The Fall of Fannie
Posted by Eddy Elfenbein on May 23rd, 2006 at 2:01 pm

The accounting scandal at Fannie Mae (FNM) is certainly one of the saddest. Few companies had the corporate image of FNM. People don’t expect much from companies like Enron, but Fannie was supposed to be different. Now we learn that it was all a charade.

Fannie Mae’s regular quarterly reports of smooth profit growth in recent years were “illusions deliberately and systematically created” by senior executives through improper accounting and manipulation of earnings, the company’s regulator said in a report issued Tuesday.
The report from the Office of Federal Housing Enterprise Oversight, or Ofheo, came as the mortgage-finance company prepared to announce a settlement with Ofheo and the Securities and Exchange Commission under which Fannie will pay a fine of $400 million.
“We are glad to resolve these matters. We have all learned some powerful lessons here about getting things right and about hubris and humility,” said Fannie Mae President and Chief Executive Daniel H. Mudd in a statement. “We are a much different company than before. But we also recognize that we have a long road ahead of us.”
Ofheo’s 340-page report blamed both the board and management for a corporate culture that allowed managers to disregard accounting standards when they got in the way of achieving earnings targets. The company then rewarded executives with huge bonuses for hitting those targets, the report said. (Read the full report.)
For the six years through 2003, the report said, $52 million of the $90 million of compensation for Franklin D. Raines, the chief executive officer, was directly tied to meeting targets for earnings per share. Mr. Raines was forced out of the company in December 2004 when regulators confirmed that Fannie had violated accounting rules. Lawyers for Mr. Raines couldn’t be reached immediately for comment.

The report showed that Raines systematically misled the public:

In the summer of 2002, interest rates fell 100 basis points in 60 days to a 40 year low, and mortgage prepayments accelerated dramatically. That acceleration caused Fannie Mae’s duration gap, the only published measure of the Enterprise’s interest rate risk exposure, to move well outside of Board-approved limits. In Fannie Mae’s 2002 Annual Report, Mr. Raines described the Enterprise’s response:
“Even though we took actions to rebalance our portfolio, the actions were routine … and had no material impact on our business or core business earnings. In fact, our core business earnings per share increased by 21 percent during 2002.”
Mr. Raines’ statements failed to mention several important facts. First, the change in the duration gap occurred because Fannie Mae had not fully hedged its exposure to mortgage prepayments — in other words, senior management had taken significant interest rate risk. Second, the decline in rates had had a multi-billion dollar economic impact — the market value of the Enterprise’s assets had risen much less than the market value of its liabilities, so that its net asset value had declined. The rebalancing required to address Fannie Mae’s duration mismatch in 2002 — accomplished through the repurchase of high-coupon long-term debt and the cancellation of pay-fixed swaps — was quite costly. Mr. Raines failed to mention that core business earnings did not reflect that cost.
Failing to Acknowledge Deficiencies
Another example of that behavior occurred during a press briefing on July 30, 2003. During that briefing Mr. Raines attempted to reassure the participants that Fannie Mae did not have the types of accounting problems then plaguing Freddie Mac. His statements about the quality of Fannie Mae’s internal control system were categorical and sweeping:
“So it is possible to run these things properly, but you’ve got to make the investments. You’ve got to say that this has got to stand scrutiny internal and external. You can’t just go get [sic] by saying, Well, let’s do the cheapest or easiest thing to do. So Fannie Mae had always made the investments. We made the investments over Y2K. We’ve made the investments in our accounting systems. We’ve centralized our accounting so we don’t have to go all over the company to find out what the facts are you can to one place….
Management does matter, and a management that cares a lot about internal control does matter. I think that’s really the important difference. It would not take 500 people for us to go back, even if we had made the same mistakes, because we have these systems automated and we can go back and quickly adjust them.”

Raines served as Director of OMB from 1996 to 1998.

The Vonage IPO
Posted by Eddy Elfenbein on May 23rd, 2006 at 1:25 pm

I know the big worry now is supposed to be inflation. I’m sorry, but I can get into it. It’s like sake. I know I’m supposed to like it, but I just…can’t. I’ve looked at the inflation numbers and it doesn’t seem like that big a deal. Sure, it’s probably true that the government understates inflation, but that’s the kind of thing governments do.
Jeff Matthews had a great post mocking the idea of the core rate of inflation. As usual, he’s right. But I’d like to add that I don’t often use gold or silver or platinum in my day-to-day dealings. If I did, then the prices probably wouldn’t bother me anyway.
Let’s remember that there are areas where prices are falling. At the same time, we’re told that Dell is a complete mess because its competitors are underpricing it, and inflation is roaring back.
If you want to watch for falling prices, just look at the Vonage (VG) IPO. Well, the offering price is certainly inflating. The offering is oversubscribed. But the price of voice-over-Internet protocol (VoIP) is plunging. And so will Vonage’s share price.
Check out this gem from a Reuters article on Vonage:

Vonage has acknowledged that it may never be profitable and is viewed with skepticism by many analysts, who cite the growing competition it faces in providing voice-over-Internet protocol (VoIP) services.
“We haven’t liked the offering since we first saw the registration,” said David Menlow, president of IPOfinancial.com. “There are so many other companies out there that can deploy this strategy or this product in a heartbeat.”

For the love of carbs! May never be profitable??
In 11 years, the company has never made a profit. All told, Vonage has lost over $460 million, which is roughly the amount it will raise from its IPO. (Irony, no?)
In the first quarter, the company had sales of $119 million, and it spent $88 million on marketing.

David Phillips on Arden Group
Posted by Eddy Elfenbein on May 23rd, 2006 at 9:44 am

David Phillips, the 10-Q Detective, looks at Arden Group (ARDNA) and likes what he sees:

Perhaps the Company should rename itself, “The Cheap Gourmet.” In 2005, despite generating operating cash flow of more than $33.0 million, capital expenditures totaled $6,390,000, which included costs of approximately $2,400,000 related to the remodeling and expansion of the Century City store. The balance sheet is in great shape, with Total Debt-to-Equity of approximately 2.0 percent.

Medtronic’s Financials
Posted by Eddy Elfenbein on May 23rd, 2006 at 7:44 am

Here are Medtronic’s numbers for the past several quarters:
Quarter………..EPS………….Sales
Jul-01…………$0.28………..$1,455.70
Oct-01………..$0.29………..$1,571.00
Jan-02………..$0.30………..$1,592.00
Apr-02………..$0.34………..$1,792.00
Jul-02…………$0.32………..$1,713.90
Oct-02………..$0.34………..$1,891.00
Jan-03………..$0.35………..$1,912.50
Apr-03………..$0.40………..$2,148.00
Jul-03…………$0.37………..$2,064.20
Oct-03………..$0.39………..$2,163.80
Jan-04………..$0.40………..$2,193.80
Apr-04………..$0.48………..$2,665.40
Jul-04…………$0.43………..$2,346.10
Oct-04………..$0.44………..$2,399.80
Jan-05………..$0.46………..$2,530.70
Apr-05………..$0.53………..$2,778.00
Jul-05…………$0.50………..$2,690.40
Oct-05………..$0.54………..$2,765.40
Jan-06………..$0.55………..$2,769.50
Apr-06………..$0.62………..$3,080.00 (est)
Jul-06…………$0.59………..$3,020.00 (est)
If the earnings report is inline with expectations, then Medtronic’s trailing P/E ratio will drop to 22, its lowest level in a decade.
In October, the company boosted earnings guidance for FY06, FY07 and FY08. Remarkably, the stock is down 11% since then.

Medtronic’s Earnings Preview
Posted by Eddy Elfenbein on May 22nd, 2006 at 11:44 am

Medtronic reports earnings tomorrow. The AP has a preview:

OVERVIEW: The acquisition of Boston Scientific Corp. and Guidant Corp. during the period changed Medtronic’s competition landscape slightly. Guidant had always been second to Medtronic in the market for implantable defibrillators _ devices implanted in the body to regulate heart rhythm _ while Medtronic seeks to grab share in the drug-coated stent market currently dominated by Boston Scientific and Johnson & Johnson Inc.
Medtronic, the world’s largest medical device maker, gained share in the defibrillator market following Guidant’s product recalls last year, but must hold onto those gains now that Boston Scientific is working to revamp its acquired product lines.
BY THE NUMBERS: Although Medtronic did not issue fourth-quarter guidance, it has fiscal-year earnings guidance of $2.20 to $2.23 per share, and revenue guidance between $11.1 billion and $11.6 billion. Given total adjusted earnings per share of $1.59 and revenue of $8.23 billion for the first three quarters, that implies a fourth-quarter estimate of 61 cents to 64 cents per share earnings on revenue of $2.87 billion to $2.92 billion. Analysts surveyed by Thomson Financial estimate earnings of 62 cents per share on revenue of $3.08 billion.
ANALYST TAKE: Lehman Brothers analyst Bob Hopkins said the upcoming earnings report is an issue of concern. The analyst estimates earnings per share of 61 cents for the quarter. Hopkins, who rates Medtronic “Overweight,” said as long as Medtronic can keep defibrillator sales at $760 million or above, the stock may avoid weakness.
Merrill Lynch’s Katherine Martinelli, with her “Buy” rating, considers Medtronic a preferred heart device stock given the premium price of competitor St. Jude Medical Inc.
WHATS AHEAD: Medtronic and other medical device makers are likely to unleash their lobbyists on Washington this summer to dispute steeper-than-expected proposed reimbursement cuts by the Centers for Medicare and Medicaid Services on such products as stents, defibrillators and pacemakers.
STOCK PERFORMANCE: Shares of Medtronic fell 12 percent to close the fiscal quarter ended April 28 at $50.12 on the New York Stock Exchange. Over the previous four quarters, shares have slid 5 percent.

The Late Cyclicals Are Being Left Behind
Posted by Eddy Elfenbein on May 22nd, 2006 at 11:30 am

I just ran this chart a few days, but it’s worth updating for today. The black line is Morgan Stanley’s index of consumer stocks. The gold is the early cyclicals, and the blue is the late cyclicals.
My point is that this is not a broad downturn. The market is being very selective. Outside of energy and metals, things aren’t so bad. Yet.

The 10-year yield just dipped below 5%.

More of the Same
Posted by Eddy Elfenbein on May 22nd, 2006 at 11:11 am

The market is moving lower, and once again, the cyclical stocks are getting hit the hardest. In fact, the divergence between cyclicals and the rest of the market appears to be accelerating.
The Dow Oil & Gas Index (^DJUSEN) is down another 10 points today to 444. Remember, this index just recently tried to break 500 on three occasions. Materials stocks are also being punished. The rest of the market is only down slightly. The Brazilian iShares (EWZ) are down over 8% today.
The Buy List is again ahead of the broader market (meaning, not down as much). Lowe’s (LOW) had a good earnings report today. The company earned $1.06 a share, which was 12 cents higher than estimates. Shares of LOW are higher, and HD is lower.
The VIX (^VIX), the market’s volatility index, is much higher today. Believe it or not, they are people who “trade” volatility, and volatility bulls are very happy today. The VIX is up to 19. It was at 13 before last week’s CPI report.
Finally, I noticed these two articles in the British press:
‘Is this a crash like 1987? No chance!’
Markets ‘are like 1987 crash’

Weekend Reading
Posted by Eddy Elfenbein on May 21st, 2006 at 4:10 pm

For a quiet Sunday:
D-I-Y Hedge Funds
The Growth of Growth Theory
Currency Markets Mistook Indonesia for Turkey

Happy 200th Birthday John Stuart Mill
Posted by Eddy Elfenbein on May 20th, 2006 at 2:28 am

Richard Reeves on John Stuart Mill:

He wrote one of the definitive 19th-century works on political economy—and also worked tirelessly for Irish land reform. He produced a landmark argument for equal rights for women, and throughout his life pushed for legal and political reform on their behalf—Millicent Fawcett described him as the “principal originator” of the women’s movement. Mill made, in his famous On Liberty, a timeless case for freedom of speech and action that has inspired generation after generation around the world. But as an elderly MP he also led the successful campaign against Disraeli’s attempt to ban demonstrations in public parks, especially Hyde park—a corner of which remains a symbol of free speech to this day.

The Nasdaq Breaks Its Losing Streak
Posted by Eddy Elfenbein on May 19th, 2006 at 4:26 pm

Not a bad day today. The 10-year bond nearly fell below 5%, and the Nasdaq broke its eight-session losing streak. Helping matters was Dell (DELL), which added 62 cents a share, or about 2.6%. AMD (AMD) was up over 11%, and Intel (INTC) fell 1.5%. On our Buy List, we had a good day from Fiserv (FISV), which was up 2.6%. Also, Sysco (SYY) announced a record sales week.
While most of the Buy List was up today, we were hurt by two big losers. Expeditors (EXPD) dropped 4%, and UnitedHealth (UNH) lost 1.9%. Next week, Donaldson (DCI) reports on Wednesday. The current estimate is for 41 cents a share.
Bloomberg reported that commodities had their worst week in 25 years.

This week, copper plunged 10 percent, the most since October 1994, and gold tumbled 7.6 percent, the biggest drop in more than 15 years. The CRB Index dropped 19.46 this week to 342.29. It reached a record 365.45 six sessions ago.
Copper futures for July delivery slid 24.2 cents, or 6.5 percent, to $3.469 a pound on the Comex division of the New York Mercantile Exchange. Prices still have gained 70 percent this year, reaching a record $4.04 on May 11.
Gold futures for June dropped $23.40, or 3.4 percent, to $657.50 an ounce on the Comex. Prices tumbled 7.6 percent this week was most since August 1990. The metal still has gained 27 percent this year. Silver futures for July fell 13 percent this week after climbing for nine straight weeks.