Daily Insight

U.S. stocks rallied as better-than-expected results out of Bed Bath and Beyond fueled consumer discretionary shares, higher oil prices boosted the energy sector and the entire market was helped by a very successful $27 billion seven-year Treasury auction. All of these factors were able to offset a disappointing jobless claims report that showed the labor market remains very fragile.

News out of Bed Bath and Beyond helped ease concerns over the consumer, but we’ve seen this story before. Expectations shouldn’t get carried away here, heck even with the demise of competitor Linens ‘n Things the home-furnishing retailer couldn’t manage an increase in same-store sales – same-store results fell 1.6% -- but this is the market we’re in, sentiment sways on a daily basis.

Oil prices pushed above $70 per barrel on Nigerian pipeline attacks. For those who watch these things, this is a monthly, sometimes weekly, event. In a really strange way this could be looked at as another sign we’ve moved to a more typical recession – when the economic world was in free-fall the market had larger issues to deal with and ignored these attacks.

The seven-year Treasury auction went very well with strong foreign bidding and a super-strong bid-to-cover of 2.82. With the massive amount of debt issuance coming down the pike, these auctions, normally a non-event, cast some anxiety over the market these days. The last few have been market positive.

Stocks also benefited from what many viewed as a successful defense by Fed Chairman Bernanke of his emergency measures related to the Bank of America and Merrill Lynch deal – the conventional wisdom views that this increases his chances of keeping the position and the market probably doesn’t want to see a changing of the guard anytime soon (Bernanke’s term is up in January). I, on the other hand, am betting Bernanke will be gone as Larry Summers (Obama’s chief economic advisor) has the job in his sights and the Treasury may need an administration insider so they can monetize these massive debts. I’m not saying that’s a good thing, as we’ve spent much time talking about over the past couple of months this is a very concerning risk, but this is what is likely to occur.

Market Activity for June 25, 2009
Final Revision to Q1 GDP

The Commerce Department reported that first-quarter GDP was revised upward slightly to show the economy contracted at a 5.5% real annual rate during, up from the -5.7% previously estimated. The main reason for the higher revision was less drag from inventory liquidation. Now that all the data for the quarter has been collected, the Bureau of Economic Analysis showed that firms didn’t quite slash stockpiles as much as previously thought – although it was still the highest degree of inventory liquidation since records began in 1947.

In my view, the most interesting aspect of the final revision was how the personal consumption (consumer activity) figure has been revised down. When the initial estimate for the first-quarter GDP reading was released at the end of April, it had personal consumption up 2.2% at an annual rate, which was a good number particularly considering the state of consumer affairs in this environment. That figure followed two massive declines in consumer activity during the third and fourth quarters of 2008 (the largest consumer contraction since the 1980 recession).

Many believed the consumer was poised to bounce back in a sustained manner after that initial consumption number. Now that is has been revised down to 1.4% (in real terms at an annual rate) its shows the figure hardly bounced from the significant two-quarter contraction. Coming out of the 1980 contraction in personal consumption the figure roared back, printing readings of 4.4% and 5.4% in the following two quarters. This will not be the case this time. It will take a considerable period, to use a Fed phrase, before the consumer is in a position to push activity higher in a sustained manner.

Initial Jobless Claims

The Labor Department reported that initial jobless claims rose more than expected in the week ended June 20, rising 15,000 to 627,000 – economists had expected the reading to fall to 600,000. The four-week average of initial claims, a figure that takes out some of the volatility, rose ever so slightly to 617,250 from 616,750 in the prior week.
Continuing claims, those on jobless benefits for more than a week, rose 29,000 to 6.738 million -- still down from the peak of 6.835 million hit a couple of weeks back, but very elevated. This shows that firms are not adding jobs, which should not be surprising as businesses want to see sustained gains in demand before doing so. This process may even take longer than normal as firms are very eager for their cost-cutting measures to flow through to the bottom line. First we must see some economic growth occur, which has yet to manifest itself.
Remember, last week was the first time continuing claims halted its record-setting run in 19 weeks. Some viewed this as a sign the labor market was on the cusp of bouncing back, but like commentary on a number of economic data releases of late, people get prematurely excited. We must see a trend emerge before making such calls, a multi-week move. In addition, we mentioned that last week’s decline in continuing claims may have been more a function of jobless benefits running out than one of laid-off workers finding employment – the exhaustion rate pretty much confirms this view.
Digressing for a moment, this development in the exhaustion rate does not bode well for credit-card delinquency rates, which will continue to be a challenge for the banking sector and consumer activity in general. Don’t be surprised to see the federal government extend, again, the duration of jobless benefits. Egad! This does nothing for economic growth. Sure, it calms the downside at the margin. But please, we need big bang pro-growth policies. An agenda that drive the tax rates on income, capital and corporate profits lower. A policy that increases current-year write-off allowance and the depreciation firms can record in the year of an equipment purchase – this jolts small business activity. These are the things that can get an economy flowing again. For now, however, we’re going to use government spending as the tool to revive growth – we’ll see how that turns out.

The insured unemployment rate, the jobless rate for those eligible for benefits, held at 5.0% for a second straight week. This is good news as the historic data shows the overall unemployment rate tops out within a year of the insured peak being reached.


Have a great day!


Brent Vondera

Daily Insight

U.S. stocks ended mixed again yesterday as the S&P 500 and NASDAQ Composite closed to the plus side, while the Dow was held back by Boeing shares for a second-straight session.

The broad market began the day nicely higher after the OECD (Organization for Economic Cooperation and Development) raised its forecast for global growth – the battle among the organizational basket cases is on, recall how it was just two days ago in which the World Bank lowered its forecast. Stocks also got a boost from a much better-than-expected durable goods orders report; however, the broad market pared those gains as traders had time to consider the internals of that report and lost additional momentum after the Federal Open Market Committee’s (FOMC) statement was released. (The FOMC is the monetary policy setting committee of the Federal Reserve System)

Tech, financial and basic material shares led the market higher and in fact all 10 major industry groups closed higher on the day.

Some 1.04 billion shares traded on the NYSE Composite, 25% below the three-month average. Activity has been subdued for about a month now, which illustrates a lack of conviction. Two stocks rose for every one that fell on the Big Board.

Market Activity for June 24, 2009
Durable Goods Orders

The Commerce Department reported that durable orders rose 1.8% in May (easily surpassing the estimate that had orders declining by 0.9%), which matched the 1.8% increase for April – that reading was revised slightly lower, initially reported as a 1.9% increase when the data was released last month. This marks the first back-to-back gain for durable goods in nearly a year.

The ex-transportation number rose 1.1%, following a 0.4% rise in April – this ex-transportation reading is important because very volatile commercial aircraft orders have a propensity to skew the overall reading. Commercial aircraft orders jumped 68% last month, which followed a 1.4% decline in April.

Driving the ex-trans figure was a 7.7% increase in machinery orders and a 2.2% rise in computer/electronics orders. This is very goods news but we need more than a one month move in these key components, a trend must present itself before we get too excited. Machinery orders have gotten thumped over the past year, down 28%; computer/electronic orders are down 12% since May 2008.

Conversely, the drags came from vehicles and parts, down 8.1% (but no surprise there), a 1.1% drop in electrical equipment and a 2.5% decline in fabricated metals.

Shipments of durable goods fell 2.1% in May, and since this is the component of the report that flows into GDP, we won’t see much help from this data for the second-quarter growth reading unless the June figure is up big. However, these back-to-back increases in orders means shipments will rise in the ensuing months, which will help deliver the first positive GDP reading in a year by the time the third-quarter growth number is reported. That has been our estimate, a mild GDP increase in the third, followed by a more substantial level of economic growth by Q4.

The most important component of this data is non-defense capital goods ex-aircraft orders (the proxy for business spending), which jumped 4.8% after a 2.9% decline in April – this figure is down 23.1% from the year-ago period but the three-month annualized decline has improved nicely, down 13.5% vs. -30.5% in last month’s report.


This really remains the big issue, will business spending begin to trend upward. I have my doubts simply based of the way fiscal policy is going. The government is in the process of massive deficit spending (the 2009 fiscal budget will record a shortfall of 12-15% as a percentage of GDP, that’s more than double the previous post-WWII record and four-five times the long-term average of 3%). Firms know what normally follows big deficit spending, and that is higher tax rates. They understand this with ultimate clarity today as the current majority constantly talks about increasing taxes on income, capital and business profits. As a result, firms worry about future growth and may decide to hold off on purchases; the recent earnings report out of Oracle is the latest example of this phenomenon.

Firms need confidence right now and to deliver it, policy makers should be implementing an aggressive tax-rate strategy that drives current-year write-off allowances and bonus depreciation higher. This is one of the fastest ways to deliver a shot to business purchases and economic growth -- jobs will follow. Alas, this is not the direction the current majority will take. Instead, they believe massive government spending will drive aggregate demand --good luck with that -- and in so doing may actually cause the opposite to occur as firms delay purchases for fear higher tax rates will shut down a nascent recovery a couple of quarters out. It will be very important to watch if business spending can muster a sustained rebound, or we’re only to see occasionally monthly bounces off of depressed levels. This is a key watch area, I can’t emphasize that enough.

New Home Sales

The Commerce Department reported that new home sales fell 0.6% in May to 342,000 at an annual rate from 344,000 in April. This figure combines with yesterday’ previously-owned home sales data to show the housing sector remain very weak despite efforts that have driven mortgage rates lower and provided substantial tax credits to first-time buyers.
(There is simply nothing that can be done to revive housing until the labor market – absolutely the largest factor in such a large decision like financing the purchase of a home – regains its health. This is where the consensus has been wrong all along. How many times have you heard a pundit state that the economy is dependent upon a housing rebound. Wrong! We must first put in place the policies that drive private sector growth. The job creation that follows will revive the housing market.)

By region, the Northeast and Midwest saw new home purchases jump 28.6% and 18.6%, respectively. However, sales in the South (the region in which the most new-home sale activity takes place) fell 8.5%. On a non-seasonally adjusted basis, there were only 33,000 new homes sold in the U.S. last month – 3K in the Northeast, 5K in the Midwest, 17k in the South and 8K in the West.

The supply of new homes, relative to sales, barely budged and remains at a very elevated level of 10.2 months worth.

However, the number of homes for sales (not adjusted to the depressed sales rate) has nearly been cut in half over the past 2 ½ years. When sales do bounce the inventory-to-sales ratio (months worth of supply) will fall in quick order, but this rebound in sales will have to wait for the labor market to come around.

FOMC

Well, Monday we touched on how the question regarding the FOMC meeting was whether the members would decide to ratchet up their quantitative easing strategy (by increasing the purchases of Treasury and mortgage-backed securities) as way to keep rates from rising, or go the tamer route of merely attempting to talk down nascent inflation concerns. That question was answered yesterday afternoon as the FOMC chose talk over action. At least for now, I think if rates begin to jump again in the near term they may choose action again.

The Fed stated, “[t]he prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.”

Not surprisingly, they stuck to this Keynesian model in the downplaying of the inflation threat. And for sure, it doesn’t take much to downplay inflation right now as the price gauges are extremely benign. The issues that some have is with commodity prices on the march, higher prices among other early-stage inputs and a declining dollar (which makes imports more expensive and will drive commodity prices higher if the trend continues) all point to trouble down the road.

In addition, if the Fed is not on top of these things, and relies on their typical signals, such as the unemployment rate, they will be slow to meet the inflation issue head on. Unemployment is a massively lagging indicator and if they continue to watch this figure as their main beacon they may find trouble as they have injected unprecedented levels of money into the system – once credit begins to flow, the money multiplier will take off and there will be no stopping a harmful rise in prices. If this occurs, an austere level of monetary tightening will be necessary, thus shutting down the economy – and that is my concern over the next 18-24 months.

All of this said, of course the Fed was not going to raise rates or enter into the so-called exit strategy just yet, but some stronger words would have been a nice balance. The only bone they threw to those concerned about future inflation was to drop the deflation risk comments in the prior meeting’s statement.

The rest of the text was pretty much unchanged:

• The bond purchases program remain the same, and will occur along the same timeline.
• The pace of economic contraction is slowing.
• Household spending shows further signs of stabilization
• Exceptionally low levels of the federal funds rate is warranted for an extended period
  

Have a great day!


Brent Vondera

Post FOMC

Bernanke and Company did a quick copy/paste job with the comments from April’s meeting this time around as it appears that both the environment and the way that the Fed plans to improve it will remain unchanged “for an extended period”.

There were no real surprises in the statements. The recent glimmers of hope in the housing market were dismissed by the committee sighting “ongoing job losses, lower housing wealth, and tight credit.” Although the Fed catches some flak from time to time for concentrating too much on unemployment, a lagging indicator, their concerns here are pretty accurate.

On the inflation front – “The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.” This also follows what we have been writing here on the Acropoblog.

Also as expected, the Fed’s securities purchases will be left unchanged.

Cliff J. Reynolds Jr., Junior Analyst

Quick Hits

• Fed Statements: Side-by-Side
• Has Apple won the smart-phone wars?
• Home-Price Recovery in U.S. May Be Undermined by Appraisals

Monsanto misses revenue estimates on weaker Roundup sales

Monsanto (MON) reported earnings that topped estimates, but revenues fell short of expectations and the company recorded negative free cash flow.

Total revenues fell 11 percent on weak sales of the company’s branded glyphosate herbicide, Roundup, which were partially offset by strong sales in the core seed and trait franchise. Roundup sales and gross profit (revenues less cost of goods sold) plunged 47% and 54%, respectively, as massive amounts of generic brands flooded the market.

According to Monsanto’s estimates, generic inventories will finish the year at a level equal to 40% of next year’s consumption, which has put extreme pricing pressure on both generic and branded products. Adding fuel to the fire, distributors are slashing prices in order to move this heap of inventory and generate cash.

Despite branded competitors’ price concessions, Monsanto has stubbornly kept Roundup prices unchanged. As a result, Monsanto estimates the price spread between Roundup and its primary competitors on a gallon basis has widened from roughly $2 in September 2008 to about $10. This premium can’t possibly be sustainable on a long-term basis and I expect Monsanto will ultimately lower Roundup prices.

On a brighter note, the seed and genomics franchise continues to deliver and recorded nice gains in market share and trait penetration. Seed and genomics gross profit has grown 22% year-to-date versus 2008, with corn seeds still the biggest driver expanding gross profit by 21% year-to-date. Monsanto expects high-single digit percentage price increases for its existing seeds, and additional pricing gains through further trait penetration.

Despite near-term concerns about Roundup, there is little reason to believe that the seed business won’t continue its break-neck growth and ultimately increase the bottom line. Agricultural productivity is a political priority in most major economies, which is driving policy that encourages better and more intensive agricultural practices.

Genetically modified seed is already the standard in corn and soy in the U.S., while Brazil and Argentina are driving a new wave of growth. Don’t be surprised if China, Russia, and Eastern Europe provide the next wave.
Monsanto is currently down 4%.

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Peter J. Lazaroff

Today - Pre FOMC

The market is a bit confused this morning as it continues to digest some conflicting information. The Organization for Economic Cooperation and Development (OECD) revised upwards its previous forecast for the combined GDP of its member states. The previous forecast made in March was for contractions of 4.3% in 2009 and .1% in 2010, both revised up today to -4.1% and +.7% respectively. This comes just one day after The World Bank revised their forecast for global GDP downward to -2.9% in 2009, from -1.7% in March. The scale of these predictions is obviously way too large to be accurate, but I just use it as an example of the contradicting information the market is dealing with in this environment.

Which brings us to what lies ahead for today. A strong Durable Goods number lead by better than expected increases in new orders for machinery and capital goods (up 7.7% and 9.5% MoM respectively) is helping futures higher pre-market, but most of the market is carefully awaiting the statement from the Federal Open Market Committee (FOMC) that is expected to maintain a 0-.25% target for Fed-Funds (the rate used for overnight lending between banks).

The real question lies in what kind of guidance they choose to give on their open market operations, namely their large scale quantitative easing campaign that they injected with steroids in March. The numbers are already huge, ($1.25 trillion in agency MBS, $300 billion in Treasuries and $200 billion in agency debentures) but some think that increasing them is not completely out of the question. Consider the effects that would have on the market. The market is forward looking, not always 20/20 but undoubtedly concerned about the future. Let say the Fed triples their Treasury purchases to $1 trillion in an attempt to lower long term rates to help worthy corporate borrowers who would benefit from lower long term rate to finance expansion. There are two quick problems with that scenario. First, the market has chilled out considerably on the inflation front in the past 3 weeks or so, but boosting quantitative easing will only renew those fears in my opinion, and along with increased inflation concerns comes higher long term rates. Result… the Fed fails to manage the long end of the curve and has only succeded in funding our Nation’s irresponsible deficit. Second, rates are already very low, sure they have run up since the beginning of this year, but mortgages are at 5.5% and a company who is rated one notch above junk can borrow for 10 years at roughly 7.5%. (HT Brent Vondera) That is far from a contractionary interest rate environment. The Fed has eased enough here in my view.

Instead of increasing the size of the total purchases, I believe the Fed if anything is more likely to slice up the pieces a little differently. Take some money away from MBS and put it towards Treasuries, and concentrate on moving the risk free curve instead of individual markets. That’s my prediction, now we just sit and wait for 2:15 ET.

Cliff J. Reynolds Jr., Junior Analyst

Daily Insight

U.S. stocks ended mixed on Tuesday as the S&P 500 managed a decent gain, able to fight off several moves into negative territory; however, the Dow and NASDAQ Composite failed to close in positive territory as tech shares led the latter lower and a 6.5% decline in Boeing shares weighed on the Dow average. Shares of Boeing subtracted 22 Dow points from that index, it would have been nicely positive otherwise.

The broad market came under pressure during the morning session after the latest housing market report showed activity remains very weak despite a number of policy decisions that were meant to offset a troubled environment for the consumer. But financial, basic material and telecom shares helped propel the S&P 500 to the plus side by the close.

Consumer discretionary shares were among the worst performing sectors after memory-chip designer Rambus Inc. reduced its second-quarter revenue forecast, citing weak demand for consumer electronics. This news certainly didn’t help tech shares either.


Market Activity for June 23, 2009
Credit Spreads

There has been a lot of talk about the narrowing of credit spreads – the difference between Treasury yields (known as the risk-free rate) and the yields on variously rated corporate bonds. This is normally a key signal regarding financial market improvement and that economic growth prospects have increased. Like so many things in this environment, however, we need to be careful as the normal green lights may be malfunctioning as the Fed’s very aggressive easing campaign, which has sent interest rates very low, has a way of causing investors to misprice risk.

Corporate spreads have certainly narrowed, no arguing that, but it’s tough to tell whether this has occurred because the market believes earnings will rebound in strong fashion (hence default risk has eased substantially) or because investors have pushed corporate bond prices higher as they hunt for yield in this very low interest rate environment. Too be sure, one should also acknowledge that spreads remain at levels seen during the typical recessionary environment. Like so many economic indicators today, what we’re seeing may not be an all-clear signal but simply a move from economic armageddon to something that more closely resembles a normal downturn scenario.

BBB Rated Spread over the 10-Year Treasury

A repeating theme of this letter over the past couple of months has been that of caution. I just want people to be aware of how things look, not only relative to the deep contraction scenario of the previous several months, but to past economic downturns. When we compare the data to past contractions it tells us that we have moved to an environment of normal recession (from the worst since at least the 1957-58 contraction) rather than to a situation in which the business cycle is poised to expand with vigor.

Existing Home Sales

Well, I tried to offer some optimism over the past few days, estimating that previously owned home sales would blow by very low expectations, but it was not the case. A 6.7% rise in the latest pending home sales data sure seemed to suggest a bounce would take place, but the credit markets remain relatively fragile and some of these mortgage contracts may not be making it to the close. In addition, fixed mortgage rates spent the month of May below the 5.00% level, and May is one of the top three sales months of the year; combine that with the tax credit of $8,000 for first-time home borrowers and if these factors couldn’t produce a larger bounce you’re not going to get it until the largest factor of them all – the job market – improves markedly.

But getting to the data, the National Association of Realtors reported that existing home sales rose 2.4% in May to 4.77 million units at an annual rate – and that was from a downwardly revised level for April. The market expected sales to rise 3% from the higher initial April reading. Even the lower-than-expected reading was boosted by a 6.1% rise in multi-family units (co-ops and condos), single-family units rose just 1.9%.

As you may remember, we’ve been gauging single-family units against the December reading (the 12-year low put in place in January was largely due to worse-than-normal weather, which skewed the bounce back in February, so that December reading is the level with which I think makes most sense to gauge things instead of simply using the previous month). Single-family units came in smack dab at that 4.25 million annual rate hit in December. So, we have yet to get past that reading to this point and while it sure appears that the housing market has bottomed we have yet to bounce off of the weather-adjusted depressed levels.

The supply of previously-owned homes (relative to the rate of sales) remains elevated at 9.0 months worth. This is down nicely from the peak of 11.0 months worth hit a year ago but needs to come down to 6-7 months worth before the residential market will begin adding to GDP again.

The median price on existing homes rose 4% last month to $172,900 after hitting $166,000 in April -- the multi-year low of $164,200 was put in in January. From a year-ago perspective, the median price for existing homes is down 17%.


Richmond Fed

The latest reading out of the Richmond Federal Reserve Bank’s manufacturing gauge continued to show nice improvement in June. The Richmond Fed index rose to 6 in June from a reading of 4 for May – a reading above zero marks expansion, unlike the nationwide ISM index and the Chicago manufacturing report in which 50 is the dividing line between expansion and contraction.

The sub-indices of the report also registered very positive results, as the new orders index jumped to 16 from 10; order backlog rose to 8 from -3; and the average workweek rose to 8 from 5.

However, respondent expectations for these readings over the next six months weakened a bit, which offset some of the aforementioned positives.

All in all, this is not a closely watched reading as the Richmond Fed index is one of the smaller regional factory reports. Still, I thought it was worthwhile to touch on the results as we’ll take every positive reading we can get.

The big ones are Chicago (the largest and most watched regional factory report) and ISM (the nationwide factory index), both of which will be released at the end of the month. The other regional surveys we received thus far for June had pretty much offset one another -- New York factory activity fell, while Philly-area manufacturing rose -- and that is why Chicago and ISM are immensely important right now. (Note: it will not take a move to expansion on Chicago to be considered a good number as everyone understands auto-industry woes will weigh on the figure. If it can manage a rise to the low 40s (the May reading fell back to 34.9) and we can get ISM back to 45 it will be very helpful for stocks.

Have a great day!


Brent Vondera

Quick Hits

• Bernanke Prepares to Defend Record as Debate Over His Reappointment Begins

Margin Analysis

Margin analysis is a great way to understand the profitability of companies. But, like all ratios, margin ratios never offer perfect information. They are only as good as the timeliness and accuracy of the financial data that gets fed into them, and analyzing them also depends on a consideration of the company’s industry and its position in the business cycle. Then why not just use net income to determine profitability? Consider this example:

In 2008, railroad company Norfolk Southern (NSC) had an annual net income of $1.7 billion on sales of about $10.6 billion. Its major competitor, Burlington Northern Santa Fe (BNI) earned about $2.1 billion for the year on sales of about $18 billion.

Comparing the Burlington’s net earnings of $2.1 billion and Norfolk’s $1.7 billion shows that Burlington earned more than Norfolk, but it doesn’t tell you very much about profitability.

If you look at the net profit margin, or the earnings generated from each dollar of sales, you’ll see that Norfolk produced 16 cents on each dollar of sales, while Burlington returned less than 12 cents. This is one of the many reasons that we value Norfolk more than Burlington.

There are three types of profit margins:

(1) Gross margin indicates how efficiently management uses labor and supplies in the production process.

Gross Margin = (Sales – Cost of Goods Sold) / Sales

Companies with high gross margins will have a lot of money left over to spend on other business operations, such as research and development or marketing. Downward trends in the gross margin rate over time are a telltale sign of future problems facing the bottom line. It’s important to remember that gross profit margins can vary drastically from business to business and from industry to industry. A perfect example of varying ratios across different industries is the airline industry and software industry with gross margins of about 5% and 90%, respectively.

(2) Operating margin compares earnings before interest and taxes (EBIT) to sales, which shows how successful a company’s management has been in generating income from the operation of the business.

Operating Margin = EBIT / Sales

High operating profits can mean the company has effective control of costs, or that sales are increasing faster than operating costs. Some consider operating profit a more reliable measure of profitability than net profit margins since it is harder to manipulate with accounting tricks than net income. Operating margin will be always be less than gross margin because it accounts not only for the costs of goods sold (COGS), but also selling, general, and administrative (SG&A) costs.

(3) Net profit margin measures the profits generated from all phases of a business, including taxes. It comes as close as possible to summing-up in a single figure how effectively managers run the business.

Net Profit Margin = Net Profits after Taxes / Sales

Companies with high net profit margins usually have one or more advantages over its competition, a bigger cushion to protect themselves during downturns, and the ability to improve market share during downturns which leaves them even better positioned when things improve again.

Comparing a company’s gross and net margins provides a sense of its non-production and non-direct costs like administration, finance, and marketing costs. Software business has an exceedingly high gross margin of 90%, but a net profit margin of only 27%. This means its marketing and administration costs are very high, while its cost of sales and operating costs are relatively low.

--

Peter J. Lazaroff

Boeing again delays the 787 Dreamliner

Already two years behind schedule, Boeing (BA) announced today that the maiden flight of the 787 Dreamliner will again be delayed. This is now the fifth delay of the initial flight of the next generation aircraft, which has been held up due to production issues and a labor strike. This delay comes as an area within the side-body section of the aircraft needs to be reinforced. Boeing said a new delivery timetable won’t be available for several weeks.

The 787 Dreamliner marked a new era for Boeing, which drastically improved their use of lighter materials as well as streamlined manufacturing and assembly processes. The company also factored in their customer’s financing needs at the design stage for the first time.

The most significant change – and in my opinion the biggest reason for the many delays – might be Boeing’s increased use of outside suppliers from Japan, Italy, and the U.S. for the development and manufacturing of the aircraft. This change made Boeing more of a systems integrator instead of a manufacturer. Consequently, this transformation has been met with many unexpected challenges in the design and engineering processes as well as the way it manages its global supply chain.

Still, the order backlog suggests the aircraft has been highly successful. Despite deferrals and cancelations related to the global recession, Boeing’s order backlog equals about seven years of production. The problem in the near-term is determining when Boeing will reach full production – before this delay it was suppose to be in the second half of 2012. On the bright side (maybe), the company said they are actively looking at a second assembly line that would amp up the full production rate.

Shares are currently down more than 7%.

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Peter J. Lazaroff

Intel strikes deal with Nokia

Bloomberg reports that Intel (INTC) will sell processors for Nokia (NOK) mobile devices, “marking the biggest breakthrough in Intel’s expansion into the phone market.”

Intel has struggled for about a decade to get a foothold in the market for mobile-phone chips. With Nokia being the biggest cell phone maker in the world, even just a piece of their business is a tremendous victory for Intel.

Intel microprocessors, which are like the central nervous system of a computer, are used in more than 80% of the world’s PCs. The mobile phone market, however, will provide important diversification for Intel, who derives about 90% of sales from computers chips.

Intel announced in February that they struck a deal with LG Electronics, the world’s third-largest phone maker, to use Intel chips in a mobile Internet device that is a cross between a mobile phone and a computer.
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Peter J. Lazaroff

Daily Insight

U.S. stocks ran into some trouble yesterday, recording the worst session in two months after the World Bank lowered its global contraction estimate. This provided the impetus for some profit taking to ensue – that’s the market we’re in right now and you could feel the low volume scenario of the last month signal the market was beginning to question the rally – as we’ll touch on below.

The World Bank stated it expects the global economy to contract 2.9% for 2009, down from their previous estimate of -1.7%. That is certainly a significant contraction from a world economic perspective, but anyone who’s watched World Bank estimates knows not to give it too much credence, their forecasts are rarely even close (which is why they adjusted the previous estimate to more closely reflect reality). This downgrade should not have been a surprise, the data we’ve seen over the past several months (even though the figures have shown some improvement over the past few weeks, a rebound from very low levels but still quite weak) has offered a clear indication the worst world recession in at least 27 years is the situation. The lowered forecast simply triggered what many have been wanting to do, take something off the table, but had held pat on the possibility of additional gains.

One of the hottest sectors of the year, second only to technology shares, has been commodity-related basic material stocks and that sector was a big loser yesterday. A couple of weeks back we began talking about how this group was poised for a pull back after jumping 55% from its March low and that has certainly occurred over the few sessions. A lot of people see this market as one that is very much like that of the back-half of the 1970s and that means you’ll see short-term profit taking.

Two of the three traditional areas of safety were among the relative winners yesterday. Utility and consumer staples shares ended the session unchanged and -0.8%, respectively. The other of the big three safety sectors, health-care, failed to perform as well as would normally be the case on a day of increased economic concern – but these are not normal times; the government is coercing drug makers into offering even larger discounts. President Obama stated, “it’s only fair” for the pharmaceutical companies to make essential concessions to help reduce costs as they’ll, according to him, benefit greatly from national health-care coverage.

Big beneficiaries, eh? If we get national health care, rationing and price controls follow, that’s been the lesson from the European and Canadian systems. For now, the drug makers make concessions hoping the crocodile will eat them last, but they’ll be eaten too a few years down the road if this national health-care scheme is not blocked, make no mistake about that. The good news is it appears some in Congress are having second thoughts.


Market Activity for June 22, 2009

Questioning the Rally

The broad market ran up nearly 40% in the two months that ended May 8 but since that time we’ve been stuck in this relatively tight range of 945-882 on the S&P 500. Which way will we go from here? Is the market spring-loaded for a significant move higher, or are the lower trading volumes of the past few weeks telling us a turn down is in the cards?

We think there has to be a move lower after such an abrupt rise from the deep depths of March, even if that low was unjustified. One thing is pretty clear, things remain fragile. If the data doesn’t begin to show meaningful improvement fairly soon investors and consumers alike may show a higher propensity to freaking out – for very understandable reasons.

If the broad market begins to turn down, investors may bolt for fear of a February/early-March style redux. This, along with an unlikely rebound in the labor market anytime soon, may also cause the consumer to increase their cash savings – nothing wrong with that as it is a prudent endeavor in this environment, but it does mean depressed retail sales activity.

So this is where we find ourselves right not and the investor needs to be aware that some pressure may ensue. When we expect a natural pullback after powerful rallies, maybe the investor class will be less prone to freaking out and driving equity values near those March lows again. It does feel that there has been the typical performance chasing going on over the past couple of weeks that has allowed the market to bounce after three spats of weakness over the past month. Those with a performance-chasing mindset need to be very careful in this environment.

A Fed Week – What will be their plan of attack?

As we mentioned yesterday, the market eagerly awaits to hear what the members of the FOMC (the monetary policy setting committee) have to say on Wednesday. We know how they’ll manage the short end of the curve – a group that is hugely dependent on the level of unemployment will hold Fed funds near zero.

The question is how they’ll manage, or attempt to manage, the long-end. Will they step up their quantitative easing strategy (increasing purchases of Treasury and mortgage-backed securities); or will they attempt to keep long rates low via comments? – comments that state the concerns over inflation are overblown.

Needless to say, with over $100 billion in debt issuance coming this week alone and $3-4 trillion over the next two years, they have a very difficult task in front of them.

Inflation Building?

And speaking of inflation expectations, they sure don’t seem terribly heightened right now. Yes, we’ve had commodity prices on a run – and some of this trade definitely has some inflation hedging in it. Yes, the jump in yields during May and early June also suggested some uneasiness, but it’s quite a stretch to say the market is seriously concerned at the moment. Heck, the 10-years TIPS breakeven can’t even hold above 200 basis points – meaning the market expects (at least currently) that inflation will run at 2% per year for the next decade. (The 10-year TIPS breakeven is the spread between the yield on the nominal 10-year Treasury note and that of the 10-year Treasury Inflation Protected Security)

But there are a number of indications that suggest prices could begin to roll in quick order if the Fed is not careful. For one, core CPI is running at an annual rate of 2.5% over the past four months – hardly scary but this an elevated level based on the economic damage we’ve endured over the past nine months. In addition, we’ve seen a building in the early stages of production regarding food prices – specifically regarding fertilizer and feed costs.

Yesterday there was a report out on how dairy farmers have had to slaughter cows due to rising feed prices. Farmers have been losing money as it has very recently cost as much as $17 to produce $10 of milk, according to the National Milk Producers Federation.

As a result, the consumer will begin to take the brunt of these higher costs as the slaughtering of dairy cows will lead to the first two-year production cut in four decades, according to data from the Department of Agriculture.

This is just another example of the ingredients being there for inflation rates to cause havoc over the next 12,18, 24 months. The timeline is the debate, I happen to believe the inflation gauges will begin to run up 12 months out, many other believe it will take more time to build. But it does seem pretty evident that we’ll have an issue on our hands whatever the time horizon happens to be. All that’s needed now is for increased credit activity and a little economic growth to stir the inflationary brew.

This morning we get existing home sales for May. If the previous pending home sales data is any indication, and it usually is, we’ll see May home sales beat expectations. Stocks may be able to bounce off of yesterday’s move if this data surpassed the estimate, but we’ve got the text from the FOMC meeting tomorrow so traders may just hold off for that release.


Have a great day!


Brent Vondera

Quick Hits

• The Lessons of 1937
• Bernanke Must Reassure ‘Confused’ Market His Strategy Will Keep Rates Low

Insider selling at Illinois Tool Works (ITW)

Barrons.com reports that just a day after Illlinois Tool Works (ITW) raised earnings guidance for the second quarter, four insiders in the company began selling shares totaling about $18 million. The report notes that ITW’s increased guidance still fell a penny below the Street’s estimates.

The diversified industrial manufacturer has had a strong run-up in recent months, and is trading at about 25 times future earnings. Last week I expressed some concern regarding the raised outlook – in essence, don’t get too excited. After all, the company’s products are largely things a growing economy would need, if it were growing.

This is not to say I am jumping ship on ITW. Restructuring benefits, stable markets, and less acquisition headwind could allow the company to double their margins by the end of the year. The company also has a history of strong acquisitions. With reasonable debt levels it would not be surprising to see ITW use the downturn to buy good assets at cheap valuations.
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Peter J. Lazaroff

Walgreen (WAG) trades lower after earnings miss estimates

Walgreen (WAG) traded lower after they reported fiscal third-quarter earnings that fell shy of estimates as falling margins offset growth in revenue and prescription sales – both of which topped expectations.

Walgreen’s total revenues increased 8% despite a weaker consumer, with the company emphasizing staples like groceries and pushing its own private-label brands. CEO Gregory Wasson said the company has seen a double-digit increase in sales of its private-label brands.

Gross margin slid to 27.5% from 28.3% on results of nonretail operations and added inventory costs. Helping overall margins were an increase in pharmacy margins as a result of the impact of generic drug sales.

Prescription sales jumped 8.2% and climbed 3.8% on a same-store (stores open for at least one year) basis. The company exceeded by 5.7 percentage points the industry-wide growth rate, excluding Walgreens, as reported by IMS. The company’s promotion of discount drug programs has helped reduce prices and led to greater use of generic drugs – which carry higher profit margins than brand name drugs.

Today’s earnings call featured detailed updates of the company’s growth initiatives – Customer Centric Retailing (CCR) and the Rewiring for Growth. Walgreen – that redirected Walgreen’s focus from rapid expansion to improving returns and in-store execution. As I said back in November of 2008, these initiatives make me very excited about Walgreen’s long-term growth prospects, and the execution to this point has been impressive.

CCR gives more attention to merchandising and customer experience, Walgreen hopes to get customers to add one more item to their basket per visit. Walgreen plans on retrofitting about 400 stores by fall, with a nationwide rollout expected throughout 2010. Cost savings from the Rewiring for Growth initiative are expected to reach $1 billion annually beginning in 2011 – although the initiative will result in net costs in 2009.
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Peter J. Lazaroff

Daily Insight

U.S. stocks ended mixed on Friday as the S&P 500 and NASDAQ Composite gained ground, while the Dow average ended lower; the Dow was dragged down by shares of United Technologies, Coca-Cola and Proctor & Gamble.

Bank stocks led the broad market higher for a second session as shares of JP Morgan led the financial index higher – the firm said it will cost less than analysts had expected to repay government funds. Technology and consumer discretionary shares also closed on the plus side. Tech shares advanced on speculation Microsoft will beat second-quarter profit estimates. Apple shares also rallied on the release of the new iPhone.

So much for that activity on Thursday in which the traditional areas of safety – utilities, consumer staples and health-care – led the way and appeared as if maybe some sector rotation was taking place. Two of these three sectors closed lower on Friday, although we did have quadruple witching so it wasn’t a great day by which to gauge trends. Quadruple witching occurs once a quarter and involves the expiration of stock-index futures and options, and single-stock futures and options contracts. It makes for a volatile session at the beginning and end of the trading day as traders settle positions due to the expiry of those contracts.

For the week, the S&P 500 lost 2.6%; the Dow fell 2.9% and the tech-laden NASDAQ Composite slipped 1.6%.

Market Activity for June 19, 2009

The Problem of Conflicting Regulation

Last week we touched on the White House’s new regulatory proposal but one aspect of the plan has come under considerable fire and it seems worthwhile to touch on this topic again, particularly since we were without an economic release on Friday.

Under the proposal, an entirely new consumer protection agency within the financial industry will greet the private sector, specifically community banks across the country. Some may wonder what the big deal is; isn’t consumer protection a good thing? Well, it’s the typical example of proposals that look good on the surface, but when it come to real world application trouble arises. One issue regarding the set up of entirely new agencies is that they generally conflict with one another and whether it be smaller firms when we are talking about the entire economy, or community banks when specifically referring to the financial industry, these players can get caught between the cracks -- or the crevasse in terms of this regulation.

Community banks will have to deal with the safety and soundness regulator saying they can’t make certain loans. While on the other side, the new consumer protection regulators will be demanding they are not making enough loans and are shutting out certain consumers. The community banks get caught in the middle

When these separate areas of a regulatory regime are part of a larger agency, banks can go to the top and ask for some mediation to this problem of confliction. Not so now. When the elephants stampede, the grass gets trampled and I think there is a serious risk that community banks may get trampled. The adverse consequence is that instead of helping consumers, they may actually be hurt over time via higher consumer-loan borrowing costs.

This Week’s Data

We’re without a data release today, but get back to it tomorrow.

Existing Home Sales for May (Tuesday)

The sale of previously owned homes is expected to rise to 4.8 million units at an annual rate, which will mark a 2.5% rise from the 4.68 million units hit in April. I think there’s a very good shot the number will come in at 5.00 million or better as the most recent pending home sales data (a good indicator for existing sales over the subsequent one-two months) jumped 6.7%. If we do get a better-than-expected move it should juice the market. That said, existing home sales, all home sales, remain very depressed and are just 4.2% above the 12-year low hit in January.

Durable Goods Orders for May (Wednesday)

Durable goods orders rose in April after getting crushed over the past several months, down 27% year-over-year. May orders are likely to fall as business-equipment orders (technically, non-defense capital goods ex-aircraft) will take some time to come back and this component is going to weigh on the overall reading. We suspect business spending will bounce sometime in mid-2010, the caveat being how far the government goes with regard to regulations, tax rates and spending. If the business community worries that an economic rebound will be short-term in nature, then purchases will be delayed.

FOMC Meeting (Wednesday)

This is the big one for the week. The market eagerly await how the Fed will choose to manage the yield curve. Will they increase their quantitative easing strategy by boosting the planned purchased of Treasury and mortgage-backed bonds? Or will they attempt to do so via comments, such as attempting to convince the market that inflation concerns are overblown?

Initial Jobless Claims for the week ended June 20 (Thursday)

The market will watch that continuing claims number. I think it is widely expected that initial jobless claims will remain above the 600K level, but that continuing claims figure halted its record-setting move for the first time in 19 weeks last week. The question is whether this suggests the job market has improved at the margin, or the decline was due to state-unemployment benefits running out and a shift to federal benefits will then show up in this weeks data. This is going to be a big one for stocks. If continuing claims begins to ascend again, investor sentiment will descend.

Personal Income and Spending for May (Friday)

We’ll look for something other than the government transfer component of the data to rise, but I wouldn’t expect much as the labor market remains very fragile. Rental income actually did rise in the last reading, so April’s increase of 0.5% (which followed six months without an advance – down 2.4% at an annual rate during that stretch) wasn’t solely due to the government side, but darned near.

On the spending side, the market will need to see an increase, after declines in eight of the past 10 months. The retail sales data for May rose 0.5%, so there’s a good shot we’ll see a positive print. The data will also include the cash savings rates (measured as a percentage of disposable income). This figure jumped to 5.7% in April, up from 4.5% in March and pretty much non-existent a year ago as the stock market was sitting 40% above the current level – the value of stock and home prices has an effect on the savings rate as consumers feel more confident about things when those prices are higher. Also, until people become worried about things, very low interest rates also have an affect on the money many people keep in bank accounts. (The traditional measure of the savings rate does not count capital gains in the stock market as savings.)

Have a great day!


Brent Vondera