Last spring, one of the phrases that was repeatedly uttered about the economy was "less bad." Or, for those who remember their calculus, it was fair to say that the second derivative was positive back in the second quarter, even if the economy was still shrinking. Then, this summer, we had a number of weeks that showed a robust recovery in certain parts of the economy (it was mostly focused on manufacturing). This week, the economic reports we received yet again showed that the pace of the recovery is losing some steam. The economy is still growing, but the rate of healing is far slower. I said it in early October and I'll say it again ... things are looking "less good." Among this week's economic reports, the industrial production figures (data released by the Federal Reserve) were perhaps the most disappointing, up only 0.1% in October after averaging 0.9% growth in the previous three months. Housing starts and building permits (data released by the Census Bureau) were also much weaker than in previous months. This data on housing can be viewed as mixed news. On one hand, fewer new houses means less supply, which should raise the value of existing homes, all else equal. On the other hand, construction adds to GDP and, as a very labor-intensive industry, weak trends here bode ill for employment--the part of our economic engine that can use the most help at the moment. In any case, it is not obvious what the economy will do from this point forward in the short term. Will the recovery regain steam in the coming weeks thanks to consumers opening their wallets for the holiday season? Do things continue to slow until we have the dreaded double-dip? Perhaps we just muddle along for a number of months like we have this autumn? Some of the increased caution the stock market appeared to show this week was, in my opinion, warranted. Changing gears, there were a number of portfolio companies that reported earnings this week, and I noticed a pattern. The stocks would lie flat in the days ahead of the reports, the earnings would be announced, and then the stock would be punished soon thereafter. Such was the case for Lowe's LOW, Home Depot HD, Autodesk ADSK, and Dell DELL. I forewarned last week that the results would be ugly across the board given the economic environment, but apparently the stock market was expecting something less ugly than my expectations or what actually occurred. C'est la vie. As usual, I've linked below to the actual reports and pasted the relevant stock analyst notes at the end of this post. While the reports this week were universally poor, they were roughly in line with our expectations. As such, our fair value estimates did not change after the receipt of this week's incremental information. My opinions also remain roughly unchanged--I think Home Depot and Lowe's look very cheap at the moment, that Autodesk is mildly undervalued, while Dell has serious problems that may prompt me to sell very shortly. In other news... --Berkshire Hathaway BRK.B this week disclosed its publicly traded equity portfolio for the third quarter, and two of Berkshire's purchases are of particular interest from my perspective. Namely, the meaningful purchases of fellow Tortoise portfolio members ExxonMobil XOM and Wal-Mart WMT. Though the portfolio of publicly traded stocks is of waning importance relative to Berkshire's wholly owned businesses, it's still interesting to see once a quarter what the Oracle of Omaha and his lieutenants are up to. --The Federal Energy Regulatory Commission this week announced investigations surrounding three natural gas pipelines that it believes might be over-earning relative to what the regulators deem a fair return. Unfortunately, the Tortoise hit into a triple play here--all three pipelines are owned by portfolio companies. The pipelines in question are Berkshire Hathaway's Northern Natural Gas system, TransCanada's TRP Great Lakes system, and Kinder Morgan's KMR Natural Gas Pipeline system. While this is a normal part of the give-and-take in a regulated industry and nothing to get too concerned about, I would not be surprised if these companies were indeed forced to modestly lower rates on these particular assets. --Monthly credit card delinquencies were announced this week, and the news was mixed at Discover DFS. Though its delinquencies rose from 5.57% to 5.72% in October, Discover's underwriting still looks vastly superior to the majority of other credit card issuers. American Express AXP, with its relatively affluent customer base, still looks the best from a credit standpoint: Its delinquencies were flat at a comparably low 4.1%. American Express was also in the news for a separate reason, as it purchased an upstart PayPal competitor named Revolution Money for $300 million. While PayPal's moat is built upon the network effect and Revolution has nowhere near the scale, the acquisition still bears watching given Amex's heft in the industry. --Speaking of PayPal, its parent company, eBay EBAY, announced this week that its deal to sell Skype has officially closed. One word--Hooray!! I'm glad to see eBay management return its focus to its core businesses and to see the Skype investment monetized at a decent price. --Costco COST and Coca-Cola KO got into a little spat this past week, as Costco will no longer stock Coca-Cola products on its shelves after a pricing dispute. It will be very interesting to see which company's moat will win the tug of war--Costco and its robust distribution, or Coke and its brands. Either way, this piece of news was immaterial to my decision to trim the Coke position in the Tortoise this week. I simply think Coke's shares look fairly valued and will gladly buy the stock back if I can get it at a lower price. --One of my other portfolio transactions this week was to purchase additional shares of Apollo APOL (as I strongly hinted I would in last week's roundup). Earlier in the week, Apollo received word that its University of Phoenix unit has been recertified by the Department of Education under its Title IV loan program. This recertification was given without condition and is good through the end of 2012. This is great news, as it ameliorates one of the company's potentially high-impact risks. We've thought all along that the odds of this risk coming to fruition were very long, and it's good to see them become that much longer. --MasterCard MA was in the news this week, as the Government Accountability Office released a long-anticipated (and Congressionally mandated) report on credit card interchange fees. Though it provided fodder for the retailers who vehemently oppose these fees, it was also a partial victory for the credit card companies, as the report also highlighted the difficulty there would be in actually unwinding these fees. The report also highlighted that most of the benefits of limiting interchange fees would accrue to retailers and not necessarily consumers. The report (linked below) is a worthwhile read for those own MasterCard, Amex, Discover or Visa V. No portfolio companies are scheduled to report earnings next week. There will, however, be a number of economic reports crammed into the early part of the week, thanks to the holiday. It should be an interesting week, albeit a short one. Have a great weekend... Paul Larson
Equities Strategist
Editor of Morningstar StockInvestor Disclosure: Paul Larson owns the following stocks mentioned in this e-mail: ADSK, APOL, AXP, BRK.B, DELL, DFS, HD, KMR, KO, LOW, MA, TRP, WMT, XOM -------------------------------------------------------------------- Related Links Lowe's Earnings Report
http://investor.shareholder.com/lowes/ReleaseDetail.cfm?ReleaseID=424328&openNews=true Home Depot Earnings Report
http://ir.homedepot.com/phoenix.zhtml?c=63646&p=irol-newsArticle&ID=1356174&highlight= Autodesk Earnings Report
http://investors.autodesk.com/phoenix.zhtml?c=117861&p=irol-newsArticle&ID=1356557&highlight= Dell Earnings Report
http://content.dell.com/us/en/corp/d/secure/2009-11-19-Q3FY10Results.aspx Federal Reserve -- Industrial Production
http://www.federalreserve.gov/releases/g17/Current/ FERC -- Natural Gas Pipeline Investigations
http://www.ferc.gov/news/news-releases/2009/2009-4/11-19-09-G-3.asp GAO -- Credit Cards Report
http://www.gao.gov/new.items/d1045.pdf -------------------------------------------------------------------- Morningstar Stock Analyst Notes Lowe's LOW | Mike Taggart, CFA Lowe's reported third-quarter results that put the company on track to meet our full-year estimates. The company's performance in the quarter was in line with our expectation that consumer spending on home improvement will remain weak in the near term. Our fair value estimate remains unchanged. Comparable-store sales declined 7.5% in the third quarter, worse than the 5.9% decline reported in the year-ago quarter but improving from a 9.5% decline in the second quarter. Total sales declined 3% to $11.4 billion, as new store contributions helped to somewhat offset the comparable-store sales decrease. Lowe's opened 12 stores and closed one during the quarter, and management expects to open about 13 new stores in the fourth quarter. Our outlook for 2009 assumes a 7% decline in comparable-store sales, a 3% decline in total sales, and 57 net new store openings, all of which continue to be in line with management's outlook. The gross margin improved very slightly to 34.2% from 34% in the year-ago period, while the operating margin continued to contract from year-ago levels, falling 160 basis points to 5.8%. The deleveraging of operating expenses across a lower revenue base and a $57 million pretax charge were the main reasons behind the decline. The charge related to a store closing, a reduced store opening pipeline, and asset-impairment charges for three existing stores. Operating cash flow of $4.4 billion was essentially flat through nine months compared with last year. Overall, the results were what we expect from Lowe's over the next few quarters as the health of consumer spending, the housing market, and the overall economy begin to stabilize, leading to a modest improvement in financial results. -------------------------------------------------------------------- Home Depot HD | Mike Taggart, CFA Home Depot reported third-quarter results that underscore our belief that the home-improvement market is stabilizing. Performance through nine months and management's guidance put the company on track to meet our full-year expectations. Our fair value estimate remains unchanged. Total sales declined 8% to $16.4 billion in the quarter, while comparable-store sales declined 6.9%, slightly better than the 7.5% comp decline reported Monday by Lowe's. Home Depot's weak top line reflects consumers' unwillingness or inability to make large-ticket purchases as well as weakness in professional sales: The average ticket declined 7.1% compared with the year-ago period to $51.89, as transactions greater than $900 declined 10% despite an increase in appliance sales (which are high-ticket items). For the quarter, the gross margin improved 30 basis points from the prior-year period to 34%, and that improvement fell down to the operating margin (7.7%) as management held operating expenses flat. Management said it is seeing stabilization in the Florida, California, and Southwestern U.S. markets, which mimics comments from Lowe's executives. The company has restarted its share-repurchase program, which we believe reflects a positive outlook from management, since the program was previously halted because of concerns about the credit markets. In our view, buying back shares is a good use of capital, as we believe Home Depot's stock is undervalued. -------------------------------------------------------------------- Autodesk ADSK | Rafael Garcia Autodesk's third-quarter results for fiscal 2010 showed a sharp decline on a year-over-year basis. However, sequential comparisons show signs of a more stable business environment. We are leaving our fair value estimate unchanged. Overall, demand for new licenses of Autodesk's solutions remains anemic. While revenue of $417 million declined 31% from the year-ago period, the flat sequential results were relatively encouraging. We expect to see depressed business activity for as long as the unemployment rate stays elevated and access to credit for new projects--particularly commercial real estate--remains scarce. Moreover, maintenance revenue--as anticipated--is now showing signs of decline as a negative lagging effect of weak new license sales over the past five quarters. In terms of geographic results, the Americas and European regions showed some glimmers of sequential growth, whereas revenue derived from emerging markets--a past driver of strong growth--has not shown signs of any significant improvement. The operating margin for the quarter of 6% remains well below Autodesk's long-term potential, in our view. Management has implemented deep restructuring initiatives to better align the company's cost structure with current revenue levels. We like management's approach of avoiding extreme cuts that would impair the company's ability to capitalize on the eventual economic recovery. We see the resumption of Autodesk's share-repurchase program after 12 months of inactivity as a sign of management's growing confidence in business stability. Still, we would have preferred to see the company buying back stock earlier this year, when its shares were trading at a significant discount to our fair value estimate. -------------------------------------------------------------------- Dell DELL | Michael Hodel, CFA Dell reported third-quarter earnings today that were in line with our expectations. Total revenue was down 15% year over year but grew 1% sequentially to $12.9 billion. Operating margin was 4.5% down from 6.7% a year ago, as the global consumer business continues to struggle with operating margins of less than 1%. Data center technologies were a source of strength, but client technologies remain the key driver of results for Dell with PCs, software and peripherals accounting for 75% of revenue. Dell continues to cede PC market share, falling from the largest to third-largest PC vendor in recent years as it largely abstains from the high-growth but poor-margin netbook market. On the surface this raises alarm, but we believe this is a rational strategy to defer Dell's entrance into the looming PC price wars where no vendor is likely to emerge victorious. This move is also consistent with our long-term thesis is that Dell needs to shift its reliance from PCs to data center technologies and services. Unfortunately, we think that the price wars will quickly accelerate up to higher-end PCs and that Dell is unlikely to accomplish the transition before this occurs. -------------------------------------------------------------------- American Express AXP | Michael Kon, CFA American Express announced Wednesday that it has agreed to acquire Revolution Money, a small startup company that developed a unique platform to deliver payments over the Internet. Amex agreed to pay about $300 million for the firm. We think Revolution Money immediately threatens existing online payment providers such as PayPal. In the long run, the firm had potential to become a disruptive force in the credit card network industry, but with Amex taking over the firm, we think this threat has receded. Although the price tag is too rich, we think this deal is immaterial to Amex, and we are leaving our fair value estimate unchanged. -------------------------------------------------------------------- Coca-Cola KO | Philip Gorham, CFA Wholesale retailer Costco COST announced that it has stopped restocking some Coca-Cola products in its stores nationwide, after the beverage giant refused to cut the prices it charges the retailer. Few details have been revealed, and we are maintaining our fair value estimate for Coke until the effects of the dispute become more apparent. We regard the move as a test of beverage manufacturers' pricing power, and we anticipate a wide range of outcomes. In the best case for Coca-Cola, the absence of Coke-branded products would slow traffic in Costco's stores, and the retailer would back down from its pricing demands. The pricing power of the leading manufacturers would be maintained or even strengthened as a result. In the worst case for Coke, store traffic would not be affected, and Costco would be able to hold firm. Coke would be faced with an unattractive choice of losing share to great rival PepsiCo PEP or cutting prices. If Coke blinks and cuts prices to Costco, other heavyweight retailers such as Wal-Mart WMT would also demand lower prices. This would lead to more fierce competition on price, as Coke and Pepsi would battle to keep their products in the stores of their largest retail customers, and the pricing power of the beverage manufacturers could be impaired in the retail channel. --------------------------------------------------------------------
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