A reader reacts to recent CC posts:

I was catching up with reading of CC blog yesterday. Is it all doom and gloom in the US and the UK? Surely there must be some good news out there? I know you don't like giving advice. But what sectors or countries are you focusing on?

Reply:
If you listen to our UK man, the world is ending. It is true that in the UK enough elements to cause economic unpleasantness are present. Similar tale in the US.

The key point is that these are unrealised menaces poised over the next two years to potentially (but not inevitably) cause big headaches rather than a simple cyclical, non-recessionary slowdown. The conundrum is how it all plays out - will the threats unwind gently or violently?

I don't know. But my feeling, based entirely on the manic depressive over-reactions of the markets, is that the economic (if not the stock market) unwinding may actually be much gentler than is assumed in the current fearful climate.

That's bar a demand shock in, say, China. The state has a thorny job to negotiate a successful slow down in infrastructural over-investment; and the property speculation this has sparked in Shanghai is itself enough of a danger before even examining any other overheated sectors.

On the other hand, there's a potential upside (in terms of import demand) from, for example, Japan should they manage to shake off their economic stupor. Indeed, with all the focus on China, Japan has been riding under the radar of many commentators despite its greater economic clout and significance.

Either way, by year end the economic picture looks set to have deteriorated enough to drag down stock markets below where they currently sit. To what degree remains to be seen. Right now, though, the US, UK and global economies are humming (and there's your good news).

As far as positions go, I'll admit only to a speculative punt taken this week on a regional US airline. They have been crucified by the oil headlines and look capable of bounce over the next couple of weeks as petrolhysteriaitis subsides.

But overall, cash is the king position.

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A wary bear is moderately long...

"The signs of recession are everywhere" replied my cynical (a badge of honour) writing partner when I suggested shares of one of the sounder UK banks were approaching bargain status. I knew exactly what he meant - enough argument covering this sentiment is to be had for free on many financial websites: US twin deficits, UK public sector debt, asset bubbles, asian central bankers etc.

And yet.

Exhibit A: Estrella-Mishkin Recession Table
The US 10 year Treasury notes minus 3 month T-bill spread has narrowed every month since May 2004 (when it was 3.7 points) to February 2005 (1.6 points). But even that is not a small enough spread to be worthy of consideration on the useful Estrella-Mishkin recession probability table (exhibit A). And even if it were, the table forecasts 4 quarters out. A more sensitive trigger would be nice.

One of the better instant gratification harbingers of doom (and boom for that matter) is the Chicago Fed National Activity Index (CFNAI). It tells a similar story (exhibit B) - just where is this recession?

Many other indicators tell similar tales: credit spreads (AAA versus 10 Year notes) haven't widened alarmingly over the last couple of quarters; the S&P500 is up over the last 6 months; the Purchasing Managers Index is well above 50; and the Philadelphia Fed's "Anxious Index" survey shows a pathetic 5% chance of negative GDP growth in Q1 2005 rising to only 8% in Q2.

Exhibit B: Chicago Fed's National Activity Index
This is terrible news - how does a bear rationalise it?

Not easily. It's true enough that the potential risks to the economy are dangerous ones. But to get from "potential" to "realised" with recessional severity does not look likely in the next 12 to 18 months. And beyond that just isn't visible.

The knives might be out, but they haven't been slid in just yet.

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MD writes:
On 7 March BAe announced the purchase for cash of United Defense Industries (UDI) of the US for $4.1bn (£2.1bn), maintaining the USA-centric policy of chief executive Mike Turner. Fears that BAe are neglecting their European market continue.

UDI were known as United Defense, LP until 1997 when venture capitalists The Carlyle Group (profile here of this, ah, interesting outfit) took them private. Carlyle then unleashed the new UDI by IPO in 2001, taking a final payment of $3m in 2002 for "services rendered". They no longer have a direct interest.

Carlyle may have made a good profit on the 2001 IPO, but they missed the post-9/11 surge in defense company stock prices. Viewed thus, the proposed BAe offer looks expensive - a 29% premium price at or near the top of a sector fiscally-primed by US government defense spending. Analysts suggest that UDI will have to grow by circa 15% annually for the next 3 years to justify the price. Good luck.

Financials:
UDI turned over $2.2bn in 2004 and made 7.5% on that ($166m) at the net income level. Not sparkling. Sales are skewed heavily to the US government agencies (81% according to UDI's 2004 10-K) so any squeeze of the defense budget will hurt.

On the UDI balance sheet it's noticeable that goodwill was $356m at the last count, not subject to amortisation and up from $343m in 2003. It was tested for impairment at year-end with the conclusion that there wasn't any (Ok guys, we believe you). Also, pension scheme obligations are increasing fast: they exceed assets, yet company contribution levels are alarmingly low. Rates of return assumptions are heroic at 8.5%.

Prized product: the Bradley
In terms of product, UDI's portfolio is diverse but the jewel is probably the Bradley fighting vehicle, a design over 25 years old but still a cash cow. The company has produced over 7,250 Bradleys and believes it's funded until about mid 2007. It is the company's single biggest programme and will now compete with the arguably better BAe Warrior fighting vehicle (spot the logic, but fortunately one of few overlaps between the companies).

Though there may yet be life in Bradley from ongoing maintenance and upgrade activities, the future may well not be as bright as BAe believe. UDI's most recent 10-K suggests (fairly) that the US Army's Future Combat Systems (FCS) programme is an opportunity. But the threat to the locked-in Bradley franchise from the FCS should also be recognised: the Army want a new wheeled, not tracked, manned ground vehicle. Not an area of proven UDI expertise.

Conclusion:
BAe look to be significantly overpaying in a toppy sector. UDI's own advisors, Lehman Brothers and JP Morgan, happily signed off a "fairness opinion" on the price offered. That would give pause for thought to some. But in any case, it is very hard to rationalise the twenty times net income of the $75/share acquisition price. Equally, there are the uncertainties over elements of the balance sheet to consider. And finally, paying for the whole deal with cash is stupendously foolish. No wonder the advising investment bankers to UDI must have smiled.

BAe shareholders should vote against this deal. UDI shareholders should hope they don't.

[Editor's 2nd opinion] The 9/11 atrocity has driven US Department of Defense budget increases of at least 10% per annum in recent years. Defense stocks have benefited accordingly.

Regression to historical valuations is likely to be hastened by the combination of:

1) considerations of how to battle the non-traditional threat of small terrorist cells. Resulting shifts in military priorities will likely come at the expense of the traditional big ticket items; and

2) growing political pressure to reduce the US federal deficit. That part of the US defense budget spent on "traditional" weapons systems will do well to beat inflation plus a couple of points.
BAe/UDI combo is sound business logic; but questionable timing and price.

[Writer nor editor hold an interest in BAe or UDI.]

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From the desk of our UK scribe...

Chesterton's, the up market Estate Agents (200 years old last January) announced on 8 March 2005 it had gone bust. The commercial arm has ceased trading; but the residential side apparently remains a going concern.

How it came to this is puzzling. The administrators Grant Thornton said that the company had run up £2m of losses in the last 7 months. Clearly, financial controls were not what they should be; not enough was being retained in the business; and no doubt too much was going in commissions.

Disingenuously, the company mentioned a high level of "voids" meaning office vacancies and a lack of lets.

This, along with other recent failures of estate agents, may mark the start of a trend.

Bubble theory update:
Avid readers will note that this commentator has wondered aloud about housing bubbles in the UK and elsewhere. As a regular visitor to Madrid in the recent past he mused who would occupy the numerous new developments springing up.

Well, he can now confirm his long held suspicion - no one. It is estimated that there are/soon will be 300,000 speculative (empty) flats in Madrid. And that's ignoring all the other speculative development on the Costas.

Phew - must go for a lie down. Thank God I don't hold any Abbey shares. Er, sorry - I mean Banco Santander.

Editor: This morning Countrywide estate agents also had less than encouraging news for UK property investors.

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Accrual writes from the UK...

There were no winners to the question posed a little while ago. And why no one took my offer of a prize seriously I don't know.

The company was Harley-Davidson, Inc. Clearly, a most compelling story. However, before you leap in a buy at something over $60 a share (not far off the 52 week high) tread with caution.

Editor: readers & subscribers should know that the writer has a number of vintage ports and Italian reds one of which he just might be pursuaded to put up as the prize. If he can be enticed to issue another question that is.

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From the desk of our UK scribe...
Excuse the vulgarity. French Connection is the first retailer to my knowledge to use the recent cold snap as an excuse for poor performance. A crap name, poor merchandise and a general slow down are also contributory factors.

However sales down 17% in the past 5 weeks are truly frightening. The UK, European and US retailing businesses were loss making last year: this further decline, coupled with an increasing cost base, suggests that the coming year will be mired in red ink.

Whilst the 5-week decline is probably exceptional - expect some sales recovery when the weather improves - management clearly has a lot to do. Wholesale and licensing will likely go sharply off the boil on the back of this.

I'd sell. If I held any.

Editor's addendum: French Connection (FCCN) shares have staged a rally since a late 2004 flop and mid-December low of 217p. They stand at 308p today. Perhaps this will continue. But the macro environment is iffy at best; the shares stand on a forward PE of 11.4; and earnings, if forecasts are anywhere near correct, will grow 4.5% and 3.5% over the next two years. The ready reckoner ratio used when making Capital Chronicle's own investments:

(forecast eps growth% + dividend yield%)*100 / (p/e ratio less extraordinaries)

shows the FCCN at only 0.4, or seriously overvalued (1 is fair value). However, determined holders of the equity can take some comfort from the mitigating factors of low gearing and price-to-sales ratios.

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We wrote about Guinness Peat Group (GPG) on 21 January, citing the attractions of the Coats plc acquisition.

GPG released preliminary 2004 results on 28 February. The Chairman's statement is largely a model of brevity and clarity and there is little point reproducing it here. Just follow the link.

The following points are useful when considering the Group's future net asset value:

    * The recently reported De Vere Group special dividend which led to GPG disposing of most of it's holding in the company represents a significant capital gain. The result falls in the next accounting period. Cash, already a big item on the balance sheet (in the name of flexibility) increases further.

    * As suggested might happen in our January 21 article, the Dawson investment (previously written-off in 2003) has come back to life and may be helped to grow by a neat GPG shifting and reduction of business risk through the sale of an unprofitable 100%-owned Coats unit to the 30%-owned Dawson where it's hoped it will fit better.

    * At Coats, goodwill has risen dramatically - by £110m to sit at £144.1m. The Chairman's attractive brevity has its limits, and in the absence of greater numeric detail it seems that within the total change positive offsets were found via a revaluation of the group's Crafts division and a reappraisal of the property portfolio (which includes a race course in India - go figure). Surplus property is to be sold off in mitigation of higher than expected plant relocation costs.
    The bottom line is that, at 31% of GPG's assets, Coats continues to be the big bet. The first 9 or so months of this year must see the complete integration and operational streamlining of Coats if GPG are true to their word and 3 year turnaround plan for the investment.

    With some measure of management credibility to be thus on the line at the 11 May Annual General Meeting, GPG share-holders should expect and press hard for an on-time start to the unlocking of the massive capital value appreciation the Coats investment is clearly capable of. All the more so in light of the goodwill adjustment, expected to hit the P&L by nearly £5m annually over its 20 year amortisation.

    The writer holds shares in Guinness Peat Group, plc.

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    Clearly, the CGI management decided time was precious when they whipped up this jewel:

    CGI Holdings mission (18 words)
    "Providing the highest level of service available to their clients, while maintaining unmatched customer service and retention."
    Short. Sweet. Unrevealing. But if the management insist on nearly quadrupling stockholders' returns (52 week stock price change +388%), so be it.

    Other boards, however, take the time to craft and re-craft a mission statement worthy of the name.

    Converium Holding AG mission (60 words)
    "We are an international multi-line reinsurer that satisfies our clients' business needs by excelling at analyzing, assuming and managing risks. In an ethical and responsible manner we provide:

    * sustainable value growth for our shareholders,
    * excellent service for our customers and intermediaries,
    * a fulfilling work environment for our employees,
    * a spirit of shared responsibility within our community"

    Deserving. Comprehensive. But becoming, from somewhere around word 35, a compelling argument in favour of euthanasia. Much like the stock price action (52 week change -82%).

    Readers are invited to email in favourite "missions" and "visions" for a future posting.

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