Monday, July 25, 2005

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. / By region / Asia-Pacific - Small telecoms market means NZT is nearly alone in its field Vitaliy N. Katsenelson, CFA

Friday, July 22, 2005

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

July 22, 2005 -
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 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.

Monday, July 18, 2005

RX - Still a Gem, Just in the Wrong Hands

July 18, 2005 -
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 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 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.

Wednesday, July 13, 2005

Why I am still in love with Abbott

July 13, 2005 - / 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 2005