Penney for My Thought

What percentage of success is attributable to luck and what percentage by design?

Ron Johnson, the new CEO of J. C. Penney and the man credited with the success of Apple Stores, so far seems to have met neither on his new job. The latest earnings report from Penney was a disaster, at least in the eyes of Wall Street. Here is how Reuter reports it.

(Reuters) - Shares of J.C. Penney Co Inc (JCP.N) opened 19 percent lower on Thursday after the department store operator reported its sharpest drop in sales since announcing a transformation plan 13 months ago.
  The results prompted at least three brokerages to cut their price targets on the stock, which has lost 48 percent of its value in the past year.

"We were most surprised by the more than 1,000 basis points decline in gross margins in the quarter," Deborah Weinswig of Citigroup wrote in a note, cutting her price target on the stock to $22 from $25.

Mr. Ron Johnson of course insists that turning around a long time failure like Penney is a multi-year project and he needs more time to execute on his new strategy. I have no basis of doubting Mr. Johnson's sincerity. However, it has been my general observation that in the world of business, predictions are never wrong; they are merely premature. Strategies are never erroneous; they always need more time. Here is a thought. Perhaps the success of Apple Stores have something to do with those iphones and ipads and less to do with selling said items on tables instead of counters. 

Bernanke to the Rescue

After a modest sell off, albeit one accompanied by a sharp rise in volatility, Mr. Bernanke once again rode to the rescue. Appearing in his semi-annual Humphrey Hawkins testimony to Congress, the Fed chairman re-assured the market.

 In the current economic environment, the benefits of asset purchases, and of policy accommodation more generally, are clear: Monetary policy is providing important support to the recovery while keeping inflation close to the FOMC's 2 percent objective. Notably, keeping longer-term interest rates low has helped spark recovery in the housing market and led to increased sales and production of automobiles and other durable goods. By raising employment and household wealth--for example, through higher home prices--these developments have in turn supported consumer sentiment and spending.

There in fact has been talks among the jittery wall street types that the Fed chairman may address the possibility of ending asset purchase sooner.  However, the effectiveness of monetary policy depend just as much on credibility as it is on setting interest rates. Whatever private concerns Mr. Bernanke may have, he has to maintain his unwavering public stance. It is clear that the Fed is trying to raise asset price to foster stronger economic activities. It will continue to do so until the stipulated bonds of inflation and unemployment rate have been breached.

Advice for investors: don't fight the Fed.

The Italian Job

Even since the release of Federal Reserve's January meeting minutes showing a few members' concerns of the long term consequences of QE, the stock market had acquired a downward bias. However, none of the subsequent trading days have showed such panic as today's closing hour. For the day, S&P 500 was down 1.8% and the volatility index rose 34%. The reason for such panic was attributed to election results in Italy. Here is a Reuters report explaining it.

The center-left coalition led by Pier Luigi Bersani won the lower house by around 125,000 votes and claimed the most seats in the Senate but was short of the majority in the upper house that it would need to govern.

Neither Grillo, a comedian-turned-politician who previously ruled out any alliance with another party, nor Silvio Berlusconi's center-right bloc, which threatened to challenge the close tally, showed any immediate willingness to negotiate.

World financial markets reacted nervously to the prospect of a government stalemate in the euro zone's third-largest economy with memories still fresh of the financial crisis that took the 17-member currency bloc to the brink of collapse in 2011.

Grillo's surge in the final weeks of the campaign threw the race open, with hundreds of thousands turning up at his rallies to hear him lay into targets ranging from corrupt politicians and bankers to German Chancellor Angela Merkel.

In just three years, his 5-Star Movement, heavily backed by a frustrated generation of young Italians increasingly shut out from permanent full-time jobs, has grown from a marginal group to one of the most talked about political forces in Europe.

Berlusconi's campaign, mixing sweeping tax cut pledges with relentless attacks on Monti and Merkel, echoed many of the themes pushed by Grillo and underlined the increasingly angry mood of the Italian electorate.

It has always been a worry for the market that how long the citizens of Europe's peripheral nations will accept the yoke of austerity. Regardless of how Italian election finally shapes up, the expanding influence of this anti-austerity block can not be denied. Mr. Grillo, who is the leader of the anti-austerity movement, wants Italy to hold a referendum to decide whether it should stay in the Euro zone. Of course, we are a long way from Italy leaving the Euro zone. But the existence of such a possibility has given the market a strong reason for pause.  

Is TI the New Model for Mature Tech Companies?

Amid the hoopla of the Dell buyout and the ensuing shareholder push back, the stock price of another Texas tech giant reached a 52 week high. In a press release last Thursday and a subsequent conference call on Friday, Texas Instrument outlined its new capital allocation strategy.

DALLAS, Feb. 21, 2013 /PRNewswire/ -- Texas Instruments Incorporated (TI) (NASDAQ: TXN) today said it will increase its quarterly dividend by 33 percent, from $0.21 per share to $0.28, payable May 20, 2013, to shareholders of record on April 30, 2013. Annualized, the new dividend will be $1.12. Additionally, TI authorized the repurchase of an additional $5 billion of its common stock bringing the total outstanding authorization to $8.4 billion.

These increases reflect the company's ability to generate cash and management's commitment to return it to shareholders. Over the past few years, TI has built a business model for growth and high margins with its focus on Analog and Embedded Processing semiconductors. As a result, TI believes it can consistently convert 20-25 percent of its revenue into free cash flow* and return 100 percent of that free cash flow (less debt repayment) to shareholders.

Much of mature tech giants today including Microsoft, Intel and Cisco are generating copious amount of free cash flow and seeing their cash holdings increase each quarter. Should these companies choose the lead of Texas instrument and pay out substantially all free cash flow, none will ever complain about an under-valued stock. Investors can only hope that TI is the new model.

Cisco and Heinz

Cisco reported earnings last night. Once upon a time, the market would move according to what Cisco reported or had to say on their earnings conference call. Today, it barely noticed. Instead, a much stodgier company grabbed the stage. Heinz was being acquired by Warren Buffett and Brazilian private equity firm 3G Capital for $72.50, about a 20% premium to previous day's close.

In late 2000, when I was a mutual fund manager canvassing around the country and ballyhooing the worthiness of my own special blend of stocks and bonds, I surveyed a roomful of financial advisers. If they could hold one stock, what would that company be? For their one and only Valentine, most advisers chose Cisco. Of course at the time, Cisco was trading in the high 60's and carried a PE multiple in the triple digits. Heinz, being a food company, of course was never showered with such affection during the growth crazed years of 1999 and 2000. In late 2000, it carried a price around $40 per share and a PE multiple of  16.

Fast forward 13 years ahead, Cisco had grown revenue from $18.93 billion in fiscal 2000 to $46.06 billion in fiscal 2012 for a compound annual growth rate of 7.1%. Earnings per share had grown from $0.39 to $1.50 during the same period for an annual growth rate of 10.9%. Heinz, on the other hand, had grown, revenue, also on a fiscal year basis, from $8.94 billion to $11.65 billion equating to 2.1% annual growth. EPS had grown from $2.51 to $2.87, a minuscule growth rate of 1% annually. Now for the number that  really matters to investors, at today's stock price of around $21, Cisco had lost more than 70% of its value and Heinz had gained more than 80% at the buyout price.

So for lesson #1, the stock market has a propensity to overvalue growth. Overpaying even a great company can have acutely negative consequences for your portfolio.

Even before today's $12 climb, Heinz at $60 was trading at 21 times it latest fiscal year end earnings while Cisco only sports a multiple of 14. Cisco is by no means an inferior business compared to the ketchup king. During the latest fiscal year, Cisco had a gross margin of 61% and return on asset of 8.8% while Heinz had a gross margin of 34.3% and return on asset of 7.7%. The natural questions is of course, why does Cisco which grows faster and has superior return characteristics, trade at a much lower multiple than Heinz. The answer is  Heinz will still be selling Ketchup 10 years from now while Cisco may very well be supplanted by an emerging technology or may have to re-invent an entirely new product line.

So here is lesson #2, the stock market has a propensity to overvalue innovation. In fact, companies with long and stable product lines always have the superior business models over companies that had to re-invent themselves.

At $72.50, Mr. Buffett is paying 19 times Heinz fiscal 2014 earnings estimate, which I believe is overly optimistic. I think given his extremely low cost of capital, Mr. Buffett is paying a fair price for an extremely slow growth company. I also tend to think that the market is also over-estimating the business risk of Cisco who occupies a dominant position in networking and is well entrenched in enterprises and governments alike.

For my money, I will bet on Cisco at $21 over Heinz at $72 for the next 10 years.

Currency War

Ever since the finance minister of Brazil announced in September of 2010 to a group of industrial leaders gathered in Sao Paulo that nations of the world were engaged in a currency war, there have been these unconvincing denials by money printing central bankers around the world that they were merely trying to resuscitate their respective moribund economies in an environment of shrinking demands. Never mind the results of money printing weakens one's currency and thus helps the nation in gaining an increasing share of limited demand. With the election of Shinzo Abe, Japan stripped away the veil by setting explicit exchange rate targets. Now the world is up in arms, thus during the gathering of G7 nations in London, they felt compeled to issue this statement:

The Group of Seven leading economies Tuesday attempted to head off a potentially destabilizing round of currency devaluations, issuing a statement that reaffirmed their commitment to let market forces determine exchange rates, and saying central bank policy will be focused solely on domestic objectives.

The question of currency devaluations is an awkward one for industrialized nations, many of which have embarked on monetary policies designed to boost their economies that have the side effect of lessening the value of their currencies. The U.S. Federal Reserve's bond-buying policy has previously sparked world-wide concern given its impact on the dollar.

In the statement, the G-7 made it clear that their central banks weren't attempting to weaken their respective currencies when they engaged in monetary stimulus, but simply were trying to support flagging domestic demand.

In international politics, the fact that nations pledge not to do it, is how we know they have been doing all along and will continue to do so.

 

Pimco's Currency ETF

Pimco is launching a currency ETF. Here is a summary of what it is all about:

PIMCO plans to launch an active currency ETF designed for investors who want to protect against a devalued U.S. dollar with the bond giant’s expertise in global markets.
The ETF will invest in foreign currencies and is expected to list on the NYSE Arca on Tuesday with the ticker FORX. The fund will charge a management fee of 0.65%, according to the prospectus.

It will be called PIMCO Foreign Currency Strategy ETF. PIMCO is putting the ETF together for investors who want to diversify with currencies if the U.S. dollar depreciates, said Don Suskind, head of global ETF product management, in a telephone interview Monday.

I must admit I am a huge fan of Bill Gross and Mohamed El-Erian. I read everything those pairs write. My image of Pimco had always been an intellectually vigorous firm who at least thought to offer products that serve the long term interest of investors. But a currency ETF seem to cater to the basest instinct of their customers. Currency trading is a zero sum game in a frictionless world. Subtracting the cost of procuring currency contracts, Pimco's management fees and the commission from your favorite discount brokers, investors are asked to play a negative sum game. With that in mind, may I so boldly predict that the overwhelming majority of FORX purchasers will end up losing money. And I don't think that is in the long term interest of investors.

In the world of fund management, ETF is where the money is. If Willie Sutton, a mere bank robber can see it, surely an intellectually vigorous firm like Pimco, can too.

Buyout Undervalues Dell, Says One Large Shareholder

Apparently, Southeastern Asset Management, the largest outside shareholder of Dell, agrees with us that the buyout price of $13.65 vastly undervalues Dell's true value. For our thesis on Dell, please see yesterday's post. While we considered Dell from a free cash flow and dividend paying potential point of view, Southeast looked at it from a hidden assets point of view. Over the years, Dell have made numerious acquisitions totaling $7.58 per share. Within Dell's vast corporate structure, their must be parts that are valued by the current market place and can readily be unlocked. I suspect that is part of Silver Lake's strategy. Dell has failed to become IBM. Thus it is time to unwind the empire. The parts are surely worth more than the sum. The letter Southeastern wrote to SEC is well thought out and worth quoting at length:

Southeastern believes that straightforward, modest valuations of Dell result in per share valuations vastly in excess of the $13.65 offer price. Net cash per share after deducting structured debt within Dell Financial Services (DFS) is $3.64. Dell Financial Services has a book value of $1.72 per share. In addition, since Michael Dell resumed his role as CEO in 2007, the Company has spent $13.7 billion or $7.58 per share on acquisitions intended to transform the Company into a sustainable IT business and lessen its reliance on the PC business. During Dell’s June 2012 analyst day, Dell Chief Financial Officer Brian Gladden said that in aggregate the acquisitions to that point had delivered a 15% internal rate of return. The Company has neither taken nor discussed the need to take any write downs of these acquisitions. We therefore conservatively believe the acquisitions are worth a minimum of their cost. Taken together, these items total $12.94 per share before we even look at the other businesses.

 

The current bid therefore places a value of less than $1.00 per share on the remainder of the Company. By any objective measure, that is woefully inadequate.

 

As highlighted in an example below, the Company could have paid shareholders a substantial special dividend (close to $12.00 per share in the example below) while still retaining the ability to generate anywhere from $1.14 to $1.34 per share of free cash flow per year (same as the Company’s measure of “non-GAAP” earnings). Using the midpoint of the free cash flow range of $1.24 based on the estimates below, the Company would produce over $2.2 billion in free cash flow annually. This level of cash flow generation provides interest coverage of 4:1 based on the numbers below.

Dell Going Private. Who are the Losers?

By now, it is old news that Dell have agreed to be taken private by private equity firm Silver Lake Partners and its founder Michael Dell. Here are some highlights from the press release.

Under the terms of the agreement, Dell stockholders will receive $13.65 in cash for each share of Dell common stock they hold, in a transaction valued at approximately $24.4 billion. The price represents a premium of 25 percent over Dell’s closing share price of $10.88 on Jan. 11, 2013, the last trading day before rumors of a possible going-private transaction were first published; a premium of approximately 35 percent over Dell’s enterprise value as of Jan. 11, 2013; and a premium of approximately 37 percent over the average closing share price during the previous 90 calendar days ending Jan. 11, 2013. The buyers will acquire for cash all of the outstanding shares of Dell not held by Mr. Dell and certain other members of management.

As of Jan 31, 2013, Dell has $14.82 billion worth of cash and short term investments and $9.25 billion of short term and long term debts. At the buyout price, dell sports an enterprise value of $18.83 billion and a EV/Ebidta valuation of only 3.5, substantially similar to the valuation of HP and less than half of well run companies like IBM.

It is a popular misconception that private equity companies are in the business of buying troubled businesses and fixing them. In the stock market hay days of 2007, both Harmon and Penn National Gaming were offered buyout deals at the peak of their then respective prices. Of course, neither companies needed any fixing. In the capital market, equity requires a higher return compared to fixed income securities. Private equity is all about arbitrage between those two types of asset classes. So its business model is not so different from your importer who buys shoes from Vietnam or your exporter who sells wines in China. So long as your business can earn a greater return than your borrowing cost, your equity value will be enhanced. Of course, if you can somehow improve the acquired business, that will just be gravy.

In the press conference, Michael Dell purportedly claimed that it would be easier for him to turn around Dell without the glare of public investors and the pressure of quarterly earnings target. Of course, the goals of both Dell and HP are to become IBM. To get there, Dell has been making acquisitions. Without the currency of the public float and a more leveraged balance sheet, it seems to me the task gets more difficult, not easier. The Dell privatization happened because of the confluence of an extremely undervalued stock and an enthusiastic credit market for the benefit of Silver Lake partners and Dell's management. To quote Jerry Seinfeld, "Not that there is anything wrong with that." This is capitalism afterall. As soon as Dell becomes a private company, substantial dividends will be paid to the new equity holders both out of existing cash on balance sheet and Dell's ample free cash flow. I am aware that Dell's cash holdings are substantially in foreign jurisdictions and can not be repatriated without tax consequences. I believe a way will be found around this issue.

The most obvious loser in Dell's privatization, yet hasn't be pointed out all that frequently, are Dell's public debt holders. For example, Dell's 6.5%38 notes were trading at 116 before story of its buyout broke. It now trades at 89. By agreeing to a leveraged buyout, Dell's credit rating will certainly fall to junk status. So the 6.5%38 note holders have just saw a 23% drop in asset value. But I believe the public stock holders were also losers. Dell is in a mature business and pretending to be a growth company. Had Dell been run primarily as a business with substantial free cash flow and paid a higher dividend, let's say $1 per share, I believe Dell's stock price would have been much higher that even the current buyout price of $13.65. Even at $1 dividend rate, Dell still would have ample cash flow to pursuit acquisition, not to mention a much higher stock as currency.

So once again, both public stock and debt holders were screwed. Ain't that always the case.

January Returns

January was a great month for stocks, but not so great if you were invested in bonds. Here is the tally:

• Treasury: -0.95%
• High Grade Corporate Bonds: -0.72%
• High Yield Corporate Bonds: 1.38%
• S&P 500: 5.18%.

So for the month, stocks significantly outperformed bonds. For the past few years, high yield bonds have closely matched the return of stocks, but so far this year, it has lagged.

The falling prices of Treasury and investment grade bonds have prompted a few strategist calling for the possibility of an unruly exit from bond land.

But an expected shift out of fixed income - particularly top-quality investment grade - and into stocks coupled with a commensurate rise in interest rates and a much more easily traded corporate debt market could send tremors through the space, Bank of America Merrill Lynch said.

"A disorderly rotation out of bonds - characterized by higher interest rates and wider credit spreads - is the biggest risk for investment grade corporate bond investors this year," Hans Mikkelsen, credit strategist at BofA, said in a note to clients. "However, history offers little guidance about how much of an increase in interest rates would prompt such disorderly scenario and how it would play out."

It is certainly possible that Treasury and high grade corporate bonds continue their incremental slide while stocks advance. However, if 10 year Treasury rates were to back up toward 2.5% or even 3% range, it is inconceivable that stocks could act as a shelter for bonds. Most likely, both asset classes would sell of severely. The policies of the Federal Reserve have certainly placed investors, particularly income investors between a rock and a hard place. The extended duration of low interest rates have elevated all asset prices which necessarily usurp future return for the service of our present balance sheet.

 

Is the Stock Market Cheap?

Doug Short of Advisor Perspective writes some of the most informative blogs on the web. His postings can be found at www.dshort.com. Today, Mr. Short shone the light on market valuation as the Dow Jones Industrial Average revisited the 14000 level for the first time since 2007.

The price to earnings ratio is of course one of the more common methods used to determine stocks and stock market valuations. However, since both prices and earnings can gyrate widely, the P/E ratio sometimes produces counter intuitive results. For example, during the market trough of 2009, the P/E ratio stood at triple digits, higher than the market peak of early 2000. Mr. Short's method of choice is the so called PE10, championed by Yale Professor Robert Shiller. Here is how he explains it:

Legendary economist and value investor Benjamin Graham noticed the same bizarre P/E behavior during the Roaring Twenties and subsequent market crash. Graham collaborated with David Dodd to devise a more accurate way to calculate the market's value, which they discussed in their 1934 classic book, Security Analysis. They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. Their solution was to divide the price by a multi-year average of earnings and suggested 5, 7 or 10-years. In recent years, Yale professor Robert Shiller, the author of Irrational Exuberance, has reintroduced the concept to a wider audience of investors and has selected the 10-year average of "real" (inflation-adjusted) earnings as the denominator. As the accompanying chart illustrates, this ratio closely tracks the real (inflation-adjusted) price of the S&P Composite. The historic average is 16.4. Shiller refers to this ratio as the Cyclically Adjusted Price Earnings Ratio, abbreviated as CAPE, or the more precise P/E10, which is my preferred abbreviation.

According to Mr. Short, the current PE10 ratio falls within the top 20% group of the highest and is 34% above its historical mean of 16.5.

I started my career in the financial industry as a quantitative analyst. Our industry has an unrivaled ability to explain the past and an abysmal record at predicting the future. Ratios such as PE10 must necesarily move at such a slow pace to be basically useless for those with income to earn and moeny to invest. An individual investor simply can not sit on 0% return for years without losing patience and a professional one can not do so without jeopardizing his job.

On the question of market valuation, I happen to think the bulls and the bears are both right. Now before you start calling me names, let me explain.

As a financial asset of indefinite life, the value of a stock is determined by two things. First, its ability to earn a return now and forever into the future. Second, the prevailing interest rate now and forever into the future. Those who are pessimistic about stocks have assailed both of these front. Their arguments are based on what will happen in the future. They have argued that corporate profit margins are above historical average and are liable to fall to the mean. The prevailing interest rate is nothing but an anomaly manufactured by the brute force of the Federal Reserve. As sound as these arguments may be, it can not counter the mathematical reality of asset valuation. Stocks have been rising because corporate profits have been resillient and interest rates have stayed low. If T-bills will stay at 0% and 10 year Tresury will hold at 2% forever, then stocks are decided undervalued trading at a trailing PE ration of around 17. The fact is it makes a huge difference to the issue of stock market valuation whether the mean reversion envisioned by the bears arrives in 2 years or in 10 years. These days market participants have simply extended those said reversions toward a more distant future.

Is it more risky to sit on 0% return or to bet on your ability to foresee storms in the distant future?

Now that is a tough question.

January Employment Report

The US economy added 157,000 jobs in January according news release from the Bureau of Labor Statistics, roughly in line with Wall Street estimates. However, you have to scroll to the last paragraph to find the surprising news.

The change in total nonfarm payroll employment for November was revised from +161,000 to +247,000, and the change for December was revised from +155,000 to +196,000.

Despite talks of fiscal cliff, the average jobs added in the last two months of the year came to 220k. This is fairly impressive by the standard of a slowly growing economy. During the turning points in labor market, the jobs report tends to underestimate the addition and subtraction to the jobs market. We could be at such a point and the labor market appears to be strengthening.