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.