Author Archive

• Welcome Barrons’ Readers
  Eddy Elfenbein, October 30th, 2005 at 6:03 pm

  Welcome! Please have a look around. You can learn more about us, check out our Buy List, peruse our archives, shoot me an e-mail. It’s all good.

• The Week Ahead
  Eddy Elfenbein, October 30th, 2005 at 5:11 pm

  This week, the Federal Reserve holds a tribal council meeting, and will almost certainly raise interest rates for the 12th straight time. This will bring the Fed funds rate up to 4.0%. They’re still not done. Right now, the futures market is telling us that the Fed has two more rate hikes to go.
  We’re now entering the tail-end of earnings season. So far, about 70% of companies have beaten expectations, but this is where things get confusing. You see, you’re expected to beat expectations; 70% is the historical average. However. Companies haven’t beaten expectations by the usual expectation (about 2% instead of 3%). That wasn’t expected. We can now expect expectations to change, perhaps more than expected.
  Part of the part of problem is that some of the sucky big-caps have sucked more than usual. General Motors (GM), for example, reminded everyone that they suck, which we knew, but they also took their suckiness to a whole new level. They lost $1.92 a share, blowing past Wall Street’s forecast of an 87 cent a share. The stock is now trading roughly on par with the ebola virus.
  Discounting for large-cap stocks like GM and Allstate (ALL), the earnings haven’t been too bad. The problem is that the forecasts for next quarter have been weak. This week, we’ll more earnings reports, including stocks like Valero Energy (VLO), Procter & Gamble (PG), Kellogg (K) and Time Warner (TWX).
  Outside our shores, there’s an interesting development in Europe. The Europeans might actually raise interest rates. The eurozone hasn’t raised rates in five years. This is a direct consequence of our economy’s strength. The euro has been slipping against the dollar, and Europe’s Greenspan, Jean-Claude Trichet, has pledged to pounce (or hop) on any sign of inflation.
  China recently said that its trade surplus will balloon to $90 billion this year, up from $32 billion last year. Obviously, the U.S. is at the other end of that surplus. Wal-Mart (WMT) is currently China’s eighth-largest trading partner. But for all the talk we hear about China and trade, thanks to oil, Russia and Saudi Arabia have trade deficits that are almost as large. Plus, the Saudis have their currency pegged to the dollar. I think it makes sense for the oil producers to diversify into another currencies. OPEC’s president recently said that oil prices are approaching an “acceptable” level. Earlier today, I filled up my tank for $2.51 a gallon. That’s the lowest I’ve seen in these here parts is a long time.
  We’re also seeing the first clear signs of a slowdown in the housing market. (Ever notice how the media loves to call the housing market a “bubble,” but that never applies to oil?) New home sales were sluggish and backlogs seem to be growing. And inventories of unsold homes increased as well. The level of unsold homes is the highest in nine years. Plus, median new home prices dropped 5.7% last month, the fourth drop in the last five months. The homebuilding stocks have been getting creamed lately. This could be just the beginning.

• The Death of Pensions
  Eddy Elfenbein, October 30th, 2005 at 1:40 am

  Forget terrorism. Forget Bird Flu. In today’s New York Times, Roger Lowenstein takes 8,000 words to look at the country’s real threat—our dysfunctional pension system.
  Corporate pension plans are underfunded by a staggering $450 billion. This is the world’s slowest-moving train wreck. The question is no longer if, but when. Years ago, companies promised their employees lifetime pensions, but now these “legacy costs” have overburdened companies. Employers simply don’t have the money to fund their pensions adequately. And newer companies don’t even bother; they just go the 401(k) route.
  (In the movie Wall Street, Gordon Gekko was initially attracted to Bluestar by its overfunded pension. An airline with an overfunded pension! Only in Hollywood.)
  Most pensions are insured by the Pension Benefit Guaranty Corporation. The problem is that this insurance invites “moral hazard,” meaning the companies don’t worry about underfunding because they know they have a government-insured safety net. This could be the S&L crises redux. Right now, the PBGC is in the red by $30 billion, and it’s projected to get worse. Much worse.
  As bad as it is for the private sector, the outlook is even bleaker for public sector pensions. In San Diego, 8% of the city’s budget goes to pensions. In West Virginia, the teachers’ pension is only 22% funded. In Illinois, the pensions are underfunded by $38 billion.
  Then there’s the issue of pension accounting. I remember I used to think accounting was simple. Take your revenues and subtract your cost. What’s left is your profit. That’s not even close. When accounting for a pension, a company selects a discount rate to price future liabilities. But companies are selecting higher and higher discount rate so they can set aside less and less money. You can completely alter your profit or loss simply by selecting a new number, and it’s all perfectly legal.
  United Airlines didn’t make any contributions to its pension from 2000 to 2002. In 2003, it made the minimum contribution and it raised pension benefits by 40%. The company filed for bankruptcy and its pension is $10 billion in the hole by. But the accounting was all legit. Imagine that by a factor of 10 and it’s how our future might look.
  Lowenstein is one of the best business writers around, but I think he’s too dismissive of 401(k) plans. Articles like this often follow the formula, here’s theme A, here’s theme not-A, here’s my resolution—watered-down A. But Lowenstein tries to find a self-defined middle ground that never addresses the problem directly. A pension by any other name is still a problem. Corporations are much more fragile entities that its critics realize. They can’t stand the weight of increased government outsourcing. I think 401(k) plans are the answer. Never underestimate the ability of people to solve problems for themselves.
  The worst problems countries face aren’t natural disasters like hurricanes or infected chickens. The worst are manmade problems, like lack of political will. Ultimately, the pension mess can be solved if we abandoned pensions all together and move to 401(k) accounts for all.

• Thoughts on the Market
  Eddy Elfenbein, October 29th, 2005 at 3:04 pm

  When I look at this market, I’m surprised by how strange it is. The market doesn’t seem to be committed to any trend or sector. If anything, it’s committed to a boring status quo. Every rally is met by a sell-off of the same amount and duration. This isn’t just frustrating, it’s bizarre. Here are a few random observations:
  Volatility: The stock market’s daily volatility has plunged. Looking at this from an historical perspective, the decline in volatility is dramatic. The S&P 500 hasn’t had a daily move of 2% or more in over two years. A 2% day used to be nothing. It happened all the time. In the last six months of 2002, the S&P 500 swung by 2% or more 43 times—that’s about one out of every three sessions. This year, the market’s daily volatility has averaged about 0.68%, which is a fall-off of nearly two-thirds since the early part of this decade. Day-traders must be pulling their hair out.
  What’s more, the volatility of every sector has plunged, except for one—Energy. The energy sector stands out from all the other sectors right now. The energy sector used to have about the same volatility as the rest of market, slightly more, but nothing like the tech sector. But now, the S&P 500 Energy Index is more than 2.5 times as volatile as the S&P 500.
  Look what’s happened to tech stocks! At its peak, the S&P 500 Technology Index was averaging swings of 4.5% a day, which was also about 2.5 times the rest of the market. Today, tech stocks swing, on average, just 0.78% a day, a measly 15% more than the rest of the market. The tech sector has become like Henry Hill in witness protection at the end of Goodfellas. They’re schmoes just like everybody else.
  The VIX (CBOE Volatility Index), which is a measure of implied volatility, has actually risen over the past few months, but it’s still very low. This summer, it reached some of its lowest readings in a decade. The impact of volatility is a heated topic among technical analysts. I’m in the camp that believes volatility is over-rated as an indicator of future performance. To the extent that low volatility means anything, it most likely means that the market is pleased with current valuations. Of course, this doesn’t mean it will stay that way. But for now, this is a market that has a hard time rewarding or punishing anything.
  Here’s a good example of how bunched up the market is. From top-to-bottom, this is how the 10 sectors of the S&P 500 have done over the past two years:
  Energy 81.67%
  Utilities 41.59%
  Industrials 21.31%
  Materials 18.01%
  S&P 500 14.48%
  Telecom 13.79%
  Financials 12.08%
  Staples 9.96%
  Healthcare 7.29%
  Discretionary 4.23%
  Tech 2.21%
  That’s very strange. Except for energy (and to a lesser extent utilities), every sector is doing roughly what the market is doing. The market is usually far more judgmental in how it treats leaders and laggards. This is the non-judgmental market. It’s energy stocks, and everybody else.
  Trading Range: Over the last year, the S&P 500 has spent about 90% of its time locked between 1167 on the low end and 1237 on the high end. There was a brief period in the spring when we tested the lower bound, and we were at the high end during part of the summer. Except for that, we’ve been in a flat line. For the last 272 trading days, the Dow has been boxed between 10000 and 11000. For much of that time, the Dow has been squeezed between 10400 and 10700.
  Long-term interest rates have also been trapped in a range. Since the middle of 2003, the 10-year T-bond has yielded between 4%-4.5% most of the time. This past week, the yield finally jumped over 4.5% for the first time in seven months.
  So what now? For a long time now, researchers have shown that stocks prices exhibit leptokurtosis. That’s a seriously geeky word that means that the stock market’s volatility is not normally distributed in the classic Bell Curve sense. (Warning: math ahead). Instead, the distribution of the market’s volatility has a “fat” tail and a “tall” peak. I’m going to skip over a whole bunch of stats (and get some stat professor somewhere angry at me) by saying that this means that the market goes from periods of stability to periods of freaking out. Right now, we’re very deep in a stable period.
  I’m waiting for this stability to break down. By that, I don’t mean a bear market, but I want to see a new leadership group emerge. Anything but energy. Normally, when long-term rates rise, I would lean towards cyclical stocks. However, energy stocks are finally starting to get hit, and it could turn into a rout. Whenever Congress makes noise, it’s a nice contrarian indicator (i.e., Schumer and the yuan). For now, the best values are in a scattering of different areas like Frontier Airlines (FRNT) and Dell (DELL).
  The theme is a lack of a theme.

• The Market Today
  Eddy Elfenbein, October 28th, 2005 at 4:58 pm

  The stock market wasn’t held back by the news of the indictment of Scooter Libby, Dick Cheney’s Chief of Staff. The Dow gained 172 points, the Nasdaq was up 26 points and the S&P 500 added 19.51 points. Our Buy List edged out the broader market by gaining 1.73% to the S&P 500’s 1.65%.
  The S&P 500 rose almost the exact percentage as it did on Monday. The market’s volatility recently hit some of its lowest levels in years, but that may be changing. The S&P didn’t have one daily change that was greater than 1.4% from May through September, but today was the fifth such move in October. Donald Luskin has more thoughts on volatility.
  Our big winner today was Frontier Airlines (FRNT), which soared higher, but gave back some of its gains to close up 8.3%. Although Stryker (SYK) and Biomet (BMET) had good days today, some of our medical device stocks like Varian (VAR) and Respironics (RESP) were laggards. Progressive (PGR) became our latest insurance stock to hit a new 52-week high.
  Outside our Buy List, Business Week looks at the growing mess at Martha Stewart Living Omnimedia (MSO). Overstock.com’s CEO takes the blame for his company’s lousy quarter. Lastly, I was struck by this line: “The economists at Merrill Lynch figure that 40 percent of after-tax personal income is now absorbed by a combination of (rising) health care, energy and interest expenses. That leaves 60 percent to make the house and car payments and pay for life’s little extras – such as groceries.” I guess consumers are becoming more and more like General Motors (GM). (H/T: The Kirk Report).

• Google Watch
  Eddy Elfenbein, October 28th, 2005 at 3:02 pm

  The WSJ profiles Eugene Walton, one of the few Google (GOOG) bears on Wall Street. Walton just raised his price target on Google from $200 to $225, which is about 35% below where Google’s shares are now.
  The difference between Walton and others on Wall Street is that he uses discounted cash flow to value Google. Wall Street prefers to use “relative valuations,” meaning to compare Google’s valuation to similar stocks like Yahoo (YHOO).
  The downside of relative valuation is that if the stocks you’re comparing to are mispriced, you still won’t know the true value of the stock you’re analyzing. All you’ll learn is that stock X is no more overpriced or underpriced than stock Y. Even though both may trade at ridiculous levels, there’s little comfort that they may do so equally.

  Many of Mr. Walton’s Wall Street peers expressed some reservations about Google’s future growth rate but still upgraded the stock, saying they believe the company will outperform the competition. Uncertainty about Google’s future warrants use of more conservative assumptions, says Mr. Walton. In his valuation, he assumes that Google’s long-term, or “terminal” growth rate — the rate at which cash flows are expected to grow, theoretically, in perpetuity — is 2%. Another analyst who uses discounted cash flow, Philip Remek at Guzman & Co. in Coral Gables, Fla., used a 7% rate to come up with a price target of $260.
  The relative-value proponents “want to play it both ways,” says Mr. Walton. “They’re being conservative about earnings beyond 2006, but they’re also trying to justify the current share price. You can’t do that.”
  Many academics contend that terminal growth rates should never be higher than the gross domestic product; otherwise, a company would eventually grow so fast that it would overtake the entire economy. Goldman Sachs estimates the GDP growth rate over time at between 3% and 3.5%.
  Aswath Damodaran, a professor at New York University’s Stern School of Business who specializes in valuation, says he isn’t surprised that analysts using the relative-value method find Google to be fairly priced or undervalued. They feed into their long-term growth assumptions “whatever irrationality is driving the stock price today,” he says.

• Dell’s Descent
  Eddy Elfenbein, October 28th, 2005 at 2:13 pm

  Dell’s (DELL) punishment continues. The stock is close to falling below $30 a share. It looks like today will mark the lowest close in over two years. The stock first broke through $30 seven years ago (adjusted for splits).
  I try not to be surprised by what I see on the market, but the falloff in Dell’s stock is pretty stunning. Put it this way: Dell and GE (GE) are now trading at roughly 16.5 times next year’s earnings. Does anybody really that think these stocks have equal growth prospects? Dell’s earnings multiple is now less than Coca-Cola’s (KO).
  The earnings report is due on November 10. To be conservative, Dell’s sales should grow around 14% or so. If Dell posts earnings of 42 cents a share or more, the stock could easily run to $40.
  

• The Morning Market
  Eddy Elfenbein, October 28th, 2005 at 11:14 am

  The markets are reacting somewhat favorably to this morning’s GDP report. Stocks and bonds are up; gold and oil are down. Thanks to Frontier Airlines (FRNT), our Buy List is on its way to another strong day. Frontier opened at $9.50 a share this morning, although it has slipped some since then. The stock was upgraded today by Calyon Securities. Shares of Frontier are currently up 10% today.
  The theme this quarter seems to be strong earnings and weak forecasts. That’s what we heard from Microsoft (MSFT) yesterday and Bristol-Myers (BMY) today. Another good example is the orthopedics business. Melissa Davis at TheStreet.com looks at the pricing pressures facing Zimmer Holdings (ZMH).

  Anticipating future price cuts, Zimmer went ahead and scaled back expectations for revenue and profit growth next year. The company now hopes to grow revenue by 8% to 9% and profits by about twice that much in 2006.

  I think it’s clear that Wall Street doesn’t pay enough attention to good small-cap stocks. At the Motley Fool, Rich Smith pointed out that Quality Systems (QSII) is followed by just four analysts. Wall Street is still ignoring it even though its shares are up 15-fold in the last five years.
  The China Construction Bank just went public on the Hong Kong exchange. This is one the largest IPOs in years. To continue to grow economically, China will have to modernize its banking sector. The China Construction Bank has a market value of $70 billion, which is more than Morgan Stanley (MWD). Also from China, China National Petroleum has completed its acquisition of PetroKazakhstan (PKZ).
  Authorities in Beijing have allowed the yuan to climb 0.32% since it was “floated.” That may not seem like a big deal, but at the time of the announcement Beijing said it would keep the yuan to a strict 0.3% trading range. The yuan is supposed to be tied to a basket of currencies, but only two major currencies are rallying–the yuan and the dollar. I think the dollar must feel pretty lonely in that basket.
  And finally, Hershey (HSY) is suing a California company called Milkdudz over patent infringement. The company makes clothing to make breast-feeding easier.

• Today’s GDP Report
  Eddy Elfenbein, October 28th, 2005 at 9:27 am

  The government reported that GDP grew by 3.8% during the third quarter. Economists were expecting a growth rate of 3.6%. The economy has now grown by over 3.3% for ten straight quarters. In real terms, the economy has expanded by 13.4% over the last four year. The GDP report will be updated two more times, and I still think the third-quarter growth rate could be revised to over 4%.

• Frontier’s Earnings
  Eddy Elfenbein, October 28th, 2005 at 6:56 am

  At 8:27 last night, it finally came….
  Frontier Airlines (FRNT) had to wait until prime time to deliver its earnings report. I won’t lie. This one had me nervous. I kept thinking of all the horrible things they could announce. They’re already an airline. Is it even possible to get worse?
  But we all knew that Frontier had to stand tall. The Evil Sith Knights over at Love Field (LUV) had invaded their turf. This could not stand.
  Congratulations Potter & Co., the earnings were out-freakin-standing. The analysts were expecting two cents a share. Frontier made 18 cents a share. Read that again: 18 cents a share. They didn’t just beat the Street—Frontier steamrolled estimates. (Note: Yes, I realize I’m mixing my metaphors, airplanes don’t steamroll, but you get the drift.)
  But then Jeff Potter, Frontier’s CEO had to drop this on us:

  Although a quarter as strong as this is certainly cause to celebrate and for our employees to congratulate each other on a job well done, we recognize that the ills that continue to plague this industry haven’t disappeared. Fuel remains at historic highs and the market still suffers from overcapacity leading to general weakness in fares. We don’t anticipate a solution to these issues in the coming quarter, and we expect that high fuel costs and weak fares will adversely affect earnings for our fiscal third quarter 2006.

  Don’t toy with my feelings like that. Later on, the company says that this quarter’s loss will “likely” exceed last quarter’s gain. The more I think about it, it appears that Frontier is keeping expectations low. The quarter isn’t even one-third over. Plus, fuel costs have been falling. This isn’t good news, but it’s not necessarily bad news.
  Let’s look at the positives. Frontier has been able to keep operational costs low. This airline can compete with any low-cost carrier. Total revenues for the quarter increased by over 20%. Also, the company was hampered by a 38% jump in fuel prices. Total fuel costs jumped nearly 60%, yet they still had a great quarter. Fuel makes up nearly 30% of their total costs. If the price for jet fuel falls, Frontier could soar. Let’s hold on and watch how the shares react this morning.
  In other news, Southwest came out with its plans for Denver.