September 2009 - Fundamentally...Disconnected

Strategic review

An accurate understanding of where we are from an economic fundamental perspective is critical for assessing likely trends in credit quality. The below lead-in to our industry review is aim at facilitating that understanding. In short, certain parts of the economy (particularly large financial firms) will continue to be anointed and others, while being propped up via special programs will be aided in the short run but cannot escape the reduction in consumer spending, which would have occurred absent the financial crisis because of the aging of the baby boomers.


Massive monetary stimulus is good for asset prices (stocks, bonds, houses, commodities) in a weak pricing environment and soft economy. The Federal Reserve has doubled its balance sheet from $1 Trillion to $2 Trillion effectively adding $1 Trillion to our economy. In addition, the Fed has through an alphabet soup of facilities i.e. Term Auction credit, Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, Term Asset Backed Securities Loan Facility, Primary Dealer and other Broker Dealer Credit, Other Credit Extensions, Term Facility, Maiden Lane LLC one, two and three, Money Market Investor Facility, added approximately $3 Trillion in loans and over $5.5 Trillion in guarantees of private investments. While these latter funds are technically loans, they get renewed regularly. AIG is still receiving funds and had at its peak over $500B in CDS liabilities. Since these CDS had virtually no CDO loan backing it, they are analogous to options that have expired with no value. To the extent that these CDS instruments have been "sold"/ used as collateral for Fed loans, they will not be repaid. In essence, the Fed is cleaning up the balance sheets of the banks, investment banks, insurance companies and other financial companies (think GE). We have long believed that this was a necessary precursor to getting our financial institutions on decent financial footing to begin the lending process and hopefully restart the multiplier.

Where has all this liquidity gone?

Financial institutions and individuals are continuing to rebuild their balance sheets. As can be seen from the charts below, lending has NOT picked up in spite of a massive increase in liquidity and a near zero Fed funds rate. While the statistics will show improvement, the consumer has a long way to go before they are in a position to spend other than to react to $8000 housing purchase stimulus or a cash for clunkers program. These programs largely move sales forward stealing from next year.

Construction loans for commercial real estate on bank balance sheets are estimated to be $300 Billion; two thirds were added in the past two years. The cap rate for many of these new and refinanced loans was just 5% when the traditional rate has been 8%. It's likely that the banks will be required to write downs the loans to an 8% cap rate. Capacity utilization is still in the high sixties suggesting no demand for more plants or for expansion of any type.


From the peak in 2007 to the first quarter of this year, household wealth declined approximately $14 Trillion. Wages and salaries have contracted at a 5% annual rate in the 2nd quarter of this year and 4.3% year over year. Income in all forms has been hard to come by as interest income is down 4.5%, dividend income is down 23% and proprietary income is down 8%. Roughly one-fifth of personal income now comes from the government.

Mortgage activity is primarily FHA or Freddie or Fannie guaranteed suggesting a very limited secondary market - in fact 47% of the housing market transactions are at the low end of the market. About half of the new foreclosures are prime rate loans with a new foreclosure action taken for every 6 to 10 jobs lost adding up to approximately 1.2 million related to job loss. Next year a large wave option ARM loans many of which include negative amortization will reset causing even more foreclosures even at current unemployment rates. In short, we have several years supply of houses.

The Baby Boomer generation account for 47% of our national spending prior to this recession but just 7% of the national saving. This group comprised 78% of the spending growth in the economy from 1995 to 2005. This has changed dramatically as a result of the large declines in wealth and likely will not come back. Since the sheer numbers of this group far outstrips any other demographic group, its permanent reduction in spending is part of the reason we think consumer spending will make up a smaller percentage of our GDP even after the economy recovers.

So where has all the money gone? The chart below shows the rise in the stock market causing the valuation to be somewhat extended in our view - some liquidity found a home here. Large rises in just the last month in small cap stocks, plus 17%; most shorted stocks, plus 17%; stocks with the lowest analyst rating out performing those with the highest rating by 380 basis points, all suggest some speculation. Corporate balance sheets have held up well as has cash flow due to massive cost cutting and reduction in supply by companies to "right size" their production. We would suggest that the demand pulling out of this recession is likely to come from capital spending from these companies rather than the traditional consumer led recoveries of the past.

Commodities have had a nice rebound from their lows with copper hitting new highs. High yield bonds have out performed investment rated bonds as investors are willing to bet on a faster recovery and start to reach for yield.

These are indications of excess liquidity finding outlets.

With the Federal Reserve "lending" vast sums to financial organizations, the government instituting numerous stimulus programs, the economy will eventually recover but the recovery will be muted as unemployment will stay persistently high and consumer spending will recover only partially. Rather, demand will come from government spending in one form or another and global demand: companies benefitting from infrastructure both domestically and globally and raw material demand both in exploration and transportation: companies receiving government funds such as technology and health care: global companies benefitting from increased consumer demand and increased industrialization in developing countries such as China, India, Brazil - these would include companies ranging from Colgate to Flour. On the negative side, sectors having difficulty recovering will be housing and housing related and retail - both sectors are severely over built. Financial companies particularly the larger "anointed" companies look increasing attractive as the Fed will supply any needed liquidity.

Review of industries

Below are our comments on various industries and companies

Improving industries

Yet another company from the H. C. Equipment & Supplies industry in the broadly defined Health Care sector of the Standard Industrial Classification list is, we believe, worthy of favorable mention in this space. Hill-Rom Holdings, Inc. (HRC), whose sole operating subsidiary is Hill- Rom Co., Inc., is perhaps best known for its hospital beds in patients' rooms, but the product line also includes specialized operating-room and intensive-care beds, and non-invasive devices to improve circulation and treat bed sores - problems often experienced by bed-confined patients. The HRC entity was formed in March 2008 with the spin-off of Batesville Casket Co. from Hillenbrand Industries. Batesville kept the Hillenbrand name, while the health care business adopted the Hill-Rom moniker. HRC's revenues have grown at a 5.6% CAGR in recent years, but in view of a now-declining trend in hospital admissions management expects a top line smaller by 7.3% - 8.6% this year, and is guiding to an EPS range of $1.03 - $1.13 vs. $1.40. HRC's net debt of $80M compared to a market cap of $1.2B indicates a high degree of flexibility. Ultimately, the financial condition of the nation's hospital system is a key determinant of HRC's growth and profitability going forward; major pressures on the system include declining elective procedures, reimbursement pressures and patient mix, significant declines in philanthropy and endowment funds, and of course the impact of health care and/or health insurance reform. Egan-Joness recent review of HRC saw fit to upgrade its rating from BBB- to BBB.

Consumer Staples – We commented recently about the diametrically opposite strategies that Coca-Cola (KO) and PepsiCo (PEP) were following with respect to their relationship with their distribution organizations, noting in the course of our report a $6B cash offer for the balance of shares of Pepsi Bottling Group Inc. (PBG; 67%) and PepsiAmericas Inc. (PAS; 57%) that it does not already own. Rejection of the offer as "grossly inadequate" by its independent board of directors puts several issues on the table relating to PBG's credit quality. One is weak and declining interest coverage as a result of an aggressive, debt-financed acquisition program. Other issues are more positive: purchase by PEP would be a major positive, as would a higher bid from a third party if it were to materialize. We note in this connection that PBG's market price has been trading at a premium to the rejected offer's $29.50/share. Egan-Jones's recent reviews of both bottling organizations resulted in upgrades, PBG from BBB to A- (subsequently affirmed, assuming an increase in the offer price) and PAS from A- to A.
Neutral industries

Information Technology – IBM was one of nine companies selected as "safe" investment ideas in our January 2009 issue of this monthly review, with more recent discussion of "Big Blue" that focused on its aborted merger negotiations with Sun Microsystems. Citing IBM's strong credit ratios and the high level of financial flexibility that supported an increase in the common dividend from $2.10 to $2.20, Egan-Jones affirmed its A+ rating. Now, we have the unusual situation of a 12% increase for June quarter earnings despite a 13% y-o-y decline (down 7% ex-currency) in revenue. The dramatic margin improvement (18.3% pretax vs. 14.2% last year) driving this result clearly justifies management's strategic shift to emphasis on services and software; sales of mainframes and other computer hardware declined 26% compared with 2Q08. Confidence in the near-term outlook prompted management to raise full-year EPS guidance from $9.20 to $9.70. Egan-Jones, meanwhile, has upgraded IBM's rating from A+ to AA-.

Drugs – As the concluding sentence of our review of this industry in January 2008, we wrote, "Five years from now, this industry will look very different." In less than two years, this statement has been validated as a result of two mega-mergers that reduce the roster of major drug houses from eight to six, namely, the combinations of Pfizer with Wyeth, and Merck with Schering-Plough. In that article we described how a long-established and highly successful business model has shown increasing evidence of breaking down under intense and persistent competitive pressure. For many years a strategy of massive research effort, rigorous efficacy and safety testing to obtain regulatory approval, and intensive marketing under patent protection to health care providers has delivered steady earnings growth at wide profit margins. The main component of the aforementioned competitive pressure has, of course, been the growth of generic versions of off-patent drugs, now reinforced by the terms of most health insurance plans as part of a collective effort to restrain the rapid growth of health care costs. The current threat has elements of each of these issues: a marked slowdown in the development of new drugs with "blockbuster" potential just as the industry is facing a surge in patent expirations over the next five years. Its strategic response will likely involve some mix of diversification, intensive cost reduction, more focused research, and perhaps consolidation. Industry-specific strategies involve the combination of new-drug pipelines and therapy expertise in the hopes of reviving slowing revenue growth, and cost reduction achieved through the elimination of duplicative sales and market development staffs. Egan-Jones rates Pfizer, Wyeth and Merck at A+ (the latter recently upgraded from A), and Schering-Plough at A-/positive.

Banks – Capital adequacy and the various issues that affect it has once again moved front and center as a key determinant of banks' credit quality, what with the number of bank failures at 81 thus far this year and the FDIC's list of endangered banks now at 416 following the addition of 111 lenders during the latest quarter. A major risk is the ticking time bomb of commercial real estate loans, mentioned twice in this space in recent months. Our June comments cited a recent Wall Street Journal analysis of 940 small and mid-size banks using methodology similar to the Fed's stress test of nineteen major banks, and its finding that close to half of the more than $200B in potential losses was attributable to commercial real estate loans that have been a traditional specialty of regional banks. The FDIC data also reveals that the total of non-performing assets and net charge-offs is rising faster than loan loss reserves are being increased, so that the industry's ratio of reserves to bad loans, at just 63.5%, is at its lowest level since 1991.

Arrayed against this negative picture, there are positive developments to report. With respect to capital adequacy, nine of the nineteen large banks included in the stress test exercise have now paid back a total of $67B of stock issued to Treasury under the TARP program with funds raised in the private capital markets. And although Citigroup's (C) management may find political considerations affecting its decision-making process (see Autos below) as a result of the preferred-for-common exchange that gives the government a 34% voting stake in the bank, that transaction at least had the benefit of substantially increasing C's tangible common equity balance. C, along with Bank of America (BAC), Goldman Sachs (GS), and J. P. Morgan Chase (JPM) all reported June quarter bottom-line earnings in the $3B - $4B ballpark, all four showed solid profits from trading operations during the quarter, and all four passed the Fed's recent stress-test program. Also making a positive contribution to the industry's better-than-expected earnings reports was the change in accounting rules - the notorious FAS 157 - announced at the beginning of April that essentially allows the deferment of mark-to-market losses. Most positive of all was the aggressive activity by strong banks as markets began to show signs of recovery. Benefiting hugely from management's decision to put more risk capital to work as markets revived, GS delivered the most profitable quarter in its storied history. The absence of many former competitors had the predictably beneficial impact on profit margins in trading markets for credit and interest rate products as well as currencies. JPM, like GS, benefited from more aggressive activity in its traditional businesses such as investment, commercial, and retail banking and asset management, and from acquisitions of Bear Stearns and Washington Mutual at bargain-basement prices. GS, JPM, C, BAC, and Morgan Stanley (MS) have all been recently upgraded by Egan-Jones.

Defense/Aerospace – Some time ago, we commented favorably on L-3 Communications Holdings, Inc. (LLL), including an admonition to our readers not to confuse LLL with Level 3 Communications Inc. (LVLT) because the gap in credit quality between the similarly-named entities has widened significantly. LLL is the sixth largest defense contractor, a solidly profitable and well-capitalized communications systems company, whereas LVLT, operating one of the world's largest internet protocol-based fiber-optic networks, has reported losses in each of the last five years and nine of the past ten quarters through June 30, 2009. Since early 2007, LLL has been upgraded twice, from BB+ to the recently affirmed BBB, while Egan-Jones has lowered LVLT from B- to C on four separate occasions. We believe the strong contrast between LVLT and LLL is actionable, and accordingly suggest switching LVLT into LLL.
Declining industries

Autos – Last month in this space we discussed our belief that political considerations could carry increasing weight at all levels of the decision-making process at GM, now that the company has emerged from bankruptcy with 60.8% of its stock owned by the U. S. Treasury Department, with the ultimate net result being highly inefficient operating performance and grossly inadequate returns for taxpayers. We sense the presence of such considerations in the publicity behind GM's Chevrolet Volt, simply because there are so few sound economic reasons for its development and marketing on the one hand, and for its purchase and use by consumers on the other. The climate-change component of the Obama Administration's domestic policy goals is visible in GM's promotion of the Volt's projected 230 miles per gallon fuel economy from a power plant that will utilize new hybrid electric-and-gasoline technology and likely win plaudits from the "green" special interests, but we question the size of the potential market for a new, non-luxury vehicle with a distinctly luxury projected price of $40,000. Even after a $7,500 government subsidy for buyers, the Volt will be too expensive for the vast majority of the car-buying public when it is launched late next year as a 2011 model. We have often cited GM's steadily shrinking market share as an important negative credit quality issue; it does not appear that the Volt is capable of contributing to stabilization, much less to reversal, of the trend. Egan-Jones's most recent review affirmed the D credit rating for GM that has been in place since 11/19/08 when it was lowered from C to its present level.

Building Materials – The industry's construction spending reports for June show a mixed pattern, with total construction down 10.2% on a y-o-y basis but up 0.3% for sequential months. Also, the public construction component of total spending was up 5.1% y-o-y, offsetting to some degree the 16.3% y-o-y decline in private construction. Private residential construction, not surprisingly, was very weak (down 30.0%), while public health care construction spending was a bright spot with a 24.0% y-o-y increase. Departing from our usual focus on the two industry leaders, Vulcan Materials and Martin Marietta Materials, our comments this month highlight Texas Industries (TXI) and U. S. Concrete (RMIX). Following the spin-off of Chaparral Steel in 2005, TXI became a pure play in building materials, with 42% of its sales provided by cement (largest producer in Texas with a 30% market share), 35% by ready-mix concrete and consumer products, and 23% by aggregates. RMIX, as its ticker symbol implies, is virtually a pure play in ready-mix, concentrating in major markets including California, Texas, New York, New Jersey and Michigan. Increased government spending for infrastructure improvement will, we believe, be focused more on highway resurfacing than on new building or rebuilding, and is therefore likely to have a greater impact on demand for asphalt than for crushed rock or stone or cement. Although both companies' recent operating results have been depressed by the weakness in overall construction activity, comparative analysis finds TXI with greater financial flexibility than the much smaller RMIX. Egan-Jones accordingly rates TXI at BB and RMIX at B-/negative.

Energy – As we learned from their 2Q09 earnings reports, the supermajor status widely accorded ExxonMobil (XOM), Chevron (CVX), and ConocoPhillips (COP) offered scant protection against the damage to profitability caused by weak oil and gas pricing that pervaded the industry's international scene during the quarter. When the dust had settled, XOM's earnings were down 66% y-o-y, CVX's down 71%, and COP's down 76%. Clearly, oil and gas prices were by far the primary driver of bottom-line results. XOM revealed that its global upstream earnings of $3.812 billion were $6.200 billion lower than last year, of which difference $6.100 billion was attributable to lower prices. The higher production volumes achieved by CVX (+5.1%) and COP (+7%) (XOM was down 3.1%) did not come close to offsetting the negative impact of prices. Despite currently depressed earnings, credit quality of these U.S.-based supermajors remains strong. The AA ratings for XOM and CVX that have been in place since 2003 remain fully justified, in our view, with the former's cash position of $$15.6 billion as of June 30 continuing to exceed debt of $9.2 billion, even though the company has drawn down somewhat a balance that exceeded $30 billion at each of the prior three year-ends and fell just shy of $39 billion as of June 30, 2008. XOM's market cap, meanwhile, is $332.46 billion. CVX is next in line with a market cap of $138 billion, cash of $9.2 billion, and debt of $12.2 billion. CVX's Board of Directors recently increased the common dividend by 4.6% from a $2.60 annual rate to $2.72. Relatively speaking, COP is the weak sister here, with a market cap of $65.5 billion, cash of $802M, and debt of $29.5 billion. Even so, Egan-Jones rates COP at the A- level.

Machinery – Caterpillar's (CAT) 2Q earnings report included a number of unusual aspects, beginning with a bottom-line net income figure that declined y-o-y by 66% on 41% lower revenue, but on an EPS basis ($0.60, after redundancy costs of $0.12) still blew away the Wall Street consensus ($0.22). We say unusual, but CAT's operating performance exemplifies what may have become the standard corporate financial model whereby intensive cost reduction trumps sluggish or non-existent revenue increases at least temporarily as the principal driver of profit growth. In CAT's case lower SG&A and R&D expenses lessened the y-o-y decline in 2Q operating profit by $291M, while an $832M reduction of CAT's inventory during the quarter was the source of a $110M LIFO profit ($0.14 per share). Although changing currency values had a negative impact on dollar-denominated revenue, the net result for operating profit was favorable by $89M due to the beneficial effect on costs. Finally, CAT's 2Q tax rate was just 10.0% vs. 28.2% last year; the income tax line item was $40M vs. $434M. In updating its guidance for full-year sales and earnings, management cited "improved expectations" in tightening the sales forecast from "about $35B" to a $32 - $36B range vs. $51.3B in 2008, and EPS in a $1.15 - $2.25 range (before redundancy costs of $0.75), vs. $5.66 last year and up from $1.25 three months ago. All this looks like CAT may be near the trough of this cycle, for which reason Egan-Jones recently upgraded its rating from BB+ to BBB-.

Chemical – We have kept a close eye on Monsanto (MON) during the past year for several reasons. One, because its fiscal year ends August 31, its quarterly earnings reports are more visible than those from the much more numerous companies on the 3-6-9-12 cycle. Two, global agriculture is the principal driver of MON's earnings rather than the spread between volatile petroleum commodity prices that define much of the industry's raw material cost structure, and demand for industrial and consumer products that, together with highly competitive global pricing, generate the industry's revenues. Finally, Egan-Jones has carried a solid A+ rating for MON since 1/3/08 that, in our opinion, continues to be justified by persistently strong operating performance. Recently-reported operating income was essentially flat for the May quarter, despite an 11% decline in revenue, as MON's very profitable seeds business offset a 50% reduction in sales of glyphosate-based herbicides (including Roundup). In significant contrast to many other companies that have either reduced EPS guidance for the current year or withdrawn it altogether, MON management expects to report full-year results in a $3.76 - $3.92 range vs. $3.62, the former after write-offs of $0.60 - $0.66 for restructuring and acquisition-related in-process R&D. Egan-Jones's recently affirmed A+ rating for MON also includes a positive-outlook modifier.

Auto Suppliers – Back from the brink - American Axle & Manufacturing (AXL) will receive up to $210M from GM, its principal customer, an agreement that could help the supplier of axles and driveshafts stave off bankruptcy, and could also allow GM to acquire a 19.9% stake in AXL. Three entities are involved in the transaction: AXL, GM, and AXL's lenders, who so far have twice waived a deadline for a breach of AXL's loan covenants. If the loan's terms can be satisfactorily revised, GM can pay AXL $110M for pre-bankruptcy contracts and also make available a loan facility of up to $100M that initially grants GM five-year warrants for up to 7.4% of AXL stock. Then, if AXL draws the full $100M, GM's option increases by a further 12.5% of AXL stock, giving GM a potential holding of 19.9% of this key parts supplier. Egan-Jones review of these developments resulted in an upgrade of AXL from D to CC, continuity of GM support going forward was cited as a key issue. We see it as likely as long as GM remains under government control.

Retail – Although most of the current news stories about cautious consumer spending identify Wal-Mart (WMT) as the store where a lot of those folks do spend the lesser amounts of cash that they are willing to part with, we'd like to discuss another discount store chain that is more than holding its own in this very difficult environment for retailers. TJX Companies, Inc. (TJX) recently reported a 4% sales increase for 2QF1009 (ended May 1) supported by a 4% positive quarterly same-store sales comparison, and a 23% boost in net income. TJX's four domestic retail chains include the two largest off-price clothing retailers, T. J. Maxx and Marshalls; HomeGoods, focused entirely on home furnishings; and A. J. Wright clothing stores aimed at lower-income shoppers. Clothing and footwear contributed 62% of F2008 revenue, home fashions 25%, and jewelry and accessories 13%. Financially, the company presents a very strong picture with cash exceeding debt, rent-adjusted coverage ratios around 30 times, and a market cap of $14.4B. Egan-Jones-s recent review of TJX resulted in an upgrade from A- to A/positive. A fashion/style disclaimer should probably be included in our suggestion of a switch from Saks, rated at the D level since earlier this year, into TJX.

Home Builders – Don't look now, but a plus sign actually appears in front of one year-over-year percentage change figure for an important industry metric. Toll Brothers' (TOL) net new orders rose 3% for 2Q09 vs. 2Q08, the first such increase for the company since 2005. Lest this be interpreted too positively as a harbinger of improving market conditions in this beleaguered industry, TOL's net new orders in dollar terms were down 5%. Pricing is still under severe pressure from a vastly oversupplied market that now includes a significant segment of banks' sales of foreclosed homes. Rating reviews by Egan-Jones since our last comments included Centex (CTX, affirmed at CC/negative), D. R. Horton (DHI, affirmed at C), Pulte Homes (PHM, affirmed at B-/negative), and Ryland Homes (RYL, affirmed at B-/negative). No ratings were changed during the past month for any of the ten homebuilders we follow.

Source: Egan-Jones Ratings And Analytics


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