"Can you guess what it is yet?"

Monday, February 28, 2005 | 0 comments »


Accrual writes, with apologies to Rolf Harris:

They manufacture in a high cost country.

Competition is strong, with fleet-footed Japanese and a few Europeans are after them.

Shipments have grown from low 10’s of thousands in 1983 to 317,000 in 2004.

Revenues in 2004 were $5.02bn, Op Income was in excess of $1.3bn and net income was $890m.

19 consecutive (record) years of growth.

Company strengths – their people love the product, customer loyalty is phenomenal (repurchase decisions >95%), every dealer runs a "club".

Have you guessed it yet? The only apparent down side last year (and this is a personal gripe to whoever said share options were free) was that they repurchased 10.6m shares for $564m, or more than twice their capital expenditure of $213m.

A prize, to be determined, to the first reader who guesses correctly [Editor: yeah, right].

[Editor: DeLorean Motor Company, surely?]

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MD writes ...

Egg plc, the accident-prone credit card lender owned by Prudential plc ("The Pru") posted another very disappointing set of figures on 23 February. Yet the market reacted more benignly than a realist would expect. Quite why "Chief Executive" Paul Gratton has survived the disaster in France beggars belief - Egg are writing off £113m on top of the loss in France for the year of £35m.

Ditto could be said of Pru Chief Executive Jonathan Bloomer who should have fired him. So having not done so in 2003 he's now allowed Gratton to go for growth in the year just completed. Wonder what they were thinking at the time...

JB: So, Paul how are you going to get us out of this mess in France?

PG: Well Jon, as you know after years of credit expansion in the UK the market is still all to play for. So I think we'll go for growth in the sub-prime market.

JB: Great idea! It worked for HSBC! And if it doesn't work out we'll both fall on our swords.

Some months later...

JB: How'd it go?

PG: Well, the good news is we will only have to write off £113m in France - like we said first time. Plus the P&L charge of £35m and the loss of £89m there last year. So we took a pretty good spanking really. To address this I thought we should go for growth but clearly the incentives were a bit awry 'cos we've written some really awful personal loan business in a generally benign UK market. I've had to increase provisions to 6.2% but - hey - who cares? The analysts don't seem to have noticed!

JB: JHC! [scribe's shorthand for a well-known historical figure] Are you sure the analysts won't notice?

PG: Yep - but they may notice we also wrote off another £21m exiting other businesses and spent £5m restructuring.

JB (getting nasty): I hope you've put something by for your own package!

PG: JB? JB!!!

[Editor: Save some of that magic for your next jobs, boys]

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MD writes...

The scribe is indebted to one P. Green (of Monaco) for issuing a collective profit warning for UK plc retailing - though no one seems to have noticed. Quote:

"...the M&S share price is not reflecting what’s going on out there. In the retail sector prices [of shares] are all ahead of events. It’s much tougher out there. Consumer confidence is more fragile."

Perhaps the oddest thing in this market is that retailers continue to sell the family silver (store freeholds - Boots most recently). Really, why bother? The cash raised won't generate a similar return, may well be squandered on a share buyback and the cost base and cash outgoings rise in one fell swoop. Let's face it - when the boys ("Analysts") want to stiff a management team they just go ahead and do it anyway - whether or not said management has listened to their "Advice".

PS/ The cold snap - those who ventured outside this week will have stumbled on the latest excuse for just about everybody (motors, shops, brewing, leisure – you name it). It was pretty damn cold out there, expect plenty of blame being ascribed to it in coming months.

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Rio Tinto has been a good firm to investors recently. The shares have been as hot as the Chinese demand for iron ore driving them; and it is Chinese demand that has allowed Rio to negotiate a 71.5% (no, not a misprint) iron ore price increase for the shipping year beginning 1 April with Japan's Nippon Steel. Nippon, lacking bargaining power in the face of Chinese demand, acted to secure supply ahead of what it feared would be even higher prices.

Brokers are accordingly excited and have marked-up earnings forecasts for big iron ore miners. Citigroup Smith Barney, for example, raised its 2005 profit estimate for Rio by 10% to US$4.3 billion; and by 13% to US$4.5 billion in 2006.


Given that the first price settlement of each year sets the mark for all other iron ore contracts in the global market, it's not a surprise that the world's three largest iron ore producers - Rio Tinto, BHP Billiton and Brazil's Companhia Vale do Rio Doce (CRVD) - are planning huge output increases. The United Nations Conference on Trade and Development estimates 450 million tonnes of additional iron ore capacity will come on stream by 2009.

Down in the steel-making trenches meanwhile, China has spent the greater part of a year trying to talk down domestic steel production. Their National Development and Reform Commission (NDRC), the main government department overseeing economic development, estimates that by end-2005 China's annual steel output will reach 330 million tons, or what the NDRC believes will be the market demand of 2010. Talk having failed, the NDRC has begun clamping down on the industry.

Maybe China will be able to control its "official" steel supply (a prop to prices); maybe their low grade "illegal" producers won't have a significant impact on overcapacity; maybe the heavy steel-consuming Shanghai construction sector won't slow either (although many commentators believe it is but a pop away); and maybe the iron ore producers will be able to control the price-impact of the additional capacity they plan.

Indeed, looking at the big iron ore miners' share prices, all one sees is this optimism. Sound advice this writer once received (albeit in a different context) was "protect the downside". It may be too early to jump from the China commodities bandwagon this cycle; but it is hard to see things getting much better than they are right now for miners' share prices.

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UK correspondent MD, a Honda driver, comments:

Alfred P. Sloan wrote in his 1964 book "My Years with General Motors" that:

"The causes of success or failure are deep and complex, and chance plays a part. Experience has convinced me, however, that for those who are responsible for a business, two important factors are motivation and opportunity. The former is supplied in good part by incentive compensation, the latter by decentralization."
Pleasing though it is to see GM and Fiat bury the hatchet for €1.55bn rather than do a Kramer vs Kramer, it remains to be seen whether GM can recapture some of the glory days they knew under Sloan. Nonetheless, this appears to be a good deal for both parties and gets them out of a sticky situation - at least for the moment.

GM has a number of structural problems in the US that it has been slow to tackle including aging plant, poor product (particularly in the field of design), a perverse brand strategy, rising healthcare and pensions benefits (see footnote) and a unionised workforce (which means structural reform is slow). None of these are unique to GM: Ford and DaimlerChrysler too have similar if proportionately lesser issues. But at GM the concerns have been blindingly obvious for years yet never properly addressed. The feeling is that both Ford and, in particular, DaimlerChrysler will tackle matters sooner.

Coupled to this are problems elsewhere in the empire, particularly in Europe. The marques in Europe have been poorly managed for years. Recent faux pas have included stupendously ugly US-inspired design of the mid-sized Vectra which, whilst now a good car (spacious, comfortable, OK to drive and well screwed together) is hampered by its predecessor's dog-like reputation and naff looks. Thankfully for GM, the new Astra (a VW Golf competitor) is much better looking and a worthy motor.

Elsewhere in Europe, Saab has been allowed to wither on the vine - the recent(ish) 9-3 "sports saloon", whilst handsome enough and quite good, doesn't match the Audi A4 or BMW 3 series. The only other product is the old 9-5, now at least 6 years old and with no indication of a replacement in the wings. Again, it was blindingly obvious that for Saab to be a success patience, investment, more product (a third model would help) and consistent marketing was required. To date everything has been half-hearted, so much so that the whole viability of the brand is again in question.

Enter stage-left, Daewoo (now to be known as Chevrolet). One questions whether GM needs yet another marque, more plant and so on - particularly as the product is not particularly cheap or particularly good ("crap" some might say). Quite why they think Chevrolet will be a brand to conjure up sales in Europe is mysterious. Equally, and although Daewoo is supposed to help in emerging markets, does GM really also need to compete against their own brands (Vauxhall and Opel) head to head?

So where next for GM? The only sure way is to put a greater emphasis on product engineering and design, drop dog brands such as Saturn and close many of their myriad plants. Whether their finances will give them the time to do this is a moot point. Conversely, over at Fiat they are already taking the appropriate steps to engineer a product-led revival - helped considerably by GM's bung.

One wonders what Mr. Sloan would have made of all this.

Healthcare footnote: GM currently service 1.1 million health care packages in the US with an $8,000 per head, per annum average cost. This cost is rising at 15% per annum, faster than the firm's materials costs. Clearly, the brakes need to be applied soon, or Chapter 11 will look a more and more sensible option. And they say doing business in Europe is more expensive than in the US.

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MD writes...

Retailers: Picking over the Ruins
So Primark, Debenhams and Philip Green have waded in and bought most of what remained of Allders. Only about 10 stores including the Oxford street flagship still seek buyers. Interestingly, part of the Philip Green buy-motive was to expand the home furnishings side of BHS: seems a funny time to be getting into this area at present, what with the demise of Courts, Allders (and Laura Ashley being on the brink). But you know what they say: when all are moving one way, the shrewd investor goes the opposite direction.

Invensys
Is it time to reappraise Invensys? This scribe thinks maybe.

Watchers of penny shares will have noted the recent (apparently short lived) strength in Invensys shares ahead of next week's announcement of their Q3 results (scheduled for 24/02/05).

Positives include renewed management focus on growing the business now that the fire fighting is almost over; companies previously earmarked for sale have been removed from the table; cash at hand has improved whilst debt maturities have been extended; key strength remains in a number of business areas (e.g. APV & Westinghouse); contracts are being won again; and the management succession is in place.

Negatives are fewer: margins suffered in the first half (explainable); turnover was down a tad; cash continued to be burnt at the operating level.

But at the end of the day this business has a turnover of >£3bn and operates in sectors where it is still a player. 2004/5 will prove to be the nadir (Editor: here's hoping).

UPDATE 27/02/2005: Well, no surprises - good or bad - in the Q3 results for Invensys (much personal relief in this quarter). Here’s to 2004/05 being the year they turned the corner.

The scribe and/or his family have shares in Invensys.

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Interesting graph from chartoftheday. May try to put together the equivalent for the UK next week.

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Is it foolhardy today to invest money in illiquid UK property assets? It's a debate accountant and Oxfordshire homeowner Accrual and I have had for 5 years. Which straightaway says something about the heat of the market.

Prices are spectacular. But so long as GDP growth remains sturdy and the labour market remains tight, from where will come the catalyst for significant declines? The chart below illustrates some trend data since 1984.

Exhibit A: UK House Price Trends, 1984-2004. Assembled from HM Treasury data.


The supports for prices are evident: first, the employment market is tight; second the leading indicator of consumer confidence is on the rise; and third, GDP growth looks robust.

Now, here's the thing. The psychology in the UK house market and the current US/UK equity markets is in some ways similar: strong prices have created a buyer's hesitation to commit, albeit tempered by a sense of missing-the-chance to cash in on a still rising market. Since 2001 it looks like fear-of-missing-the-boat has won out as double-digit annual gains have become the norm - perhaps assisted by the negative returns of offered by UK equities over the period 2001-2003.

But peering forward there are the forecasts of GDP to consider. Most independent pundits don't see it outstripping 2.5%-2.7% in 2005: the Chancellor of the Exchequer forecasts 3%-3.5%. If he's wrong there will be a major tax revenue hole (given Labour's spending commitments), tax rises and higher interest rates. And all that beginning from perhaps as early as the November 2005 Budget. The UK yield curve is already slightly inverted - this scenario at least keeps it that way.

How sharply rates might rise under this scenario determines the fate of UK property values in the medium term. Yet - although it's too early to be definitive on this - the expectation of rises already seems such that it's modestly cooling prices. If that proves to be the case it reduces the probability of a rate-hiking drama. So, short of a shock, a soft-landing appears possible. For prospective owner-occupiers planning to stay put awhile, this simplifies decision-making. And they are 80% of the residential market.

Investors, on the other hand, will want to think carefully about opportunity costs. Buying now means owning a pricey market where even gross yields in many areas are lower than the Bank of England base rate. In fact, not one region offers a net yield superior to the lending rate.

With uncertain weather on the economic horizon, that's poor odds.

UPDATE:
This from the FT (15 Feb 2005) reports lending to UK property investors dropped off significantly in the second half of 2004.

Useful reading and data on the UK and other international housing markets is to be found at the Investment Property Databank , the source for the yield data in this article.

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Pillows now - seats next?

Wednesday, February 09, 2005 | 0 comments »


US airlines operate in an industry where over-capacity is nurtured by US Chapter 11 bankruptcy legislation: dead companies, like lost luggage, keep coming back. Well, usually.

So it's not surprising they are always looking to cut costs. This link from USA Today covers American Air's decision to get rid of pillows.

Spokesman Tim Wagner's take:
"We had some resistance from customers initially, but complaints dropped off"
"Dropped off"? Gulp.

Memo to self: review holdings in US domestic airlines.

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MD writes...

Retailers
Seasoned readers of this occasional column will know that the scribe doesn't like to crow {Editor: Yeah, right}, but more evidence of a retailing bloodbath continues to emerge from the UK High Street.

Retail sales apparently dropped by 2% over the Christmas period, sales in January have also been weak but retailers are hopeful that February sales will bounce back. Well, don't bank on it. The UK remains the most over-shopped market in Europe by some margin and the trend, to this observer, remains downward.

Speaking of which, the collapse of Allders last week (25/01/05) only highlights the problems faced by many on the High Street. Allders, burdened by buy-out debt (and no doubt management fees) and an unfashionable image, simply couldn't keep the balls in the air any longer. MD Terry Green has received some stick about this–. Many analysts (and the previous MD) said he must have been mad remodelling some of the stores which, together with the in-store offer, was going to alienate his existing customers.

Come on, who are they kidding? The problem was not alienation, just too few customers.

This observer visited his local Allders store today and he was pleasantly surprised. The store was bright, had good stuff (labels, own stuff, and the full range - clothes, bedding, electricals, to cookware) at generally reasonable prices. Yet it still managed something for the traditional shopper. Frankly, it is the best department store in his town! And this is a town with a local market, a Debenhams, a family owned Department store, BHS and of course M&S (both arguably in a different market). So what’s the rub? Well I, and many others, hardly visit: my last was two years ago during the previous management's dire regime.

The recipe for success for whomever takes over? Don't change the formula, just advertise your presence!

Shell
Great to see the stonking profit numbers from Shell last week. Still, there were further disappointments regarding their reserves, but surely this is a sign of ultra conservatism. The key going forward is finding new sources of oil outside of Russia, China and India where the respective Governments seem intent on creating their own oil giants - and why shouldn't they?

Mortgages
Amid all the fuss over the UK property market there have been alarming increases in the Spanish and French property market in the last 12 months - particularly in Spain. Those who visit Madrid (or the Costa del Sol) regularly will wonder who on earth is going to live in / buy all the spanking new properties being built. Locals shake their heads and mutter about speculative building.

You have been warned.

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February 23 sees the release of US CPI and core CPI figures for January 2005.

Screwing the pooch. Not a pretty image. But, if you hold US sovereign debt or save in a US dollar denominated account, get used to Fido. If you haven't already.

Some US investors have long complained that the core CPI used by the Fed does not include energy or food costs. It's common on Earth to accept these two items as essential expenses. Why those from Planet Fed fix on a "core" rate excluding food and energy is one of the mysteries of the cosmos.

The result is that the Fed gets ownership of a 2.2% core CPI rate as of December 2004 (it is thought they target 2%) and disowns, or so it appears, the broader CPI rate of 3.3% (also a December number).

But even the trim, slim "core" CPI understates inflation. In fact, both CPI rates do because of the way they tackle housing costs. In the CPI computation there is a small part of housing cost which is considered pure rental; and then there is, debatably, a much larger part called "owners' equivalent rent".

I'm not a statistician. Nor do I portray one on television. But I believe if something is labeled "owners' equivalent rent" it is not measuring mortgage costs. Convenient since rents have probably not risen anything like as much as house prices and their associated mortgage costs. Or at least that is my intuitive assumption given that the latest data shows an average annual house price increase of 13%.

Factor in, too, the effect of the "hedonic" adjustment made to CPI. I thank my UK writing partner for pointing this out to me via this article about relative US and European GDP growth rates. Whether it adds as much to CPI as the point-and-a-half cited is not agreed. But speakers of econometrics do seem to agree that it adds something.

All in all, significantly understating both its CPI measures might have been a brilliant and (if deliberate) devious way for the Fed to try claw back the budget deficit: just let inflation eat away at the debt. Unfortunately (but small wonder) ordinary citizens saw through and admired the scheme so much they emulated it. And, lo, there were twin deficits.

Well, I simplify. But if you're a saver and/or debt holder, it bites all the same.

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Our UK scribe writes:

Lots of excitement last weekend over this mega-deal and even the sage of Omaha thinks it's good. But is everyone not getting a bit carried away?

The combined giant will have sales in excess of $60bn (roughly $10bn from Gillette & the rest with P&G). Yet the companies are apparently talking of a present value of revenue and cost synergies of $14bn-$16bn. You'll have to help me out here guys, 'cos that is plain rubbish.

Over what time-frame do these heroic numbers apply? What exactly are the claimed savings? And what rate of return was assumed? The FT's Lex column smelt a rat and had a go at analysing these the other day but rather lost the plot.

Here's an alternate view:
Fact: Combined revenues c: $60bn;
Fact: Combined advertising spend c: $3bn;
Fact: Announced headcount savings c: 6,000;

Potential savings
Headcount: say $600mn (assume an average salary of $100,000 x 6,000). NB, not realisable on day 1;

Advertising synergies
Say 10% or $300mn. NB, not realisable on day 1;

Other head office / improved purchasing
Yr2 onwards as contracts are renegotiated and companies are better integrated. Say, $300mn - is it really certain that this merger will be a bigger cost-saver at the negotiating table with Wal-Mart, Aldi, Carrefour et al?

Total
: $1,200bn or 2.00%

Cash savings
Yr 1 Erm, none (all those payoffs, see)

Revenue synergies
Difficult to identify but would include some unquantifiable benefit from increased selling power. Worth, say, 1% (and I'm being generous here) or $600mn. Also, increased sales for Gillette in emerging markets of, say, $600mn pa (more generosity) over a few years.
Great deal guys - glad to see the investment bankers haven't lost their Midas touch.

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RJH writes...

I once heard someone insult an undeserving victim that, if he had a dog as ugly, he'd shave its butt and teach it to walk backwards. Many holders of equity in big cap pharmaceutical companies may be having similar sentiments about their investments in the sector: Merck and Pfizer price charts look as though the two are in a race to zero.

Big pharma has been a whipping boy for some time. Any negative news is amplified such is the fear of (especially) litigation but also failed drug-trials, holes in the pipelines, and generic competition. But in the case of some firms, sentiment is outweighing fundamentals - how much longer will this go on?

I'm not calling a bottom generally. But pharma in the UK (don't have the US data handy) has returned over 19% a year since 1965. So the bigger picture demands that investors ask if this long term trend really has been broken by the recent atrocious period of underperformance (honourable exceptions noted).

Often cash-flow rich and brilliantly managed, currently at rarely seen valuations and defensive in times of uncertainty, the contrarian in me says no.

Not a disinterested commentator, RJH twice has bought Astrazeneca plc shares in the last 5 weeks.

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