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

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