Wednesday, October 27, 2004

Sara Lee Struggling to Pass on Higher Commodity Prices

October 27, 2004 - Street Insight

  • Premium consumer brands no longer guarantee pricing power.

Sara Lee (SLE) reported earnings at the higher end of estimates, producing 44 cents per share. However, these results include 15 cents received from the sale of its European cut-tobacco business. Sales grew 4% during the quarter, with net income lagging a tad behind, growing 3%. The sour spot in the company's performance was the meat business. High commodity prices have impacted demand for its meats. Actually, looking over sales and volume growth segment by segment, the story is very similar. Across the board, volumes were either flat or slightly negative and sales were in large part helped by favorable currency translation. It is very hard to judge SLE's performance so far since the company is going through a transition. It is rationalizing its businesses, shifting focus on core brands, putting marketing dollars behind them, and either divesting or trying to maximize cash flows in its non-core brands. SLE's earnings call was very interesting in some respects. It convinced me even more that companies have very little pricing power in this market. It seems any time Sara Lee has tried to increase prices, it has resulted in lower volumes and subsequent lost of market share. Commodity price increases are felt throughout the whole company and though management has indicated that it sees lower commodity prices in the second half of the year, I personally place very little value on its crystal ball. Though it is almost a given that lower cotton prices will help the company in the second half of the year, I am not sure that will be the case in other segments. To tackle a larger issue, the power of brands, strong brands are supposed to command higher pricing and should have lower price elasticity. Interestingly, that has not been the case here. Sara Lee, Hanes, Jimmy Dean, Hillshire Farms, Ball Park, L'eggs and many other brands that are known outside the U.S. are very respectable brands. But it is apparent every time the company tries to charge a premium price for its brands (in passing higher commodity prices on to the consumer), demand drops off substantially. This brings me to the conclusion that consumer brands (at least in this environment) don't guarantee a higher selling price (higher margin) but guarantee shelf space and higher volume if a company chooses to price its products in line with "generics." I believe SLE's problems stem from a deeper issue. Consumers are overwhelmed by an abundance of brands in retail channels. Any innovation by one "strong brand" company is quickly copied by another with a similarly strong brand identity. Thus, brand is becoming necessary to participate in the game, but it doesn't guarantee premium pricing -- not anymore. Thus I think SLE's problems are likely to continue going forward even after the commodity prices decline.

Vitaliy N. Katsenelson, CFA Copyright 2004

Tuesday, October 26, 2004

First Horizon on the Rise

October 26, 2004 - StreetInsight

  • FHN is taking market share in the mortgage business from defunct small players.
  • Management is not managing the business for the short-term; its building a strong, viable franchise for the long term.
  • The company was able to maintain flat earnings year-over-year despite huge exposure to the refi market.

I had a very interesting conversation with a friend of mine who is a mortgage originator at First Horizon National (FHN). I used his services when I bought my house in May. Here are some observations on FHN and the mortgage industry in general: · FHN is taking market share in the mortgage business from defunct small players. Facing a difficult environment (to say the least), small players (most of whom have entered the industry as the refi bubble was taking its last breath) have returned to their day jobs -- washing cars, cleaning streets, and serving food. · FNH has raised fees for Home Equity Line of Credit (HELOCs). New accounts will face a $50 annual maintenance fee and $200 fee if the account is closed within three years. The big boys such as U.S. Bancorp (USB), Wells Fargo (WFC), and others have had fees attached to their HELOCs for a long time and my understanding is that their fees are still higher than FHN's. These fees will be helping FHN's business in the next quarter, and will be providing a consistent source of income in the long run. · Facing a steep drop-off in refis, FHN has shifted its focus on builders in a very interesting way. It allows builder's clients (homebuyers) to lock rates for nine months to a year ahead, thus removing the uncertainty ofwhat rates are going to do from the time of the buying decision (builders and customers must love that). I remember that was a significant concern for my wife and me when we were buying our house. I need to check into this more to see how FHN hedges this rising interest rates exposure. I don't know how widespread this practice is in the industry at this time (I welcome anyone's input on that). If it is widely used by builders, than homebuilders will not be hurt immediately when rates rise. · FHN is extremely efficient in the mortgage business. The aforementioned big boys decentralize underwriting and processing functions. It is not uncommon for a loan to be originated in Denver, processed in Wyoming, and underwritten in Washington. At FHN, the underwriting and processing function are done by the same person who resides in the local office where the loan is originated. So First Horizon is able to originate loans faster. The loan originator has a better understanding of the nuances of the customer's loan and is able to provide better customer service to clients that have an ocean and a bucket of mortgage companies to choose from. In my personal experience, my loan was processed and completed in a matter of days, not weeks. · A very interesting comment on management: My friend is a top producer, so every year he goes to the presidential club gathering. Every year at that shindig, top brass sets very quantifiable goals for the company for the next year, which often seem unreachable at the time. But the goals are always achieved the next year. This management is all about execution. From listening to the conference call, I also got the impression that FHN's management is not managing the business for the short term; it is not focusing on meeting or beating Street estimates. This management team is there to build a strong, viable franchise for the long term (something sell-side analysts may find frustrating and confusing).

· Another observation that resonates with Doug Kass' and Jeff Bagley's comments. Based on my friend's experience (warning: this is only a sample of one person), consumers are stretching to buy expensive houses at any cost, even if it means getting an ARM or an interest-only loan. (I will address that issue in greater detail in the near future.) Obviously, this development is not good for the housing market in general, but I believe it will have long-lasting consequences reaching far beyond the housing market. Overall, the more I learn about the FHN, the more I like this company and especially its management. I found that in retail and banking where products are very homogeneous, a good management team makes all the difference. I don't have to go very far: FHN was able to maintain flat earnings year-over-year despite huge exposure to the refi market, where Washington Mutual's (WM) earnings dropped 34% in the current quarter. I believe the difference in performance between these companies has everything to do with management. As bullish as I am on the stock, I do not own FHN right now because I hope that I can buy it cheaper.

Vitaliy N. Katsenelson, CFA Copyright 2004 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.

Friday, October 22, 2004

Sirius Has Made a Deal with the Devil ...

October 22, 2004 - Street Insight ... and I don't want to be around when payment is due.

  • Paying $500 million for Howard Stern only works if Stern generates 40 years worth of revenue.
  • And consumer tastes do change, even for vice.

I thought I had seen the epitome of stupid management decisions during the dot-com bubble when ludicrous sums of money were thrown at pie-in-the-sky ideas under the guise of "strategic investments." But Sirius' (SIRI) management has proven me wrong. The firm has agreed to pay $500 million (real, not Happy Meal) dollars to Howard Stern for five years of his invaluable services. Assuming Stern works 500 hours a year, this amounts to $3,333 a minute for Stern's uncompromising pursuit of radio excellence. Surely this is a bargain for someone who has spent years honing his interview skills with women in various stages of undress. The Sirius/Stern deal reminds me of when agreed in 1999 to pay AOL $89 million over four years for a non-exclusive agreement to link to AOL users. did what any self-respecting Web site would do after it paid 220 times revenues for a user base that doesn't want to buy its product -- it went bankrupt. To the credit of Sirius management, it appears to be far more conservative than Dr. Koop's, since its payment to Mr. Stern is only forty times revenues. There are several things that puzzle me about the Sirius deal (aside from how management is keeping their jobs after announcing that deal):

  • First is the reaction of Wall Street to this deal. Sirius' stock actually went up on the announcement. I think this is an indication of the current "happy" indifferent state of the market (low VIX numbers are a good indication of that), not unlike the market in July 1999 when Dr. Koop announced the AOL deal. And we know what happened after that.
  • Second is the viability of Sirius, especially since its competitive advantage now depends on Howard Stern. Based on that deal, the only thing Sirius has going for it is Howard Stern. This is the most pathetic business model I have ever heard of. And it puts Sirius completely at the mercy of someone who values self-promotion above all else (just ask his ex-wife). In five years, maybe Stern will ask for $1 billion, and Sirius will be in no position to negotiate.
  • What if American consumers' tastes change? This is what consumers do best, after all. What if consumers grow up? What if Howard Stern grows up? What if the FCC cracks down on satellite radio and enforces the same decency standards of broadcast TV? What if Howard Stern does something really stupid? (Wait a minute -- then his show will be even more successful.) What if, what if, what if?

It is very hard to predict which satellite company will succeed, if any. It seems that aside from exclusive arrangements with car manufacturers, programming is the only competitive advantage that satellite radio companies have discovered to date. Thus, using their cheap currencies (grossly overpriced stock), they have bid up the prices for content to levels which make no business sense. The problem that Sirius and XM Satellite Radio Holdings (XM) are facing down the road is their stock will not be cheap currency forever, and at some point they will have to pony up real, not inflated, dollars. That is when the sad reality will sink in: Sirius' (and XM's) business model will only be able to afford content like NPR (National Public Radio). And, it will only be able to afford that if it uses a Safeway (SWY) discount card. Not that there is anything wrong with NPR; I am a big fan. But I surely don't want to be there when this happens (at least on the long side of Sirius or XM). I remember watching the Dr. Koop deal unfold in 1999. Dr. Koop management was saying that the AOL deal was a must for its survival. The lesson learned: Stay away from any company that says it has to make this deal or that it is essential for its survival, especially when the company pays several decades of current revenues to make the deal happen.

Disclaimer: I admit that I used to watch Howard Stern when I first came to the U.S. at age eighteen. I hope the reader will excuse this youthful indiscretion on the pretext that I needed to learn English.

Vitaliy N. Katsenelson, CFA

Copyright 2004

Thursday, October 14, 2004

GM Bond Rating Downgraded by Fitch, Moody's

October 14th 2004 - Street Insight

  • If an investor was looking for a catalyst to short GM, this is probably a good starting point.
  • Timing is essential because GM pays a 4.8% dividend, though I believe downside in this stock is significant.

Editor's Note: Vitaliy Katsenelson described the perfect storm of rising interest rates, incentives and declining profit margins heading for General Motors (GM:NYSE) in a Market Insight post last week.

Yesterday, Fitch lowered the bond rating for General Motors (GM:NYSE) and GMAC from BBB+ to BBB, two notches above junk. Fitch cited concerns based on lower margins in the U.S. and Europe and higher retiree benefit obligations. Fitch also indicated that GM and GMAC's debt is on a negative watch list for further downgrades. Today, Moody's followed suit, also downgrading GM's bond rating, and S&P is considering downgrading it as well.

I believe the declining profit margins that the rating agencies cited in the downgrades are a very valid concern, and I addressed it last week. The issue of rising retiree benefits obligations is not a new issue; it's been hovering over GM for a long time. In fact, last year, GM contributed $18 billion to its defined benefit plan (most of which it borrowed).

However, GM's defined benefit plan is still underfunded by $8 billion. To make things worse, the return assumptions that GM used to arrive to the value of the plan assets is 9% (it was reduced from 10% last year). On the surface, 9% doesn't look unreasonable, however, one has to take into account that a large portion of GM's workforce has either retired or is about to retire. Thus, a significant part of plan assets should be in lower-earning (especially now) fixed income instruments, which it is.

According to GM's 10k, current asset allocation is 49% in equities, 31% in debt, 8% in real estate, and 12% in other. Even if the returns from equity and fixed income markets during the next decade resembled returns that were observed during the last century, with the current asset allocation, a 9% return is still not achievable (considering that allocation to the fixed income portion will be rising over time). In addition, stock market returns for the next 10 years are expected to be lower than the historical average due to currently high equity valuations.

At some point in the not-so-distant future, after frustration with disappointing returns, GM's actuaries will lower return assumptions and GM will have to cough up an additional several billion dollars to fund its defined benefit plan. Unfortunately, as it usually happens, it will be the time when those billions will be desperately needed to make interest payments. I always tell my students that the automotive sector is the second worst industry after the airline industry. Well, not surprisingly, it is very likely that the bankruptcy and pension problems the airlines are facing today will be GM's problems several years down the road.

Note well: GM is not a Lone Ranger when it comes to giddy assumptions on asset returns, so for long-term investors, I strongly recommend reviewing assumptions made for discount rate, compensation rate of increase and long-term rate of return. One should ask how reasonable it is for the company to achieve those assumptions.

Vitaliy N. Katsenelson, CFA Copyright

Wednesday, October 06, 2004

The Perfect Storm Is About To Hit Automotive Stocks

October 6, 2004 - Street Insight

  • Rising interest rates, incentives, and declining profit margins are swirling around the automakers.

The perfect storm is brewing on the horizon for the automotive industry and, unfortunately, the industry will be unable to dodge it. It will have dire consequences on this already over-leveraged, mismanaged and over-unionized industry. So far, the autos have been able to postpone their date with destiny and even managed to maintain profitability, however this postponement was largely driven by incentives that carry a heavy price: future profitability. The three components of the storm are: rising interest rates, incentives, and declining profit margins. Low interest rates won't remain low forever. Aside from the mortgage and housing industries, I cannot think of another industry that has benefited as much from the low-interest-rate environment as the automotive industry. Several days ago, General Motors (GM:NYSE) announced six-year 0% financing for its trucks and SUVs (Ford (F:NYSE) followed with similar promotions promptly), thus saving the consumer $6,645 over a six-year period on a $35,000 SUV (assuming 5.9% interest rate that the consumer would pay otherwise). Since the consumer is leveraged, overleveraged and then leveraged some more, GM had to stretch its loans to six years thus making their more expensive vehicles more affordable to consumers. However, six-year loans created a substantial problem for the automotive industry in the long run -- consumers will likely hold on to their cars longer. Thus, this selling tactic is stealing from future sales for years to come. A lot of hopes in the automotive world are placed on the improving economy. However, an improved economy will bring higher interest rates, hurting an already feeble consumer, which in turn will offset any benefit gained from an improved economic climate. Also, higher interest rates will make 0% finance subsidies more costly to auto companies, in the absence of which demand would definitely suffer. Incentives will have a lasting impact on consumer behavior. Automotive manufacturers are giving out incentives as if they were going out of style; well, actually 2004 cars are going out of style. My coworker just bought a 2004 Ford Explorer and received $8,500 worth of incentives, which is close to 25% of the $34,500 sticker price. In addition, she was able to finance it 5.9% for six years, which is still a very low interest rate by historical standards. Incentives are very addictive (though I don't expect tobacco-like lawsuits anytime soon) and will be impacting consumer behavior for a long time. Incentive abstinence will be driving demand down unless automotive companies can do something they have not done in years (especially the big three): come up with innovative cars that consumers want to buy in the absence of promotions. Incentives are also having unintended consequences on the used-car market, accelerating depreciation of used cars and making leases very unappealing, a very important factor since leases have gained popularity with the consumer over the last five years. Margins will be compressing from the changing product mix and rising costs. High gasoline prices are pushing consumers to smaller and cheaper cars, which are a lot less profitable for automotive companies than gas-hungry SUVs and trucks. Federal Reserve data suggests that the average price of vehicles financed has dropped to a 16-month low. If that was not enough, automotive companies are facing substantial price inflation on three fronts:

  • Oil prices. Dow Chemical (DOW:NYSE) the (largest supplier of plastics and adhesive to the auto industry) has demanded 25-40% price increases from its customers, citing that it cannot cut costs fast enough to compensate for rising oil prices. Dow threatened that if customers do not amend long-term contracts, it will cut R&D for those customers' products.
  • Steel prices have doubled since January due to enormous demand from China. It is very unlikely that long-term contracts that have protected this industry in the past will remain intact this time.
  • Healthcare costs - automotive companies will have a hard time fully passing rising health care costs on to their employees due to the very contentious relationship they have with their unions.

The three major forces mentioned above have created a perfect storm. It has been in the works for a long time and we believe the magnitude of its impact on automotive companies and their suppliers will be very dramatic. The high-fixed-cost nature of the business will encourage those companies to keep the incentives going even at the point where they are losing money on every car sold. On the other hand, losing money is something to which the auto industry is very accustomed .

Aside from the attractive dividend, I cannot see a single reason why anybody would want to own automotive stocks and especially in this environment (our company, through the 25 years of its existence, has never owned an automotive stock). And though the dividend looks very secure right now, earnings do not, so if you have not checked your automotive stock lately, check again. Side note: Looking through GM's financials, GM is losing money in the manufacturing segment, as all of its profits come from its finance arm. I am not sure what impact higher interest rates will have on its finance subsidiary, however, if owned the stock I would definitely want to find out.

Vitaliy N. Katsenelson, CFA

Copyright 2004