Mullaneblog

Saving The Economy or Saving Their Ass?

US banks are going to set up an $80 billion fund to limit the credit crunch, Reuters reports. The fund will buy ailing mortgage securities and other assets in a bid to prevent the credit crunch from further hurting the global economy, anonymous sources said who were too embarrassed to disclose their identity for the newswire’s story.

How noble for these titans of industry to perform such a task for the masses.

The source neglected to say that it was the lack of controls and self-discipline of management at these money-center banks that created the crunch in the first place. Enticed by huge bonuses, there was little concern for the well being of the US economy when no-money-down mortgages and leveraging transactions at 8x EBITDA were being committed to ad-infinitum.

The Reuters report goes on to say representatives from the U.S. Treasury have organized conversations among top global banks, as financial institutions grow increasingly concerned that a certain type of investment fund linked to banks may have to dump billions of dollars of repackaged loans onto financial markets. The reason why Treasury officials have to speak to global banks is due to the outstanding job US bankers did selling this junk to investors from around the world.

Further, US bankers are saying that a fire-sale of assets could lift borrowing costs globally, trigger big losses from investors and force banks to further write down some holdings on their balance sheets. No kidding! That is what is supposed to happen after you make bad loans.

This news report shows that the depth and duration of this debt problem is coming home to roost. The credit evaluation process for many of these loans has moved away from the investment banking departments to the CFO’s department at many of the major money-center banks.

A month ago bankers were claiming it would take three to six months to work through the $300 billion pipeline of private equity transactions. But, after having some success with financing the First Data transaction, it is not going so well for the other deals. Banks have to write the checks for the commitments they have made with limited interest by lenders to scoop up the debt in other transactions. Supposedly, private transactions are being negotiated to place this debt with big discounts being suggested–meaning the writedowns that big money-center banks took in this recent quarter will continue in upcoming quarters.

The bankers’ plea to suggest that they are attempting to help the US economy by setting up this fund is pure hogwash. The fact of the matter is that regulators and CFOs are now running the show. And they are concluding that these masters-of-universe investment bankers did some real dumb things and have a big hole to climb out of.

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Negative Sentiment of the Dollar Continues To Build

Gold, the Canadian dollar, the euro and the lowering of short-term interest rates does not bode well for the U.S. dollar. Or at least that is what conventional wisdom is saying. You will be hard pressed to find a financial TV show or publication saying anything positive about the greenback these days.

Arguments are a plenty: the dollar is weak because the Fed added to much liquidity to U.S. economy in 2001 and 2002, the dollar is weak because of our huge trade and budget deficits, the dollar is weak because we are a people who are undisciplined and cannot save. The arguments go on and on. Someone in Barron’s actually wrote that the dollar is weak because inflation is high. Outside of housing there does not seem to be a lot of price deflation, but taking the leap to suggest inflation is pervasive enough to cause the dollar to weaken is somewhat of a stretch.

As we have blogged a few times this past month, the U.S. dollar is weak because currency traders have a trend-is-your-friend mentality. They will lever up and follow that trend until they get spanked by central banks. Currency reversals are driven by Treasury secretaries working with central bankers to change the direction of a currency. Expect that to soon happen particularly with the U.S. dollar reversing against the euro. The seeds are already being sown to spank those currency traders good and to drive the U.S. dollar higher. The U.S. economy remains the place to be and the global leader in new business creation. Do not sell the dollar short, go long the greenback.

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Is It Time To Jump Into Financial Stocks?

Historically, when the Fed has started cutting rates, investing in financial stocks has proven profitable for investors. Will the same hold true in today’s easing cycle? Probably not.

The Bear Stearns (BSC) model for its mortgage business might point to problems ahead for the financial industry in general. The financial services industry has done an outstanding job during the past twenty years developing new products and marketing them to institutions who specialize in buying these new instruments — primarily hedge funds. With mortgage hedge funds, publicly traded vehicles such as mortgage REITs and other investors now shutting their doors to these products, who gets stuck with them? You guessed it! The investment firms and large commercial banks.

Now let’s go to $300 billion of private equity debt that needs to be placed. Who is buying that up? While some institutions are, much of it is staying on the books of the investment firms and banks. Will funds be formed to invest in this debt? Yes, but it will take time.

Also, a point worth noting is that much of the debt for private equity deals is in the form of leveraged loans — meaning floating rate debt. If a series of events unfold where these interest rates have to be set higher, many companies that have gone private will have a tough time making their interest payments. Not too different than what is currently happening to homebuyers who purchased homes with adjustable rate mortgages.

Further, as the Fed starts priming the pump to keep the economy going, the liquidity will not flow into the sector that just went bust. Following the tech and telecom bubble of the late 1990s, when the Fed dropped rates, money went into real estate, not back into tech and telecom. As this current easing cycle unfolds, money is unlikely to flow back into the mortgage market and PE deals.

While the investment firms and commercial banks are not going bust like many did in the earlier 1980s and early 1990s, they will have trouble growing earnings for the next few years. Also, it appears the Fed’s easing cycle may not create the steep yield curve for financial firms to make easy money. All totaled, earnings growth in the financial sector will be hard to come by during the next few years and the stocks’ performance will mirror the companies’ inconsistent earnings performance.

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Don’t Forget About The Large Telcos

While investors are focusing on the ensuing battle between AT&T (T) and the big cable companies over providing voice, video and data to the home, many might need to be reminded that the telco giants have a massive enterprise business that is ripe to benefit from improved pricing.

Remember there are few companies that can provide high-level enterprise service on a nationwide basis — AT&T and Verizon Communications (VZ) are pretty much it. You would be hard pressed to name another.

Qwest Communications (Q) has not said much about what it wants to do with its fiber network and although Level 3 Communications (LVLT) is picking up its business, it will not be enough to threaten the positions of the two behemoths.AT&T and Verizon’s stock performance, while doing well recently, has been held back by investors wondering where the revenue growth is.

Now it appears that growth might be ready to return. Jim Crowe, Level 3’s CEO, said a few months back that one issue the industry no longer has is pricing, a big change from a few years ago.Verizon and AT&T have been written about more positively over the past few days, as Bear Stearns and Citigroup are both recommending the stocks. Sometimes the best stocks are in the most obvious places. AT&T and Verizon are two large companies that are worth looking at again.

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Gold Up Big: Stay With Newmont Mining

Yesterday, gold was up over $23 in trading, hitting a seven month high. A CPI report of 2.7% helped send gold flying.

The concern is that with energy and home prices having declined since the spring of 2006, that the CPI would be close to zero or even negative by now. Yesterday’s data show there is still plenty of liquidity in the economy to keep it going and rate decreases are going to be pushed out for a while. The possibility of an increase or two exists if growth ticks up a bit too much.

We blogged in October about the merits of investing in Newmont Mining (NEM). Our rationale was the huge correction in its stock price and the discount it sold for relative to the value of its gold reserves. The value of its gold reserves are estimated to be 20% to 50% higher than its stock price.

Newmont reports earnings today, not that it really matters since it trades relative to the price of gold price. But it would be worth a listen.

There are a number of factors which favor the outlook for gold. Most countries have floating currencies or have their currencies backed by floating currencies. Central banking mistakes will lead to higher levels of inflation–and we know that central banks will make mistakes.

Newmont is a good hedge in a world of floating currencies and awash with cash.

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Holy Clarity

This Fly has never read an earnings release from Whole Foods Market (WFMI) prior to last night. I recommend those who have read plenty of them to read this one. The clarity and transparency is refreshing.

In particular is the table which breaks down the age of stores, their comp growth rate and the return on invested capital. For example, for stores open for 11 years, Whole Foods stores show a same-store-sales growth rate of 3.8%, which is pretty good for a store open that long.

More impressive, however, is the ROIC for stores open eleven years is 77%.

Whole Foods’ stock peaked at $78 in December 2005. It is now around $46, a big correction. Despite increased competition in the organic food space, Whole Foods has built a powerful brand name. In addition, its acquisition of Wild Oats is not a bad idea. Wild Oats has been restructuring the past few years and should not require too much work to integrate these stores.

It is time to do more work on Whole Foods. This looks like a good growth stock selling at a low valuation.

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Hewlett-Packard may Pull Back

Cost discipline and revenue growth go hand in hand, said CEO Mark Hurd during Hewlett-Packard’s (HPQ) conference call last night. HP emphasized its unit volume growth for the quarter.

* Notebook units up 57%; 40% revenue growth
* Printer hardware units up 18%; revenue up 7%
* Personal system group, in total, was up 19% in units, with revenue up 17%

HP was able to gain market share gains while improving margins. The margin improvement in such a competitive market was impressive, as GAAP operating margin increased to 7.3% up from 6.6%.

However, the balance sheet and cash flow statement metrics showed signs which historically preceded difficult times for the PC business. Guidance was a bit weak and inventory has jumped up. In addition, there was concern about the apples to apples comparisons of gross margin due to the Mercury acquisition. In addition, there was some concern about sources and uses of cash. Particularly about $1.48 billion cash outflow for rebates and other uses–also a signal of a weakening PC business.

HP is a stock you do not have to rush into. There are warning signs that this stock might run into a couple of quarters of weak results. Stay on the sidelines for now.

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Home Depot Holds Up Despite Awful Results

The Home Depot (HD) declined a mere $0.37 in trading yesterday despite reporting awful results. Same store sales were down 6.6% for the quarter and in one month were down 11%–that is pretty bad.

However, despite these tough results, management appeared to be confident that the weakness is manageable and measurable. It appears the worst might be hitting Home Depot currently and the poor operating performance could bottom in the first half of 2007.

While Home Depot’s supply business rolled over, the real concern appears to be its decision to enter the electronics appliance business. Home Depot mentioned this business was very disappointing. This could be a business line they exit.

Due to the relatively good stock performance following such awful results, investors need to start looking at this stock again. Home Depot will most likely be a Fed stock — meaning when there is enough evidence that the Fed might start dropping rates, Home Depot stock might be off to the races.

The other thing to look for is a bottoming in its same store sales decline.

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Oddity Of The Airline Industry Comes Home To Roost

If you invest in turn around situations, you will have spent a lot of time focused on airline stocks during the last five years.

When interviewing airline executives, they universally say the same thing: the airline industry is different than other industries, as you grow there is point at which your costs substantially increase as a percent of sales. The old concept of economies of scale does not work the same way in the airline industry.

This appears to be happening at JetBlue (JBLU). When asking airline executives about JetBlue as a competitor, many said that at some point its costs are going to have to go up.

The JetBlue irony is that the start-up airline is having trouble when legacy airlines are actually raising prices. There is no price war going on.

What are the reasons cited for JetBlue’s blues? Regulation, as pilots need to follow federally established rest rules; poor communications — a big expense; failed reservation systems — very expensive; employees are in locations where they are unable to provide a helping hand — more expenses.

JetBlue appears to have reached a size where it needs massive infrastructure investment. It will be interesting to hear if management comes clean on how much all the investments will cost.

The airline had scheduled 600 flights for Presidents Day, more than the 550 to 575 flights on a typical Monday. So far, 139 flights have been canceled.

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Solid Quarter For A Solid Company

Agilent (A), the tech equipment company that was spun-off from Hewlett-Packard (HPQ), reported solid results yesterday. While they might not drive the stock higher, it is a good stock to keep up to date with and buy on a market correction.

• Handset test measurement business was weak, which should not be a surprise since we have been blogging about weakness in the handset market for the past three or four months.
• Bio-analytical business is doing very well, having a “blow-out” quarter. Revenue was up 22% year-over-year. Operating profit in this business was up 69%. Sales to China and India were up 33% and 38%, respectively.

Many of the people who made HP into a great company decade after decade are with Agilent. The company is a strong product innovator and also is run increase shareholder value.

Keep an eye on Agilent and jump in during market sell-offs. Agilent has a strong balance sheet and good product innovation to be around for a long time.

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