have a huge amount intellectual and financial capital? – Yes. However, so do many other companies. I don’t have the answers, but I am trying to instill a sense of “gravity” (ok, call it skepticism). Google is kind of like Starbucks, which broke all the rules and turned skeptics into $5 latte-drinking believers. Maybe a healthy dose of doubt (skepticism) is still in required as gravity can only go into hibernation for so long.

Vitaliy N. Katsenelson, CFA

Copyright Minyanville.com

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Mailbag: Wal Mart - The Capitalist Pig

Vitaliy Very interesting article on Wal Mart (WMT). Here's my two cents.

Capitalism, without a social context, is a pretty simple equation. From this perspective, go Wal Mart! On the other hand, people need to look at the social externalities of Wal-Mart's economic model...the goods are cheaper if you don't consider that their existence makes their typical customer less wealthy, that their practices eliminate competition necessary to keep prices down, that their policies leave the environment less valuable to everyone. These are all very real costs, just ones that the average Wal-Mart customer/employee doesn't see at a glance, until the results are very clear. Internalize these costs, and it's not really such a good deal.

I see Wal-Mart's philosophy as the opposite of Ford's (which so many Americans cite as a milestone in capitalistic thinking). From my understanding (this is the dumbed down version), Ford's model was pay their employees a fair wage, because common people with a fair wage were more likely to buy a car. Wal-Mart, on the other hand, pays employees very little, because common people with sub-standard wages need to purchase the least expensive goods (such as Wal-Mart provides). A capitalist achievement, yes, but one that I fear takes wind out of the sails of the American economy in the long run.

You make a good point, that pure capitalism results in an incentive to become educated, which does benefit us all. Still, that shouldn't imply that Wal-Mart has any incentive to improve the level of education among their employees or customers (quite the opposite is true). This argument feels like calling Darth Vader good, because he inadvertently gives incentive for more people to join The Force.

As you can tell, I side with the anti-Wal-Mart camp. What's my solution? Brow-beating or crying to Wal-Mart will never have an effect. I have faith that their model will sink them soon enough. I suppose time will tell how Wal-Mart impacts the "American way".

Good article. I really enjoy reading economic discussion.

- Tom

Tom, loved your arguments. Here are some thoughts on them:

• The wages that Wal-Mart pays are the byproduct of supply and demand, if we had a larger layer of educated people than Wal-Mart would have to pay higher wages to attract a smaller supply of of less educated labor - laws of economics.
• The consumer is less wealthy not because of WMT, but because of the external cirucumstances that have nothing to do with WMT - high enery costs, unaffordable healthcare, corporate investments in productivity, etc...
• I could be wrong, but I thought Ford's (F) biggest achievement (and a competetive advantage for awhile) was a creation of conveyor lines and specialization of production. It allowed for Ford to make cars cheaper than its rivals. Ford was able to pay higher wages because it was more efficient than everybody else. Arguably that's what set WMT apart from its competition from the very beginning - efficiency. However, as inventory management technology became ubiquitous, its competitors became more efficient, thus WMT needed a different edge - its size is providing that edge: bargaining power.
• Nobody has to sell goods at WMT, nobody forces suppliers to sell goods there - it is there choice.
• I agree with you on the last point - Wal-Mart will have to adjust to market forces even if that force is public opinion - that is how the free market works. Involvement of political "leaders" or unionization are not the solutions. If people will perceive that WMT abuses its workers - they'll stop shopping there (if they can afford to). Public opinion is growing more negative on WMT and if I worked for WMT I probably wouldn't like it much either. But I have a luxury of not having a personal involvement with WMT thus my opinion is unbiased. Wal-Mart may have to figure out how to do even more with less, but higher paid labor.

- Vitaliy

Vitaliy N. Katsenelson, CFA Copyright Minyanville.com This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Wal Mart - The Capitalist Pig

October 26, 2005 - Minyanville.com

I got two words for that: Who cares? Care about them? Why? They didn't care about you. They sucked you dry. You have no responsibility to them. For the last ten years this company bled your money. Did this community ever say, 'We know times are tough? We'll lower taxes, reduce water and sewer.' Check it out: You're paying twice what you did ten years ago. And our devoted employees, who have taken no increases for the past three years, are still making twice what they made ten years ago; and our stock -- one-sixth what it was ten years ago.” - Larry the Liquidator, Other People’s Money

The nice thing about being a capitalistic “Red” pig is that I don’t have to think about political correctness. I am shielded by economic (efficient allocation of resources) immunity. Oh and the best part I can be an equal opportunity offender as I am not running for election so I don't have to sell my soul to please everybody at once.). What will be called “The Memo” by the media will create a lot of discussion about the evils of Wal-Mart Stores (WMT). So to serve as balance to a very unbalanced discussion here are my capitalist “Red” pig thoughts. The majority of the associate jobs in Wal-Mart are commodities. Associate’s skills are true commodities – skills are very generic, they add very little value to the end product and their skills are as abundant in society as leaves on the trees. To work at Wal-Mart (or any other retailer) associates have to meet a very low standard: have legal working papers, smell appropriately and speak a small amount of English. They don’t need to have a high school diploma as they don’t need to know how to count (cash register will do it for them). Writing skills are preferred but not required as “skilled” management will help to fill out the job application. In general, it is extremely difficult to differentiate in the retail space; price is the biggest differentiator. To be the low price leader one needs to have the lowest cost, which is achieved by being extremely efficient. We assume that a clerk that works in a store for seven years should make more money than the one that works there for one year. Why? The only reason is that he/she should make more money if he/she is more experienced and thus more efficient than the one who worked at the store for fewer years. The learning curve of stocking shelves is not very steep, thus it makes sense that after a year on the job an employee is at the peak of his/her performance. I am a true believer in meritocracy, but one’s compensation should not be based on the time served – timetocracy (this is what I love about English I can make up my own words). I admire Wal-Mart as it is one of the purest capitalistic forms in existence; it drove less efficient competitors such as K-Mart and Montgomery Ward out of business and forced unionized socialist grocery stores to put themselves on the auction block. I believe Wal-Mart serves as a very important role in the economy – it forces people to go to school. In fact high schools and colleges are missing a golden opportunity to use Wal-Mart in their stay-in-school commercials. I worked at a grocery store (not much different than working for Wal-Mart) for two weeks – I am still thankful for that job as it motivated me to go to college. Wal-Mart is run for shareholder benefit which makes a lot of sense since it is still largely owned by insiders. Larry the Liquidator would have really admired that company.

Vitaliy N. Katsenelson, CFA

Copyright Minyanville.com

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Thoughts on Abbott Labs and Lloyds TSB

October 20th 2005 - Minyanville.com

Thoughts on Abbott Lab's 3rd Quarter Results

I was more than satisfied with Abbott Laboratories (ABT) 3rd quarter performance. Its margins were depressed in the quarter as for several reasons: It took several charges (some of which should actually benefit the company in the future); sales of Mobic, a low margin drug, were up 146% and R&D was up 15% (ahead of sales growth which excluding Mobic was still up 10.7%) as ABT was ramping up spending on development of its own stent. ABT’s performance should improve in 2006 as margins are likely to rebound (they are up sequentially but still down versus last quarter) as the company renegotiated its Mobic distribution contract. Abbott is introducing a new stent that it expects to capture significant market share over the next six months (current valuation doesn’t reflect that). ABT had some wins and losses this quarter on the drug front, but nothing was of the large Vioxx-like magnitude – the beauty of Abbott! As I mentioned before, it has a very diversified product line – all little engines of growth, as one engine misfires another one picks up the load. I am taking a 30 thousand feet approach to Abbott, not obsessing about each win and loss. I have confidence in the company’s management. I want to have exposure to the pharmaceutical industry and I am very comfortable with Abbott’s long-term risk return profile (as always, not advice).

Thoughts from the meetig with Lloyds TSB's management Yesterday, I met with management from Lloyds TSB; here are some thoughts from that meeting: The stock is down on a single concern that its 8% dividend will be cut. Management said – it will NOT happen. There are only two reasons to cut a dividend: not enough capital or capital is needed to grow the business - neither one is an issue. The company is well capitalized and it has excess capital for a rainy day. It is not planning to make large acquisitions thus there is no reason to build up a war chest. As I mentioned yesterday US Bankcorp (USB) has a similar total payout (80% of earnings paid out between dividends and stock buy backs) – so high dividend payouts are not unprecedented in this industry.

LYG is one of the most conservatively operated banks. A nice stat that proves that fact is that its mortgage portfolio average loan to value is 40%. Housing prices need to decline over 60% for LYG to start losing its collateral – no wonder it is one of two triple A rated banks in the world. Both the life insurance and wholesale (corporate) banking segments (two thirds of the business) are firing on all cylinders and should offset any weakness in the UK consumer (if the US consumer is up to his/her ears in debt the UK consumer is only up to their chest).

Another realization I had during the meeting was that the Chinese Banking industry is in many ways a sham. In general, banks give out loans and expect to get paid back (on a large portion of the loans).

It seems that Chinese banks are really just flea markets that give out money in a semi organized fashion, with interest rate they charge their clients not based on clients’ risk profile but rather on the value of client's political connections.

We will not be seeing LYG buying an interest in any Chinese “financial flea markets” anytime soon, to say the least.

Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Positions: LYG and ABT

Copyright Minyanville.com

The Good, the Bad and the Ugly – US Bank - 3rd Quarter 2005

October 19th 2005 - Minyanville.com

In the first quarter of 2005 I put USB stock on double secret probation. After the second quarter I took it off probation. This quarter's performance earns USB a get-out-of-jail-free card.

As I've mentioned previously I have a checklist of things I look for in a bank. Specifically, growing assets – a source of loans; growing checking accounts – a source of free (cheap) funds; growth of fees – provides stable income, which is not sensitive to interest rate volatility. In addition I would like to see expenses as a percent of revenues (efficiency ratio) constantly declining – as a function of operational leverage, which a banking business has plenty of. Oh, and I would like to get a nice, fat return on assets and return on equity. On top of all that, I want that bank to be well capitalized and not follow the pesky practice of giving out loans to people that don't pay them back. Is that so much to ask?

Evidently I am not asking too much as US Bank’s (USB) third quarter performance was an example that with EPS up 10.7% to $0.62. Performance was solid on all fronts:

Growing assets: Loans grew 10.1%. Growth was consistent in almost every segment, with mortgages leading the pack by growing 28.6%. Though mortgage growth is unlikely to be sustained going forward, excluding mortgages, loans still grew 7.6% - still a very respectable performance.

Side Note: home equity and second mortgages went up only 4.9% in the quarter and actually were down 0.1% sequentially. USB has a large enough company wide geographic presence that speaks to the overall the state of the economy. The aforementioned growth in loans and the relatively slow growth in home equity loans maybe a leading indicator that housing market is still growing very fast, but consumer spending is likely to slow down as consumers reliance on home equity loans (the main engine of “other people’s money” growth) showed signs of fatigue.

In my approximation unsecured consumer loans is roughly 11% of USB’s total loans. Any exposure to unsecured consumer lending is a negative if one is concerned with the consumer’s ability to keep spending other people’s money. Let me correct myself, spending is not the issue - paying those liabilities back is. However, in the context of the overall impact on USB’s profitability, unsecured consumer exposure is not nerve racking considering that a very large portion of USB’s earnings (46%) come from fee income which is somewhat insensitive to consumer solvency.

Growth of fees: On the negative side, net interest margin decreased in the quarter by 27 basis points to 3.95% due to the flattening yield curve and increased price competition. Though USB was not the one who started the price war, it can take on any competitor as it has one of the lowest cost structures in the industry. This is a great competitive advantage for a company in a commoditized industry. Even after the decline USB’s net interest margin is still better than most banks (i.e. AmSouth’s (ASO) 3rd quarter net margin was 3.31%).

On a positive note: after taking out a security gain taken in 2004, interest income grew 9.7% with the bulk of that growth was organic. Fee income is somewhat independent of interest rate structure thus it brings a welcomed predictability to earnings.

Expenses as a percent of revenues (efficiency ratio) constantly declining: Non interest expense was up 3.1% (after normalizing for intangible value changes) - that is what I want to see. Operating expenses grew at a lower pace than revenues. This is operational leverage at its best. Tangible efficiency ratio (non interest expenses divided by revenues) declined to 40% from 40.6%. US Bank has one of the lowest efficiency ratios in the industry, thus seeing it decline even further speaks highly of a quality of the management.

Giving out loans to people who pay them back: credit quality has improved – as net charge offs declined to 0.46% from 0.52%. This number is probably seen its bottom (or very close to it) as net charge off are likely to start rising as interest rates increase.

Well capitalized: common equity declined to 9.6% from 10.2% as USB was an aggressive buyer of its stock, returning 102% of earnings to shareholders since 2003. Though equity as a percent of total assets is still very high, USB cannot continue to buying back stock and paying a dividend at the pace it has in the past. Management indicated that its goal to return at least 80% of USB earnings back to shareholders, a more sustainable practice. (Note: Lloyds TSB (LYG) has a similar payout resulting in an 8% dividend.)

USB is a very shareholder friendly company: it bought back 2.8% of shares, thus combining that with its 4.3% dividend it returned 7.1% of capital back to shareholders.

Growing checking accounts: total deposits grew 4.9% (good), however, similar to last quarter, depositors shifted to higher yielding products, driving the cost of funds higher – not a positive development. As interest rates increase an opportunity cost of holding funds in non-interest bearing checking account rises as well, thus driving customers to shift they deposits to higher interest paying demand deposits or CDs.

Nice, fat return on assets: Both return on assets and return on equity went up in the quarter to 2.23% and 22.8%, respectively. High return on capital allows USB to maintain payout a very large payout ratio and still grow its loans at very respectable rates.

Quality: USB is one of the most conservatively run banks in the US. It has a very diverse customer base, stable and predictable fee business. It is not involved in proprietary trading game that turned many money center banks into leveraged hedge funds. Its low cost structure provides the company a sustainable competitive advantage.

Value: At 10 times projected 2006 earnings USB is cheap. It trades at a comparable valuation to money center banks, but has a no waking-up-one-morning-seeing-equity-wiped-out-due-to-trade-gone-bad risk. Nor does it have a large acquisition integration risk still hanging over Bank of America (BAC) and JP Morgan (JPM). In fact, on the conference call USB management stated that it is not interested in making any large acquisitions. For these reasons USB deserves to trade at a premium to the aforementioned banks in my view. I would not rule out 20-40% PE expansion as historically USB traded at about 14 times earnings.

Growth: with 4.3% dividend and 3% share buyback, USB doesn’t have to do anything heroic to deliver a total return in excess of 10% to its shareholders. Let’s go through the numbers: 3-5% loan growth should translate to 5-7% net income growth due to operational leverage abundant in banking business, adding 3% share buyback brings us to 8-10% EPS growth, combine that with a dividend and we are looking at 12-14% total return without taking a lot of risk. Our kind of stock!

Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Position: USB

Copyright Minyanville.com

A Good Company Versus a Good Stock

October 12, 2005 - Minyanville

I know very little about baseball. Football (a sport that is insulted in this country as soccer), hockey and chess (a spectator sport in Russia) are the national sports in Russia. This is a true story: about thirteen years ago I went to my first baseball game. I was patiently waiting for the game to start for a long time, doing the baseball thing - eating hotdogs and looking at the field. After awhile, admittedly bored, I asked a fellow spectator when the game would start. He informed me that it started fifty minutes ago.

As you can see I’ll not make the MIM3 (Minyans in the Mountains conference) softball team. Also, I cannot relate to baseball analogies very well. However, I can relate to the comment John Succo (fellow contributor) made yesterday about waiting for your pitch and controlling emotions while trading (and investing).

Investors often don’t make a distinction between a good company and a good stock – a very important and often an emotional error. It is perhaps one of the biggest fallacies in investing.

It is very easy to identify a great company: it has great brands, a bullet proof balance sheet, often great margins (true for consumer but not the case for retail stocks), high return on capital – the usual suspects. However, EVERYBODY recognizes those qualities and thus turning these companies into “religion stocks” - you-cannot-go-wrong-owning-this-company type of stocks and thus pushing their valuations to ridiculous levels.

The sad reality is: Yes, you can go wrong owning these kind of stocks. Pull up a ten year chart for almost any super large cap stock (it doesn’t have to be a technology stock). I’ll throw in some names: WalMart (WMT), First Data Corp (FDC), Microsoft (MSFT) (ok it is a technology one), Cintas (CTAS), Coca-Cola (KO), Colgate-Palmolive (CL), Procter & Gamble (PG), Pfizer (PFE) (is still far below the Viagra high) … I can keep typing... there are plenty of great companies that have not gone anywhere since the late ‘90s. Everybody will recognize the aforementioned companies as icons of corporate America, however, their stocks were significantly overpriced in the late ‘90s trading at over 30 times earnings (KO was trading at 53 times earnings in 1998).

Most of these companies (probably with exception of KO) have grown earnings in low to mid teens but their stocks still have not gone anywhere. As earnings were growing those very high P/E’s were shrinking and coming come back to earth.

I look at more than a hundred companies every year at various levels of analysis. Often I find a company I’d love to own because of the quality of its business, however, its stock doesn’t meet my valuation criteria. I put that company on my watch list. To be more exact I figure out what P/E (or price to cash flows) I am willing to pay for the stock and once it reaches my valuation target I’ll take a second look. Cintas (CTAS) is a great example, I looked at the company in 1999 – loved the business, but the stock was too expensive. Finally it is approaching my valuation target, though it is not quite there yet, however, once it does I’ll have to take a look if the fundamentals that I liked six years ago are still intact.

I take separating companies and stocks very seriously. In fact my graduate students have to make two conclusions in their analysis: is it a good company and is it a good investment. They are two very different conclusions to make.

I found that creating a watch list allows me to take the emotional element out and avoid falling in love with a stock. Also for every stock in our portfolio I set a P/E (and/or price) level at which I’ll sell the stock. Thus when it reaches our target the decision to sell becomes unemotional.

I wrote a very important article on the psychology of “religion stocks” – I recommend you read it as part of this discussion.

Vitaliy N. Katsenelson, CFA

Copyright Minyanville.com

This article is written for educational purposes only. It is not intended as a recommendation to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Show some respect for a solid British bank

October 11 2005 - Financial Times

Lloyds? Lloyds TSB? Is that a property and casualty insurance company?" "No, a British bank." "Oh . . . " I'd imagine this is the start of a typical conversation between Lloyds TSB's management team and US investors, [at the time feeling like Yogi Berra when he said, “I wish I had an answer to that because I'm tired of answering that question.”]

Lloyds TSB is the largest UK-based, non-multinational bank but new investors outside of the country confuse the company with that icon of risk UK commercial property and casualty insurer Lloyd's of London.

Ironically, Lloyds TSB is the epitome of conservatism. Moody's, the rating agency, strongly agrees with this assessment by granting a triple A rating to Lloyds TSB's debt. Such ratings are very scarce, especially for banks, Wells Fargo is the only other non-government sponsored bank that commands it.

Lloyds TSB is comprised of three similar size businesses: retail banking, wholesale banking, and insurance. The majority of the insurance business is conducted by Scottish Widows - a life insurance subsidiary acquired in 2000, one of the most strongly capitalised life insurance comp­anies in the UK - the rest is in home-grown property and casualty insurance, serving the retail segment (not the high risk, more volatile commercial segment), representing about 6 per cent of total company earnings.

The late Rodney Dangerfield would have said Lloyds TSB is getting no respect, and he would be right. The stock is hovering only a couple points away from its recent lows because of fears about UK consumers giving in to economic slowdown. The UK is a couple of years ahead of the US in its economic cycle, its strong housing market has softened, the economy's growth has slowed and central banking has started to lower rates.

Economic softening has led to a reversal of a long-term trend of declining debt impairments; the first half of 2005 was arguably an inflection point in that trend reversal. On the surface, bad debt impairments have jumped 51 per cent in the first half of 2005. However, that is far from the economic reality, as most of the jump was driven by implementation of IFRS (International Financial Reporting Standards).

But fears about consumer weakness are overblown. Lloyds TSB has stayed away from high-risk areas of near- and sub-prime lending and thus growth in impairment charges in personal loans and credit cards was about 15 per cent, slightly higher than growth in loans. Commercial loan impairments declined 28 per cent, reflecting the strength of UK corporations. Overall growth of bad debt impairments, excluding the IFRS impact, was just a bit above 7 per cent - resulting in a decline in impairments as a percent of assets, a vital sign of a healthy company, not a struggling one.

Lloyds TSB is getting even less respect considering its solid operating performance in all segments, which we expect to continue. Since it divested international operations in 2003, it has consistently increased earnings in mid single digits, achieving a remarkable 7 per cent operating earnings growth in the first half of 2005, excluding IFRS impact, loans grew 12 per cent and customer deposits rose 9 per cent. All this growth was organic and achieved at a time when the company maintained a 80 per cent dividend payout, rewarding shareholders with a 7.2 per cent dividend yield.

Although the bank's dividend payout is fairly high relative to other banks, its dividend appears to be safe. The company showed a remarkable ability to increase earnings with the current dividend structure, through deepening relationships with existing customers, and it has plenty of room for growth. Investments into the Six Sigma programme are paying off in improved efficiency - costs are growing at a slower pace than revenues, resulting in operating profits growth exceeding revenue growth - operating leverage, the beauty of a banking business.

Lloyds TSB uses derivatives for interest rate risk hedging only. It doesn't play the "proprietary trading" game that turned many banks into super leveraged hedge funds on steroids. Thus it deserves to trade at a premium to the "global" banks as its investors are not taking the risk of waking up one morning and seeing shareholder equity dissipating into thin air (Barings bank comes to mind here).

Lloyds TSB is trading at about 11 times 2006 projected earnings, in line with its peers, although due to its above industry average dividend, impeccable-Aaa -rated balance sheet, predictability and sustainability of earnings growth should command an above average industry PE.

The stock works as a great hedge against a declining dollar, as the dividend paid in pounds and converted into US dollars becomes even more valuable to US investors if the dollar declines. In addition, a high dividend yield creates a solid support under the stock as it is a big attraction for current income hungry investors. Also, as an unexpected bonus, Lloyds TSB would be an optimal acquisition target for a bank looking to set a solid footprint in UK.

The author is a portfolio manager with Denver-based Investment Management Associates and teaches equity research at the University of Colorado. His company owns shares in Lloyds TSB.

Vitaliy N. Katsenelson, CFA

Copyright Financial Times 2005 This article is written for educational purposes only. It is not intended as a recommendation to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Mailbag: The Russian Front: Oil, Putin and Prosperity

Why I don't Follow Russia

Hi Vitaliy, I'm just curious as to why you don't follow Russian market? Is this a choice (it is for me, and I missed the best stock market in the world for the last 6 years), or just "so happened"?

Thanks, Alex MA-

There are several reasons why I don’t follow the Russian market:

• I was educated in the United States and though I do speak and read Russian, my Russian business vocabulary is very limited. Speaking in Russian on a business topic is a very painful experience as I keep looking for the appropriate translation for investment / business words.
• I don’t know Russian GAAP, nor do I trust the numbers put out by Russian companies. That being said (to be fair), the Enron and WorldCom disasters did not happen in Russia. But Russia is still riddled with corruption. Bribery is widespread, though it is not an official expense line on the income statement – it should be - as it is a cost of doing business in Russia. I resented bribery all my life, it is opposite of taxation (not that I am big fan of taxes) – economic resources are shifted from the poor to the rich. The majority of us never encountered bribery that is instilled into the economical and political system. I remember when we were leaving Russia for the United States, on the way to the airport (a forty mile stretch), our car got pulled over three times by the police for no reason at all and every time the policemen wanted a bribe to let us go. We obliged. These types of incidents don’t cultivate fondness about the country and put it at a significant competitive disadvantage. Maybe that is in part the reason why Singapore has such a successful economy – the most uncorrupt country in the world (albeit without any bubble gum).
• The US stock market is much more fun to follow; it has a lot more breadth and width than the Russian market. The Russian stock market is dominated by three industries: energy, industrials and banks – very limiting in terms of constructing a diversified portfolio. I suspect that high oil prices are the reason why the Russian stock market (and economy) has done well lately. I would not want to have my future tied to only one single commodity.
• I left Russia and never looked back. It honestly still puzzles me why I write about it. I have mentioned several times before, and I’ll do it again – I am a capitalistic pig (and I think like one). In the 1980’s Brezhnev came up with a slogan: “The economy has to be economical” – I am still not sure what that means.

Personal Note: My memories from living in Russia are mixed. All of my fondest memories come from my family; all the bad ones came from the external environment – secondary school and college etc. I was not a good fit within a culture that encouraged uniformity and discouraged creative and descending thinking. Vitaliy,

Thanks for your terrific message. I am a bit perplexed however as even the Russians acknowledge their exports of crude oil have peaked and will decline soon yet you say: “Political stability in Russia will insure a stable flow of energy resources out of Russia. “ Where are these extra “energy resources?" The KGB has always lied yet even they say their energy exports have peaked. What do you know that the rest of us do not? They have been stripping assets rather than investing in new productive capacity [as you point out] so how does this lead to more energy rather than a decline as even the KGB acknowledges?

-J

Russia and Oil

J, I think you are making an excellent point. You are right about Russian production - it has peaked. Privatization in large was responsible for oil production growth in Russia, as economic (free market) incentives that were put in place stimulated production growth (production grew from 6 million barrels a day in 1998 to 9 in 2004). On another hand, de-privatization of oil companies is likely to do the opposite. Gazprom going on an acquisition spree and becoming one of the largest oil companies (if not the largest) affirms that fear, as it will be run to maximize cash flows for the short run (you said it: thus stripping assets rather than investing in new production). I cannot argue with that logic as it makes total sense.

This paragraph also confirms your point: “Press reports from January 2005 are already attributing late 2004 production decreases to the Yukos 'affair.'" Also, a recent report from the Siberian branch of the Russian Academy of Sciences says that nearly 60% of all proven reserves in Western Siberia are near depletion.” As I mentioned I really don’t follow Russian markets very closely, I spend most of my time analyzing U.S. and lately European companies (our play on a belief that dollar will weaken). However, talking to my relatives (especially my father who follows Russia very closely), I gather that there is a lot of pressure on Putin to please retirees.

It is very likely that Gazprom’s oil/gas revenue will be diverted from capital expenditures on improving existing production and looking for more oil/gas to raise or probably just maintain pension benefits to retirees - an enormous liability for Russia. However, a very sad reality--relatively low life expectancy (61 years (men), 73 years (women) Source: UN) is working in Mr. Putin’s favor.

In my article I was making a general point, that the flow of oil out of Russia will be less predictable and lower in case of political unrest. So in other words, the bleak picture of peaking production (that you and I agree on) is likely to get bleaker in case of political unrest. And lower oil prices (not a prediction, though I do believe in mean reversion) are likely to create that political unrest. -Vitaliy

Did I just comment on Russia again?

My friend John Ray pointed out an excellent Business Week article that describes surging Russian government spending. Budget expenditures surged from $34 billion in 2000 to $129.5 billion this year, where tax revenue grew even faster, from $40 billion (in 2000), to $153 billion today. My limited knowledge of government spending tells me that it is a lot easier to raise spending than to cut it, thus this increase in spending is likely to stick while oil revenues may not. Note though that Russia did use oil revenues to payoff a very large chunk of its foreign debt.

Vitaliy N. Katsenelson, CFA

Copyright Minyanville.com

The Russian Front: Oil, Putin and Prosperity

September 29, 2005 - Minyanville.com

Putin's time ends in 2008. Will Russia's begin? I don't follow Russian markets and recently I discovered that I don’t understand the psyche of Russian people (that discovery was made after talking to my high school buddies that still reside in Russia and my capitalistic dialect is not understood well there). I don’t even have a decent inventory of hard liquor at home, a disgrace by any Russian standard (or so I've been told). And please don’t be misguided by my Russian first name and “sophisticated” Russian accent when I talk about the country.

However, I want to point out a very important but lost headline: Putin will not be running for re-election in 2008. The Russian Constitution allows the president to serve only two terms and Mr. Putin’s second term ends in 2008. Mr. Putin’s consolidation of power over the last several years--which has left the country less of a democracy and more akin to a pre-Gorbachev Russia--had convinced many that he’d seek an amendment to the Constitution to allow a third term. His decision not to amend the Constitution increased my respect for Mr. Putin exponentially--considering he is close to possessing absolute power. And as we know absolute power corrupts absolutely.

The outcome of the 2008 election scares me a little. It’ll scare me even more if oil prices return to their long-term average. The devil we know now is better than devil we don’t (though I’m not calling Mr. Putin a devil, just an expression, Mr. Russian President). Though from a western perspective, Mr. Putin’s actions were very questionable to say the least. To a certain degree we know where he stands.

Russia’s recent prosperity, funded primarily by the western world, has been driven by high energy prices. According to the CIA World Factbook, oil, natural gas, metals, and timber account for more than 80% of Russia’s exports, thus leaving the country vulnerable to swings in world energy prices.

A turn away from this prosperity could prove to be dangerous and create an even more volatile economic situation. Hungry people are not famous for making rational decisions. Arguably that is how Hitler came to power in Germany. Though on the surface this statement appears eye catching, it is a reality of Russia. I remember the time when Zherinovskiy (not much different from Hitler on many levels) ran for president opposing Yeltsin in early 90s, and he received a very large vote count, considering how extreme his positions were on political and ethnic issues.

Russia has a chance that a country gets every 30 years or so to reinvent itself. If it captures this opportunity and reinvests huge inflows of funds from oil exports into developing other industries (and Russia has plenty of engineering talent to do so), it may come out stronger at the end.

Maybe this is my Russian skepticism talking, but Mr. Putin still has two years to change his mind, as he is only 52 years old - an infant in political years (ask Senator Byrd). A large terrorist event (god forbid) happening between now and the 2008 election would certainly provide justification for him to change his mind and amend the Russian Constitution.

Why do US investors care what happens in Russia? A fair question. Political stability in Russia will insure a stable flow of energy resources out of Russia. Russia is still the among the largest nuclear powers. Russia engulfed in political unrest will be a feeding ground for terrorists looking to get their hands on nuclear weapons.

Vitaliy N. Katsenelson, CFA Copyright Minyanville.com 2005

Discussion on Katrina

I have a had a very interesting discussion with David Miller, a fellow contributor to Minyanville.com, on Federal government’s role in hurricane Katrina. David publishes Biotech Monthly and knows biotech industry inside and out. I wrote the following:

I think the Federal government is to blame in part for the level of destruction caused by the hurricane. This is not a political statement but rather an economical one; remember I am a capitalist pig (not a political one)!

There is a very good reason why insurance companies did not want to underwrite flood insurance in New Orleans. The probability of a city residing below sea level being flooded is very high, and thus private insurance companies would have had to charge premiums that would make living in New Orleans unaffordable. The Federal government was selling flood insurance below its true market cost, thus tax payers have subsidized the true cost of living in New Orleans.

In the absence of Federal government intervention, people would have thought twice about building houses in a high risk flood area, as the "market" cost of insurance would have entered into economic equation of that decision.

This unfortunately is catch up time financially, as taxpayers across the United States will be rebuilding New Orleans, and yes, this $2000 is coming from their pockets. Is it the right thing to do? Yes, we have to help our own in such an unbelievably terrible time of disaster. However, we should be mindful of what impact government actions (even those which are driven by good intentions) will have on the human behavior and the resulting externalities.

According to the WSJ, Allstate (ALL) is gradually pulling out from Florida, as local insurance bureaucrats don't allow the company to raise rates to charge local residents enough for the risk of non-recurring events - hurricanes - which “non-recur” every August and September. Allstate is a not a government entity thus it makes decisions that are arguably economically sound. David Miller responded:

If the federal government doesn't underwrite insurance in the hurricane areas, then it would also have to ignore the consequences of not being insured. Our society is simply not capable of that. If we "merely" assume the lack of subsidy would cause people to move, then the additional concentration of population in "non-at risk areas" (wherever the heck that is) has a significant (and almost always unintended or ignored) cost that also must be factored in.

I saw such unintended consequences occur in coastal Washington state when reliance on flawed science eliminated immense tracts of productive farm land from active production. Populations streamed to the cities to flee the resulting economic destruction, causing significant financial burdens. Education which, by State constitutional mandate, was funded by the proceeds from this farming has been chronically underfunded ever since (creating a downward economic spiral).

Those who make the pure capitalist/economic/whatever argument it makes no sense to rebuild New Orleans or other areas demolished by recurring natural disasters (Northridge, CA; tornado alley, nearly all river basins; etc.) naively assume it isn't a zero-sum game. Those displaced folks have to go somewhere and there is a hard dollar and economic cost to that. I replied:

David - great counter argument! Of course the lack of Federal government intervention would have changed human behavior, but then it would have been a rational decision made without outside interference. Let me run this exaggerated, but realistic example by you.

The Federal government started underwriting volcano destruction insurance and selling it at a small fraction of the cost. Towns built on the top of active volcanoes could enjoy a spectacular view of the ocean, and have become a huge tourist attraction. The land is cheap, so why not build a house? The bank will give a loan, but will require volcano destruction insurance. By this action the government has augmented human behavior transferring the cost of the insurance to tax payers, who have not reaped the full benefits of enjoying a spectacular ocean view, and at the most visited the volcano town once in awhile while staying in an overpriced bed and breakfast.

Next time you go to Florida and see a multi million-dollar villa built on the side of the ocean, remember you are paying for that with your hard earned taxes.

Oh, and one more thing...

I read in the Economist a couple days ago that recent reforms in Germany called Agenda 2010, which are pushing Germany from Socialism towards Capitalism, appear to be paying off.

All Germany had to do was remove the incentive instituted by the government for unemployed people not to look for a job. And yes, there was a side effect: it has lowered consumer confidence. But I'd rather live in the country with higher employment and less confident than other way around. David Miller responded:

OK, Vitaliy. I love the illogical extreme example so let's run with that... I'll grant you the government screwed up. With that in hand, we have a decision about those volcano dwellers. Do we let them suffer and figure it out themselves? How about prohibiting them from rebuilding there? If we prohibit them from rebuilding there, where exactly do they build that is immune from natural disaster and still allows them to economically prosper? Where could we move these hospitality industry workers that would have the appeal of volcano-top resorts?

The beach? Oops, hurricanes (or earthquakes). The river? Oops, flooding. The city? Oops, who want to get away from it all ten block up town? A "hill" in Kansas? Not exactly the same experience (and tornados).

My point is decisions repealing the "moral hazard" have a dollar cost and an opportunity cost. I am unconvinced those costs are less than what we are doing right now.

I replied: Dave this is what we do. We save them, help them and than let them decide what they want to do. However, if they want to move to the volcano land they'd have to buy insurance from the private companies that would insure a true risk. Why should you and I pay for their love of ocean views and volcanoes?

You are right! Nothing (except Colorado - that is what I keep telling my wife) is safe from natural disasters. But let people subjecting themselves to the risk of those disasters pay a true cost of those disasters. Private (as opposed to government) insurance companies will do their best to gage the risk and they'll price insurance polices accordingly.

Vitaliy N. Katsenelson, CFA Copyright Minyanville.com

This article is written for educational purposes only. It is not intended as a recommendation to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Approach to risk management

Our approach to risk management shows through our research process. To finish first, first you must finish. Thus looking down (for risk) often is more important than looking up (for return). In a long only portfolio there are three interrelated pillars to risk management: diversification, stock selection, and valuation. Diversification Diversification – is the only free lunch an investor will ever get, as risk reduction doesn’t need to lead to subsequent reduction in return. Taking diversification a step further, stress testing a portfolio for probable risks coming to fruition is critical, as it exposes the weakness of the portfolio in the event probability turns into reality.

Stock Selection and Valuation:

We look for three things in every stock Quality, Value, and Growth: Quality - companies don’t operate in a competitive vacuum, even the most successful will stumble at some point. Where the strong (quality) get up and regroup to move forward, weaker ones may not. These are the characteristics that define high quality companies: Sustainable Competitive Advantages – a deep moat around its business often created by strong brands, high barriers to entry, patent protection etc - allowing a company to have a leg up against competitive threats.

Predictable Earnings – companies that have high recurring revenue components usually exhibit lower sales volatility and higher predictability of their earnings and cash flows, thus have less operational risk.

Significant Free Cash Flows (operating cash flows less capital expenditures) – is very important for several reasons: first of all, these companies are usually not as capital intensive which often leads to a higher return on capital. Second, it lowers the risk of the business as the company doesn’t rely much on outside financing. Third, a great source for raising dividends and buying back stock – possibly providing an additional source of shareholder return.

High Return on Capital (and economic value added returns) far exceeding the cost of capital, another scorecard for value creation.

Strong Balance Sheets – our stock selection process usually leads to companies that underutilize debt, as companies that have high return on capital and great cash flows (usually far past their infancy stage) tend to finance their growth from their cash flows.

Value – we utilize a multi-prong approach to determine a company’s appropriate valuation. To determine direction of the value we utilize discounted cash flows. It is a great tool to measure the market expectations that are built into a stock’s valuation; also the process of going through the model is invaluable as it shows the drivers of value in the company (i.e. margins, sales growth, working capital, capital expenditures etc…) However, discounted cash flows is not exact and is very sensitive to assumptions To estimate a more appropriate valuation level, we use relative (to peers and historical valuations) and absolute valuation metrics i.e. price to earnings, price to operating cash flows and price to free cash flows.

Margin of safety – we cannot stress enough its importance for many reasons. Margin of safety provides room for disappointment. It is only a matter of time before even the best company will disappoint Wall Street. However, a company that trades at a discount to its ‘appropriate’ valuation (margin of safety) is likely to respond less violently to the disappointment. If we made a mistake in our projections for earnings growth the punishment rendered for our miscalculation is not as severe when we have a large margin of safety.

Growth – since we approach investments from a very long term perspective, often we don’t know when the market will fall in love with our companies again, in fact we love to buy stocks that have fallen out of favor. However, if companies have grown their earnings our patience will be compensated when the love affair resumes, as PE will be expanding on top of higher “E” – earnings. Key Themes: In today’s environment the following secular risk/trends are a concern to us: · Substantial slowdown in the Chinese economy and its impact on demand for US products. · Rise or fall of oil prices – our portfolios are positioned mostly to benefit from the likelihood of long-term decline in oil prices. We have some exposure to oil stocks as a hedge in case oil prices climb further or stay high. · The US housing bubble imploding and its impact on consumer discretionary spending and/or rising interest rates and their impact on the overleveraged US consumer, we are limiting our exposure to consumer discretionary stocks. · The US trade deficit causing a further decline in the US dollar - we added some high quality, very high yielding European ADRs to mitigate that risk. Outlook for the financial markets: Investors will be paying for the excesses of the last bull market for a long time. We expect the stock market to go nowhere with plenty of volatility and micro bear and bull markets in the interim. This market will require some fine-tuning to the investment strategy for even a long-term investor. “The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us”. -- Peter Bernstein There is another risk that may be even more damaging than risks described above – our emotions. Understanding “the linkage between effect and cause” helps to regain control over ones emotions. To achieve that control an investor should do the following: · Understand the companies in your portfolio. Understand the drivers of growth and the risks inherent in the business. If you don’t understand them don’t buy it. Show me an investor who understood Enron). Warren Buffett doesn’t buy companies he doesn’t understand and we advise you to do the same. · Do your own research – to be a rational investor, one needs to come to a decision on his own, not on somebody else’s advice. · Write, write, write – write down in depth your rationale for making an investment decision. This will achieve two things: it will give the clear reasons why you bought the stock in the first place. At the time when emotions are trying to get the best of you, you’ll have clear, rational thoughts on paper, making an unemotional decision a lot easier. Finally, it is easier to lie to yourself, than to the paper, writing things down forces one to be honest with oneself and rational. Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Merck - Back of the Envelope Analysis

I played around with Merck's financials this morning. It appears that MRK will be able to keep paying the dividend despite major blockbuster expirations (Zocor and Fosomax) without dipping substantially into its $13 billion war chest. Here is my back of the envelope analysis (excel spreadsheet). Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Earnings Games

August 24, 2005 - Minyanville.com

I wrote this article after Minyans in the Mountains conference that took place in sunny Ojai. I was one of the panelists on fundamental panel where I was in the great company of Herb Greenberg, Fil Zucchi and Jeff Macke. JeffMacke© and I usually agree on things. (Though he recently mentioned that my four-year-old son will never meet his two and half old daughter.) However, in our fundamental panel discussion at MIM2, I discovered that Macke and I disagree on the issue of management's earnings guidance. I'll let Macke state his view, as my attempts would only bleach the colorful (psychedelic) way only Macke can express himself.

Here is my view: Wall Street's preoccupation with (public) corporate America meeting and beating its earnings forecasts has had a corrosive effect. In fact management's constant pursuit to appease a short-term minded Wall Street has spread to the ranks of the best of the breed.

This was the response of Costco's (COST) CEO to an analyst's question on what he loses sleep over...

"What I lose sleep over, and not a lot frankly, is more as it relates to the short-term stock price movements, because short-term stock price movement is impacted by expectations and the fact that at some point, and perhaps this quarter is a good example that we just announced, that if you look at quarters two, three and four last year we beat those by a little bit." (CallStreet.com, Transcript of Costco's Q3 2004 earnings call.)

One would argue, what is the harm? How do a CEO's sleeping habits impact shareholders? A fair question. The apparent consequences of a CEO caving into the pressure to deliver the goods quarter after quarter came to light when the accounting scandals erupted at then unsuspecting places such as Enron, WorldCom, Bristol-Myers Squibb (BMY), HealthSouth, Fannie Mae (FNM) and many others. However, the hidden-to-the-naked-eye impact is morphed much deeper into the ranks of corporate America.

On a daily basis corporate management makes decisions that aim to benefit corporate performance in the short run versus the long run and vice versa. Though not all short-run and long-run decisions are mutually exclusive, to grow a tree (a long-term investment) seeds have to be planted (immediate expense). Management faces these decisions on a daily basis and unfortunately often destroys long-term value to please the short-run junkies.

A couple of years ago I had an informal breakfast meeting with the management of a wholesale club (not Costco). I asked why they did not open more pharmacies at their existing clubs, as the company had plenty of free cash flow and opening pharmacies seemed to improve traffic.

The response I received was: "Yes, pharmacies are a good investment, but it takes a while for them to reach profitability thus we'd be taking a short-term hit on earnings. Therefore, we are stretching the openings out."

Management has given up a good investment opportunity in favor of the short-term gratification of Wall Street.

During the break between the session at MIM2 (more in later posts), I had the pleasure of speaking with Professor Neal Dingmann (what a great, modest, sharp guy). Neil pointed out that in the oil industry, results choosing short run in lieu of the long run may have grave consequences on the company's long-term profitability. As companies strive to make the production numbers (and thus revenue) they may abuse the wells and potentially undermine their structural integrity and long-term profitability.

The pressure spills far beyond the retail and oil industries, for example, to a well-known beer maker. According to a CFA friend of mine, (an industry insider) often when the company feels the pressure to deliver the "expected" numbers, it sells beer to liquor stores at large discounts to its regular price. Beer has a limited shelf life (I try to explain this to my wife quite often), thus if it's not sold by the expiration date it must be returned back to the beer maker. By artificially stuffing inventory channels (demand did not warrant it) the beer company has cut into its next quarter's sales and increased its expenses as expired product will make it back to the warehouse.

As Macke mentioned in the panel discussion, Sarbanes-Oxley did not fix things because you cannot mandate ethical behavior.

However, it did enrich an army of consultants and imposed a great cost on public companies (especially smaller ones). The true cost of meeting the numbers game is truly impossible to measure, as we'll never know what projects companies have foregone to please the Street's crowd.

Over time the Street's obsession with short-term goals has shifted management focus from creating long-term value for shareholders to becoming Wall Street's lap dog trying to jump every quarter to the plank that was raised by its masters. I understand the pressure that companies face every quarter, as for many of them a declining stock price means an exodus of option-linked talent. However, there are creative ways to compensate their employees, where stock options and (short-term) stock performance are not the only solution to employee retention.

John Succo noted that Citigroup (C), the world's largest bank, has fiddled with its asset gains to make its numbers for the quarter. And he asked me, how do I deal with it? I tear a company's financials apart, trying to arrive to core operating performance--The Good, The Bad, and The Ugly series are a good example of that. In the case of Citigroup, I'd simply avoid the stock (Todd Harrison: not advice) as it'll consume the whole quarter for me to analyze the very complex financials of the giant conglomerate.

Every time I stumble on a company with complex financial statements, I remind myself that I want to only own companies whose financials (and business) I can understand. To make a rational decision one has to be able to analyze (in a timely manner) the information.

Vitaliy N. Katsenelson, CFA Copyright Minyanville.com This article is written for educational purposes only. It is not intended as a recommendation to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Nokia poised to ring investors' bells

Financial Times - August 8, 2005

Nokia is a perfect showcase for contrarian value investing. It is easy not to like Nokia stock, especially for US investors, as Nokia has not come up with a decent cell phone in the US for a while. Motorola has risen from the dead and offers a great portfolio. In addition, the latest quarter did little to provide comfort as margins in the mobile phone segment declined more than 3 per cent from 19.8 per cent to 16.2.

However, all these developments are widely known and more than priced into the stock, where many positive developments went unnoticed.

In the second quarter, Nokia's market share grew in the US sequentially, a miracle considering a below-average product range. Though 45 per cent of Nokia's shareholders live in the US and it is the single largest cell phone market, Nokia sales in the US represent only 8 per cent of its total sales - a considerable decline from 15 per cent last year. There is a lot more upside than downside in the US for Nokia.

Revenue in the second quarter grew 25 per cent and it was true organic growth, without acquisitions. An unfavourable product mix, a decline in the average selling price (ASP) of 5 per cent and intensified competition were responsible for margin erosion. The deterioration was due to explosive sales growth in emerging markets where sales are dominated by cheaper handsets.

The US situation is puzzling. Yogi Berra would describe it as Nokia making too many wrong mistakes. The company let Motorola take the lead in the US by missing the flip phone trend. Motorola deserves credit, as it did a wonderful job producing phones that US consumers wanted. Outside the US, Nokia is a dominant player owing to a strong brand and innovative products. Its problems in the US stemmed from its unwillingness to sacrifice manufacturing efficiency and to customise its phones to US carriers' specifications. Last year Nokia made needed modifications to its operating system that should have allowed customising phones on the software level without handicapping its manufacturing efficiencies.

Nokia is likely to approach the US market differently from the way it does the rest of the world. It will have to make phones just for the US - a significant shift in strategy. Nokia has all the ingredients to recapture the market, though I believe it will take some time. US will be the icing on the cake for Nokia as its overall success is not driven by its success in the US since it represents a small portion of its sales.

Nokia is by far the largest cell phone producer and it spends considerably more on research and development than its closest competitor Motorola. R&D is much needed to keep consumers in developed countries excited about new, feature-rich phones.

Nokia is also the low-cost producer, the Dell of cell phones, which is crucial as competition in the low end products is mostly price-driven. In the lower end phones in emerging markets, as long as features are comparable with other phones and the brand perceived to be of good quality, price is a deciding factor on a purchase. To put things in perspective, Nokia's record low operating margins are still much higher than Motorola's record high. The multimedia phone segment was a shining star for Nokia in the second quarter as it turned into a profitable (9.2 per cent margin) growth machine. Revenues were up 89 per cent. This segment was bleeding money in the past as it lacked much-needed scale. Nokia's portfolio in this segment is rich and it is likely to offset some margin compression in the mobile phone segment. Also, there is still room for margin expansion as its margins should be at least as high as - or higher than - mobile phone's 16.2 per cent. The company has virtually no debt and a $15bn cash stockpile in the bank (20 per cent of the market capitalisation) and has a great return on capital. The stock trades at 14.6 times 2004 free cash flows, and at 15 times - recently lowered but likely to be revised up - 2006 estimated earnings. The valuation is even more attractive if the cash stockpile is taken into consideration. In spite of falling ASPs and the difficulty in the US, Nokia's sales are likely to grow as the global market for cell phones is increasing rapidly.

The company expects to gain market share at the expense of the smaller players. Its margins are at record lows, thus their future movement is likely to be upward. Finally, Nokia pays a dividend yielding 2.4 per cent and is buying back stock (using its huge cash pile) as if it was going out of fashion.

The author is a portfolio manager with Denver-based Investment Management Associates and teaches equity research at the University of Colorado. His firm owns shares in Nokia.

Vitaliy N. Katsenelson, CFA Copyright Financial Times

Small telecoms market means NZT is nearly alone in its field

July 25, 2005 - Financial Times The stocks of American local telephone companies are down substantially from their heyday of the late 1990s and they have been facing problems on many fronts, including fierce competition from cable operators. But not all phone companies are created equal. In the middle of the South Pacific, Telecom Corp of New Zealand, or NZT, competes in a quite different environment. A unique geography and a relatively small market are responsible for a very atypical competitive environment. New Zealand's two forgotten islands are roughly the size of Colorado, with a population of 4m people. Cellular: There are only two players in the wireless market, Telecom of New Zealand and Vodafone, competing in a cosy duopoly environment. The relatively small market size and fairly large terrain can only support a few wireless market players. Economies of scale are crucial in this business. It would be very difficult for a new player to enter the market at a scale large enough to compete effectively against the incumbents in such a small market. Both NZT and Vodafone are aware that they have it as good as it gets, and are likely to milk the good thing for as long as they can. In fact, in its earning press release NZT hints (to investors as much to Vodafone) that its only aspiration is to grow along with its roughly 50 per cent market share. Although New Zealand's wireless market is quite saturated, with a 80 per cent installed base (this number is likely to be overstated by prepaid customers), the growth is coming from the provision of previously unavailable but very popular data services: texting, instant messaging, ringtones downloads and so on. Data accounted for 15 per cent of wireless revenues and grew 90 per cent in the last quarter - it is likely to remain strong in the future. Broadband: The story only gets better. Cable service is basically non-existent in New Zealand, paid television services are offered through satellite, making NZT a de facto monopoly in the wired line and broadband spaces. It introduced a DSL product in a meaningful way only last year (although DSL is available in 92 per cent of the country), and it is one of the main drivers of revenue growth. NZT has a more than 50 per cent market share of the very competitive dial-up market. It has been making a graceful exit from that arena by switching customers from dial-up to DSL (a much higher margin product). NZT's DSL penetration is still a relatively small 13 per cent, thus this segment will be growing at a fast pace for a long time as consumers switch to a faster, more convenient internet connection. Wireless services are much more expensive in New Zealand than in the US, hence you do not see the level of defections from landlines to cellphones as observed in the US. In the absence of cable competition, there is little rivalry left in the residential line business. Revenues in this segment declined 1 per cent, due in part to the decrease in number of second phone lines as customers switch to DSL. NZT subsidises the DSL modems and cell phones it provides to customers, the cost of which is expensed right away, not depreciated. NZT's earnings growth over last year was hindered by the explosive growth of the DSL and wireless business. As these costs gradually filter through, NZT's margins should expand back to typical levels and its operating profitability should start keeping pace with its top line. The weakest link in NZT's performance is its long-distance business, which declined 11 per cent. Long distance is a shrinking market. However, it has been in decline for a while and as it gets smaller the rate of decline should decelerate and it should have less impact on the bottom line as its base shrinks.

Telecom New Zealand easily passes the quality, value, and growth test. Quality: NZT has strong and sustainable competitive advantages, which show in its above industry margins and return on capital of 18 per cent, twice that of Verizon or SBC. Its debt is rated A by S&P and debt payoff ratios are respectable considering the stable and recurring nature of NZT's cash flows. Value: NZT trades at about 13 times earnings and about 12 times free cash flows. Based on our discounted cash flow model, there is no growth priced into the stock, an unlikely scenario. In addition, NZT's secure dividend yield of 7 per cent should serve as a cushion in the market that has delivered no returns for the last seven years. Growth: NZT generates ample cash flows to invest for growth, pay a dividend and pay down debt. As the declining long distance business gets smaller and fast growing DSL and cellular businesses get larger, NZT's bottom line growth should accelerate to about 5 per cent a year. Adding a 7 per cent dividend on top of that produces a respectable rate total return and that is without factoring in any price earnings expansion, which is warranted. NZT has another unique feature: because it is a foreign-listed ADR, it could also work well as a hedge against the falling dollar. The author is a portfolio manager with Denver-based Investment Management Associates and teaches equity research at the University of Colorado. His firm owns shares in New Zealand Telecom. FT.com / By region / Asia-Pacific - Small telecoms market means NZT is nearly alone in its field Vitaliy N. Katsenelson, CFA

The Good, the Bad and the Ugly – US Bank - 2nd Quarter 2005

July 22, 2005 - Minyanville.com

The light at the end of the tunnel appears very bright for banking stocks as aging baby boomers will likely demand more of their products and services as they get deeper into the retirement stage of their lives. However, in the meantime the light is flickering somewhat as banks are going through some tough times with net interest margins under pressure due to the flattening of the yield curve. However, considering attractive valuations, appealing long-term prospects and above average dividend yields, this group may indeed represent a very attractive investment alternative.

Last quarter following less-than-spectacular performance I placed USB on “double secret probation”. Thus I studied USB’s performance with some extra curiosity.

In general banks’ financials are very complex and require a multidimensional analysis, linking the balance sheet and income statement, while filtering out the noise created by various balance sheet adjustments. USB’s financials are not any different so I had to make a lot of adjustments to get to the true operating performance.

Credit losses have been on a positive trend for a while at USB (true for most banks), further declining to 0.44%. That's a very good sign however, we are probably close to the bottom of that trend, as the benefits from declining credit losses have primarily run their course.

Higher interest rates (something I would not rule out considering the fact that interest rates are sitting at an all-time low) tend to make borrowing more expensive putting more stress on companies and consumers and resulting in higher credit losses. Interestingly as interest rates rise, credit spreads are likely to widen on the new loans as banks price higher expected default rates. However, the benefits from higher interest margins are likely to be somewhat offset by increased credit losses in existing loan portfolios.

The most impressive part of the company’s second quarter earnings report was a nice 8.3% growth in loans – a rough proxy for future earnings growth. However, about 2% of that growth came from residential mortgages, likely driven by a recent drop in long term rates. On a positive note, growth in loans in most business lines was very solid. Side note: investors should be cautious of banks which derive a large portion of profitability from their mortgage business and refi business as higher rates are likely to have a significant impact on that area.

Reported EPS was up 10.9% year over year which looks great on the surface. But this is an instance where the surface needs some serious scratching. In my analysis, I'd like to exclude one-time and non-operating items to get to a better measure of true operating performance. Why do we do that? True operating performance presents an accurate scorecard of management and the company’s performance and is therefore the best indicator of achievable future results. One time items (good or bad) will eventually run their course. Key Points:

So here it is (all comparison with the second quarter 2004):

Net interest income (before the provisions for losses) declined 1% - nothing to be excited about - though not utterly unexpected considering the flattened yield curve and intensified competition. According to my estimates the flatter curve shaved 5% from USB’s net income growth.

There are several ways a company can deal with a flatter curve (net interest margins declined 29 basis points to 3.99%): cut costs (more on that later), originate more loans (check), and drive fee revenues (check).

On the surface, non-interest income (fee revenues) grew 24.1%. However, after excluding security gains, growth was lower but still a very impressive 8.9%. This figure is extremely important for several reasons: in the current flat yield curve environment, fees become a great source of profitability. Also they are not subject to the whims of the external factors and therefore are very predictable and a stable source of growth.

The majority of the growth in that segment was organic, as it was fueled by increases in the payment services segment growing at a very fast pace due to increasing popularity (and acceptance) of debit and credit cards. USB is the third largest merchant processor in U.S. after First Data (FDC) and Bank of America (BAC).

Non-interest expense rose 29.4%, however, after excluding intangibles and debt repayments, the figure was only up 6.4%. I would like to see that number lower, as the banking business lends itself to substantial operational leverage (large fixed costs), thus growth in expenses ideally should lag behind the growth in top line.

Intangibles were mostly comprised of Mortgage Servicing Rights (MSRs) write-downs caused by recent dip in interest rates, something the company has little control over. Actually if one assumes that rates will not stay at an all-time low level forever, MSRs may be an undervalued long-term asset as they become more valuable in the higher interest rate environment. (Rising interest rates cause loan refinancing to decline thus increasing the life of the loans).

Reported income after taxes was up 8.1%, however, that was mostly driven by a lower tax rate in the current quarter, where operating income before taxes was up only 1.3% (excluding one time items, see my calculations.)

After factoring a 3.1% share count decline in the quarter (share buy backs), true EPS growth was about 4.5% - far below the company reported number of 10.9%. Again based on my estimates, in the absence of flattening of the yield curve, USB’s EPS would have grown more than 9%. Add to that a 4% dividend yield and we are talking about a very good rate of total return.

USB returned 92% of net income to shareholders through stock buy backs (share count declined 3.1%) and dividends – very good as long as it doesn’t jeopardize USB's future growth (which doesn’t seem to be the case here.)

Tier 1 ratio (capital to adjusted total assets – the higher the ratio the more capitalized the bank is) has continued to decline to 8.1% from last year’s level of 8.7%. This is in large part due to the payout of the bulk of the net income in dividends and share buy backs, paying of some preferreds and issuing new debt. Overall, the tier 1 ratio still stands at a very respectable level and is likely to normalize here in my view.

Efficiency ratio – very important (the lower the better) – as it is indicative of the company’s cost structure. A lower cost structure obviously provides a competitive advantage in the banking industry as choosing one bank over another is often decided on price (interest rates) USB’s efficiency ratio increased in the quarter from 38.6% to 48.3%. However, it is grossly distorted by a write down of MSRs and debt pre-payment, (in absence of which it increased only slightly by about 1%.)

Expenses grew at a faster rate than sales:USB is still in the midst of a very aggressive program of building new branches in grocery stores, and that in part is responsible for higher expenses in the quarter. According to management it takes 18-35 months for the inside grocery store branches to reach profitability. In addition, about a third of the increase in expenses is attributable to the integration of several acquisitions that USB made in the payment processing business. Once those acquisitions are switched to the USB platform the expense structure should normalize.

Management stressed on the conference call that investors should start seeing revenue growth outpacing expenses (operational leverage at work) – resulting in margin expansion and acceleration of EPS growth. I will be watching for those numbers over the next several quarters. Non-interest businesses (especially payment services) are likely to be the driver of growth in both the short and long runs, as the majority of them showed double digit growth in the quarter. Though some of the growth in that business came from acquisition, the bulk of the growth was organic (the cheapest way to grow.)

Overall, this quarter was not spectacular but it provided a favorable glimpse into the future as management demonstrated its ability to grow loans and fee revenues. USB’s footprint is OK but not the best in the industry as only about half the branches are located in the faster growing states. However, most of the new branch growth is coming from higher growth states – a long term positive. USB’s valuation is still very attractive as it trades at 11.6 times 2006 earnings. There some room for P/E expansion and very little risk of P/E compression in my view. A 4% dividend yield and 8-10% long term EPS growth rate make USB an interesting company to consider further.

Side note: Zions Bancorporation (ZION) – has one of the best footprints i.e. California, Arizona, Nevada, Colorado. I’ll be watching Zions very carefully as a stock decline may present a buying opportunity. Not advice.Vitaliy N. Katsenelson, CFA Vitaliy N. Katsenelson, CFA Positions: USB

Copyright Minyanville.com This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

RX - Still a Gem, Just in the Wrong Hands

July 18, 2005 - Minyanville.com

A couple of days ago headlines read, "Dutch company VNU, Inc (VNUVY) announced they would buy IMS Health (RX) for $6.9 billion” (a modest 15% premium). However, in its press release, RX announced that it is merging with VNU. Did VNU buy RX or was it a merger? According to RX, VNU did not approach RX and the ‘merger’ was a byproduct of mutual affection of one company for another. VNU (a larger company) paid a small premium to exert control over the combined entity. It is a merger of unequals, as VNU will have a 60% control of the combined board.

This ‘merger’ took a lot of investors by surprise. A small brush up on RX history is required to understand the reason for that. RX was spun off from Dun & Bradstreet in the mid '90s. At the time of spin off it was bundled with a collection of loosely related businesses, and since then RX has desperately tried to simplify and restructure by shedding these businesses. It took years of endless spin-offs and financial engineering to make progress on simplifying the businesses.

In the process management got so infatuated with financial engineering that it almost reversed merged the company into a dot.com company that was a fraction of RX’s size. Luckily Wall Street saw through the ridiculousness of the proposed reverse merger and it was aborted. Soon after the CEO was given a very fancy go away package and Dave Thomas (an outsider who was lured from IBM) took over the helm at RX.

Mr. Thomas brought vision and much needed execution to RX. The company enjoys a close to monopoly position over the pharmaceutical data market which at the time made the company a very complacent giant that lost its customer focus. In addition Dave refocused the company from just a data provider to a solution provider in the pharmaceutical industry. Over the last several years, RX made relatively small tuck-in acquisitions in consulting and pharmaceutical data areas. Those acquisitions made perfect sense as the company was moving to enhance its product offering to its customers. Also the acquisitions were relatively small and not disruptive to the core business. Indeed many of them were so small that they did not require a conference call – a good sign right there.

The company finally had a clear plan and was executing it; the company’s efforts were finally paying off as top line and bottom line showed solid signs of growth.

RX is a truly unique company as it enjoys incredible return on capital, abundant free cash flows (business is not very capital intensive), and over the years RX created great barriers to entry into the industry and thus commanded Microsoft like margins.

Now when things have finally started progressing as management promised, the VNU merger was dumped on RX shareholder shoulders essentially forcing a “To Be or Not to Be” question.

Does the merger make sense? Both management teams sounded very optimistic on the joint conference call, giving the usual synergy, cost cutting, go where nobody has gone before talk.

I have a theory that there is a “Mergers for Dummies” handbook secretly floating in corporate hallways, as all merger/acquisition conference calls sound identical. Both companies are excited, the praises are sung to the quality of opposing management team. Words like synergy (used 7 times in RX/VNU conference call) is only superseded by “opportunity” (used 14 times in RX/VNU conference call). Management usually makes sure to insert at least one of them in every sentence. Since it is assumed that employees from combined companies are listening layoffs are downplayed and no specifics are given. Very few large mergers work out, most mergers fail miserably as egos, incompatibility of corporate cultures and premiums paid make it very difficult. This one looks no different to me.

Ironically the two largest operating units of VNU (AC Nielson and Neilson Media) used to be a part of the same company – Dun and Bradstreet. At the time DNB thought RX and Nielsons should not be together; thus they were spun off separately. According to RX times have changed - they always do. But have they changed enough for two companies with very little overlap in business to merge?

RX’s management is touting an existence of great synergies in OTC data market with AC Nielsen and matching TV advertising and viewership with drug sales data. All this sounds great, but awfully problematic. In my conversation with RX management I brought up the idea of a joint venture. I was told such joint ventures are very difficult as the negotiation on its structure often results in decision paralysis. Though there is some truth to that argument, the cost of a failed merger is a lot higher than joint ventures failure. As failure of a joint venture leads to an easy dating-like separation, and failure of a merger brings the company to a Hollywood-like divorce. Also, RX could simply buy needed data from VNU’s units, since that's what VNU does – sell data.

Both companies are mainly in the data gathering business, however, they often serve very dissimilar customers in unrelated markets. In addition touted cost savings will be harder to come by as they operate on completely different software systems.

The merger is likely to destroy shareholder value rather than create it as the multiple of the combined company is likely to shrink.

First of all, RX has enjoyed a premium valuation to the market as it is a company that enjoys the benefits stemming from baby boomers’ ever rising demand for pharmaceuticals without the worries of drug expirations and competition from generics that surround large Pharma.

RX has a market dominance and easy to understand business -- the seeds for above market P/E multiple. A quick comparison of VNU and RX’s fundamental performance will show how inferior VNU’s businesses are to RX. VNU / RX: Tale of the Tape Pretax Margin: 6.60% / 26.80% Return on Assets: 1.30% / 15.10% Source: S&P Compustat ©

Second, VNU’s businesses are not growing rapidly and face plenty of problems that are absent from RX’s business. The Nielsen Media business (which networks love to hate) could become a lot less relevant with the fast rising popularity of Tivo.

Third, VNU’s management promises to list an ADR on the NYSE before the merger goes through. Keep in mind ADR's usually trade at a discount to the pure NYSE listed companies. It is hard to tell why ADRs trade at discount to pure counterparts. Maybe it is because VNU is a Dutch company, most folks cannot so much as find Dutchland (Netherlands) on the map. Or it simply may reflect the ambiguity of the reporting requirements for ADRs and the frequency of the report filings (ADRs report earnings twice a year versus four times from U.S. companies).

Finally, the combined company will be less transparent and more difficult to understand. Simple, easy to understand, financials were something RX had desperately tried to achieve over the years and it finally did.

All these reasons lead us to believe that we don’t want to be a shareholder of the soon to be created entity. The spread between the offer and RX’s price is very tight (4%) - an indication that the Street believes that the merger (unfortunately) will go through. We have very little confidence in VNU stock which RX’s price is closely linked to now. Therefore, we have decided to vote on the merger with our feet.

Vitaliy N. Katsenelson, CFA Copyright Minyanville.com 2005

This article is written for educational purposes only. It is not intended as a recommendation to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Why I am still in love with Abbott

July 13, 2005 - Minyanville.com / MarketWatch

Commentary: Weakness driven by shortsightedness DENVER (MarketWatch) -- Abbott Labs got a less than happy round of applause Wednesday from the market even as it beat the consensus earnings number by a penny. The top line growth, however, was more than impressive as sales grew 15.2% in constant currency; bottom line growth mostly followed the sales growth. Cost of goods sold has soared in the quarter due to a very fast growth of lower margin drugs Mobic and Flomax. Is this a problem? Well I would love to see sales grow and margins expand at the same time, but I wish all my companies had Abbott's (ABT: news, chart, profile) problem. Margin shrinkage that is due to an unfavorable (to margins) product mix doesn't really worry me. I would be more concerned if the margin compression was driven by competitive forces or price decreases. After backing out acquired R&D from the last year's numbers to equalize the comparisons, operating earnings still grew 14% -- a very respectable number. There was plenty of one-time noise below the operating earnings number from higher taxes due to foreign cash repatriation etc; I am not going to waste my breath on it. I'll let the sell-side analysts worry about that, as analyzing that noise and asking 'smart' questions on the conference calls seems to be enough justification for their existence. What I really liked about company's performance in the quarter is that growth was broad based (very typical for Abbott) in almost all of its segments -- screaming quality. As I mentioned before, Abbott's product line is extremely diversified. It doesn't have a typical blockbuster exposure that has been haunting many large pharmaceutical companies. Putting all the noise aside (i.e. Abbott projected a third-quarter number 2 cents below analyst estimates, though it kept estimates for the full year intact), long-term prospects for the stock are outstanding. See April comments on Abbott here. Valuation of Abbott is still very attractive, and actually just became more attractive after Wednesday's sell off (not advice). It trades at 17 times 2006 earnings. There is a hidden call option embedded in the stock, as the market doesn't put any value on a drug coated stent that is still in development. So far Abbott is only incurring R&D costs related with stent development but no revenues, thus further depressing its margins. In my view, weakness in the stock is most likely a buying opportunity (not advice -- I mean it), especially when the weakness is driven by Wall Street shortsightedness.

Vitaliy N. Katsenelson, CFA At the time the article was published author's firm had a position in Abbott. Copyright Minyanville.com 2005

China Speed - Running into the Great Wall?

June 22, 2005 - Minyanville.com / Bloomberg According to the Economist, the Chinese economy grew 9.4% in the first quarter in 2005 with industrial production being up an astounding 16%. Surprisingly most of that growth was real, as inflation was only 1.8%. It is impossible to say how accurate these numbers are, since they are put out by a very political and secretive entity – the Chinese government. In my view, the government would not hesitate to interrogate the data until it confesses to the party line numbers. These government produced numbers have little use if one is looking for inflection points of economic growth. However, it is hard to argue with the fact that the Chinese economy is growing at a very fast rate by any modern standard. The Chinese economy reminds me of the movie "Speed" (the flick that arguably sent Keanu Reeves to stardom status). In the movie, a bad guy with a grudge, masterfully played by Dennis Hopper, rigs a transit bus with multiple explosives, one of which is triggered if the bus goes slower than 50 miles per hour. How does that apply to China? The Chinese economy is akin to a bus with 1.2 billion people on board, where massive financial and operation leverage are the explosives that would likely blow up if the economic growth falls below its current pace. Even a small speed bump is likely to send this monstrous economy into a severe recession. Here is why: Chinese economic growth is largely driven by the manufacturing sector - industrial production growing at the double rate of GDP supports this argument. China has become a de facto manufacturer for the world. With exception of food products, it is very difficult to find a product that was not, at least in part, manufactured in China. The manufacturing industry is very capital intensive. To build a factory a large upfront investment is required (with commodity costs on the rise, the required investment has increased over the years) and once it’s built there is a fixed cost associated with running a factory that is somewhat independent of utilization level – a classical definition of operational leverage. Debt is the instrument of choice to finance ever-growing factories in China. A June 20th Financial Times article highlights the point: “In the first quarter of this year Chinese businesses relied on banks for 99% percent of their official fundraising, the highest rate in at least decade…. The lack of fund raising alternatives means that many private companies – the motors of growth in the modern Chinese economy – borrow money from start-up finance ‘underground’ banks that charge high interest rates.” Debt (financial leverage) coupled with high fixed costs (operational leverage) create total operational leverage. Total operational leverage in China is elevated further as factories are built to accommodate a future demand, which has been rising in the past and thus automatically projected to climb in the future. This highly leveraged growth formula works fine as long as the economy is growing at super fast rates. As sales are growing, costs are not growing as fast as they are largely fixed (due to operational leverage) leading to expansion of operating margins (the beauty of leverage). Unfortunately leverage works both ways, as sales growth slows down the opposite takes place. The airline industry in the U.S. is the poster-child for a high degree of total leverage, as planes costs over a hundred million dollars and most of the time are financed with debt (yes, leases are just another off balance sheet form of debt). Add to that a very unionized, overpaid, difficult to lay off labor and the deep cyclicality of the industry and you have a recipe for disaster. That’s a fair description of the airline industry. Arguably Chinese labor is not as grossly over-compensated as United Airline’s flight attendants or pilots, but laying-off workers in China is a politically sensitive process (according to FT) thus creating another layer of fixed costs. I can think of many reasons that could cause the fatal slow down in Chinese economic growth: Slow down of the U.S. economy, the biggest trading ‘partner’ with China. China is financing its biggest customer – the U.S. consumer. Not unlike Lucent while it was inducing its sales growth by financing its dot.com customers. China is financing U.S. consumers by buying U.S. Treasuries as if they were going out of style (pushing prices higher), thus keeping the U.S. interest rates at very low levels and creating what Mr. Greenspan calls a ‘conundrum’. At some point, either because of the higher interest rates or simply due to debt overdose, U.S. consumer spending will temper, lowering demand for Chinese produced goods. A mounting pile of politically motivated bad loans may bring the Chinese banking system to a halt. Though China is trying to move closer to Western lending practices, a combination of semi-market economy and a government controlled banks is very dangerous. Loans are often made not on the merit of investment but based on political connection. Overcapacity - It is a human tendency to draw straight lines and direct projections from past into the future. During the fast growth times the angle of the straight lines is usually tilted upward, causing over investment in fixed assets, as inability to keep up with demand may cause manufacturers to lose valuable customers. In the height of the dot.com mania, telecom equipment companies often could not keep up with ever-rising demand, and therefore constantly increased capacity. Overcapacity is a death sentence in the manufacturing (fixed costs) world since it leads to price wars – a fatal deflation. Currency float – there is a good reason why the Chinese don’t want the renminbi to float (appreciate). As it would chip away some of the comparatively low-cost producer advantage, it would likely reduce the U.S. demand for its products. In addition, renminbi appreciation will devalue the Chinese stock pile of U.S. Treasuries. Most companies stress their China strategy on their conference calls, in a similar fashion as companies were stressing their internet strategies in the late 90s. I don’t foresee companies re-naming themselves to incorporate China into their names though (as many did with dot.com in the late stages of internet bubble). It is very apparent that many are making large investments in China – B of A’s $3 billion investment into the Chinese bank comes to mind here. As usually happens after the bubble pops, the past asset turns into today’s liability. Thus, Chinese exposure that is looked upon as a source of revenue growth today, may turn into a written-off investment tomorrow. It is not a question of ‘if’ but more of a question of ‘when’ the Chinese economy will cross that metaphorical 50 miles per hour mark and fall into the deep abyss of prolonged recession in my view. China is living through one of the greatest historical bubbles. Dozens of books will likely be written to describe how it happened and how it imploded, but as always, they’ll be written after the fact. I even have suggestions for the book titles: “The Chinese Conundrum” or “The Great Chinese Bubble” or “Irrational Exuberance 2”. But, as with any bubble timing, the pop is very difficult. Bears are usually too early to call it and bulls are usually too late to see it. As government published numbers of economic growth cannot be trusted, investors should look for anecdotal clues for the inflection point. Conference calls of U.S. companies doing business in China are probably the best source of information. The risk of the Chinese bubble is real, thus it may be wise to prepare by immunizing portfolios from that risk. Though being completely rid of the China risk is impossible and impractical, it is very important to stress-test a portfolio against that risk, one stock at a time. Vitaliy N. Katsenelson, CFA Copyright Minyanville.com

Beware the boredom of the bear market

May 24 2005 - Financial Times In the last century, every prolonged bull market, which ran about 16 years, was followed by a similar length bear market. I believe this is not a random pattern. It takes a long time for an emotional cycle to reach its climax, and it takes a similar time to reverse that cycle and drive valuations to the other extreme. In a bull market rising prices intensify optimism and euphoria. The more persistent the ascent the more certain investors become of their abilities. As the perception of risk gets duller, even the most risk averse become risk seekers. In a bear market the opposite happens. Optimism turns to pessimism, euphoria to anguish, and jubilation to desolation. Risk tolerance does not change but the risk senses sharpen. Even low probability risks are magnified. Most bear markets in the last century were range-bound or gradually declining. Bear markets are boring. After several years of losses or no returns, investors lose interest in stock investing. Investor indifference induces further market declines that in turn lead to greater indifference - the start of the vicious circle. The extremes of human emotion prevent the market spending much time in a rational state at fair valuation. In the second half of the 20th century stocks traded on average at 15 times earnings (perceived fair valuation level). But stocks spent less than 20 per cent of the time with a price/earnings ration of 14-16 during the same time frame. In the majority of cases the market reached its fair valuation in passing from one irrational extreme to another. Today's market valuation is still fairly high, the Standard & Poor's 500 is trading at 21 times last year's earnings and 16 times projected 2005 operating earnings (excluding never ending one-time charges). And P/E multiples are likely to get higher as companies start expensing stock options at the end of the year. Current valuations have little bearing on what the market will do over the next 10 years. The Dow Jones Industrial Average is at the same level it was in 1998; most other leading US indices are down substantially from their highs. A seven-year descent from the biggest stock bubble of the 20th century has provided plenty of negative confirmations to investors and has planted the seeds of indifference that are fertilised with every passing day. Stocks are unlikely to settle at their fair valuation. Emotions that have accumulated over the last seven years are apt to drive stock prices far below their intrinsic value, as has happened almost every time in the last century. At the end of each bear market in the last century P/E fell below 10. At the end of the 1966-1982 bear market, the average stock reached a P/E of 7.4. But this does not mean investors should avoid stocks - the alternatives are no better - but traditional investment approaches do need tweaking. Buy Discipline: although the fundamental analysis of the business should not change, valuation analysis needs adjustment. Look for a greater margin of safety in valuing stocks. This will increase the difficulty in selection but should reduce the risk of P/E compression. Relative valuation tools should be used with caution as they benchmark to valuations achieved in the past bull market, not those likely to be observed for a long time ahead. Absolute valuation tools, such as discounted cash flow analysis, although they have other drawbacks, do not suffer from the benchmarking error, making them a necessity in an analyst's tool box. Cash should be a viable alternative to owning overvalued or marginal quality stocks. Bear markets present opportunities to own great businesses at great prices, thus patience and dry powder (cash) is rewarded. Sell Discipline: the traditional buy and hold approach should be put on hold. An oscillating market rises and ebbs continuously, thus navigation requires a lot more maneuvering. In bull markets, stocks often overshoot their fair valuation level. In bear markets that happens to a lesser degree, thus specific price (valuation) targets for each stock need to be set and strictly followed. This ebb and flow volatility should be taken advantage of as it should provide a source of capital appreciation. Dividends and Value: dividend yield accounted for almost all the return in the last bear market. Investors in this market should buy companies that generate significant free cash flows and can raise their dividend payout without hindering future growth. Stocks that pay a nice dividend and trade at low valuation will have a cushion to soften P/E contraction, where growth stocks are likely to be the largest casualty. Finally, index funds should change the sign on their doors to read "a place of low fees and no returns". Vitaliy N. Katsenelson, CFA

Copyright Financial Times 2004

Demoting General Motors

May 12, 2005 - Minyaville.com Excellent article on General Motors (GM) in the May 9th edition of Business Week. Here are some important points and my thoughts:

• GM is saddled with $1,600 of legacy costs per vehicle - retiree health and pension benefit costs.
• Because of 15 year old union agreements, GM must run plants at 80% capacity, whether it makes money or not. (I believe this is another substantial legacy cost. This also upsets their dealers since they are flooded with inventory. Its Japanese counterparts are famous for regulating production to control inventory at the lots level. That is a main reason why Toyota and Honda’s dealership franchises are so much more profitable and valuable than GM’s)
• The idea of being number 1 (at any cost) is etched into GM’s culture and unlikely to be dropped by current management.
• GM has enormous liquidity: $19.8 bln in cash, $8.3 bln in bank lines (I am not sure how junk status would impact that), $5 bln it can draw from GMAC, $1.1 bln could be saved from canceling the dividend. In addition, it could raise $10-15 bln from selling GMAC (I am not sure that they would do that since it is the only part of the company that makes money. However, that liquidity may not protect GM if gas prices go higher, commodity costs increase, economy slows down etc…)
• Discontinuation of the Oldsmobile brand cost GM a billion dollars. According to Business Week, GM must discontinue some of its brands i.e. Buick and Saab but it will cost GM a lot of money. GM needs to keep making old outdated cars just to keep plants running. This is the most important: GM spent $7 bln on R&D last year vs $15.3 bln by Toyota. That R&D spending is spread over 89 auto models and 8 divisions, versus 26 name plates and three divisions for Toyota. Toyota changes its cars every three years, where GM changes every four years.

The bottom line: In my opinion, GM has too many brands that are under-researched and with few exceptions stand for nothing. The obvious under-investment into R&D almost guarantees that GM will not be making good cars that are competitive on features and price any time soon. Its legacy union contracts are forcing the company into making mediocre cars, and it seems to me that the gap between GM and Japanese is likely to widen going forward, not shrink. I wrote an article on U.S. automakers awhile ago that highlighted additional problems faced by GM and Ford awhile ago, but these problems are still facing both companies today. Side

Note: GM’s pension plan’s return assumptions are too optimistic, GM assumes 9% long-term rate of return on its assets. Considering the age of its workforce, a very large of portion of its assets should be in bonds. Maybe GM is welcoming the downgrade and loading up on its own junk bonds (I am pretty sure they are not doing it, but I cannot contain my sarcasm). I just cannot see how the company will produce this rate of return for the foreseeable future.

Vitaliy N. Katsenelson, CFA

Copyright Minyanville.com

The Good, The Bad, and The Ugly: Cendant

May 10, 2005 - Minyanville.com The Good:

• The company increased the dividend 22% to $0.11 - resulting in a yield of 2.1%.
• CD will be buying close to 4% of its