Sleeping with an Elephant- Emerging Markets-How Diversified are You?

In a terrific U.S. Equity Strategy piece from Citigroup's Tobias Levkovich, dated May 25th, he reminds us of some interesting connections that he sees among emerging markets, energy, and commodities.

The important observation that Tobias makes is that bets on many emerging economies have a sinister side...they are merely leveraged trades on the U.S. consumer. China and India may well develop their own consumer base over time, but for the next few years, success relies on exports to the U.S.

Pierre Trudeau, the late former prime minister of Canada observed that Canada's relations with the U.S. were like sleeping with an elephant..."no matter how friendly and even-tempered the beast, one is affected by every twitch and grunt."

Weakness in the U.S. consumer will be a twitch and grunt that will be amplified through these emerging economies and markets.

Weakness in the U.S. dollar won't do others any good either.

As Tobias observes, money flows into emerging markets have been astonishing...in fact, money flows into emerging markets funds as a percentage of total money flows, is four standard deviations above the average. If regression to the mean is something you believe in, and I do, the outflow will not be pretty, especially if the US consumer economy softens.

If commodities and basic materials markets are a derivative on global growth in the developing world, there may be negative impact felt here.

Think about the sectors that got killed this month...basic commodities, energy, and emerging markets. It may not be a coincidence. There appears to be considerable convergence and consequent correlation in the economic drivers for each of these sectors.

You may be less diversified than you think. Simply owning different names across different economies does not provide risk reduction. If your holdings correlate in the market, they may have common economic drivers.

Now that the term BRIC (Brazil, Russia, India and China) has entered the investment lexicon, think of the derived demand picture. Back in 2000-2002, media and Internet convergence killed many investors. Diversification by names alone provided false comfort. Most companies were rooting for exactly the same thing and there was a common driver to the stocks.


Don't let it happen to you again.

Brunswick-Bargain Basement Boating?

Brunswick Corp (BC) is the leading global manufacturer of boats including everything from inflatables, deck and pontoon boats, to sportfishing convertibles and motoryachts. As well, the company manufactures sterndrives, outboard and inboard engines and trolling motors, GPS navigation and marine electronics and even marina management systems. In other recreational product areas, the company manufactures fitness equipment, bowling products, billiard tables, and foosball and Air Hockey tables. Finally, it does operate Brunswick bowling centers as well as retail billiard stores.

The company is explicit in its strategy. Growth, operating margin improvement, and creation of shareholder value are company mantras.

Growth will be achieved by innovation, by deployment of leading edge technologies, by brand building, by internationalization, and by improving and leveraging the core competencies of its supply chain. 

Operating margin improvement will be achieved by technological investment and effective cost management.

Finally, the objective of shareholder value enhancement will be achieved by getting returns on investment that exceed cost of capital...I just love seeing this explicitly proclaimed!

The Boat segment represents some $2.8 billion in sales. Brands include Albemarle, Hatteras, Sea Ray, Bayliner, Maxum, and Meridian as well as Boston Whaler, Baja, Crestliner, Lowe, Princecraft and many more. In short, if you are a boat dealer, to satisfy your customers' needs, you almost certainly need to carry some aspect of the Brunswick line. About 2300 dealers carry at least one of the boat brands.

Marine Engines has the largest dollar sales volume of recreational marine engines in the world and had sales of $2.7 billion last year. Brands include Mercury, MerCruiser, Mercury Marine, and Mercury Jet Drive. Engines and propulsion systems are sold through over 7000 dealers and distributors.

Fitness is focused on commercial fitness and includes the Life Fitness and Hammer Strength lines, again representing the largest dollar sales volume of commercial fitness equipment in the world. Sales here are about $550 million.

Bowling and Billiards is a $465 million segment. As well as manufacturing and distributing products, this segment operates 113 bowling centers in the US, Canada, and Europe. The company has manufactured billiards tables since 1845!

Finally, the company has a 49% interest in a joint venture finance company, Brunswick Acceptance that is co-owned with GE Commercial Finance. This segment provides floor-plan financing to boat and engine dealers.

International sales represent about 35% of total sales with boat segment sales constituting 29% of international sales and marine engines 52%.

This is a cyclical growth business that Brunswick continues to dominate. The valuation of the business is extremely cheap in my opinion at EV/EBIT of 8.3 times. EV/EBITDA is only 6.1 times. These valuations are based on trailing twelve month numbers.

In a recent TWST interview, Elizabeth Osur, an analyst with  Citigroup indicated :

"While 2006 could be a tough year for boating sales, the stock is attractively priced, likely limiting the downside and providing some potential for
sizable upside. If they can execute a couple of acquisitions in Europe, the company may see some accretion."

The margins in Europe tend to be somewhat better than North American
margins, and the company has been highly successful in building its
brands through acquisition.

Cash flow from operations have always exceeded net income over the last five years and have totalled about $2 billion over that time. Contrast that with reported net income of $950 million. Capex over that time was also substantial representing almost $800 million. Free cash flow for the period totalled about $1.2 billion. Only about $60 million in stock has been repurchased in that time (all of that in 2005) and dividends totalled about $250 million.

Return on invested capital tend toward 5% in the cyclical low years and upwards of about 12% in the cyclical peak years though in 2000, ROIC hit 15.6%. The company generates about $2.19 in sales for every dollar of capital employed. Receivables and inventory tunover numbers have steadily improved over the last five years.

Long term debt to capital has tended down from what generally has been about 33% debt to its current 27%. Cash per share is over $5.00.

The stock is down about 25% from its peak valuation.

"The average boat buyer is 49 years old, very near the "sweet spot" pf the baby boomer population" according to Mark Keller of A G Edwards in an interview with TWST. The trade-up boater is becoming a more important part of the boating population and Brunswick is gearing its product line to satisfy that demand.

Though fuel prices and the economic outlook have made investors near-term skittish about ongoing demand, in my view the long term competitive advantages that Brunswick possesses should make this an attractive investment from these levels.

Disclaimer: Neither I, my family, or clients have a current position in Brunswick.

Claires Stores Inc

I know the stock market sucks. I know consumer confidence is dwindling. But when Mr. Market is having one of his downers, it's time to pull out the calculator and have a look at some decent businesses that may be getting cut unmercifully.

I believe that Claires Stores (CLE) is one of those kinds of businesses. Down about 26% from its peak of April (most of that fall occurred in May,) the company continues to demonstrate significant profitability, predictability, and at this point, decent valuation characteristics.

Enterprise value is about $2.2 billion reflecting zero debt and just under $400 million in cash. CFFO for last year was $243 million with capex of $82.5 million for free cash flow of $160.4 million. Hence, a FCF yield of 7.3%.

Not a random occurrence...free cash flow was generated in each of the last five years totalling $602 million. Dividends of $120.3 million were paid over that period. Share buybacks are non-existent but share issuance has been miniscule amounting to less than $20 million. Dividend growth rate for five years is 52% i.e. they have treated shareholders as partners.

Valuation has just dropped below 9 times EV/EBIT. Less than 7.5 times EV/EBITDA.

ROIC on a TTM basis is 19.8%. Average ROIC in the last five years has been 16.6%.

Long term growth estimates range from 12 to 18%. Let's use 9%. Operating margins have been running near 18% recently. Lowest operating margins in the last five years were 7%, median was 14%. Let's use 14%. I come up with a DCF of over $30 using these very conservative inputs versus its current price of $26.12.

As of January 28, 2006, Claires operated a total of 2,878 stores in all 50 states of the United States, Puerto Rico, Canada, the Virgin Islands, the United Kingdom, Switzerland, Austria, Germany, France, Ireland, Spain, Holland and Belgium. The Company has two store concepts: Claire's Accessories and Icing by Claire's. About 29% of sales are outside the U.S.

Please find an interview with Marla Schaefer, the co-chairman of Claires that was recently conducted in The Wall Street Transcript.

Seems to me that even in the worst of economic environments, young girls will still want to be buying low priced accessories. As Ms Schaefer describes it, "we appeal to people 2 to 92 because when it comes to fun items that are well priced and impulse driven, we are the place to go."

Seems to me that even in the ugliest of stock market environments, investors will still want to own low priced stocks.

Neither I, nor my family, or clients have a current position in Claires Stores.

A Few New Links

Regular readers (and I do appreciate your coming back!) will notice a few new links that I have added. I enjoy roaming blogland and do appreciate the insight that in demonstrated by the authors of these blogs!

The Confused Capitalist is written by Jay Walker in beautiful British Columbia. Far from confused, Jay has authored an investing text for "everyman" entitled The Brink's Truck Burst Open on Wall Street. His perspective is refreshing and different. Jay views Value Discipline as being updated perhaps not as regularly as others. Maybe he thinks I am some kind of slacker. In any event, he writes in a very straightforward way...and regularly!

Dah Hui Lau known as David has begun to fill in Shai Dardashti's former role as the top chronicler of Berkshire Hathaway news now that Shai has dedicated his full time to building his investment partnership. David has written some insightful and well organized analysis recently regarding Dell. David is a physician in the U.K. and has dispelled the stereotype that physicians can't invest! David certainly can and I suspect that he may follow his dream to be a super-investor! In my view, the only way to get there is through value investing, to which he dedicates himself. David believes that the way to knowledge is through sharing. That is precisely why I blog and that's how all of us can learn. David is just much better at sharing than I am.

MarketMoneyLetter is written by Kevin. Kevin started this blog in February and I have only recently become aware of it. Kevin has written some excellent fundamentally strong reviews of activist newsworthy companies. Infrequent posts are so because of a desire to publish only in stocks in which he feels he has an edge. Kevin appears to have a great understanding of the supremacy and utility of cash flow from operations rather than earnings. Makes a lot of sense to me. Plus his breadth of coverage incorporates companies such as WalMart as well as International Speedway. A worthwhile read in my opinion.

If you have suggestions as to other fundamental blogs that you find helpful, please let me know. Again, thank you for your continued interest and readership!

Is Price Stability Enough?

Very rarely do I come across an economic reading that is worth delving into. As a value investor, my economic realm tends to be micro-  rather than macro oriented. But  a recent paper is worth thinking about.

Resourceinvestor.com highlighted this interesting paper, entitled "Is Price Stability Enough?" The article is written by William White, an economist at the Bank for International Settlements.

Being old enough to have seen WIN buttons (Whip Inflation Now) and having  presided over the asset-liability matching for an annuity driven life insurance company in the late 70's and early 80's, I embraced the plan of Paul Volcker to stymy inflationary thinking. As a  portfolio manager in the 80's and 90's I embraced the notion of disinflationary stocks completely, as well as rode the bond market's rally or yield collapse. Drummed into most of us in that era was a resolve to believe that economic growth and economic policy that embraced disinflation was tightly correlated. Watching the economic experience of Japan through the 90's reminded us that deflation was an even more difficult issue to overcome...even zero real rates would not be stimulative when the country was awash with capacity.

In this paper, White suggests that pursuit of price stability might have to be applied more flexibly and with a longer-run focus than has been the case for most central banks.

Having price stability as the hallmark of central bank policy is no guarantee of growth. White notes that "A preceding period of price stability is not sufficient to avoid serious macroeconomic downturns." Extreme events (such as the Japanese collapse of the 90's, the emerging market crisis for Eastern Asia in 1997 and 1998 and the Great Depression) were preceded by credit-fuelled investment booms that occured during an era of stable inflation.

White argues that "a combination of technological change and deregulation has led to a quickening process of disintermediation from banks, growing reliance on market processes, globalization  and institutional consoldidation. In short, we now have a liberalized system which seems much more likely to show boom-bust characteristics than the previously repressed one."

He warns, "The longer the period of macroeconomic stability, the greater the underlying excesses in investment and borrowing are likely to become."

A corollary of inflation targetting in a relatively benign environment is to encourage excessive debt accumulation.

What should policy emphasize? Identify the serious imbalances first. Develop incentives to encourage monetary policymakers to respond. Why? Overextended corporate and household balance sheets can also be the source of significant “headwinds”, reducing economic growth to levels well below potential. As far as the providing incentives to policymakers to respond, they should express publicly their intention to respond to emerging financial imbalances even if, occasionally, this leads to an undershooting of near-term
inflation targets.

Bottom line, a little inflation may be a far better thing to contend with over the short term than the repercussions of the economic imbalances.

Overall, I think this is a worthwhile paper to contemplate this weekend from your lounge chair.

Have a good weekend!

UBS Index of Investor Optimism isn't very Optimistic

Sentiment is souring among investors, at least according to the most recent UBS/ Gallup survey. The concerns:

Energy prices-     92% of investors believe that energy prices are having a negative effect on the investment climate.

The dollar-            64% believe that the dollar problems are negatively influencing the investment climate.

Housing-               63% believe the softening housing market is hurting the investment climate.

Interest rates-       47% believe that the current level of interest rates is hurting the investment climate.

Investment Executive Survey

Eastman Kodak-What If Tomorrow Never Comes?

Value investors tend to congregate around distressed companies much like drivers rubberneck on the turnpike to observe an accident. Some truly brilliant managers such as Bill Miller at Legg Mason (who remains brilliant however his portfolio ranks this year relative to the S&P) and Bruce Sherman of Private Capital Management have been adding to their positions in this name.

One of my favorite expressions is, "The obvious should not be an impediment." Sometimes, the obvious demise of a business or at least in this case, a segment of a business evokes more sentiment than reason, more hope than sense. Fallen angels require investors to have a backbone not a wishbone! Is the demise of this business just too obvious?

The more I look at the challenges that confront Eastman Kodak (EK,) the more I sense continued deterioration rather than progress. I really prefer to be optimistic but facts should supercede opinion.

What prompts this note is an announcement from Canon (CAJ) earlier today.Canon announced that it would consider halting the development of new film cameras as it focuses its resources on digital models. The company would consider whether it needs to continue producing both compact and single lens reflex (SLR) film models because the market for both is shrinking.

Earlier this year, Nikon announced that except for a few professional products, it would stop producing film cameras. Konica Minolta also came to the same conclusion this year. The exit of Agfa and Konica from the production of film should have removed excess capacity from the industry, but it appears at least anecdotally that Fuji has been dropping prices to maintain share. So much for pricing discipline in a duopoly.

I know the argument that there is a ton of conventional photography equipment out there but year to date, Kodak rolled film volume is down 38.4% versus last year (to end of March) Single use camera volume is down almost 25% for the same time frame. Fuji's numbers are slightly worse.

Film and photofinishing systems represented 32% of revenues for Kodak in the first quarter of this year. Photofinishing services were down 50%. EBIT dropped almost 60% from $71 million to $29 million on $916 million in sales, a 3.1% operating margin.

In a Wall Street Transcript interview, Kyle Legg of Legg Mason describes the investment in Kodak as, "We currently own Eastman Kodak (EK), a company that is still widely viewed as dependent on a dying industry, traditional film manufacturing. Our view, on theother hand, is that Eastman Kodak is a business that is leveraging its powerful global brand recognition and strong relationships withretailers to make the transition from traditional film company todigital imaging company, and that once it becomes clear that EastmanKodak will successfully complete this transition, the market will reward it. Although we were certainly early in identifying this opportunity,we're confident that Eastman Kodak is very attractively priced."

Consumer Digital Imaging represented 17% of revenues for Q1. Pricing erosion and slowing sales already seem to be a challenge in this business. Revenues in this segment were down 10% versus last year's quarter, gross margins fell, and the unit lost $94 million versus $58 million, in the first quarter of last year. The notion of turning the digital camera business into a razor/ razor blade business that will drive the consumption of consumable products such as color ink jets is not yet working. The penetration of digital cameras in American households is somewhere around 50% but the conversion of all of those shots into a "snapshot" is happening in far different ways than are helpful to EK's profitability. Hewlett Packard's Snapfish and privately held Shutterfly seem to be capturing share, again from anecdotal evidence. Attractive images of family, friends and faraway places are stored in my hard drive and rarely hit paper for most of us.

Graphics Communications represented about 30% of revenues in the first quarter and appears to be driving and defining success at EK. As the commercial printing market becomes increasingly digital, EK is well positioned here. Many parts of this business have been acquired in just the last year and a half or two years but the operating profitability has increased to $31 million in Q1 06 versus a loss in the corresponding quarter last year. Gross margins have significantly expanded though operating margins are still small at 3.6%.

The Health Group represents about 20% of revenues. A few years ago, this was ballyhooed as the crown jewel, but now management is looking for strategic alternatives for this biz. Operating margins here were almost 8% and in fact represented over half of the operating profits of the entire business. Not so long ago, this was viewed as potentially a mid teens operating margin business, just last year it was 12%. Traditional radiography, X-Ray film probably represent about one third of this business, the remainder being digital archiving and various esoteric digital forms of radiography. Parts or all of these businesses could be sold.

The digital transformation of this company has been unbelievably difficult. The parts of the business that represent the future represent very new, largely non-integrated entities. Silver prices and petroleum products prices impact costs of goods negatively.

Compounding the difficulties is the credit side. To quote the Fitch Rating: "Fitch downgraded EK's Issuer Default Rating (IDR) to 'B' from 'BB-' and the company's senior unsecured debt to 'B-' from 'B+' on May 16, 2006. The Outlook remains Negative. The ratings reflect Fitch's growing concern regarding EK's ability to generate profitable organic digital revenue growth and sufficient free cash flow to offset continual declines in the company's traditional business." This was last rated investment grade by Fitch in May of 2003 (BBB)

The leverage ratio (assets/equity) is 6.7 times and long term debt represents about 56% of total capital. Free cash flow per share is negative for the TTM at about -$2.00. Work through the Altman score on this company for yourself. The number I came up with is not very assuring. Kodak debt 9.95% of July 2018 maturity is trading at just under 10% yield to maturity. There is a message in that too.

Geoff Gannon, who publishes that marvellous blog Gannon on Investing wrote exactly a month ago "On Inflexible Enterprises" where he said, businesses put down roots. The deep-seated roots at EK as in so many companies forestalled or impeded acceptance of what seems so perfectly obvious now. The obvious should not be an impediment. The gradual transition at Kodak into the digital world was what Geoff call "the tempting possibility." But it seems that the technological shift has been too rapid, the areas where the company has strengths seem to lack scale, and the sub-normal returns persist if not worsen. Reduction in capacity does not appear to have helped.

As I said wishbone rather than backbone.

Hopefully, the business transition strategy can ward off the ills that the historical numbers indicate. But in the cold hard competitive world hope can be a dangerous word.

Bill Miller is infinitely brighter than I am and willing to accept the risk. Bruce Sherman at Private Capital is also a terrific "discretionary cash flow" investor. He owns the stock. But remember that for Miller, this is a 2.75% of portfolio position. For Sherman, 3.22%. For those who wish to "hope," make sure that the weight of this name in your portfolio is similar. In my view, the risks are high and the outcome highly uncertain.

Disclaimer: Neither I, my family, or my clients currently have a position in Eastman Kodak.

Aspect Medical Systems Reprise

Way back when Value Discipline started, in November of 2005, I had expressed some concern about the valuation of Aspect Medical Systems (ASPM.)

Link- Aspect Medical Systems (ASPM)

Following the approval of a brain monitoring system by Japanese health regulators, a number of brokers were recommending the stock. I had commented on its generous valuation and in particular on the language used in one of the "research" reports:

"We believe traditional metrics do not reflect the market upside potential for Aspect Medical."

On the close of the day of that post, the stock went out at $37.91. Today, the stock was hit fairly hard and went out at $20.95 down 6.9% for the day and about 45% since we last posted.

Aspect Medical is a leading manufacturer of brain monitoring solutions for surgeries using general anesthesia in the operating room and patients under sedation in the ICU. The Company has 3 additional potential applications for the Depression, Alzheimer's and Sedation markets.

Other than the obvious dramatic fall in market capitalization, the business itself is doing well. The company is developing a razor/ razor blade model of selling high margin sensors and lower margin monitors. Although combined revenue from monitors and modules increased only 11% in 1Q06, unit sales were up more than 38%. This sort of discounting is very unusual for a company that tends to portray itself as having leading edge technology. But not to over-react, gross margins on a TTM basis are still very healthy at 78.3%. Return on invested capital is 13.8% over the TTM and the company is generating a tiny amount of free cash flow.

I am pleased to see costs come under better control with SG&A growing only about 6.6% YOY relative to the fast pace of revenues of almost 30% on a YTD versus last year's YTD.

Enterprise value is now only about $445.6 million versus last November's $786 million. But back to those metrics...EV/EBITDA is now 52 times, well down from last November's 122 times but still nosebleed territory for a value guy. Similarly, EV/ EBIT is now 63.5 times.

A little more on recent clinical news. Psychiatrists have been concerned about the effectiveness of SSRI ( Selective Serotonin Reuptake Inhibitors) in children and adolescents. Such antidepressant drugs include Prozac, Zoloft, and Paxil. Findings from two
studies presented yesterday at the annual meeting of the American
Psychiatric Association document the capability of Aspect Medical
System's EEG-based research technology to predict an individual's
likelihood of responding to treatment of depression with an SSRI at
one week after initiating medication. Generally, it takes several
weeks to determine if a patient has responded to this regimen. ASPM's technology predicted the 8 week clinical response with 73% accuracy after only one week of treatment. Expansion of the trial into nine centers provides some encouragement about this technology. An accuracy rate of 73% seems low, but clearly is an improvement over today's hit or miss approach. Major depressive disease afflicts some 15 million Americans annually and the unpredictable response of patients to expensive therapeutics is currently based on trial and error.

The potential remains significant for this company and at least the price has come down to somewhat more understandable levels. Wall Street remains infatuated with this company and its prospects with a consensus earnings growth rate of about 44%.

Though the science is very interesting, the risks remain high with this cheery consensus.

Disclaimer: Neither I, my family, nor my clients have a current position in this stock.

Fannie Mae and Income Smoothing

The Office of Federal Housing Enterprise Oversight completed a scathing report on Fannie Mae (FNM.) The report, released this morning, contains some very interesting observations which should make us think about the treadmill of quarterly earnings management. In light of my most recent post, I think the message is pertinent and timely.

A few quotes:

"During the period covered by this report—1998 to mid-2004—Fannie Mae reported extremely smooth profit growth and hit announced targets for earnings per share precisely each quarter. Those achievements were illusions deliberately and systematically created by the Enterprise’s senior management with the aid of inappropriate accounting and improper earnings management."

"By deliberately and intentionally manipulating accounting to hit earnings targets, senior management maximized the bonuses and other executive compensation they received, at the expense of shareholders. Earnings management made a significant contribution to the compensation of Fannie Mae Chairman and CEO Franklin Raines, which totaled over $90 million from 1998 through 2003. Of that total, over $52 million was directly tied to achieving earnings per share targets."

"Management intentionally developed accounting policies and selected and applied accounting methods to inappropriately reduce earnings volatility and to provide themselves inordinate flexibility in determining the amount of income and expense recognized in any accounting period. In that regard, the amortization policies that management developed and the methods they applied created a “cookie jar” reserve."

"Management deliberately developed and adopted accounting policies to spread estimated income or expense that exceeded pre-determined thresholds over multiple reporting periods;
Management established a materiality threshold for estimated income and expense, within which management could avoid making adjustments that would otherwise be required under FAS 91;
Management made discretionary adjustments to the financial statement for the sole purpose of minimizing volatility and achieving desired financial results"

"Under the Fannie Mae executive compensation program, senior management reaped financial rewards when the Enterprise met earnings per share (EPS) growth targets established, measured, and set by senior management itself. The structure of the executive compensation program created the incentive and opportunity for senior executives to benefit at the expense of safety and soundness."

"Fannie Mae tied major portions of executive compensation to EPS, a metric easily manipulated by management." (my emphasis)

"The extreme predictability of the financial results reported by Fannie Mae from 1998 through 2003 was an illusion deliberately and systematically created by management."

The reaping of massive incentives for a management that sets EPS targets, measure EPS, manipulates EPS constitutes theft in my opinion. Shifting EPS routinely to future years when the EPS target has been exceeded smooths earnings, an act which tends to be applauded by Wall Street analysts. Rather than recognizing the deliberate manipulation, many analysts applauded the predictability, and the notion of controlled, disciplined growth.

Disclaimer: Neither I, my family, nor clients have a current position in Fannie Mae.

Getting Off the Quarterly Guidance Treadmill

Much of the blather of the stock market revolves around the significance of quarterly earnings results and whether or not there was a surprise element relative to expectations. CNBC commentators try to provide instant analysis..."Wow, they beat by 3 cents." or alternatively, look skeptically, "Is that before options expense?" Analysts promulgate the game with their comments both in their written reports and in their fawning before managements in conference calls, "Nice quarter, guys!"

In fact, some years ago as academics investigated the relevance of earnings surprise, entire companies rose up to meet the "need" for determining earnings forecasts, and measuring the surprises. Hence, the birth of Zacks and I/B/E/S. The assumption that all of this was somehow pertinent to determining the future trajectory of a stock seemed to drive research and an entire infrastucture of analysis. The accuracy of earnings forecasts became one of the criterion in determining analyst compensation.

Warren Buffett, Mike Jensen, and Jeff Diermeyer, the president and CEO of the CFA Institute agree that companies should get off the earnings treadmill and suspend providing guidance. Diermeyer writes in the May/June edition of the CFA Institute Magazine that there is no problem with quarterly guidance per se, but rather with the value-impairing behaviors it engenders.

He cites four value-impairing behaviors that derive from quarterly guidance:

Because, over the short-term earnings surprises are effective, it is almost Pavlovian for companies to learn to manage expectations. Diermeyer states,"The aggressive management of expectations distracts from the bond of trust between firm and investor. Corporate managements simply did not think their major investors were mature enough to realize that the world is not perfect and that companies and leadership suffered challenges and frailties."

"Quarterly earnings guidance encourages manipulation through accounting chicanery." Though chicanery has been evident in some companies, many more companies utilize aggressive accounting largely because GAAP permits a broad scope of choices and estimates. It is a huge mistake to assume that earnings represent a precise quantum of anything...cash is real, earnings are merely an opinion...my words, not Diermeyer's.

"All of the effort that goes into 'making the quarter' wastes valuable management time that could be put to better use in building and maintaining the business." As Diermeyer describes so eloquently, "This problem goes beyond the effort made every 13 weeks to figure out how much product to move a few feet off the company dock or how to change reserve policy to free up reserves." Failing to consider the long term by forgoing the necessary investment in order to preserve the targeted earnings is disingenuous to investors and value destructive in my opinion.

"Finally and perhaps the most destructive of all. such behavior sets a terrible example at the top. In effect, the rank and file....are given the impression that the firm makes their numbers by making up their numbers, rather than competing successfully in the marketplace."

I have commented on the "game" before. Please check, "How to Beat the Quarter- Playing Mouse Olympics." When we as investors fall for this game of extremely low hurdles and somehow attribute a management with prowess or skill for successfully scaling this, we are ignoring the reality of what really drives returns. As I said back then, " Shareholder value is, in my opinion, not created by earnings surprises,
except for an evanescent moment where the hallelujah chorus of Wall
Street ballyhoos the spasmodic 'success.' Shareholder value only comes
from building a business that can generate cash in excess of its needs,
and earn a return on its capital in excess of its cost."

According to the Diermeyer article quoting a recent poll, 76% of my fellow CFAs support companies moving away from quarterly earnings guidance and of those affirmative responses, 95% indicated that when quarterly results are released, companies should also provide additional information on the fundamental, longer term drivers of the business. I couldn't be prouder of my fellow analysts. I do wonder what the 24% who were against this notion were thinking!

The value disciplines that I describe in these posts are inherent in value thinking and investing. Do your own thinking. Understand what the competitive advantage of a business is about. Try to project its longevity. Understand the cost of capital and the potential for return on invested capital. Look for businesses that generate free cash flow.

Earnings surprise is essentially a spasmodic jolt, not unlike a shudder, or chattering your teeth. I suspect that you would not consider seeking medical attention when these things occur to you. Similarly, earnings surprise has little diagnostic value in understanding a business. A penny or two of upside or downside has no more fundamental relevance to a company than a hiccup or a belch have in understanding your gastrointestinal system.

Despite the protestations of both managements and informed investors, this silly game rages on. Skills of managements and the analysts that follow them are still being assessed on this ridculous yardstick.

I'll take fundamentals over managed numbers any day. Get those numbers in the marketplace and the factory floor, not out of the accounting office. Work on building a competitive advantage not a meaningless scorecard.

Harman International- An Auto Parts Growth Story

Harman International (HAR) is a worldwide leader in audio, electronics, and "infotainment" with such brand names as JBL, Infinity, Harmon/Kardon, Mark Levinson, and Becker. The company is a worldwide leader in the markets it serves including Automotive, Consumer, and Professional segments. This is much more than an auto parts story, but automotive, representing 70% of sales versus only 62% three years ago, is dominant.

Automotive sells to DaimlerChrysler, the BMW Group, Toyota, Audi, Porsche, Land Rover, Renault, Hyundai, Kia, the PSA Group, and Volvo. Infotainment systems may include voice-activated telephone and climate controls, navigation, rear seat entertainment, Internet access, hard disk recording, MP3 playback and Windows Media Audio playback. Automotive sales in the most recent quarter have grown by 8.6% but ex-currency by 16%. Operating margins, despite dealing in the very competitive automotive segment are a healthy 16%.

Dave Leiker, an old friend at Robert Baird, in TWST last year, described Harman as one of the few growth stories in automotive parts. Why? Less than 10% of HAR's business comes from GM, Ford, and Chrysler. To quote TWST, " It’s primarily the German automakers, where they’ve developed a very sophisticated infotainment system using a fiber-optic network and digital technology. This consolidates multiple devices, such as radio, climate control, CD, DVD and cellphone into a common unit with a single user interface. Today, they effectively have 100% of the German auto market."

Consumer Systems, sells through speciallty stores and chains such as Circuit City and Best Buy as well as MediaMarkt in Eurioe. Products include Multimedia that is  geared to enhanced sound for AppleiPods and MP3 players as well as home audio and video systems. Consumer operating income was $5.2 million representing a fairly slim 4.9% operating margin.. Consumer operating income was 27% lower than a year ago, primarily due to 2.1 million of increased investments in R&D for new multimedia products and the acquisition of PhatNoise. The company expects that operating margin in this area can improve to a 9% level within a few quarters.

The professional segment designs, manufactures and markets loudspeakers and electronics for audio professionals in concert halls staiums, and broadcast applications. The company is a world leader in professional applications. Operating profits in this segment have grown 35% yoy and currently represent about 11% margins at the operating level.

The company has won $1.5 billion in new business over the last year as a technical and R&D market leader. R&D spending in the third quarter was about 9.2% of sales, versus 6.9% of sales in the prior year. R&D spending increased in each of the three operating groups with the largest increase in automotive.

More than 60% of HAR's sales and operating profits come from outside the U.S. and consequently foreign currency effects are significant.

The company has excellent visibility of the future from the automotive segment with a backlog of $13 billion out to 2013. The premium branded audio systems are quite ubiquitous optimizing acoustic performance and minimizing space and weight requirements. Infinity branded car audio systems are offered by DaimlerChrysler's Chrysler Division, Dodge and Jeep lines as well as by Mitsubishi and Hyundai/Kia (in North America). DaimlerChrysler's Mercedes−Benz Division, the BMW Group, Land Rover, Porsche and Saab provide Harman/Kardon branded audio systems in their cars. The premium Mark Levinson system is offered by Lexus. Rolls Royce vehicles come standard with a Lexicon branded audio system. Toyota, the PSA Group and Hyundai/Kia (in Korea) offer JBL branded audio systems. HAR provides infotainment systems in Mercedes-Benz, Porsche, Audi, Renaul, and Land Rover. There appears to be unprecedented consumer demand for information and entertainment in the car.

The company has proven to be a good partner to its shareholders. It has reported options as an expense since 2003, not kicking and screaming like most companies that were required to implement options expensing this year. The company's CFFO continuously has exceeded reported earnings with CFFO for the last five years totalling $1.4 billion versus net income reported for that period of $586 million. Harman's capex for the last five years has been sginificant too at $655 million.The company has bought back about $223 million net of issuance in the last five years as well. In the current fiscal year (June year) the company has accelerated its buyback with the purchase of $116 million in stock. The dividend is negligible representing a payout ratio of less than 1%.

The stock price is down about 16% YTD and is selling at an EV/EBIT of about 13.8 times. Enterprise value is about $5.44 billion reflecting only about $330 million in long term debt offset by about $400 million in cash. Return on invested capital is about 18% for the last twelve months and has significantly improved over the last five years from the mid-single digit level.

The operating return on assets for the automotive segment is in the mid-20's an extraordinary level for what might be thought of as an extended auto-parts business.

Clearly, this is a global competitor and a leader that does not appear to be very well known to most retail investors. The 8 Wall Street analysts that cover have growth expectations of 18-25% with the consensus at 21.75%. Even with a much more modest 15% growth rate that I am using and overall operating margins at 11%, I can come up with a value much closer to $130 for HAR  compared to its current $82.35, just four dollars above its 52-week low.

Disclaimer: Neither I, my family, nor my clients have a current position in Harman International.

Let's Be Careful Out There!

Is the pullback a buying opportunity?

Though the market seems to have become unhinged by fears of inflation that arose this week, in my opinion, other factors are weighing in. Some considerations:

The corporate earnings cycle is at a fairly advanced if not ancient age. Corporate profitability is at 40 year highs relative to other sectors based on National Income (NIPA) stats. S&P 500 earnings growth has been double digit YOY in the first quarter, but largely due to energy earnings growth. Ex-energy, earnings growth is at 11%. Decent, but slowing.

Pricing pressures are starting to develop in both materials and labor markets. Margins at some point will likely start to drop. Not seeing the wage-price death spiral but nonetheless, there may be a fairly tough spell for profitability.

Chairman Bernanke may need to establish his credibility and dismiss the Helicopter Ben image. Though most of the market was viewing 5% as a Fed Funds ceiling, I believe the potential exists to take rates to 5.50%.

A policy induced slowdown would slow the advancing earnings cycle.

Let’s look at last week’s list of high volume losers:

MSN Investor Link

The list seems largely littered with casualties from the metals, energy, and alternative energy investments. The “too far too fast” crowd would argue that this is a healthy correction in the market leaders. Isn’t it possible that the market is starting to think about slowing economic growth?

Believe me, I have little desire to look at markets from the 30,000 foot level or to base strategy one week’s evidence. But I am beginning to see the risks gathering and a lot of zeal to buy the correction. My stock picking will as always emphasize protecting the downside rather than some hoped for spectacular upside. Cash returns have become increasingly competitive and represent a tougher hurdle for equity valuations to overcome.

None of us can pick tops or bottoms in the market. But valuations for some very high quality stocks seem cheap at least relatively. Emphasize quality and predictability in your stock selections. These will be havens. Don’t let your nostrils flare for the high growth speculative stories that are out there. Above all, don’t panic...take a careful, judicious look at your holdings. Don’t let hope for prices that existed two weeks ago represent your target price...emphasize quality at times of great uncertainty.

As they said on Hill Street Blues, “Let’s Be Careful Out There!”

Two Parts to the Inflation Story

Inflation is ticking up a bit and is at the high end of a "comfort zone." The major factor in "headline" inflation was higher energy prices...where's the surprise here?

YOY, core inflation is up merely 2.3%, however, three- and six-month annualized changes in core inflation are over 3%...some acceleration from the last few months.

In my view, the recent inflation experience should be thought of in essentially two parts: 1) A short term adjustment of "pass through" inflation. Energy and commodity prices have risen mostly due to "shocks" mostly politically related. Part 2: Secular inflation. This relates to falling productivity and rising wage pressures. This is the more vicious of the sources of inflation in my opinion and the part that seems to be reasonably well contained.

As to Part I Inflation, my guess is that we are in late innings of a speculative blow-off especially in metals like copper. Energy as well seems to be ignoring the current inventories and has already wiped out, at least mentally, a lot of refining capacity and energy production from hurrican season. Who knows what the weather brings, but it seems to me that most of the bullish arguments are specious if not paranoid.

As to Part II Inflation, productivity gains in the first quarter had slowed to the mid 2% range from a long period of mid-3% gains. Nevertheless, productivity gains continue to undermine the prospects for long term inflation pressures. Average hourly wages are starting to show some upward pressure but, in manufacturing, unit labor costs are down about 1.6% YOY. I am more nervous about the dollar's decline and the potential for significant cost pressure from imports. But overall, there seems to be little evidence that we are in for a vicious wage-price spiral, one of the most destructive forces in economics.

Despite the backdrop of panic and fear that I saw today, it is important to remember that in economic terms, the planet is doing very well. For the first time in some years, the world economy is in a synchronous recovery. Global profitability should be in decent shape.

As I have suggested, don't forget about international stocks in your allocations! Some of our international holdings were down for seemingly no reason today and I believe represent excellent value. Allianz (AZ) and Aegon (AEG) have provided decent earnings results recently, are cheaper than their North American analogs and got hit for 5% today.

Disclaimer: I, my family and clients have current positions in Allianz and Aegon.

HP in a Nutshell

HP expectations have been high and the company delivered. Lots of comments around today, but what it comes down to is this, at least as fa as revenues and unit growth:

Printing and Imaging-HP outperforms Lexmark (LXK)- HP revs down 1% YOY on 3% unit growth 10% growth in supplies. Compare to LXK revs down 6% with negative 18% in units and 3% growth in supplies.

PCs-HP outperforms industry -HP revs +10% on 16% unit growth. Dell has preannounced first quarter with effects of price cutting. Overall PC market revs +3% on 13% unit growth. HP notebooks +27% on 48% unit growth versus industry notebooks revs +10% on 31% unit growth.

Servers-HP underperforms SUNW- Revs +2% versus SUNW's revs +4%.

Services-HP essentially in line with IBM-HP revs decline 2% versus IBM's decline 1%.

Disclaimer: I and my family do not have a position in HPQ, DELL, LXK, SUNW, or IBM. Certain clients do own a current position in HPQ and LXK.

Whaddya Pay for Foreign Earnings Power- BUCY

Maybe it's from just coming off the Berkshire weekend. Maybe it's re-reading Empire of Debt. Maybe it's too many hits of dailyreckoning.com. Maybe, it's the sinking feeling that I had when I lived in Canada and watched the currency go from an articially high level near 90 cents to 62 cents. Now all the way back as a revitalized petro-currency and a stalwart of fiscal responsibility. Looking for shelter from US dollar weakness is really becoming an important focus as an investment theme.

What to do? Where are the opportunities? I agree with Buffett's views on commodities in general....speculative excess, silly money chasing after it. I was too damned early in getting out of base metals but I still feel comfortable about the decision. Yesterday's thrashing may not have been the end in my view, but certainly demonstrated that ownership of the theme is falling into increasingly weaker hands. Gold as a commodity remains interesting but most gold mining stocks have In my view discounted the hereafter, perhaps even using a negative discount rate. Memories of late 70's and early 80's valuations of gold mining stocks, battles for St. Joe Minerals and Amax are all coming back. The same tape is being re-played. Inco and Falconbridge are referred to as Canadian jewels in the Wall Street Journal.

In my view,foreign earnings power will be an important aspect of investing over the next few years, obviously if Buffett's views about the dollar are correct. The ideal investment target should have costs domiciled largely in the States and revenues elsewhere. This kind of thinking was successful for many Canadian manufacturing businesses when the Canadian dollar was beset with scorn and disdain and traded below 70 cents U.S. But pure dependence on currency weakening and consequent export sales is not a sufficient business strategy. Using the window of opportunity to restructure and re-position will work for businesses that are savvy.

As always, thematic or macro viewpoints seem so obvious, yet successful investing requires some determination of value and margin of safety. I note an upgrade of Bucyrus Erie (BUCY) that occured today.

BUCY fits the macro bill beautifully. Some 75% of its sales are export. The end markets for its products are heavy cyclical businesses such as coal and copper mines. Cash generation has been humongous with debt to capital representing 100% of capital in 2002 down to only 23% currently. trailing twelve month return on invested capital is stellar at 20.5% in sharp contrast to the negative returns of 2002 and 2003.

The sustainability of the business is propped by a large maintenance and replacement parts business which represents about 70% of revenues. This part of the business has grown at about a 17% rate since 2002. The sales of machinery have grown at a stellar CAGR of 56%. The street consensus for sales growth over the next three years is a 25% CAGR. Earnings growth of 35% is the current consensus for earnings growth.

In my view, investors are paying up for a rather cheery consensus. Operating margins which have run on a TTM basis at 13% might not be sustainable over the long run. Other international competitors exist such as Komatsu of Japan, Atlas Copco of Sweden, and United Heavy Machinery of Russia also compete in this business. On an EV/EBIT basis BUCY is trading at 20.6 times TTM EBIT.Komatsu is at 16 times, and Atlas Copco at 13 times.

Great theme, wrong price in my opinion. At least for the margin of safety that I look for.

Disclaimer: Neither I, my family, or clients have a current position in any of the stocks mentioned in this post.

Satisfying your Dividend Appetite...Is there Danger in Dividends?

In this weekend's Barron's "Other Voices" section, there is an interesting article entitled "There's Danger in Dividends." (subscription required)

The author, Richard Wiggins, describes the current vogue for dividend paying stocks. His concern is that the dividend strategy has become too popular largely because of the tacit assumptions that investors make when they focus on yield. In the article, he describes that a "dividend - hungry portfolio often will be concentrated in financial and utility stocks, which are extremely sensitive to shifts in inflation and interest rates."

He also describes the nature of the market as a "complex adaptive system," one which mutates and evolves as it goes along, one whose trajectory using previous rules of thumb and strategies cannot be predicted, in short, you can't play last year's strategy for this year's game. As Wiggins describes, "Your edge is dulled as competitors pile onto your strategy; eventually you get crowded out."

It is quite true that well-worn strategies tend to lose their effectiveness, in other words, if everyone is thinking the same, no one is really thinking.

Dividends and yield have always some some place in investment thinking and portfolio selection. After all, a good part of valuation theory in finance is based on dividend discount or dividend growth models. In fact, equity allocations for many insurance portfolios in the 1950's used equities only when equity dividends exceeded the prevailing bond yields. Ultimately, most institutional portfolios accepted the notion of growth both of capital and dividends. The changes in taxation in the US in 2003 lowered the tax on most dividends to 15% thus evoking a major change in investor's thinking as well as corporate behavior. It appears that this treatment will be extended to at least 2010.

Why the special treatment? High dividend taxes reduce the incentive to pay out rather than retain earnings.High dividend taxes create a bias against savings and investment. Finally, high dividend taxes cause corporations to rely more heavily on debt financing rather than equity financing which makes corporations more bankruptcy vulnerable in downturns.

But are dividends becoming too popular as a strategy? Here are the current dividend ETF's:
iShares Dow Jones Select Dividend (DVY)
PowerShares High Yield Equity Dividend Achievers (PEY)
PowerShares Dividend Achievers (PFM)
PowerShares High Growth Rate Dividend Achievers (PHJ)
PowerShares International Dividend Achievers (PID)
State Street SPDR Dividend (SDY)
First Trust Morningstar Dividend Leaders (FDL)
Vanguard Dividend Appreciation Index Vipers (VIG)

There are significant differences among these ETF's. Some have fundamental tests of payout ratios, such as FDL. Others look for Mergent or S&P Dividend Aristocrats characteristics of consistent raising of dividends such as SDY and VIG.

Over the long run, dividends have been an important source of overall returns for stocks. In this working paper by Fama and French, the important role of dividends over time is discussed. Returns are broken down into three components,

1. the dividend
2. the growth rate of book equity due to reinvestment, and
3. the growth rate of the price/book ratio

During 1963-2003, dividends contribute more to the returns on value stocks. But an interesting result is that the higher dividends of value stocks are special to 1963-2003. For 1926-1962 the contribution of dividends to average returns is not systematically different for value and growth stocks. Growth stocks, paying lower dividends tend to have higher reinvestment and consequently, higher growth rates of book equity. However, over time, their price to book ratio declines resulting in lesser relative performance compared to value stocks. Value stocks, on the other hand, tend to enjoy expansion of their price to book ratios over time.

The total market return for the period 1926-2003 was 9.86% of which 3.97% was due to dividends or about 40%, clearly not insignificant. The effect of dividends was particularly strong for large cap value stocks in the pre 1963 period where dividends contributed 4.75% of the total return of 10.46% or 45%. For small cap value stocks, the dividend effect was much less, 3.6% of 11.61% or 31%.

For the post 1963 period, dividends represented 4.76% of 12.67% or 38% of returns for large cap value stocks and 2.94% of 16.69% returns for small cap value stocks or only about 18%. Remember that these studies end in 2003, prior to the effect of tax legislation on corporate and individual behaviors.

Wiggins points to the financial service and utilities sectors as being particularly vulnerable to rising interest rates. No debate here. But financial services stocks in the S&P yield about 2.25% for the XLF, Financial Select SPDRs. The median yield for the sector is a very modest 1.77%, not exactly a comforting level. Utilities, on the other hand, for the XLU Utilities SPDR yield 3.34% but the median yield is significantly higher, at 4.17%.

My conclusions: Two observations that I would note...the lower the aggregate return, the greater the significance of dividends. The higher the market cap, the greater the significance of dividends.

One final thought. Dividend yields are nice but dividend growth is even nicer. Dividend growth is a corollary of improving profitability, improving free cash flow, and improving return on invested capital. Companies which exhibit superior profitability characteristics are often likely to share the wealth with their minority "partners" through dividend growth or buying back of stock. If returns on capital are exceedingly high, the propensity to reinvest and grow the business is also a terrific decision.

Evaluating companies on the basis of yield alone can be dangerous...remember the example of Eastman Kodak which, because of its high yield qualified as a member of the Dogs of the Dow. Dividend cuts will occur as tough corporate economics dictate lower payout ratios.

The significance of dividends will ebb and flow over time as the Fama and French paper suggests. But following a discipline of determining intrinsic value and ensuring that one pays a reasonable discount (margin of safety) to that value will keep you out of trouble.

Disclaimer: I and my family do not currently own any of the ETF's mentioned in this post. One of my clients has a position in SDY.

Going International

Ten or fifteen years ago, institutional investors began a quest for international investing. The question was rarely whether to invest internationally but how much allocation should one have. Individual investors have pursued international diversification with greater zeal in the last few years, but primarily in emerging economies and markets.

Diversification per se is useful only if correlations between stocks or asset classes is low. It reduces risk or volatility of an overall portfolio and consequently tends to improve risk-adjusted returns.

But increasing correlation of returns, at least in well-developed international markets and the U.S. market have increased significantly through the last decade. Markets such as Japan through most of the 90's represented a sinkhole of returns, negative correlation but dreadful returns. Most other markets provided not especially compelling returns and increased correlation, thus the sought after reduction in portfolio volatility never happened.

The tendency toward dropping restrictive trade barriers leads to greater integration and less segmentation of markets. Consequently, international diversification should offer diminishing opportunities as an aggregate strategy as economies become more connected. But as Buffett says, if past history was all there was to the game, the richest people would be librarians.

For the value investor who believes that diversification is a protection against ignorance, international diversification per se holds little appeal. What is most important however, is the increase opportunity set that global markets provide.

Consequently, my portfolio often will incorporate some international stocks. In every case, they represent some value characteristic whether price or profitability that is superior to what is available within the U.S. marketplace.

Buffett's purchase of Iscar is partially an "escape" out of US dollar denominated businesses reflecting his bearishness for the currency. But more importantly, the company enjoys wonderful economics as the best in the industry. Please check out previous posts on Iscar and its major competitor Sandvik.

A Little More on Iscar, Its Reputation, Its Major Competitor

Iscar Comments from Berkshire Meeting

People have asked about Kennametal (KMT) and its position in this industry. Though returns on capital are improving at Kennametal, they have moved up to 9% versus years of 6 and 7% returns. Contrast this with Sandvik and the reputed returns of Iscar which have hovered at 20% or better for some time. Yet Kennametal and Sandvik trade at parity with each other on an EV/EBIT basis.

How do we find these discrepancies, other than individual stock analysis? I always look at companies on an individual basis and apply computer screens for the attractive characteristics that any value investor would seek. In pursuing DCF models, it is always useful to apply a somewhat heavier discount rate for foreign companies due to lesser disclosure, lesser transparency, lower governance standards, etc. Buffett describes this process well in his description of his PetroChina (PTR) investment. Much as speculation circled about his attitude about China in 2003 when he made the investment, speculation has been rife in Israel. Nothing further in Chinese stocks ensued from the initial foray. Buffett does not pursue global investments, merely excellent investments. He is not Jim Rogers though their views on the dollar are quite parallel.

Relative performance statistics for the S&P Global 1200 versus the S&P 500 may disclose some interesting discrepancies within the sectors. Here are YTD figures as of last night:

Global Domestic
Energy......................................17.45%........................16.60%
Materials..................................25.89%........................13.58%
Industrials................................13.72%........................11.07%
Consumer Discretionary........10.96%..........................5.12%
Consumer Staples.....................5.99%...........................1.97%
Healthcare..................................1.33%.........................(4.09%)
Financials..................................12.73%..........................5.49%
Info Technology.........................2.65%........................(0.89%)
Telecom.......................................8.87%.........................8.62%
Utilities.......................................11.04%.......................(0.04%)

Bottomline, the benefits from pursuing international diversification for its own sake seem exaggerated. The extraordinary returns of the US market relative to international markets sacrificed returns for this cause through much of the 90's. Increasing correlations, as a corollary of international trade flows reduced the risk/return benefits. For the value investor, in my view, the role of international stocks should be to augment the opportunity set. Careful research will still provide opportunities here despite the reduced diversification benefit.

Terrestrial Radio -The Great Shrink

The overall market seems to want to ignore terrestrial radio and delight in speculating about satellite. Most of the market place seems to agree with Howard and just says no to terrestrial.

"I'm very flattered terrestrial radio can't let go of me. But I would throw up if I had to go back."

But peculiar things are going on with terrestrial radio. Owners are consolidating their positions. Smart private equity firms are participating in buyouts. The industry is disappearing from the public markets under a massive shrink.

This morning, Cumulus Media(CMLS) announced its intent to initiate a Dutch auction to buy back up to 11.5 million shares of its stock (about 24.1%.) Cumulus combined with partners Bain, Blackstone, and Thomas Lee had announced the acquisition of Susquehanna radio assets at 13.0 times EBITDA just last October for $1.2 billion. Obviously, CMLS is seeing value a little differently than the capital markets.

Just on Monday, Emmis Corp (EMMS) received an offer from its CEO to take the company private for $15.25 cash. The company, since then has traded through the offering price.

Citadel Broadcasting (CDL) announced in February its pending takeover of the ABC radio network for $2.7 billion or roughly 13.5 times EBITDA.

EMMS consists of both broadcasting and publishing assets, consequently a 13 multiple on EBITDA would likely be a stretch in valuation with publishing assets tending toward 8-9 times multiples. Nevertheless, management at EMMS has already sold off two television assets, the Orlando affiliate for $217.5 million and the Phoenix affiliate for $77.5 million in order to bring overall leverage down and ease the financing needs and costs.

The private equity buyers are endorsing capital structure with leverage ratios of 7 and 8 times equity. Companies like Entercom (ETM) have a leverage ratio of only 1.9 times Westwood One (WON) only 1.8 times. Contrast this with Sirius (SIRI) at 6.4 times. For most of these companies, there is ample room for additional debt. Given the buyback programs that we are witnessing as well as the outright acquisitions of broadcast properties, there is decent interest in providing financing to the industry.

If terrestrial radio is so dead as evidenced by the low multiples to cash flow, the high free cash flow yields, and the terrible performance of the group, why is there so much buying interest by private equity interests and the major stakeholders?

Disclaimer: I, my family, and clients have a current position in Westwood One.

Avoiding the Torpedoes

Preserving and growing capital...no risk of permanent loss of capital...good investment practice revolves around respecting the downside first and worrying about the upside later. Things can always go mishugena, forecasts especially about the future are tough. But sometimes hope prevails over reason, greed over sense.

An example for today, Glenayre Technologies (GEMS) down about 38%. How can we avoid these torpedoes?

Valuation seemed to reflect a cheery consensus...EV/EBIT of 30 times relative to Return on Capital for the TTM of about 5%.

Gross margin declines: 2005 GPM was 31.1% versus the prior year's 49.4%. Drops like this are very unusual and should cause you to avoid the stock until you find out why this is occurring.

Operating Margins: In ten years of history, operating margins were negative for seven years. Not what successful businesses generally demonstrate.

Read the 10-K for management's views of risks in the business. Here is a quote from the most recent 10-K:  "Competition in the Company’s industries is intense. Some of the Company’s competitors have substantially greater financial, technical, marketing and distribution resources than the Company and the Company may be unable to successfully compete with these competitors. In addition, competitive pricing pressures exist in the Company’s industries, which may have an adverse effect on the Company’s profits margins in the future."

Check the balance sheet. Total debt to equity was about 80%, total liabilities/ assets  were up substantially to 68% from prior year's 20% or so.

Calculate an Altman score. The Altman Z-score is a decent guide to look at the riskiness of a business in a simple to caluclate measure. The Altman Z for the last 12 months was .09, well below my comfort zone.

Check what insiders are doing. Insiders on balance are sellers of most stocks, but sometimes, sales at what seem to be rather low levels relative to where the stock is trading can signal something. Note these sales between $$3.08 and $3.30.

Understand your investments, rely on your judgment but base it on fundamentals. I suspect that many investors who would have looked at the facts might have thought twice about being involved.

Disclaimer: I, my family, and my clients do not have a current position in GEMS.

A Little More on Iscar, Its Reputation, Its Major Competitor

The Iscar transaction has been widely lauded in Israel. A little more information has come out about the profitability of this company.

Link

If what is described in this link is accurate, Iscar enjoys very high net margins somewhere in the 25% area. From my own due diligence of Iscar distributors that I have spoken to today, the company does enjoy an excellent reputation for its innovation. As the blog suggests and Buffett appeared to confirm on Saturday:

"Iscar is an amazing business run by a visionary family that attracted Buffett as much for its management skills as for its existing business."

The product is highly regarded and the company does appear to keep very careful tabs on the practices of its distributors to ensure a high level of customer service.

During the Berkshire meeting, Charlie Munger described Iscar as the second biggest company, but the best. This raises the issue of just who is the biggest and what do their economics look like.

It appears that the largest company selling carbide metal cutting tools is Sandvik, a well-established Swedish company whose division Sandvik Tooling and Seco Tools appear to be the major Iscar competitors. Sandvik does trade as an ADR in the pink sheets SDVKY.PK

Though perhaps not regarded by Charlie as “the best” they certainly ain’t terrible! Check out these operating margins over time:


Year……………Sandvik Tooling…………… Seco Tools

2005……………21.2%.....................................22.36%
2004……………20.1%.....................................19.48%
2003……………12.64%...................................17.35%
2002……………15.2%.....................................17.15%
2001……………17.9%.....................................18.48%
2000……………20.22%..................................19.55%

The strategic goals for Sandvik sound very similar to the strengths that Mr. Wertheimer described at the Berkshire meeting:

1. -Strong focus on the enhancement of customers’ overall machining economy.
2. -Comprehensive brand and product portfolio for all types of metal cutting.
3. -Considerable expenditure on R&D in close cooperation with customers.
4. -Market leader with a strong global presence and extensive operations in rapidly growing markets.

Some of the drivers of business that Sandvik cites are certainly important drivers for Iscar's business:

1. -The growing demand for lighter components in more difficult-to-machine materials increases tool consumption.
2. -Increased environmental awareness creates a greater demand for more durable tools that can perform metal machining without the use of environmentally adverse cutting fluids.
3. -The current globalization trend favors Sandvik Tooling since international customers prefer suppliers with a global presence.
4. -The industrial expansion in such regions as Asia and Eastern Europe impacts positively on the business area, which has an extensive presence and market share in these areas.
5. -Growing awareness of the crucial significance of tools to the customers’ total production economy increases the demands for competence and knowledge of the customers’ processes – a strong competitive edge for Sandvik Tooling.

The total size of the metal cutting industry is estimated by Sandvik to be about SEK 100 billion or about $14 billion of which some 75% is related to carbide tools. There appears to be a trend toward metal cutting and away from grinding.

The returns on capital for Sandvik including less profitable operations in materials technology and mining and construction are very impressive as well:

2005…………..23.7%
2004…………..20.5%
2003…………..13.4%
2002…………..15.4%
2001…………..17.4%
2000…………..20.3%

Sandvik Tooling in 2005 accounted for one third of Sandvik sales but 46% of the operating profits.

The cyclicality that one would expect for a business whose customers are automotive, engineering and heavy industry does not appear to be very significant. The profitability is very respectable. And in Berkshire, apparently we own the better competitor!

Sandvik demonstrates very high quality attributes as you can see, but offers them at an EV/EBIT of only about 13 times. I would regard this as being quite reasonably priced. But given the valuation of Berkshire at a significant discount to intrinsic, and now owning an even better competitor, I am hard pressed to consider it in my portfolio.

Disclaimer: I, my family and clients have a current position in Berkshire Hathaway. None of us have a current position in Sandvik.

Berkshire on Manufactured Housing

One of the questions that was posed today at the Berkshire meeting related to the outlook for the manufactured housing industry. The question related to Berkshire’s holdings in Clayton Homes, the leader in manufactured housing.

His response was that one would have to go back 40 years to find the volume of manufactured homes as low as they have been recently (outside of FEMA demand.) Historically, the total production of manufactured homes has represented as much as 20% of housing starts versus the current pace of about 6%.

Lending to manufactured home buyers has increased in a meaningful way. Buffett feels that houses are of much higher quality than just 10 years ago.He described the abuses of credit that had occurred 4 to 5 years ago and that it has taken some time to get over that “hangover.” He also added that the number of manufacturing plants had dropped significantly as well as the number of retailers.

He anticipates that ex-FEMA, manufactured housing demand could reach 150,000 units soon. In Charlie Munger’s  view, the efficiency of stick-builders (conventional construction) had improved dramatically over the years and had become more formidable competitors to the manufactured homes industry.

Buffett responded that manufactured housing industry conditions are much improved, that selling prices of $45 per square foot compared favorably with those of stick builders, and that he anticipated that Clayton could well become the largest homebuilder in the US.

Munger then commented that the “ridiculous” financing that characterized manufactured housing conditions five years ago had shifted to stick-built. The poor lending practices of some banks have been facilitated by “contemptible accounting.”

In an interview that TWST recently conducted with Joseph Stegmayer of Cavco Industries( CVCO  the 7th largest manufacturer) about manufactured housing conditions, he replied:

“Our industry has been somewhat counter-cyclical to the traditional housing business. While housing has had an extremely strong run through the past eight years, manufactured housing has had a tougher time. Because interest rates are very low, people have been able to buy bigger homes for the same monthly payment, so price points tend to get pushed up and buyers can afford more expensive site-built homes. The low interest rates in combination with widespread use of special financing incentives and programs by site builders, which have not generally been available to our industry, have had an adverse effect on the manufactured home market in recent years. However, as rates move up, we do tend to attract many home buyers back as we become the much more affordable housing option.”

The May 1st edition of TWST includes interviews with five different manufactured home industry executives as well as an analyst from Sidoti & Company.

I have commented on this industry previously with a post on Nobility Homes (NOBH) Please note the comment from David Phillips, the 10-Q detective. He provides a highly useful and entertaining blog on accounting issues and has some concerns about Nobility’s slowing inventory turns that you should consider. Inventory turns have slowed recently, but accounts receivables turnover has improved as has days payable outstanding. Overall cash conversion cycle appears to have deteriorated slightly to 92 days versus an average in the last three years of about 80 days.

Disclaimer: Neither I, my family, or clients have a current position in Nobility Homes or Cavco.

Berkshire-Comments on Corporate Governance

When asked about the upside or downside of plurality versus majority voting, Buffett and Munger expressed the view that these sorts of minor issues have little effect on corporate governance. These minor changes in fashion of governance will not fix the troubles of American corporations.

Buffett alluded to the recent "crop" of activists, referring to them as a "mixed crowd." He questioned to what extent they act like owners.

Expressing my own views rather than Buffett's, I believe there is a tremendous difference between activists like ValuAct Capital Partners who have long term ownership horizons, and those of "investors" such as Trian and Nelson Peltz.

Ultimately, the degree to which activists think and act like long term owners of the business is what we must judge.

Buffett further articulated the role of a board:

1. To get the right CEO.
2. To prevent the CEO from over-reaching.
3. To exercise independent judgment when acquisitions are made.

He further articulated the role of large institutional investors. He said the only cure for better corporate governance will occur when really large shareholders (8-10 largest institutional groups) tackle these issues. He said that many of the largest shareholders have farmed out their votes and don't want to think like owners.

When compensation packages do not make sense, it is the responsibility of the largest shareholders, not haphazardly organized small shareholders to effectively demand change.

Speaking personally, I applaud those minority shareholders that do speak out, that do propose shareholder proposals in proxies. The egregious excesses of compensation that occur without commentary or effort to effect change by the owners demonstrate an incredible laissez-faire attitude. Institutional investors have a fiduciary obligation, in my view, to monitor and protect the interests that they represent, that is, the mutual fund unitholders and the participants in 401-K and other retirement plans.

In fact, in my view, it is the responsibility of all shareholders both large and small to monitor the managements that are hired to serve their ownership interests.

Iscar-Comments from Berkshire Meeting

At today’s meeting, Warren Buffet was effusive in his praise of Iscar. This is a company that started from very modest beginnings .The purchase is significant, not only in terms of the amount of capital deployed $4 billion) but also the fact that this was the first business that Buffett has purchased outside the U.S.

Jacob Wertheimer, the owner of this family enterprise had an opportunity to address the crowd of 24,000 people at the meeting and to present a video that provided a sense of the geographic breadth of the business and its diverse customer base. Iscar is the second largest cutting tool company in the world, but as Charlie Munger described it, it is the best in the world. Interestingly, it is the main supplier of cutting tools in the Far East and consequently has an important role as a supplier to Asian based automotive companies as well as otrher global automotive producers. In addition, Iscar is a supplier to heavy industry, to the aerospace industry, and to general engineering. The importance of innovation was stressed...when the world demands better solutions, that's why we are in business.

As described, “the average quality of management is not only extraordinary, it is off the chart.” “It is a real quality enterprise.” Finally, “These people know how to do things we don’t know how to do.”

The importance of the intangible asset of people was stressed in Mr. Wertheimer’s discussion. “There are many companies with lots of buildings and real estate, but in the end, it’s only people that make a difference.”

Buffett added, as he generally has, that Berkshire has never participated in an auction process where a company was being sold to the highest bidder. He indicated that he is interested in businesses that are too important to auction. Management must care enough about the business that they do not want to put it up “like a piece of meat” at auction.

He added that a hallmark of businesses that would be considered have owners that are “concerned about the people who are here... the customers who are here are also so important...the owners care about the ultimate home in which the business will reside.”

Berkshire Buys 80% of Iscar Metalworking of Israel

Iscar is a manufacturer of high precision carbide cutting tools for most applications in the metal cutting industry.

The company apparently has a reputation for innovation with half of its sales coming from products developed in the last five years as well as being a business that spends 10% of revenues on R&D.

Hopefully, we will learn more tomorrow at the meeting.

Not a Confused Capitalist at all

Some terrific advice from Jay Walker, the Confused Capitalist in today's post. Jay portrays himself as being confused, but seems to come up with a great deal of sage advice.

Appropriate to the Omaha weekend celebration of value investing is today's post where Jay highlights the wisdom of Tom Stanley.

Most of us realize that we have to be different in order to achieve different results, but the behavioral weakness that many of us have, or a vigilent supervisor or manager, compels us to try to fit in. It's just a hell of a lot easier to be a lemming than a "misfit."

I can recall one investment strategist telling me post 1987 crash how he still had faith in the consumer and was weighting the retail sector at 5% rather than the S&P's 3.5%. When I admitted that I had 25% of the portfolio in retail, he went ashen. He told me that I was reckless.

The need to think differently just for the sake of being different is just as foolhardy. Have a rationale for your thinking, not just a bravado. The notion of long term horizons is also important. Almost every contrarian looks like an idiot for the near term. Wealth is built over the long term, not by settlement day. Almost every really good idea I have had in 25 years of portfolio management and unfortunately I think there were perhaps five, resulted in immediate loss of capital, clients, or the threat of a loss of my job. The stupid ideas tend to blow by quickly...always sell them when you recognize your fallacy. The great ones take time and some of them are still ripening as we speak.

Long term profitability can be much easier to forecast than what next quarter will be. Yet Wall Street, Bay Street, and every other den of capital iniquity (or un-equity) focuses on what that next quarter and maybe year will look like. Project a return on invested capital for businesses that truly have a competitive advantage...don't bother getting out your calculator for those that don't.

Have a great weekend and if you're in Omaha, maybe we'll run into each other.

Seth Klarman notes

Many value investors have clamored for a copy of Seth Klarman's "Margin of Safety. "Controlled Greed" features a post from Motley Fool that provides some useful and thoughtful excerpts from this wonderful but sadly out of print book.

Controlled Greed

Motley Fool Link

An excerpt:

Investors in a stock expect to profit in at least one of three possible ways:

a) From free cash flow generated by the underlying business which will eventually be reflected in a higher share price ordistributed as dividends.

b) From an increase in the multiple that investors are willing to pay for the underlying business as reflected in a higher share price.

c) Or by narrowing of the gap between share price and underlying business value.

Great perspective for the value faithful as we gather here in Omaha for Woodstock for Capitalists.

CECO-Are the Storm Clouds Back?

As readers may recall, I have a strong interest in the education stocks. This is prompted by a number of factors:

• -the proposed private equity takeover of Education Management (EDMC)
• -some reduction in the SEC’s witch hunt about accounting in this industry
• -high returns on invested capital
• -generation of free cash flow

Please check the following links to see previous commentary

Getting an Education in Education Stocks

CECO Revisited-The Clouds are Parting

Career Education (CECO) cratered today. The company’s first quarter announcement was essentially in line with the consensus view, however, the Street was perturbed over the enrolment trends.

A month ago, I did warn that issues remained despite the excellent progress that the company has made in getting through some of the legal morass, both from a class-action and an SEC investigation standpoint.

What to make of last night’s enrolment figures? Total population as of 4/30/06 was 97,100, up just 0.4% YOY from 96,700. The combination of negative press and uncertainty about accreditation at AIU has had a significant impact on the on-campus enrolment. New student enrolment declined by 12.9%. On-line enrolment was up 23.5% YOY but was down slightly sequentially Q/Q.

The street and obviously many students are concerned about AIU, yet AIU operating margins declined less than 1% YOY. The overall university segment (AIU & CTU) actually showed improved operating profits (because revs were up 15%) nut lower operating margins....not exactly horrible at 33.8%! (compared to 37.2% a year ago!!!

Gibbs is an unmitigated disaster and the culinary schools were surprisingly disappointing. Healthcare training was a nice positive surprise.

One positive that was mentioned in the conference call and missed by most of the Street was the fact that retention rates have actually improved YOY.

Operating margins did decline to 17.7% for the quarter, a decline from last year’s 19.4%

The company generated $105 million in FCF, well ahead of the comparable quarter last year which came in at $86 million. Great cost controls and restrained capex account for the improvement.

The analyst community was rightfully disappointed in the lack of guidance or the unwillingness to re-iterate guidance.
The biggest issue remains the accreditation of AIU as I warned a month ago. To quote,

“The most serious problem for CECO appears to be the probationary status of AIU, American Intercontinental University, which is operating on a probationary basis, a situation that threatens its accreditation (by the Southern Association of Colleges and Schools,) and has obviously impacted enrollment negatively. Management appears to be addressing the specific concerns by adding administrative staff, qualified admissions staff as well as full time faculty. The school's accreditation will be reviewed again in December...”

The valuation statistics have a great deal of appeal. CECO offers a free cash flow yield of 8.7%. Contrast that with its competitors APOL at 6.3%, ESI at 4.3% and DV at 2.2%. Return on invested capital has been just over 20%, below the astronomical returns of Apollo and ITT Education but still quite a healthy return relative to most industry.

On an EV/EBIT basis the stock stands out, trading at merely 7.6 times EBIT. APOL is 12.2 times, DV at about 29 times, and ESI at 14.6 times.

The proxy contest at CECO bears watching. The quarterly results provided an opportunity for Steve Bostic to express his disappointment. Bostic is a 1% shareholder who is battling management for three board seats at the upcoming annual meeting. The battle has gotten quite nasty and personal as the company ran a recent newspaper ad questioning Bostic’s capabilities.

Disclaimer.: Neither I, nor my family have a current position in CECO or any of the other education stocks that were mentioned in this post. Several clients have a current position in CECO.



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Nu Skin Enterprises- Brutal Honesty and Corporate Governance

Nu Skin Enterprises (NUS) is essentially a publicly traded version of Amway selling through a multi-level sales organization. The company does most of its sales globally rather than in the U.S. but is based in Provo, Utah. The company sells directly to consumers through a network of distributors. The company operates through three divisions: Nu Skin which offers daily skin-care products, advanced skin treatments, and other personal-care products; Pharmanex, which offers nutritional supplements; and Big Planet, which offers high-technology products and services.

NUS has tested investors patience since last year's third quarter when they started to see a decline in Japan and China. Poor earnings results, in fact a loss was reported for the first quarter this morning. The stock is down more than 13% as I write.

The press release speaks to the necessary business transformation in the usual sort of hollow happy speak that we expect from companies when they run into trouble:

"During the quarter we made great progress in the development and implementation of our business transformation initiative, which is designed to achieve three objectives: first, aligning our efforts and resources to better support our sales leaders; second, simplifying and clarifying our growth drivers in each geographic market; and, third, streamlining our organization to invest in growth initiatives."

But brutal honesty and frankness came from the CEO, Truman Hunt which is rarely heard inside most corporations let alone outside. The tough message rang out during the conference call:

"The first question being asked by many is whether our decline in Japan is related to external market factors....industry trends or the economic environment. The reality is that some of our industry peers have declined, but others have fared well...the environment in Japan is not the definitive factor in determining success or failure."

"Our field leaders identify this (the negative impact of last year's compensation plan changes) as the number one reason for their struggle over the past year..."

"The issues...have to do with simple execution issues...we have had simply too many fundamental execution failures, issues such as product formulation problems, stockouts, miscalculations in the impact of promotions that have hurt us in Japan. These blocking and tackling issues are not just a Japan management issue. On both sides of the water we have not been as attentive to Japan's needs as we need to be."

"Over the years we have had the tendency to overwhelm our sales leaders with too many products and programs emanating from each of our three product divisions."

I applaud the refreshing honesty and laying of blame on senior management, himself included.

Speaking of honesty and frankness, check out the proxy statement:

Under the CEO's new employment agreement, he is to be paid $650,000 as a base salary. Mr. Hunt elected last month to maintain it at his previous $550,000, where it has been for 3 years. The compensation committee offered him 200,000 options as his annual grant. Mr. Hunt accepted only 50,000 options.

In addition, no bonuses were paid to executive officers with respect to third or fourth quarter or second half incentive targets.

The mistakes and miscues will hinder results for a couple of quarters. But the seeds of recovery have been sown. The first and toughest step is recognizing the mistake. This management has clearly done so. Cost savings and a more strategically aligned organization will ensue. The focus on accountability and ownership of the core processes will address many issues. Simple advertising programs in Japan to increase brand awareness are being undertaken. The approvals of the right authorities in Beijing are frustratingly slow, but Avon (AVP) recently was issued the first licence for direct selling. It is possible...I wish I could say likely.

A simple fix in South Korea resulted in a 24% improvement in revenues in the quarter. But Japanese revenues declined 11% in local currency, Mainland China down 12%. The distributor count in mainland China was off by 14%.

Operationally, the business does earn great gross margins, still above 82% both this quarter and a year ago. G&A expenses went up by roughly $3 million despite the $24 million fall in total revenues. However, adjusting for stock option expenses and the formerly every 18 month distributor convention expenses (now going to every 2 years), G&A expenses as a percentage of sales were at 31.27% versus the previous year's 30.13%...not too bad given the dramatic fall in revenues.

On the operating line is where we saw the worst damage, coming in at 6.2% (before non-recurring) versus last year's almost 10%.

The balance sheet looks fine with merely $150 million in long term debt including current portion of LT debt. Cash position is still strong. On an EV/EBIT basis, the company is trading at 9.44 times TTM EBIT. ROIC has been in the 17-18% range before the Asian issues, and had trailed down to 12% prior to this quarter.

Given its valuation, and the honest assessment of blame, as well as the fairness of its management with respect to their own compensation, the company does deserve some consideration as an investment. A positive announcement from China would shed a totally different light on the valuation. Similarly, potential success in Russia could become the next anecdotal evidence to bolster its valuation.

In the interim, likely management will have to demonstrate the credibility and effectiveness of these restructuring moves.

Disclaimer: Neither I, nor my family have a position currently in NUS. However, certain clients do maintain a current position in NUS.