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.

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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

Treasury Announces Next Week's Supply

The Treasury will auction $104 billion in two-, five- and seven-year notes next week, more than the $101 billion the market was expecting, sending Treasury prices lower and yield higher in today’s trading. Yields are still higher than this time last week, despite today’s selloff.

2-Year Yield

10-Year Yield

Cliff J. Reynolds Jr., Junior Analyst

The-Year TIPS Breakevens

The measure of inflation that uses the spread between the yield on the Inflation Protected Treasury and the Nominal Treasury has come down from its high of 2.08% on 6/10. Disappointing PPI and CPI readings this week and a rally in the nominal coupons have eased concerns in the short term that, as you can tell from the graph below, have really spiked since mid-April.


The inflation trade is more of a long term play than some in the market might think. Sure, the market has been flooded with cash, but the recent run up was a little overdone for an event that is most likely a year away. A choppy market will likely persist while supply concerns for the Treasury market as a whole continue to ebb and flow.




Cliff J. Reynolds Jr., Junior Analyst

Daily Insight

U.S. stocks ended mixed on Wednesday as the S&P 500 ended lower, while the tech-laden NASDAQ Composite managed a nice gain. The broad market, while lower for the third-straight session, was helped by a rally in health-care shares. Commodity-related shares pared earlier losses to help the overall market bounce back from its morning lows.

The latest results out of FedEx, and its downbeat forecast, sent the market lower at the open. While the world’s second-largest package delivery provider posted results that beat expectations and the 55% drop in operating profit (based on the year-ago level) was an improvement from the previous quarter’s yoy decline of 75%, the company stated current economic conditions continue to “throttle” the results.

If not for aggressive cost-cutting the firm’s results probably wouldn’t have beat expectations. Businesses can’t build on bottom line results via cost-cutting for an extended period without some business-cycle expansion. Now, a few quarters out, this reduction in costs means that profits can be high-powered when activity does bounce. For the meantime, however, the market was disappointed this major economic bellwether did not offer somewhat optimistic guidance.

Financial shares were the biggest losers yesterday after Standard & Poor’s reduced its rating on 18 U.S. banks, citing tighter regulations and the implementation of changes to reflect this new environment.


Market Activity for June 17, 2009
New Regime

The big news of the day was the proposed changes to the way the government oversees financial markets -- the new regulatory regime. I’m not going to waste a bunch of space on the specifics – besides it would be kind of tough to do so since I chose not the read the 80 page manifesto (opted for the summary instead), but will only touch on the overall issue and comment on the way the current administration views these things.

One can’t measure the cost, or more accurately the unintended consequences, these regulations will have on the economy – especially after Congress has its say. But I can take issue with President Obama’s belief that strong regulation is why people invest in the U.S. (Team Obama wants to guard against market participants taking “exorbitant” risks. But this topic of discussion is incomplete without acknowledging that the Fed’s reckless monetary policy, specifically in the years 2002-2005, drove real Fed funds negative and therefore played a key role in engendering a move farther out on the risk curve – a massive mispricing of risk as investors’ hunt for yield was on. There is also no mention of Washington’s two-decade drive to socially engineer the housing market. When that social engineering combined with negative real interest rates... well, that was a nasty brew.)

Actually, the reason capital is deployed in the U.S. is because of strong property rights law, low taxes on capital (and thus higher after-tax return expectations) and sound money policy. In the end, it’s a high risk-adjusted after-tax rate of return on capital that is the reason the world invests in America.

Problem is the administration sees no problem in forcing the abrogation of contract law (the Chrysler workout) and desires to raise tax rates on capital, while the Fed has not implemented sound monetary policy for several years. These issues are likely to create problems for us.

Let’s be clear, simply implementing massive levels of regulations – even if some aspects may prove beneficial (such as the receivership authority with regard to the largest financial institutions, which makes much more sense than ad hoc “bailouts”), you know many more will do harm – is not what attracts capital, capital that is very mobile and free to go almost anywhere it desires. If this were the case, hedge funds would find it impossible to raise capital.

Another disturbing aspect of the regulatory plan is that it seems to substantially change the structure of the Federal Reserve system by seeking to shift the process of regional bank presidents from the current appointment process (currently appointed by local boards) to a structure that is based on Senate approval. Uh, this is a major issue. The Fed is currently in very dangerous territory as most people already believe that they have lost their independence.

This proposed change, if implemented, would really increase doubt over the Fed’s ability to remain unlinked from the political process. It is a necessary condition for the Fed to be independent from politics -- when they are not, decisions that are essential to price stability are replaced by short-term politically expedient policy. This could be a major problem and if the market by and large believes the independent status has broken down, this will have adverse consequences with regard to inflation expectations. But Messrs. Obama, Geithner and Summers clearly believe they are smart enough to pull all of this off – maybe too smart for everyone else’s own good. We shall see, maybe I’m completely off base.

Mortgage Applications

The Mortgage Bankers Association reported that their mortgage apps index fell again, down 15.8% for the week ended June 12 – this marks the fourth week of decline as refinancing activity stopped when the 30-year fixed rate began to rise back toward 5.00%.

Purchases, which had risen (albeit slight) for three-straight weeks, fell 3.5% last week.

As we touched on yesterday, home sales just can’t keep going with the unemployment rate near 10% and likely to move above that level. The Fed can boost sales at the margin by taking action that pushes interest rates lower, but even this has a short window; if the market becomes concerned about future rates of inflation and massive debt issuance it will easily overwhelm anything the Fed has the capability of doing – unless they are going to take things to an entirely new level, which will assure runaway inflation down the road.

Consumer Price Index (CPI)

The Labor Department reported that the consumer price index registered another benign reading, rising just 0.1% in May. The core rate, which excludes food and energy, also rose 0.1% for the month.

The decline within the housing and food components, which make up 60% of the index, were the main reasons CPI remained so tame. I’m going to predict food prices will not remain held down for long, particularly with the heavy rain in the U.S. this spring. Farmers have been unable to get corn planted and wheat fields are flooded, just to name a couple of the big crops, and this should have an effect on the food component within the inflation gauges. Further, the producer price data shows some building in foods price within the early stages of production.

The gasoline component within CPI rose 3.6%, but this was partially offset by a large decline in utility costs – the third large monthly decline, down 1.3% in May, 1.7% in April and 1.4% in March. The rise in gasoline prices was held back due to the seasonal adjustment and with oil above $70 and wholesale gasoline up 10% in June, one should expect the energy component to boost the next print on CPI.

On a year-over-year basis, CPI fell 1.3% in May, the largest decline since 1949. This will change. Currently, the year-over-year readings are matched against the figures that reflected the commodity-price spike of last spring/summer. By the end of the year, this will change in a meaningful manner.

The core rate rose 1.8% year-over-year, a slight deceleration from the 1.9% in April.

People will become, and have been, lulled into thinking inflation will not arise for a very long time, if at all. But these things take a little time to build; the ingredients are all there, they just need to be mixed together and that occurs when the economy bounces and credit begins to pick up again. Recall, the last time the Fed monetized the debt – coming out of the 1940s to ease the burden of financing WWII – CPI jumped from -2.9% on a year-over-year basis in July of 1949 to 9.5% by March of 1951.

This is just an example to make a point; it is not to say things will turn out the exact way this time. Inflation will begin a large issue at some point, and the problem for the economy is that this means the Fed will need to aggressively tighten -- unwind what they are currently doing and beyond.

The FOMC won’t do anything for a while as they will view a high unemployment rate and low capacity utilization as impediments to higher prices, which increases the chances of inflation rolling – we’ve known for three decades now that these Keynesian models are flawed. The tightening that will be necessary will be a major issue for the economy and will very likely make the eventual recovery short-lived – there’s just no way to get around what we are doing, and have done with regard to monetary policy for quite some years now. I’m looking down the road a ways, 18 (maybe 24) months, but short-sighted thinking can be dangerous in this environment.


Have a great day!


Brent Vondera

FedEx reports earnings

FedEx reported earnings that topped the consensus estimate, but delivered downside guidance due to the recent run-up in fuel prices. FedEx did not provide a full-year outlook for fiscal 2010 citing a lack of visibility into the economic recovery and jet-fuel costs.

Revenues fell 20% year-over-year to $7.85 billion, short of the $8.32 billion consensus, hurt by lower volumes due to the global recession as well as reduced fuel surcharges and lower shipment weight.

On the bright side, some numbers suggest that the decline has leveled off. International priority deliveries, one of FedEx’s most profitable offerings, slid 12%, less than the 13% drop in the previous quarter. U.S. express package volumes fell 2%, the smallest in five quarters.

Another positive note is the aggressive cost-cutting measures, such as idling planes and cutting back its work force, which resulted in higher cost savings than many anticipated.

The results also included $1.2 billion in write-downs, most of which was attributed to its 2004 acquisition of Kinko’s Inc. FedEx has taken write-downs totaling about 70% of Kinko’s purchase price.
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Peter J. Lazaroff

The Next Generation of Nuclear Reactors

The Wall Street Journal reports that four power companies are expected to split $18.5 billion in federal financing to build the next generation of nuclear reactors, one of which is Southern Co. (SO). The companies would start building the reactors as early as 2011, with the plants expected to come online by 2015 or 2016.
The report describes this federal financing as “the biggest step in three decades to revive the U.S. nuclear industry and one that could vault the utilities ahead of some of the sector’s strongest players.”

New nuclear-utility builds is also good news for Curtiss-Wright (CW) who makes the pumps for nuclear-generating plants and companies that make nuclear reactors like General Electric (GE).

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Peter J. Lazaroff

Consumer Price Index

Consumer prices rose .1% in May from the previous month, excluding food and energy prices also rose .1%. On a yearly basis, CPI fell 1.3%, the largest decrease since April 1950. The YoY number will probably continue to worsen, considering we have yet to compare this recent trend in prices to last summer where YoY CPI hit a peak of +5.6% in July and was still +.3.7 in September.

This part of the business cycle also makes it very difficult for business to pass along production costs to the consumer. With so much money in the market today, thank you Helicopter Ben, it shouldn’t take much of a turnaround there to reverse the current trend in consumer prices.



Cliff J. Reynolds Jr., Junior Analyst

Free Cash Flow (Part II)

Yesterday provided an introduction to the basics of using free cash flow in a company analysis. Part II of this discussion focuses on free cash flows limitations.

There are two ways to calculate free cash flow. The first uses the company’s cash flow statement and balance sheet.

Free Cash Flow = Cash Flow From Operations – Capital Expenditures

The second uses the income statement and balance sheet.

Net income
+ Depreciation/Amortization
-Change in Working Capital
-Capital Expenditure
-------------------------------
= Free Cash Flow

Without a regulatory standard for determining free cash flow, investors often disagree on exactly which items should classified as capital expenditures. As a result, it is important to “check under the hood” of companies with high levels of free cash flow and see if they under report capital expenditures and R&D.

Companies can also temporarily boost free cash flow by stretching out their payments, tightening payment collection policies, and depleting inventories. These activities diminish current liabilities and changes to working capital.

A more complicated accounting is the hiding of receivables. This occurs when a company records a revenue in which cash will not be received within a year, but places the receivable in another line item outside of “non-current” assets. Accordingly, revenue is recorded and cash from operations increases, but no current account receivable is recorded to offset revenues. Thus, cash from operations and free cash flow enjoy a big but unjustified boost.

Like all performance metrics, free cash flow has its limitations. Still, it is a great place to start searching for quality investments.

--

Peter J. Lazaroff

Daily Insight

U.S. stocks dropped for a second-straight session as Best Buy posted poor same-store sales and another ugly industrial production reading outweighed a bounce in housing starts. Commodity prices fell for a third-straight day, here’s that retracement we’ve talked about – let’s see how far it goes, and basic material shares led the broad market lower as a result. People are beginning to doubt the timeline of the recovery as the data has yet to illustrate substantial improvement rather than just stabilization at a low level.

Best Buy reported that same-store sales plunged 6.7% last quarter, a 2.3% decline was expected and one would think they’d had been able to meet that number with major competitor Circuit City out of the game. Traffic in all stores was weak (the same-store sales figures measures just those stores open for more than a year). This didn’t seem to have an effect on investor sentiment initially, but when it combined with a poor industrial production reading, the market sold off.

A lot of people seem to be expecting consumer activity to bounce in the near-term simply because the numbers have been so weak. But this economy has to face big headwinds, one being debt liquidation within the consumer arena and this will weigh on the largest segment of the economy for an extended period.

Market Activity for June 16, 2009


Housing Starts

The Commerce Department reported that builders broke ground on significantly more houses than expected in May, offering signs that the industry has roused from its four-year slumber.

Housing starts jumped 17% in May to an annual rate of 532,000 after making a new low of 454,000 in April. Starts were led by a 61.7% leap in multi-family units after back-to-back declines in April and March of 49.4% and 26.3%, respectively. Single-family starts rose 7.5% in May.


These are nice improvements -- certainly the multi-family number is a surge but it’s from a deep record low and this segment is highly volatile – yet we still have a large supply burden to work off and this increase in housing starts is not going to help that glut. In terms of GDP, if this move continues into June, which the rise in building permits suggests will be the case (also released yesterday), residential construction may just contribute to economic activity for the first time in 10 quarters.

I think economists should refrain from getting too excited, which appeared to be the case by the reporting, that this jump in starts signals something has changed. I have no desire to offer a negative view here, but the levels are very depressed and any pickup is going to add to supply. Fact is sales will not bounce with the jobless rate at these heights unless fixed mortgage rates move well below 5.00% again, which seems unlikely.

I’ve been comparing the past few readings to the December figure, rather than simply using the previous month. The December reading is the one to gauge ensuing data against simply because the January and February readings really skewed things. (January housing starts were depressed because of really bad weather and February saw a big bounce as weather was better than normal). We have yet to get back to the level in December. When that reading is surpassed, which a mild increase for June should accomplish, it will then be safe to say we’ve seen the worst from this market. But without a sustained bounce in sales, I don’t see how residential construction can help GDP outside of possibly offering a little boost this quarter as we come out of the lowest activity on record.

Building permits rose 4% last month from the record low hit in April.


Industrial Production (IP)

Commerce also reported that industrial production fell for the 16th time in the past 17 months for May. This marks the deepest and most prolonged slump since the draw down in production coming out of WWII. And the decline cannot be blamed solely on a weak auto sector as declines in consumer goods and business-equipment production illustrate the manufacturing slump is broad based.

Industrial production (output at factories, mines and utilities) fell 1.1% in May, slightly worse than the 1.0% decline that was expected. A 7.9% plunge in motor vehicles and parts led the decline, but this segment makes up less than 5% of the index. Ex-vehicles, production fell 0.9%, which follows a 0.7% decline in April and is off by 12.2% from the year-ago level.

In terms of industry groups, manufacturing output fell 1.0%, utility output fell 1.4% (not weather-related as the national temp was slightly above average) and mining production slumped 2.1%.

In terms of market groups, consumer-goods production was off by 0.8% (down 7.1% year-over-year), pushed lower by a large 1.9% drop in home electronics; business equipment fell 1.4% (down 16.5% year-over-year), driven by a 1.0% decline in business supplies.

As we’ve stated over the past couple of months, people can talk about the second derivative (declining at a slower rate) all they want but the market will eventually become tired of this reality. Soon, industrial production will have to turn positive, and specifically this is true for the manufacturing sector, for the equity markets to expand upon this very nice surge we’ve enjoyed from the March lows. We continue to believe GDP will post a mild increase for the third quarter, but this IP reading better follow a plus sign when the June figure is released or we may have to push that estimate out a quarter.

On the positive side, corporate profits should explode a couple of quarters out. The slash and burn with regard to expenses (both payroll and overall business spending) means that it won’t take much in the way of higher sales to fuel the bottom line – year-ago comps will be easier to beat as well. Before we get there though, we may still have to fight through some rough waters.

Have a great day!


Brent Vondera

Free Cash Flow

Many investors tend to use a company’s earnings to evaluate performance, but net income can easily be distorted by accounting gimmicks. Free cash flow, on the other hand, is difficult to fake (though not impossible) and provides a more transparent view of a company’s ability to generate cash and profits.

Free cash flow is the cash left over after a company meets its necessary expenses. A company can reinvest their free cash to grow its own business and, in turn, boost shareholder returns. Alternatively, free cash flow can be returned to shareholders through bigger dividend payments or share buybacks.

There are many ways to use free cash flow in a company analysis. I will use beverage giant Coca-Cola (KO), which is a great example of a company that consistently generates high free cash flows, which often exceed its reported net income – a sign of high earnings quality.

Free cash flow to Revenue
In 2008, Coca-Cola produced $5.6 billion in free cash flow from $31.9 billion revenues. Thus, Coca-Cola’s free cash flow to revenue ratio was an impressive 16.6 percent – a good rule of thumb is to look for companies with free cash flow that is more than 10 percent of sales revenue.

Free cash flow multiples
It is also important to look at free cash flow multiples. Free cash flow yield allows you to compare how much cash power the share price buys, or how much investors pay for one dollar of free cash flow. Price to free cash flow is similar to the more commonly known price/earnings (P/E) ratio.

Comparing Coca-Cola to direct competitor Pepsi Co. using these multiples suggests that Coca-Cola is reasonably priced.

Efficiency Ratios
Besides looking for low free cash flow multiples, we also seek out attractive efficiency ratios. An attractive Return on Equity (ROE) can help ensure that the company is reinvesting its cash at a high rate of return.

On this front, Coca-Cola performed exceedingly well with a ROE of nearly 26%. In other words, Coca-Cola was able to generate 26 cents worth of profits from each dollar invested by shareholders.

To double check that the company is not using debt leverage to give ROE an artificial boost, we also examine Return on Assets (ROA).

A ROA higher than 5% is normally considered to be solid for most companies. Coca-Cola has an impressive 12.6 % ROA, which should reassure investors that the company is doing a good job of reinvesting its free cash flow.

--

Peter J. Lazaroff

Producer Price Index

The headline number for May PPI came in at +.2% MoM, (+.6% expected) while the core (excluding food and energy) was -.1% MoM (+.1% expected). Although TIPS are indexed off of CPI, a measure of prices paid by consumers, the correlation between PPI and CPI is dependent on producer’s ability to pass along an increase in costs to consumers. TIPS sold off soon after the release of the data and are underperforming nominal Treasuries today by .4% as of this post. The CPI for May will be released tomorrow morning.

Cliff J. Reynolds Jr., Junior Analyst

Amgen's cancer drug is a potential blockbuster

Bloomberg posted an interesting article today about Amgen’s (AMGN) experimental drug denosumab. One of the biggest reasons that we like Amgen is our expectations for this potential blockbuster – a drug that generates $1 billion in annual sales – which we expect to be a key growth driver.

Amgen is currently seeking U.S. approval to sell denosumab for osteoporosis, but studies have shown that the drug can also halt cancer’s spread in bones. According to some estimates, denosumab could generate $1.8 billion a year for halting prostate tumors and an added $1.2 billion for breast malignancies.

Amgen’s currently has five blockbuster drugs, which helped push global sales to $15 billion in 2008. Still, a potential blockbuster like denosumab could really help take the pressure off Amgen’s other drugs, which are facing higher scrutiny from the FDA as well as increased competition from both branded and biosimilar (generic biologic).

--
Peter J. Lazaroff

Daily Insight

U.S. stocks sold off on Monday, led by commodity-related shares, as concerns over global economic growth increased after New York-area manufacturing activity contracted in June at a greater rate than the previous month. And it’s not only the worry that a global expansion may take longer to arrive than many had hoped but one should also view a 2.40% pull back (and frankly more days like this should be expected) as a natural occurrence after the 14-week gain that had sent the broad market 40% above the deep depths of March.

Commodity prices in general, as measured by the CRB, have sold off about 4% in the past two days and the basic materials index, which largely tracks the direction of commodity prices, has given back five percentage points of the 56% gain from the March lows. As we touched on last Monday, such things are to be expected after a run of this magnitude. Additional short-term weakness is likely but it’s doubtful this group will remain down as a declining dollar, large global infrastructure projects, an eventual bounce in economic activity and the probability that China will continue to stockpile commodities (as a dollar hedge) foments the resumption of the uptrend.

Financial shares were also one of the main losers yesterday. I think it’s likely the group will weigh on the market again today as traders will avoid the sector until President Obama unveils his regulatory oversight plan on Wednesday – in fact, unless today’s economic data surprises to the upside traders may sit on the sidelines altogether. We’ve got a decent outline of what they want to do (and the model will give the Fed enormous authority and oversight – let’s hope the Federal Reserve regains its independence, which is not currently the case) but the devil is in the details so there will likely be a wait and see approach.

Market Activity for June 15, 2009


Empire Manufacturing

The New York Federal Reserve Bank stated factory activity in the region contracted at a faster pace this month, falling to -9.4 after posting -4.6 for May. (Readings below zero on Empire Manufacturing mark contraction, whereas 50 is the line of demarcation for the nation-wide ISM and Chicago surveys, just to clarify for new readers)

The road to recovery within the factory sector will take additional time, particularly as auto-sector woes continue to put pressure on the figures. What we are watching here is for the inventory and workweek gauges to tick higher. At some point, the inventory dynamic (stockpiles have been liquidated on a massive scale and it will take little in the way of a demand boost to drive inventories to dangerous levels, which means increased production when it occurs) will occur to catalyze growth; the market is betting on this to take place soon, hence these will be the two most important aspect of the factory reports for a while.

To this point, these indicators have yet to show signs of a bounce. The inventory index remains very weak, firms are unwilling to boost stockpiles as a sales rebound has yet to occur.

The workweek reading is another key indicator as one cannot expect the employment picture to improve. Businesses are never quick to boost hiring when an economy turns as they wit to make sure the recovery is for real. As a result, they demand more output from existing workers, and this will show up via marginal improvement in the workweek index. Nothing so far illustrates such activity has taken place – only stabilization from very low levels.

If a bounce within these segments of the manufacturing sector fails to occur in the next two months, you’ll see third-quarter GDP expectations (which currently call for GDP to post its first positive print in a year) reduced and that could weigh heavily on stocks. We continue to believe that growth will show a mild advance in the third quarter, followed by a more robust reading by the fourth, but the economy faces major headwinds (debt liquidation within the consumer arena and the affect higher tax rates and regulations will have on the business community) so it is especially difficult to judge..

The market has received a boost as these manufacturing readings ascended from the deep levels of contraction the economy endured late-2008/early-2009. From here, continued improvement will be needed to go much higher; the market is watching these regional reports very closely for signs of progress.

Empire Manufacturing also offered a series of supplemental questions, chief among them was an inquiry into capital spending plans for 2009 relative to their actual 2008 spending. To no one’s surprise capital outlays will be lower, significantly lower in fact. Across all respondents, firms averaged $1.9 million in capital spending plans, down 24% from 2008 spending.

Net Foreign Investment Flows

Net foreign investment flows into U.S. financial assets (equities, government and corporate notes, bonds and agency bonds) grew but at a slower pace in April, up $11.2 billion compared to $55.4 billion in March – analysts expected an increase of $60 billion and I haven’t seen the forecast missed by this degree in a long time. However, foreign holdings of Treasury securities, alone, rose $41.9 billion compared with $55.3 in March – despite the big miss from an expectations standpoint on the headline figure, this last number is pretty good and the latest Treasury auctions showed foreign demand remains healthy.

The concern here is based on a longer-term perspective. China, Brazil, Russia, et al. have expressed a desire for a new global currency reserve as the dollar’s value hasn’t exactly been stable for several years (a direct result of monetary policy up until now; from here massive budget deficits may also put pressure on the greenback). But a new currency reserve will not occur overnight, which means we have time to get monetary and fiscal policy right again. What these numbers can illustrate in the meantime is the direction of interest rates over time. If we get a multi-month period in which foreign purchases of Treasurys slows, watch out.

It will be important to keep the watch segmented (specifically to the Treasury aspect of the report) as the hunt for yield resulted in a flood into corporate debt, which will drive the overall readings in coming months. Rates will move prior to the release of these figures due to the lag, but the readings can still give the market a picture of where rates will go from there based on this inflows trend and the extent to which foreign government become fed up with their dollar holdings, if only at the margin.

There are really only two ways to create a relatively strong and stable currency: one is sound monetary policy and the other is low tax rates on capital. When both of these policies move in the other direction, unsound monetary policy combined with higher tax rates on capital, you can be sure the greenback will lose purchasing power over time. Our deep and liquid markets can offset some of this pressure for a while, but eventually the world will find something better if the dollar is not it.


Have a great day!


Brent Vondera