This blog dissects Wall Street by providing readers to some of the best articles and insight available on the web. The site will also discuss the University of Chicago GSB experience and matters related to the MBA community.
The M&A markets remain hot and Goldman is atop the league tables. The buyout bonanza is a large part of the enormous fees that investment banks are reaping.
posted by Chicago2008 @ 5:20 PM
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Interesting speculation of match rigging at Wimbledon. Check out the aticle.
posted by Chicago2008 @ 1:36 PM
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Here is the complete Barron's Roundtable from a few weeks ago.
Second-Half Outlook
What happens next? We're glad you asked. And who better to supply the answer than the members of the Barron's Roundtable? Our midyear update features the investment insights -- and specific stock picks -- of the same 12 market luminaries who grace our annual Roundtable, which last convened Jan. 9. For "The Midyear," as we call it, we rang up each and every one, dutifully recording their divergent views of the economy, the stock market and the Federal Reserve's new man on the spot, Ben Bernanke. On one thing, however, our experts all agree: The shares of many good companies haven't been this cheap in ages.
Consider this your survival guide to the next six months and beyond. Read it, and keep.
ART SAMBERG
Art, is the market doomed?
Samberg: It's going to be ugly until a clear macro environment emerges -- that is, until Mr. Bernanke has enough hard data on what's going on to make clear what he should do next. I recently met him, and there is nothing unclear about this man. People are confusing his clarity with their uncertainty. Bernanke is focused on the risk of long-term inflation. You can measure the fact that steel prices are back up to $650 a ton, world growth is continuing and energy prices are staying sticky high. Bernanke is a very data-driven man, and he's looking at tons of data on the housing market, 10 or 15 different indicators. The rest of us can have flights of fancy about what's going on, but he's handling this as a serious policy-maker should. He's not going to ease until the data say the housing market and economy are weak. Could he do it wrong? Sure, but to say he's unclear about what he's doing is nonsense. Until the data show clarity, we're going to have one cruddy market.
It already is cruddy, Thursday's stampede excepted.
The only people doing well were those who had made bets in areas benefiting from global growth, which is now being called into question because of U.S. monetary policy and foreign central banks' draining of liquidity. People who had bravely stayed in the leaders have seen their year disappear, and now they're into risk control. They're selling the very stocks that helped make them. As a result, the weakest stocks have the best fundamentals.
![[paneists]](http://online.barrons.com/public/resources/images/BA-AE894A_RT_Pa_20060616192414.gif)
That's good news for people with cash to spend.
You got it. I'd like to re-emphasize Foster Wheeler, which I recommended in January. This is an architectural-engineering company that makes steam boilers and similar stuff. Business is the best it's been in 30 years, and prices are going up. Anybody focused on supplying capital equipment for an area of the economy that has been starved for 30 years is doing extremely well. There is a shortage of engineers and capacity, and the stars are lined up. Yet, the stock is down.
Any particular reason?
More sellers than buyers. Hedge funds are trying to get flat. The stock is owned by a bunch of us, and everybody's in risk-reduction mode. It is relatively thinly traded and it just got puked. It's a good time to buy it.
I also like ABB, which is in power and architectural engineering. They're all over the world. They have a 40% to 50% market share in their businesses, especially in transmission and distribution. The developing world needs this stuff, but the U.S. also is underinvested in electrical-power infrastructure. The company thinks the U.S. market could grow from $5 billion to $10 billion over the next few years. ABB could earn about 80 cents this year, and the stock sells for 11. Next year it could do a little over $1, and as much as $1.50 in 2008. All these companies had trouble in the 1990s because nobody spent on power and infrastructure. Foster Wheeler and ABB both did stupid things. They bought a bunch of non-core businesses they later had to get rid of. So they're turnaround stories with ballistic demand.
Anything else?
I get my best ideas from Barron's, so I'd like to reinforce the bullish case you made for Micron Technology a few weeks ago ["Micron's New Muscle3," June 5]. Micron used to be strictly a DRAM company. Now they're moving into image sensors using CMOS chips. The percentage of sales coming from the core commodity business, which six years ago at the top of the bubble was 90%, now is about 60%. By August it should be 40%.
Two things are happening. People are not bringing on capacity as fast in the commodity-PC DRAM business. It still grows, but it's a smaller part of the business. And at some point, maybe some decade, Microsoft [ticker: MSFT] will launch Vista. Whenever you have a new operating system, it's a memory hog. So Micron's core business might see some better growth next year because of Vista. They've also got a deal with Intel [INTC] to make NAND chips that Intel markets, and they're making 40% margins on these CMOS image sensors. The whole mix is going in the right direction, and the stock is selling for only 1.6 times book value, with a P/E [price-earnings ratio] of 16 times 2007 earnings estimates.
| Company | Ticker | Price 6/14/06 |
| Foster Wheeler | FWLT | $37.57 |
| ABB | ABB | 11.02 |
| Micron Technology | MU | 15.26 |
| Oracle | ORCL | 13.19 |
How does tech look generally?
It's had a round trip this year, but I think tech's OK. A lot of new applications are going into consumer-oriented products, not industrial products. Oracle, for instance, is in a period of consolidation. They've got a new product offering. A lot of industries that hadn't spent on technology are upgrading their plant and data systems, and a bunch of newcomers are starting to spend some money. So things are improving. We like Oracle. I still have the utmost confidence in everything I recommended in January. The market is going to be sloppy through the summer, and then will rally strongly. For next year, all bets are off.
JOHN NEFF
John, your beloved home builders have taken it on the chin. Have you sold or are you hanging on?
Neff: Hanging on, though I sold a fair hunk of stock when they were happy. But I bought them back, and they continue to go down. D.R. Horton is down 35% and KB Home [KBH] is down 36%. Horton, in particular, is in a pretty good position to handle the challenge. The market seems to have overlooked the fact that a correction in housing is occurring in the 40% of the country where things were super. The other 60% is plugging along.
What do you make of the rest of the market?
It's OK. Corporate profits are set to rise 8% to 10% this year, and I'm looking for the same next year. The economy is growing by 3%-3½%. Wage increases are moderate. You're getting some increase in prices here and there, and productivity continues to be good. With the S&P 500 at 14 times next year's earnings, the stock market isn't exactly a giveaway, but look at the alternatives. Commercial real estate has been wrongly exploited beyond the fundamentals. And who wants to buy bonds? At best, all you'll earn is the coupon -- on long governments, 5%. That isn't very good, relative to a market that will give you 8% to 10%, plus 2% on dividends. People forget the yield.
It's looking good these days.
Aside from the home builders, my biggest holding is Citigroup. The market is coming around to some of the big guys that have something to offer and are reasonably priced. I like Citi. The stock is around 50. I've got them earning about $4.50 this year. The pundits have $4.30 or so, but they are overlooking a lot of things, particularly stock buybacks. First-quarter earnings were up about 4%, but earnings per share were up 8%. Citi has been buying in a slug of stock, which helps earnings per share and supports the shares.
Like you, the company sees a bargain.
It is entrepreneurial and has economies of scale. Another plus: There's no new bankruptcy law this year, unlike in 2005, which helps their credit-card business. One thing the market is overlooking is that about a third of Citi's earnings are from emerging countries. For shareholders, it is a cowardly way of investing abroad. The market is very happy, or was until recently, with the stocks of those same countries. Also, overseas, there are economies of scale.
What will it take to re-energize the shares?
Citi has done better in recent months and it's always a subject of conversation. The market will relate to it at some point, as it demonstrates the utility of a 12% growth rate, plus a 4% yield. That's a 16% total return, at a little over 10 times earnings. Hell, that's awfully reasonable. At some point, the stock goes up maybe 10%.
How about a new idea?
Lyondell Chemical has come a long way. The stock is around 23, and the company is going to earn four bucks this year. It sells for an astronomical 5.7 times earnings and has a 3.9% yield. It was spun out of Atlantic Richfield in the late 1980s, and is probably the third-largest chemical company. It's pretty broadline. The market effectively has dismissed it as just another cyclical, but the difference between this and your standard copper or steel or nickel company, or whatever you are beguiled by, is that there's still some growth in the chemical industry. When I came into the industry over 50 years ago as a chemicals analyst, the DuPonts and Union Carbides and Dow Chemicals were bank and institutional-investor favorites. They sold at 20 times earnings. The growth in chemicals isn't as remarkable as the growth in some areas of technology, but it's a lot better than some other businesses, and the industry hasn't spent much money on capital expenditures in recent years. It's operating pretty close to capacity in a lot of chemicals.
Many people would agree with me that Lyondell will earn $4 a share this year. But they would not agree with my forecast for next year, when I've got them earning $4.40-$4.50. The economy is OK, and if anything, supply and demand relationships could tighten a bit. Lyondell also has improving financials. Their debt is not investment-grade, as they're highly leveraged, but they have been paying down debt in the last 18 to 24 months. They'll have about $7 of cash flow per share this year, and they're about to become investment-grade.
If that isn't enough, they've got a refinery in Houston, the eighth largest in the country, which utilizes high-sulfur oil coming out of Venezuela. They own 59%, and Venezuela owns 41%. They put it up for sale, and it will probably go for $4 billion or $5 billion. They'll get almost 60%, which immediately makes them investment-grade. With the excess cash flow, they are thinking about buying in stock and raising the dividend.
Have they suffered much from higher oil prices?
Because of tight supply and demand, they have been able to pass along higher costs. Crude prices will come down to $55-$60 a barrel from $71 or so. There is plenty of oil, and most of OPEC is willing to produce. Saudi Arabia has available crude, but a lot of it is high-sulfur, so-called gunk, which sells at a nice discount. Refiners like Lyondell and Valero Energy [VLO] can get good margins.
My next stock is YRC Worldwide, the former Yellow Roadways. It hasn't done much since I talked about it in January. It had a disappointing first quarter, which took the stock down 15% in one day. The Wal-Marts of the world were taking down their inventories in the quarter, and accordingly weren't shipping as much stuff. The first quarter is the poorest seasonally, which exaggerated the impact. I expect the company to earn $5.75 a share this year. The stock is 38.60, or about 6.7 times earnings.
| Company | Ticker | Price 6/14/06 |
| Citigroup | C | $47.80 |
| Lyondell Chemical | LYO | 21.77 |
| YRC Worldwide | YRCW | 38.73 |
| D.R. Horton | DHI | 23.67 |
What does YRC do?
It is one of the nation's largest truckers, with 60% of the long-haul, less-than-truckload market, and about 200 terminals around the country. This allows for economies of scale, particularly as the company makes acquisitions. They get about a 15% return on equity. Someone needs to take imported goods from our ports and distribute them through the retail chain. YRC does that. The company is out of favor with investors. Despite its scale, it has only a $2.3 billion market cap. With all the private-equity capital around, something like this, or even Lyondell, could come into buyers' sites.
YRC is union, which is a disadvantage, except that it is hard to get truck drivers these days. Therefore, the difference between union and nonunion pay has narrowed. Also, they are somewhat leveraged, two-thirds equity and a third debt. They acquire other companies with debt, which builds up. YRC has to deliver, but I think it's going to. At some point, the market comes around.
Is that your take on the home builders, too?
I'm still recommending D.R. Horton. It will earn $5.25 a share in the year ending September. The stock is 23, down 45% from its high, which would put it at 4.4 times earnings. The company's got good internal generation, and has been using cash flow to buy land. But they have six years of land now, and have said that at some point they'll use the cash flow to buy back stock. When that happens, the stock will move up 20% in three days. The current quarter is a tough one for the industry, and everybody and his brother is pre-announcing a 29%, 30%, 35% drop in orders unitwise. But some areas of the country have not thrown in the towel on housing. Texas and the South, I'll bet, are down a lot less than 30%.
FRED HICKEY
What an ugly market, Fred. No doubt, you expect the misery to continue.
Hickey: That is correct. If you are bearish on the market, as I am, the ingredients are perfect. Instead of the Goldilocks environment people were celebrating just a few weeks ago -- not too hot, not too cold -- investors now are worried about stagflation, and rightly so. There are also cycle problems, such as the four-year stock-market cycle. You have rising interest rates and less liquidity around the world, $72 oil and an untested chairman of the Fed, with questionable inflation-fighting credentials.
At least he's talking tough.
We'll see if he acts tough. You've got a declining dollar and a housing collapse, too. All this could lead to a pretty typical September-October slide. We could see 9,000 on the Dow and a 15% drop in both the S&P 500 and Nasdaq.
Any chance you'll turn bullish after that?
I would like to, if valuations are intact. I could turn bullish in the short term, at least.
Which of your litany of woes is most serious?
The higher-interest-rate/lower-liquidity scenario, and the housing market, which is imploding. The latest data indicate a 30% increase in inventories of existing homes for sale and a close-to-30% increase in new-home inventories. There's about six months of inventory on hand and seven months for condos, which is pretty scary.
| LONG | ||
| Company | Ticker | Price 6/14/06 |
| Newmont Mining | NEM | $48.59 |
| SHORT | ||
| Company | Ticker | Price 6/14/06 |
| OmniVision Technologies | OVTI | $25.50 |
There hasn't been a consumer recession in 15 years. In order to sustain spending, the public dipped into home equity, pulling out an estimated $750 billion last year. A drop in home prices will put a lid on consumers' ability to tap that equity. That's bad news for technology, for sure. Tech stocks have been miserable performers this year, even with the strength in end markets. PC [personal computer] sales have been in an upcycle for three years, and cellular-phone sales have been extraordinarily strong. Heaven help the sector when unit sales start dropping, which could happen in the second half.
Let's have some picks -- and, naturally, pans.
Newmont Mining is by far my biggest position now. Gold is in a long-term bull market, whereas tech is in a long-term bear market. At the January Roundtable I recommended gold ETFs [exchange-traded funds]. When gold went over $700 an ounce, I sold much of the position but jumped back in via mining stocks. Gold has had a 24% move, yet Newmont is down on the year.
Isn't the problem largely political?
Investors were concerned about the possibility of nationalization of mines in Peru, where Newmont has a large operation. With the recent election of Alan Garcia as president, instead of Ollanta Humala, a lot of the pressure has been lifted. Garcia is not a nationalizer.
Normally, mining stocks rise two to three times faster than the price of gold, but in Newmont's case higher costs have kept earnings down. That is starting to change as the price of gold goes up. Plus, the company has three new mines coming on this year, two in Nevada and one in Ghana. For the first time in quite awhile, Newmont is going to benefit from lower costs and new production. I like the company's oil-sands investments, which haven't been reflected in their results. And I like management. In the past two years Newmont has had huge moves, starting in May. The stock is around 51 now.
How high can it go?
To 75-80, at least, depending on the price of gold. With gold up $100 an ounce this quarter, that's pure profit. Earnings estimates are much too low for this quarter and next. Newmont earned 37 cents a share from operations in the first quarter, and analysts think they'll do 46 cents this quarter, but in fact they'll do more than 50 cents. Sentiment will change as earnings take off.
What else have you brought us?
We are short OmniVision Technologies, a leading maker of image sensors used in digital and cellphone cameras. The stock has gone from 20 to 30 this year, but the market is very competitive. There are about 40 makers of such sensors. Micron Technology has come from nowhere in 2003 to $600 million in the past six months, and is now No. 1. The chip makers are attracted by the industry's gross margins. Samsung and Toshiba also are moving in. I don't know how OmniVision can compete with that kind of manufacturing muscle. In addition, the digital-camera market is slowing. A big squeeze is coming, probably in the second half of the year.
What do you think of Microsoft? The CEO, Steve Ballmer, recently got a cool reception on Wall Street.
A lot of value buyers have been probing Microsoft, and that's not a bad idea. Relative to everything else out there, it's a good idea. The problem might be timing, because the results probably aren't going to get better until next year or even 2008, when the new Vista operating system becomes more of a certainty. Microsoft still hasn't admitted to that. The beta version just went out, and there are a lot of problems with it. This is not good for the PC market, which is their primary end market. We're likely to see a slowdown in PC sales ahead of Vista's launch, especially with the economy and the consumer slowing. Also, Microsoft has to spend a lot, battling Google [GOOG]. That's not good for 2006 either.
I wouldn't buy the stock here [at 22 a share] because I think it's going lower. But that would set us up for a nice buying opportunity later this year. When I turn bullish, the first thing on my Buy list might be Microsoft, because of its tremendous cash flow, strong market position, dividend and the possibility of another special dividend. Plus, the company is making big inroads in the videogame-console market. The Sony PlayStation 3 coming out in November is too expensive. This gives Microsoft an opportunity to gain share with Xbox. If it succeeds, it will make a lot of money on the related software. The value buyers aren't off course.
BILL GROSS
Interest rates are a good deal higher than you expected in January. What happened?
Gross: The global economy has been stronger than I expected. That strength is beginning to threaten the inflationary boundaries set by central banks. The U.S. doesn't inflation-target -- or doesn't officially, yet -- but the current level of core inflation is near the edges of what the Fed governors would like to see. Secondly, Fed tightening, which has been under way for two years or so, is only one part of the global liquidity spectrum. We must look not just to Bernanke but to the Bank of Japan. Despite the fact that the Fed has raised interest rates 16 times, by a total of 400 basis points [four percentage points], and now appears to be on the verge of a 17th rate increase, the BOJ hasn't even started. It has kept interest rates at zero for a long, long time, allowing the world to borrow at zero percent and invest in anything else with a return or yield higher than zero.
How long will it take, then, for all the world's central banks to finish tightening?
Liquidity is being withdrawn from the market. The U.S. is at the front end, the ECB [European Central Bank] is on the margins, and now the BOJ is taking some steps in the same direction. Typically, central-bank tightening is a 12-to-18-month thing. In concert, how far along are we? Maybe six to 12 months. The global slowdown is probably three to six months out. But it is coming.
And the U.S. slowdown?
Our economy is dominated by housing. The housing market has been very inventive in figuring out how to extend credit to new home buyers and existing homeowners who want to equitize and spend some of their profits. Mortgage bankers have managed to continue offering teaser loans at 1.5%, interest-only loans and 50-year mortgages. At some point it has to end, but so far they've kept the dream alive.
Housing works with a long lead time in its effect on the economy, and that's even more so now because adjustable-rate mortgages ratchet up slowly. Bernanke has an appreciation for this. The problem is, because the "funny money" mortgages are so new and so inventive in their ability to keep the game going, it is difficult to model exactly when they will have a significant impact. Bernanke is a classic modeler, so this is difficult territory for him, and for me and anybody who has tried to figure out where the Fed stops. Even if Bernanke stopped at 5%, the adjustables are going to keep adjusting in 2007 and 2008. For people like me, who suggested the Fed would stop around 4%, it's frustrating.
| Fund | Ticker | Yield 6/14/06 |
| iShares MSCI EAFE Idx Fund | EFA | 1.8% |
| BlackRock Glbl Floating Rate Inc Trust | BGT | 8.2 |
| Pimco Muni Inc Fund | PMF | 5.9 |
So, is 5¼ the magic number?
Well, yeah, because I thought they'd stop before rates got to 5%. The economy is slowing in classic fashion. The job market is looking tenuous. There comes a point when the Fed looks through six months' worth of inflation and says, 'We'd better stop now.' We're in that territory.
When it happens, will stocks have a huge rally?
Maybe, temporarily. My take on the stock market and risk assets, whether they be commodities or emerging-market debt or equities, is not dependent on 5% or 5¼% yields from the Fed. It depends on what the BOJ does, because they've provided literally a trillion dollars worth of credit to the world through their zero-interest-rate policies. I assume the Fed is basically done and the BOJ is beginning.
How will U.S. stocks fare over six to 12 months?
I don't think they go up. The economy will slow, but there won't necessarily be a recession. If the economy slows to 2% or so, profit growth will fall. Also, investors are beginning to sense a change in the political winds. In November we might have a split Congress. Tax policies are as favorable as they possibly could be for corporations. A few years down the road, they could change. The heyday of corporate profitability soon will be behind us. While stocks can still go up, there is no basis for them to rise as substantially as they might have in the late 1990s or the past two years. If the Fed makes a mistake or the softness in housing snowballs, we could see more downside. Additionally, how restrictive will the BOJ be?
Where do you put your money in this environment?
I recommended the iShares MSCI EAFE Index fund in January, and I still like it if only because it is not dollar-based. I am still bearish on the dollar. If investors want equity exposure, they should get it outside the U.S. and dollar-denominated assets. That's my best pick, though my reservations about the U.S. stock market might apply to the rest of the world as well.
I'm also a fan of some closed-end funds, particularly floating-rate bank-loan funds such as BlackRock Global Floating Rate Income Trust, another January recommendation. These funds benefit from higher short-term rates. Yields on the genre are in the 8% to 9% category, and are likely to remain there for at least 12 to 18 months. My third idea is closed-end muni-bond funds, such as Pimco Muni Income Fund. They've done fairly well relative to the rest of the market. Because these funds use a mild amount of leverage, they have tax-free yields that exceed the yield of the taxable U.S. Treasury.
How's Bernanke been doing?
He's off to a rocky start. I think Greenspan would have done it differently, but he was a rookie, too -- in 1987. So let's give Bernanke some time.
MARC FABER
What's next for the U.S. economy?
Faber: The Fed's policy options are limited. Since Bernanke was appointed Fed chairman in October, he has lost a lot of credibility. In November the price of gold was $480. It subsequently topped $720, and is now $620. [Gold fell to $580 after our conversation.] Commodity prices went up sharply, the dollar went down and bond prices sold off, reflecting concern in the investment community that he is a money printer. The economy probably already is significantly weaker than the statistics would show, particularly housing.
Bernanke could either keep increasing rates, which would support the dollar and lead to a bond-market rally and further stock weakness. Or he could recognize the economy is weakening, and pause or begin to cut interest rates. In that case, the stock market might have a modest recovery, but the dollar would get hit hard.
Which option will he choose?
The first, to regain credibility. From now until October or November, we will have unattractive asset markets. Commodity prices will continue to fall. Emerging markets, which have significantly outperformed the U.S. stock market since 2003, are especially vulnerable. It's payback time. As for the U.S., the S&P 500 now has huge resistance, between 1290 and 1320. The highs we've seen may well be the highs for the year. But U.S. assets have grossly underperformed assets in emerging economies and Europe since 2002, so for the next few months they could modestly outperform foreign assets.
| Pick | Yield 6/14/06 | |
| 2-Year U.S. Treasury | 5.12% | |
| ASIAN REAL ESTATE | ||
| Company | Ticker | Price 6/14/06 |
| Suntec REIT | SUN SP | S$1.18 |
| Macquarie MEAG Prime REIT | MMP SP | S$0.91 |
| Rojana Industrial Park | ROJANA TB | 10.70 baht |
| Ticon Industrial Connection | TICON TB | 15.20 baht |
| Thai Reinsurance | THRE TB | 4.60 baht |
| LONG: | ||
| Gold: Buy when price falls to $540-$580 per ounce | ||
| SHORT: | ||
| Copper | $3.20 per pound |
What happens after November?
Mine is a short-term call, but you never know, when markets begin to go down, how serious the downturn will be. Two-year U.S. Treasuries are not a bad alternative in this market. You're not going to become rich, but you're not going to lose money, either. Lots of stocks are modestly valued, but even these can go lower still as money flows out of emerging economies. If you must be in equities, you want very defensive stocks with relatively low valuations.
In January I mentioned several Singapore real-estate investment trusts, Suntec REIT and Macquarie MEAG Prime REIT. The Singapore dollar is strong, and the financial condition of Singapore is rock solid. You don't have large downside risk. I also recommended two Thai real-estate companies, Rojana Industrial Park and Ticon Industrial Connection. They've had big moves and now have sold off. The Thai market has been weak because the political situation looks bad, so stocks could be under further pressure. But these two companies are attractive at current levels.
What about gold?
If gold sells down to $540-$580, start accumulating it again.
And other commodities?
Industrial commodities have had huge moves. As the economy weakens, they are not attractive. The price of copper more than doubled since Mr. Bernanke became Fed chairman. From their recent peaks, prices easily could drop 40%. I would short copper, using the futures contracts.
On a relative basis, gold will do better than the Dow Jones industrials. On the one hand, if the Dow falls to 5,000 and home prices in America sink 30% and there are massive problems in the credit system, the price of gold will stay around $500-$600 an ounce. On the other, if Bernanke prints money in earnest and the Dow triples to, say, 33,000, we'll see gold prices between $5,000 and $6,000.
You have an active imagination.
Paper money has lost a lot of its purchasing power. It buys fewer goods than it did 20 years ago, and there are more losses to come. In the long run, with its exploding debts, the U.S. has no other option but to print money.
Going back to stocks, Thai Reinsurance shares recently eased by about 15%, and are in buying range. The Vietnamese market at one stage was up 100%. It's still up 77%. If it declines another 30%, I would consider increasing exposure.
SCOTT BLACK
Did the recent selloff surprise you, Scott?
Black: The biggest surprise is that the S&P could be down on the year, given that corporate earnings are rising by double digits and price-earnings multiples aren't all that high. Using $78.50 in earning for '06, the S&P is trading at a 15.7 multiple. The historic median is 14 to 16. This is the lowest P/E in 10 years.
The stocks that are cheapest are the ones getting blasted, like Apache [APA]. In the oil sector, people don't want to believe that $65-$70 oil is here to stay. For companies like Whiting Petroleum [WLL], which I recommended in January, you'd think the world was coming to an end. Yet, these companies are generating lots of free cash and have high returns on equity. Other than cash, there's been no place to hide.
How do you explain it?
First, let's take the other plusses. Unemployment is at its lowest level since the Bush administration took office. Home ownership is at record highs. But we were able to get away with the monetary punch bowl for a long time because we didn't have much inflation. Alan Greenspan was able to keep nominal interest rates low, and people backed out over $4 trillion on their mortgages to defend their consumption. Last year it was about $800 billion. So far this year it's about $250 billion. I'm not going to blame Bernanke. He arrived at the wrong time. But he's doing a poor job.
What would you do differently?
Bernanke reminds me of a first-year student at Harvard Business School. You go into the class. You take your nameplate. There are 80-odd students. They are all smart, competing for attention. You want to make sure the professor knows you, so you add to the discourse every day. Bernanke is smart but he has to prove he's smart. He doesn't know how to manage the press. He's got everybody focusing on the last piece of data. He talks too much. Like Greenspan or [former Treasury Secretary Robert] Rubin, Bernanke needs to say something that imparts confidence to investors.
Why is this all happening? Besides the fact that we have inflation, deficits don't matter, according to Mr. Cheney. Unfortunately, they do. We are running a $700 billion trade deficit and a fiscal deficit of over $400 billion. More than half of the $9 trillion accumulated deficit is owned by foreigners. If they demand higher rates, we're in trouble. The underpinnings of this economy are terrible. We're still getting a free lunch on interest rates. With an average interest cost of 5%, you're looking at $450 billion in annual interest expense alone. When Bill Clinton left office, we had a surplus as far as the eye could see. Today we're paying for the sins of the Bush administration's fiscal policy.
So stocks are cheap but the system is rotten at the core. What is an investor to do?
We try to buy good companies with high returns on equity and low multiples. I can't worry about the short-term vicissitudes in oil prices when I invest in Apache at 7.5 times earnings, or Whiting, which has a breakup value of 60 and a stock price of 37. Value will out. Today I like Arrow Electronics, which trades for 31. It has 123.5 million fully diluted shares and a market cap of $3.8 billion. Arrow and Avnet [AVT] are the two largest electronics distributors in the world.
Arrow's ROE is on the mend. Last year it was 11.1%. This year they'll do about 14.3%. Revenues in 2005 were $11.2 billion, though two acquisitions were not in the full-year numbers. If they had been included, results would have been $12.1 billion. Take that up 10% for '06, and they'll have $13.4 billion. We're using 4.8% operating margins to get you to $643 million of operating income. Equity in unconsolidated affiliates is $4 million-plus. Interest expense will run about $96 million, which gets you to a pretax profit of $551 million. After taxes at 34%, they'll earn $364 million, or $2.95 a share. It's got a P/E of 10.5. This is a poor man's play on tech.
| Company | Ticker | Price 6/14/06 |
| Arrow Electronics | ARW | $30.61 |
| Abercrombie & Fitch | ANF | 55.55 |
It is a lot cheaper than the companies it supplies.
It's a way to get tech without having to pay 18 or 20 multiples on a semiconductor and semi-equipment companies. And the balance sheet is clean. Stated book value is $20.41, but tangible book is only $11.67 a share.
My second name is Abercrombie & Fitch. We owned it at 23 and sold it around 60. Now it's in the mid-50s and we're buying it again. This company is a bank in the retail business. It has cash equivalents of $429 million and zero debt. The company last year made 40% on equity. The Abercrombie & Fitch division is for teens and young adults. It has 348 stores and attracts high-end consumers. The Abercrombie division, with 161 stores, is for kids. Hollister, with 327 stores, features the California surfer look. That's where the big rollout is coming. Hollister is going to add 70 stores this year. The average store is 6,500 square feet and the average price point is 70% of A&F's prices. Finally, Ruehl is a new chain.
Give us the numbers.
For '06 I'm taking revenues up 15% -- 11% on square footage, 4% on comparable-store growth -- to $3.2 billion. Operating margins will improve to 19.5% from 19.3%, giving you $624 million in operating income. Interest income is $23 million, which gives you pretax income of $647 million. The tax rate is 39.2%, and earnings per share are $4.40. At current prices, you're paying 12.5 times earnings. It's a terrific business. Last year they did $65 million in free cash. We're not projecting the moon with big comps, just 4% comparable-store growth.
How high could the stock trade?
American Eagle [AEOS], which I also like, trades for 16 times earnings. Put a 16 multiple on Abercrombie and you've got a $70 stock.
FELIX ZULAUF
It's been the best of times and the worst of times.
Zulauf: I'm not sure it's the worst of times yet, but it is pretty ugly. In January the hope was we could sidestep the four-year presidential cycle, which calls for a bear market from spring to fall in the midterm year. I thought we could sidestep it because inflation would not be a major problem, and therefore central banks would not be crunching the market. That is usually the trigger for a bear market, followed by a recession.
| Pick | Yield 6/14/06 | |
| 3-month Treasuries | 4.89% |
Central banks around the world are somewhat more hawkish these days. Everyone is looking at the U.S. central bank, but the key development took place in Japan. Through quantitative easing, the BOJ at the margin has been the biggest liquidity generator for the credit system and financial markets of the world. In late March it announced the end of quantitative easing and said it was targeting a neutral bank-reserve position, with reserves of about six trillion yen. At that time reserves were ¥30 trillion. Now they're ¥13 trillion. In dollar terms, the BOJ withdrew $200 billion.
That's a lot of dough -- and yen.
It came at a time when bank-loan growth was accelerating for the first time in years. The banks first had to sell their JGBs [Japanese government bonds] to raise liquidity. Then they had to sell U.S. Treasuries. Third, they bought back yen and changed them into dollars. This was the trigger behind the bond-market and dollar weakness in April and May. It started with the currency, really.
And the stock market's weakness?
These days huge amounts of money are managed according to what is called value at risk. As volatility shoots up, such investors have to shrink their books, and that is what we're going through. The long-only guys haven't moved yet, but the more aggressive money has been selling.
This comes at a time when global economic growth is peaking. The central banks are misjudging the economy. They believe, particularly in Europe and Japan, that economic expansion is self-supporting. Therefore, they will hike rates and stay hawkish. Unlike the markets, however, which think inflation is a major risk, I believe the risk is big disappointments in economic growth, and therefore lower earnings. Estimates will be cut. This is not a P/E correction. It's an E correction.
When will world economies start to roll over?
In the second half of the year in the U.S., and probably a little later in Europe and Japan. The weakness lasts well into 2007. The bear market in stocks probably will be a six-month affair. I don't know whether we'll have a market meltdown, or big swings in volatility that will leave us lower late in the third quarter or early in the fourth.
And after this setback?
Central banks will realize they've overdone it, and that inflation is not the risk. They will change course and start easing. Usually at the end of the correction there is some sort of crisis. A big company goes belly up or a leveraged player is in hot water. When it happens it will mark the end. Then you can return to the assets that have done so well in recent years, particularly equities in emerging markets, infrastructure plays, natural-resources stocks and commodities, which will also correct. So we'll have a classic bear-market cycle, but compressed in time. These are usually brutal.
How many points will it cost the S&P and the Dow?
The U.S. market probably will fall the least, because it hasn't done much on the upside. We haven't seen the same kind of froth as in riskier, less liquid markets, which will fall harder. The major markets in Europe could fall 20%-plus, the U.S. a little less and Japan a little more. Emerging markets could go down, on average, 30%-plus. I do not believe this is a major bear market that will carry on for years, although there are risks out there nobody is talking about, like housing and major imbalances in the financial system.
How should investors position themselves for the next six months?
The average investor should seek shelter in cash -- say, three-month Treasury bills -- and aggressive types should play the market from the short side. With stocks down more than 10% over the past three weeks, however, now is not the time to step in with a short-sale recommendation. Also, at some point there will be a rally in the bond market. Bonds have very little risk here, but they're not ready for a big rally yet, because the banking system is under a bit of stress and banks need to sell some bonds. Sometime in the summer there will be a great rally in bonds. But it's a trade, not an investment.
In January, Felix, you liked gold and nickel. Give us an update, please.
Gold probably has completed the first up-cycle in a secular bull market. It has corrected by over $100 an ounce. We need time to repair the damage, and a trigger for the next cycle, which will be a reversal of central-bank policy that will come later this year. Also, there's a seasonality to gold stocks, which typically hit their lows in August and rally into the new year. I'm still a believer in the long-term bull market in the stocks, as well as bullion. At these levels I would stick with them.
Nickel is similar. The fundamentals are fine, but with the deceleration in world economic growth, nickel will correct. It has not been frothy, unlike copper or zinc, so the risk is relatively low. Norilsk Nickel (NILSY), which I recommended in January, is half-palladium, half-nickel. It is affected by the emerging-market decline, but I like the idea long term. I also recommended KarstadtQuelle, the German retailer, in January, at 15 euros a share. We sold it in the low €20s, and it's now €21-€22. Much of the promise of the turnaround has been realized, and it's not a cheap stock now.
Thanks for the update.
OSCAR SCHAFER
Where do we go from here?
Schafer: As far as the U.S. economy is concerned, it's important to see what happens to housing. If prices don't decline much, the wealth effect will stay intact. But if the recent decline in orders from major home builders translates into a sharp decline in housing prices and sales, then the long-awaited bubble will hurt the economy. Perhaps the Sandlers' sale of Golden West Financial tells what at least one smart couple feels about the housing market's future.
Good point, Oscar.
Americans have extracted something like $839 billion annually in mortgage equity from their homes. That's will help consumer spending. Business still is good except for housing and housing-related stuff. At the beginning of June retailers did pretty well, although there are some soft spots. Also, oil demand seems good around the world. The stock market is forecasting a worse business environment than I perceive. I don't know whether the stock market is telling us something or not. That's the conundrum.
| Company | Ticker | Price 6/14/06 |
| Kos Pharmaceuticals | KOSP | $37.00 |
| Dresser-Rand Group | DRC | 19.06 |
If I were a consultant and Ben Bernanke were the CEO, and he asked me what to do, there would be no question in my mind that I would tell him to tighten because he's got to be seen as a hawk on inflation. The data is iffy enough so that he can err on the tough side, and if the economy cools he can reverse. He's got time to act because there is a six-to-12-month lag between what the Fed does and how the economy reacts.
Are you buying into the selloff?
We're finding good values, which, frankly, keep going down. For the past two months, stocks that are attractive have been getting more attractive. It's a buying opportunity for us. It's about six months through the year, but it feels like it's been a year and a half.
Let's talk about some of those good values.
Kos Pharmaceuticals is a specialty pharmaceutical company, but the core of its portfolio is focused on the cardiovascular market. Kos' flagship drug, Niaspan, an extended-release prescription formulation of niacin, which was approved and launched in 1997, targets the treatment of cholesterol disorders by raising HDL, the good cholesterol. Niaspan has a strong efficacy profile showing significant reductions in cardiac events. Kos is working on Simcor, a combination of Niaspan and simvastatin, for which the company expects to file an NDA [new drug application] in the first half of '07, with the launch expected in the first half of '08. Simcor combines the benefits of raising HDL and lowering LDL.
Are there any side effects?
Niaspan often causes flushing, but it is easily managed by taking an aspirin or anti-inflammatory 30 minutes before taking Niaspan. But few people comply, and it's made it hard for them to grow. In fact, sales have flattened out around $500 million, but Kos recently developed a new version, Niaspan MF, which reduces the severity and duration of flushing. This product could be launched in '07.
Part of the slowdown in Niaspan sales also was due to uncertainty surrounding Medicare, but that's been cleared up. Also, the product is being sold by Takeda, the Japanese pharmaceutical company, and their agreement ends this year. So Kos is building up its own dedicated sales force. In the meantime, there's not much incentive for Takeda salesmen to sell the Kos product, when they know at the end of the year they won't have it.
Will the company form a partnership with another distributor?
As of now, they are going to do it on their own. They also have a respiratory franchise with a product called Azmacort, and they've licensed a new product called Flutiform. It's a metered-dose inhaler for asthma. The market potential for this is huge, ranging from $500 million to $1 billion, but it won't be out for a few years.
Kos is cheap because people are worried about Merck [MRK], which has announced a triple-combination drug going after the Niaspan franchise. But Merck has already had delays. The triple combination is difficult to formulate. I don't believe Merck will have much of an impact on them.
Where is the stock trading?
It's around 40. At the end of the first quarter, Kos had more than $9 a share in cash and no debt. It should earn $2.75 a share in '07, excluding stock-option expense of 55 cents, which would represent a 12 multiple, adjusted for the cash. Most specialty-pharmaceutical companies are trading for 20 times 2007 earnings. Kos' board, realizing the attractive investment that its own stock represents, recently authorized a share-repurchase program for up to seven million shares, representing around 15% of the current shares outstanding. This company could be a compelling acquisition or partnering opportunity for a large pharmaceutical company, which would be able to leverage the core cholesterol franchise as part of a strategy in the cardiovascular market.
Has it had any inquiries?
I don't know. I'm sure people have it on their screens, but I doubt the founder, Michael Jaharis, would want to sell. I would advocate he partner, because at these prices it would be accretive for virtually any large pharmaceutical company that also could realize sales synergies. The stock is under the radar screens of a lot of people.
Not any more!
My next name is Dresser-Rand Group, a manufacturer of large-scale compressors and turbines. It serves all three sectors of the oil and gas industry: exploration and production, refining and petrochemical. It has the largest installed base of compressors and turbines in the industry, about 40% of the market, which provides it with a source of recurring, high-margin aftermarket revenue from parts and services. Approximately 50% of the company's revenue and 85% of operating profits come from the sale of aftermarket parts and services. This business requires little capital to grow and deserves a high multiple because it is a growing annuity stream. The aftermarket business currently services about 50% of its installed equipment base.
Sales of new equipment historically have occurred at a low margin. This is like the razor/razor-blade model. However, prices are beginning to rise, thanks to a tightening in global fabrication and capacity utilization. Dresser will be able to capitalize on this opportunity, given that it has access to spare capacity from its manufacturing outsourcing arrangements. We expect units to grow by double digits over the next few years.
What does this mean for earnings?
Analysts are looking for earnings per share of $1.60 in 2007. But there is approximately 40 cents a share excess of depreciation and amortization, versus maintenance capital expenditures. Current estimates are conservative and do not take into account increased pricing, lower interest expense and the impact from operating leverage in both segments. At about $20, or 10 times 2007's after-tax free cash flow, the shares are way too cheap. Free cash flow could be as high as $2.50 a share in '07, and the stock could sell above 30.
ABBY JOSEPH COHEN
What has been killing this market, Abby?
Cohen: Investors are having a delayed and dramatic reaction to things they should have been thinking about sooner. Interest rates in the U.S. troughed 16 Federal Reserve rate increases ago. Core inflation troughed 18 months ago. There have been several important inflection points in the market. For one, the source of economic energy in the U.S. is shifting away from the consumer to the industrial side of the economy. For many months we've been advising clients to focus on technology and industrials, and to be very careful of the consumer and interest-rate-sensitive issues. We've also been telling them for a year to tread carefully in fixed income, as intermediate and long rates should have been higher than they were. Now, though, the pendulum has swung too far in a negative direction.
Does that mean it's ready to swing back?
First, let's talk about where fair value is. To determine that, we make several assumptions. The first is the move from consumers to the industrial side of the economy. No. 2, the economy is slowing. First-quarter growth in gross domestic product of 5.3% is not sustainable. By the end of this year GDP growth may slow to 2½%-3%. As the U.S. consumer slows, the rest of global economy is becoming more vital, which is good news. No. 3, the Federal Reserve is almost finished raising interest rates. While investors are anxious about another increase of 25 or 50 basis points, the Fed has raised short rates quite a bit, and the rates on intermediate and long bonds are close to where they should be.
| Company | Ticker | Price 6/14/06 |
| Marvell Tech Group | MRVL | $48.73 |
| eBay | EBAY | 30.66 |
| Qualcomm | QCOM | 43.25 |
Finally, we use a dividend-discount model to figure where fair value would be if the market were to move toward equilibrium. We peg long-term earnings growth at 6% to 6.5% for the S&P 500, which is below historical trend. We've plugged in a 5.5% Treasury yield, which is 50 basis points above the current rate. And we've plugged in a core inflation rate of 3.5%, which is well above the actual number.
In other words, you've assumed a worst-case scenario.
Correct. Using this model, we get 1400 on the S&P 500. When investors calm themselves, the market should move higher. The question is when, and I'm not sure. Valuation models are not timing devices. Investors need to recognize that the step-up in volatility was a long time coming. In the past three years the standard deviation of daily price change in the S&P has been running about 10%, well below the normal range of 16% to 18%. Also, the economy will slow but there will not be a recession. Profit growth will decline, but from abnormally high levels. And the Fed already has done a lot, though we have not yet seen the full impact.
Our economics department has said for more than a year that when the economy slows, most of the slowdown will come from a rise in interest rates and the impact on the housing market. We are not expecting a housing-market collapse, though we're concerned that mortgage equity withdrawals are really slowing down. Many families, particularly middle-income families, were taking advantage of lower interest rates to refinance continually and take equity out of their homes. With rates moving up and home prices no longer rising, such withdrawals no longer are going to provide as much fuel. As a result, there will be much less support from consumption. But it is not a bad thing for consumer spending to decelerate and the savings rate to start moving higher.
What sort of stock advice are you giving investors now?
There are many investors who have dramatically shortened their time horizons. That always happens when volatility picks up, and in some ways it adds to the volatility because these investors look at momentum rather than value. When that happens, value gets created. High quality is the place to be.
I've got three technology picks -- Marvell Technology Group, eBay and Qualcomm. They're all recommended by Goldman Sachs analysts. The fundamentals on technology are OK even though the U.S. economy is decelerating, because the deceleration is coming from the consumer and not the capital-spending sector. Also, we see some improvement in demand for U.S. capital goods outside the U.S. In addition, in the selloff over the past few weeks, technology and other high-beta stocks have been among those most afflicted. They were beneficiaries of momentum and are now feeling the pain.
What do you like about Marvell?
It will grow faster than the rest of the semiconductor industry. Our analyst sees robust revenue growth this year and next. In calendar 2006 revenues will grow in excess of 40%. Next year it will slow to a more organic 16%. Marvell's design and execution is outstanding in three separate areas. Ethernet, or enterprise network, is being upgraded, and they are big beneficiaries of that. The same goes for Wi-Fi. There are many new wireless applications, especially in the consumer area. The third area includes a host of emerging products that use embedded processors, such as optical disk drives and voice over Internet.
Marvell's fiscal year ends in January. For fiscal '07 we are forecasting $1.36 a share in earnings, and for the subsequent fiscal year $1.61. Our numbers are notably below the consensus because we've made full adjustment for ESO [employee stock option] expenses. The company's P/E ratio is 34.6 times for fiscal '07 and 29.2 times for fiscal '08. The stock is around 47, off its 52-week high of 73.67. It has a market cap of about $16 billion.
EBay is also down sharply, from 47.86 to 30.
It fits nicely with what we're looking for in Internet companies: the ability to engage customers, monetize businesses and expand globally. In addition to its own R&D, the company has acquired significant growth opportunities in PayPal, Skype and, in Asia, Kijiji. EBay recently struck a strategic alliance with Yahoo!, in which Yahoo! will use PayPal.
We're forecasting revenue and earnings growth for eBay of 25% to 30% over the next few years. Revenue in 2006 will be about $5.9 billion, and in 2007 it will be $7.5 billion, for growth of about 27%. Our earnings are just a shade higher than consensus: $1.04 a share for 2006 and $1.30 for 2007, up about 25%. Long-term earnings growth will be somewhat lower. Also, the valuation of the stock is much more appealing than it had been.
What is the case for Qualcomm?
Qualcomm has a commanding market share in WCDMA wireless cellphone technology, which is dominating the 3G cellphone market all over the world. We think the company can grow 15% a year. The adoption of 3G around the world is going to be a five-to-seven-year process, and we're just about into the second year of it. For the year ending September 2006, the company could earn $1.45 a share. For fiscal '07 we have earnings of $1.66. That translates into a P/E of 30.7 this year and 26.8 next year. Revenues could grow on the order of 17%.
All these companies have strong R&D and solid products. In the case of Qualcomm, earnings visibility is better than it might be for some other companies. In addition, the company has $9 billion, or more than $5 a share of cash on its balance sheet. It has no debt. Some investors are concerned about legal issues with regard to royalties that are paid to Qualcomm. We are watching the situation.
MERYL WITMER
Give us your view of the world.
Witmer: Stocks got a little ahead of themselves. Also, a lot of hedge funds are very, very leveraged. If your long positions go down a lot, and your shorts don't go up enough, you can have some real margin calls. It seems there has been some hedge-fund liquidation. Much of the selling has been concentrated in certain names owned by hedge funds. As a result, for the first time in a few years, it has been easy for me to come up with a lot of cheap stocks.
Good for you, and for our readers.
Chaparral Steel, which I recommended in January, is our largest position, and we added to it this week. It is in the mid-segment of the steel market. It produces structural steel, mainly used in nonresidential construction, and steel pilings for levies. It's a nice place in which to sit. There are only three producers of structural steel and two of pilings; foreign competition is nil, especially with the weak dollar, and worldwide demand is strong. Major American infrastructure projects that were delayed by municipalities in 2004 when steel was in the $800s are now being restarted with steel in the mid-$600s per ton. Also, nonresidential construction has picked up dramatically and will continue. My previous estimates -- $4 of earnings per share, and $5.50 of cash flow -- were low. Chaparral is on track to report $9 a share in earnings over the next year, and $10.50 in free cash. In six to nine months it should be net debt-free. The stock is 52, up from 29 in January, and trades for five times earnings.
How much higher do you expect it to get?
To put it a different way, I think the shares should trade between $70 and $90. Right now. My next pick is another old name, Media General. It has newspaper, broadcast-TV and complementary online assets. It is focused on growth markets in the Southeast, and delivering local news. I know everyone is down on newspaper assets.
| Company | Ticker | Price 6/14/06 | |
| Chaparral Steel | CHAP | $53.59 | |
| Media General | MEG | 35.93 | |
| Mueller Water Products | MWA | 14.23 |
Not us!
At Media General, circulation has been declining by about 1% a year. But advertising revenue per subscriber has been growing by 5%. This growth has been masked by increased newsprint costs, which affected earnings per share by 25 cents in 2005. But they are now under control. On the broadcast-TV side, they are good operators who consistently outperform their competitors in the local markets. Also, with broadcast signals upgrading to digital, the company will be able to broadcast up to six additional stations per market. These TV stations have a lot more bandwidth. Cable stations that want to reach people who can't get cable can buy up some airwaves from these broadcast stations. That's not in my numbers, but it could be significant.
In addition, Media General just acquired four NBC stations, which have upside due to the company's operational capabilities and an NBC recovery. The company also will get $150 million in tax shelters from this acquisition. Like other names in newspaper and TV, Media General's share price has been trounced by concerns about ad dollars shifting to the Internet. The company is capitalizing on this trend with its online enterprise. Online revenues are growing 50% a year, and their top Websites already are profitable.
Do they charge for it?
No. Revenue comes from advertising. Media General would have a much higher stock price if its management allocated capital more judiciously. In the past decade the company has overpaid for newspaper and TV stations instead of repurchasing shares at a tremendous discount to their value. The shares are so cheap right now that this makes up for their lack of financial savvy. Media General is generating a significant amount of free cash, which will be used for capital expenditures and debt repayment in the next few years. In mid-'08, assuming little growth, the company will have good interest coverage and generate free cash flow of just under $6 per share. The stock is $36 and our target is $60 to $70 a share.
That's nice upside. How about another name?
Mueller Water Products, a recent IPO, is the largest supplier of water and natural-gas flow-control products used by municipalities. Revenue growth is driven by new infrastructure and repairs to the nation's aging water infrastructure, which was given the grade of D minus by the American Society of Civil Engineers in 2005. A lot of repairs are coming down the pike. MWA has a large installed base and an excellent distribution network, and is a low-cost producer. Importantly, its CEO, Dale Smith, purchased $1.5 million of stock recently.
MWA has some leverage but generates gobs of cash to pay it down. They should get $50 million of cost savings from synergies after a recent acquisition. If Mueller does not otherwise grow its operating income from this acquisition, it should earn 92 cents a share in the fiscal year ending September '07, growing to $1.13 in fiscal '08. If it grows operating income just 4% and achieves cost savings, it should earn $1.25 in '08, and have $1.60 in free cash flow. A business of this quality deserves at least a 14 to 15 multiple of free cash flow, so our one-year target is $20 to $24. The stock is 14.80 now.
MARIO GABELLI
Before we talk about the market, can you tell us about your settlement with the government over the cellphone-license suit?
Gabelli: In my role as chairman of Lynch Interactive [LICT.PK], a small-cap, publicly traded rural telephone company, I can't comment about that yet. As for the market, things are playing out much as we expected at the beginning of the year. The fourth quarter of '05 was not strong. We had a catch-up in the first quarter because of the extra spending associated with Wilma, Katrina and Rita, plus favorable weather. GDP came in at the upper end of even our optimistic expectations. Obviously, it's unsustainable. The economy over the balance of the year and into the first half of '07 will remain in positive territory, but grow at a much lower rate. The dollar weakens, as well. Profit margins peaked in the first half of '06. Those are the issues we're dealing with domestically.
Bernanke is taking the right approach to start his administration as an inflation fighter. And breaking inflation expectations gives him a lot of flexibility, because it is hard to quantify what inflation expectations are, except through TIPS [Treasury inflation-protected securities]. As for the global economy, as the dollar weakens, the economies of Japan and Europe remain robust. The CRIB countries -- China, Russia, India and Brazil -- will remain vibrant.
What does this mean for the U.S. stock market?
We'll have a very strong fourth quarter, as the market looks to recover from a soft landing. The market probably will be up 5% to 10% for the year, though you could have an old-fashioned 10%-15% correction, as we're seeing now. There are three wild cards: a potential derivatives meltdown, a geopolitical crisis involving Iran and a possible Democratic landslide in November. But from a money-management point of view, we're harvesting gains from takeover stocks and keeping money in liquid alternatives. We continue to focus on dividends and deals, the theme we focused on earlier in the year. We are positioning our portfolios to take advantage of any sharp market correction.
What looks appealing now?
We try to buy good businesses at a discount to their intrinsic value. One area that will do well in 2007 is food products. Campbell Soup [CPB] has had good pickup because of internal dynamics. H.J. Heinz [HNZ] has done well because of external as well as internal dynamics. We like Cadbury Schweppes. The symbol in London is CBRY, and it trades in New York under CSG. In London it is selling for £5.13, and has an enterprise value of £14 billion. There are two billion shares outstanding. For 2006 they are going to earn 33 pence. We think those earnings grow by 11% over the next five years, and we've got a 15 price-earnings multiple.
Cadbury is best known for its confectionery business. In the U.S. it bought the Adams family of gum from Pfizer [PFE] in '03, and has done a good job with it. They're also in the beverage business, with Dr Pepper and Snapple. We like the cash-flow characteristics of the company, and management. This is a cheap stock, and at some point we would expect some kind of financial engineering, such as a spinoff or sale of the beverage business. We still like Danone [DA] and General Mills [GIS]. Coca-Cola [KO], too. The whole sector will do well, particularly with a weak dollar.
How about another name?
Tribune trades for 30 and has a $9 billion market cap. Total enterprise value [market value plus net debt] is about $10.6 billion. Our analyst thinks they can earn as much as $2 a share this year. Everybody knows the argument against old media companies. Tribune bought Times Mirror and wound up with a tax issue. It has had circulation problems. But we think [Chairman Dennis] FitzSimons did the right thing by announcing a Dutch auction to buy back 53 million shares in a range of 28 to 32.50. It is absolutely right strategy to buy back company stock at a 7.5 multiple of Ebitda [earnings before interest, taxes, depreciation and amoritzation].
The Chandler family, Tribune's second-largest holder, opposes the buyback and says the company should be broken up. Do you favor a breakup, too?
The company has alternatives, including the repurchase of a big block of stock, which I like. Over time, they could do more of that. The shareholders who want to remain will get a bigger piece of a more valuable company.
How much is Tribune worth?
Using a 10 multiple on the newspapers, and a little more on some of their entertainment and radio assets, we get to $45 to $55 a share. That doesn't mean we're not going to tender at 28-32, but it also doesn't mean we might not buy more. Looking toward 2008, you'll get a better regulatory environment for media companies. Government regulation in this industry is so far behind the technology dynamics that it can't get much worse. You have to allow companies to consolidate.
My third idea is Liberty Capital [LCAPA]. It was created a month ago as a tracking stock. For every 100 shares of the old Liberty Media you get five shares of LCAPA. There are about 141 million shares outstanding. The stock is trading at 79.56, so it has a market value of $11 billion. With $4 billion of debt, enterprise value is $15 billion.
What does it track?
You get a basket of media and telecom securities that are worth about $130 a share, net of debt. This is a private-equity investment in public form, and you're not paying they typical 20% management fee. You're getting News Corp. for 50 cents on the dollar; shares in Time Warner, Sprint, Motorola, Viacom and CBS, and some other entities. John Malone is working hard to unleash value. There could be some kind of a transaction with News Corp. down the road so that he can start spinning off pieces of the company on a tax-free basis. That's how you'll see a cash-rich spinoff with Time Warner. When Time Warner buys their stock back from John, John gets cash and the Atlanta Braves. He somehow figures a way to spin that off to his shareholders or he buys back stock.
| Company | Ticker | Price 6/14/06 |
| Cadbury Schweppes | CSG | $37.50 |
| Tribune | TRB | 31.94 |
| Liberty Capital | LCAPA | 79.12 |
| Ladbrokes | LAD LN | £3.77 |
| Tredegar | TG | $14.20 |
It's vintage Malone.
It's financial engineering, but it's no different from what other private-equity firms are doing. My next pick is Ladbrokes, formerly Hilton Group. It is based in the U.K., and I recommended it in January. The stock is trading for £3.90. There are 623 million shares. The company had a reverse split, giving holders six new shares for every 17 old ones. Ladbrokes is great brand and cash generator, and at some point they figure out a way to leverage their technological skills in the gambling business on a global basis, particularly in the U.S.
Now, to touch on one of my favorite subjects: demographics. We've made a lot of money in dental companies. We like body-parts companies. Today's subject is incontinence. I'm talking about the disposable-diaper market.
Diapers?
The number of people in the U.S. over the age of 65 is going to double in the next 20 years. The number of people 85 and older is going to double, assuming no unusual dynamics. Tredegar, in Richmond, Va., provides diaper components. The stock is 14.40 a share. Tredegar has a market cap of $560 million, and the enterprise value is $650 million. The company makes various diaper parts, such as the plastic outer sheet. They are also in the aluminum-products business, which is not as interesting to me. The company was hurt by rising raw-material costs, which it couldn't pass along. If oil stabilizes at $70 and natural gas prices stay down, earnings will stabilize. Plus, they have secular growth opportunities.
Interesting. Thanks, Mario.
ARCHIE MACALLASTER
You're an optimist by nature. Give us some good news.
MacAllaster: The Fed has decided to get in there and fight inflation. Put another way, they are going to protect the U.S. dollar, and I think they have to. On a long-term basis the U.S. stock market will do well because the Fed is doing what it should. In the near term, it's going to be volatile and iffy. Gross domestic product will grow by 3.5% to 4% this year. Corporate earnings will be up 8% to 10%. When the market finds a base, it will do all right. In the meantime you have to get out of the way. There has been a lot of speculation, and there is an enormous amount of leverage. People are doing all sorts of exotic things besides buying and selling common stocks. I don't understand them and I tend to believe they don't, either.
Nevertheless, the economy is doing fine, and the dollar is in good shape. And I'm completely in agreement with the president's decision to appoint a sound, conservative guy [Goldman Sachs Chairman Henry M. Paulson] as Treasury secretary. The White House almost has to listen to him now.
Let's hope so. How about some fresh investment ideas?
I have two leverage plays, starting with SuperValu, which sells for about 29 on the Big Board. It pays a dividend of 65 cents and yields about 2½%. The stock is just above its 52-week low. SuperValu bought the grocery division of Albertson's. It is more than doubling sales to about $45 billion, but also putting on an enormous amount of debt.
In the fiscal year ended February 2006, the company earned $2.24 a share. My estimate for 2007 is $2.75-$2.80, before acquisition costs of about 30-35 cents a share. They've made an enormous bet. SuperValu can compete with anybody in the industry, which is basically saying it can compete with Wal-Mart Stores. I think it can. Earnings in fiscal '08 could be as much as $3.20 a share. The stock trades for 10 times next year's earnings.
And your second leverage play?
JetBlue Airways. I've used their services to and from Florida, and I like the way they do business. Everybody is friendly and the prices are low. The stock is about 10.50 and the 52-week range has been just under 17 to 8.93. The company has 173 million shares and revenue of $1.7 billion, so there's a lot of leverage in the revenue. This year revenues will rise about 35%-36%, to about $2.3 billion. The company lost money in the first quarter but says it will be in the black in the next three quarters. They are still expanding their routes. They've been growing at better than 30% for years and next year will continue to grow by 20%-25%.
| Company | Ticker | Price 6/14/06 |
| SuperValu | SVU | $29.58 |
| JetBlue | JBLU | 10.87 |
| Doral Financial | DRL | 6.28 |
Why is the stock down? Fuel costs?
Yes, and the fact that they stopped making money. They've been able to raise prices and expect to make about 50 cents a share next year, even if oil is $75 or so. I think oil will fall to $50-$55. Next year, JetBlue can earn about 50 cents to $1. That's a wide range, but it depends on the price of oil. Airlines in general are going to do well.
You recommended Doral Financial in January around 11; it's come down to 6. Why?
Doral [DRL] has taken about a year longer to fix its finances, but it's close now It got called on the carpet for certain business practices in Puerto Rico. The company is the largest generator of mortgages in Puerto Rico, which gives them a lot of leverage. There are $17 billion of assets and about 110 million shares. They basically had to buy back a couple blocks of mortgages from two different banks. They did so and resold them right away. The company has earnings power of about $2 a share. Home ownership in Puerto Rico is higher than in the U.S. -- 63% versus 58% in the U.S. Doral's prospects are very good.
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posted by Chicago2008 @ 4:45 PM
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