Archive for December, 2011

Expect Slow Economic Growth in the US to Continue Through Early 2012

This article analyzes the indicators comprising the Conference Board’s Lagging, Coincident and Leading Economic Indexes. Each indicator is analyzed individually, scored -1, 0, or +1 for mostly negative, neutral, or mostly positive, and then averaged into Lagging, Coincident and Leading diffusion indexes scaled from -100% (economic free fall) to +100% (robust expansion).

Here’s the upshot of the article: The first graph below depicts the equally-weighted diffusion indexes. The Lagging indicator score of +14% corroborates that the US economy was experiencing painfully slow growth during most of 2011. The Coincident indicator score of +25% suggests improving business conditions and accelerating growth late in 2011. The Leading indicator score of -10% suggests that the recent improvement in business conditions will not accelerate further, and the slow-growth environment will persist through the first half of 2012, at least.

If the indexes are calculated using the Conference Board’s weights, the results are similar, as shown in the graph below. The Lagging, Coincident and Leading scores equal +11%, +16%, and -11%, respectively.

Conclusion: The Conference Board’s Economic Indicators confirm that the US economy grew slowly in 2011. Conditions for growth improved slightly in the 4th quarter. Growth is not expected to accelerate for the first half of 2012, however, and may slow further. The US economy remains vulnerable to the forces that may have already tipped Europe into a recession.

Lagging Indicators

Average Bank Prime Rate (28.1%). Real Total Business Loans are also depicted (red line). A rising average prime rate indicates increasing demand for credit, as banks mark up the price of interest. Thus far the prime rate has failed to turn upwards in sync with business borrowing as it did in 2004. Score this indicator -1, as it fails to corroborate the 2011 economic expansion.

Consumer Price Index for Services (19.1%). This indicator peaks midway during a recession. It has displayed no meaningful trend since 2009. Score this indicator zero for neutral.

Ratio of Consumer Credit to Personal Income (18.9%). Real Personal Income is also depicted (red line). Consumer Credit/Personal Income is expected to display a trough several months after Real Personal Income begins rising, which is exactly what the indicator shows for late 2011. Score this indicator +1.

Inventory to Sales Ratio, Manufacturing and Trade (12.6%). This indicator rises during recessions as inventories accumulate, and declines during expansions. The indicator trended downwards in 2011, thus earning a score of +1.

Commercial and Industrial Loans (11.1%). Both the nominal and real series are displayed. Both series display a significant uptrend, confirming economic expansion as they did in 2004-2005. Score this indicator +1.

Unit Labor Cost, Manufacturing (6.2%). Both the nominal and real series are displayed. Unit Labor Costs are expected to peak midway through a recession, which occurred in 2009. But Real Unit Labor Costs have been in a downtrend for 15 years, which may be good for business, but bad for the working class. Score this indicator zero for a mixed or neutral reading.

Median Duration of Unemployment (3.7%). The Labor Force Participation Rate is also shown. Unemployment Duration is expected to gradually decline as an expansion picks up steam. All official unemployment series get an unnatural boost from not counting the underemployed and discouraged labor force dropouts, however. The staggeringly high median duration of 22 weeks merits a score of -1. It is worth noting that the series took a long time to begin trending downward following the last recession, however, so improvements in this series may be forthcoming.

The summary table of Lagging Indicators is shown below. The equally-weighted and Conference Board-weighted scores of +14% and +11% confirm that the US economy experienced growth in 2011, but this growth was painfully slow.

Coincident Indicators

Employees on Nonagricultural Payrolls (54.1%). Total Nonfarm Payrolls (blue) and Total Nonfarm Hiring (red) are shown below. While both series have indeed turned upward, the US employs the same number of workers as it did in 2001, and is adding new workers at an almost ridiculously slow pace. Score this indicator zero for neutral, as the positive percentage changes are offset by the low level of the series.

Personal Income Less Transfer Payments (19.1%). Real Personal Income Less Real Transfer Payments is shown below. (A more granular view appears in the 2nd graph.) The series has bottomed, but the trend is flat, rather than rising.

Personal Income, Personal Consumption, and Transfer Payments (green) are depicted below. Total Transfer Payments fueled much of the rise in Personal Income over the past 2 years. With Transfer Payments leveling off (and predicted to decline in 2012), growth in Real Personal Income will most likely stagnate for a while. This indicator is right on the border, but the trend is up so I will score it +1.

Industrial Production (14.9%). The Nominal and Real series are shown. Nominal Industrial Production displays a promising rebound, but when adjusted for inflation, the long-term downtrend in the series is more evident. Score this series -1, as it bespeaks an economy in a long-term decline.

Real Manufacturing and Trade Sales (11.9%). Total Household Debt is also shown (as much of the sales growth from the past decade was fueled by debt). The series shows a smart rebound, and merits a score of +1.

The scores of the four Coincident Indicators are shown below. The diffusion scores are 25% (equally-weighted) and 16% (Conference Board weights), respectively, slightly higher than the Lagging Indicator scores. This suggests modest improvements in business conditions and economic growth in late 2011.

Leading Economic Indicators

Real M2 Money Supply (35.5%). Real M2 is depicted below, along with Real Consumer and Business Loans. The 2nd graph charts Real M2 with the Velocity of M2.

The Real M2 Leading Indicator reveals some of the weaknesses in the Conference Board system, which scores series based on their percentage changes. Real M2 is definitely rising, but not due to market forces (strong demand for credit or liquidity) — it’s mainly driven by Federal Reserve intervention (manipulation?). Neither total borrowing nor velocity (shown below) is rising. Score this indicator zero — M2 is rising, but the damage from the Fed’s loose money policies will most likely plague us for a generation (see the inflation statistics below).

Average Length of the Manufacturing Workweek (25.5%). The average length of the Construction Workweek is also depicted. This is another Conference Board indicator that looks good on the surface, as the Manufacturing Workweek has rebounded to its pre-recession levels.

With a bit more context, the apparently positive signal looks somewhat different, however. Consider Total Employment in Manufacturing and Construction, depicted in the graph below. The length of the respective workweeks was restored at the cost of permanently eliminating 5 million high-paying middle- and working-class jobs. Score this indicator zero, as the rising workweek is offset by signs of a dramatically contracting labor market.

Interest Rate Spread, 10-Year Yield Minus Fed Funds (10.2%). The yield on the 10-year T-note minus the Fed Funds rate is really a proxy for the slope of the yield curve, depicted in the 2nd graph below.

The Yield Curve flattened considerably in 2011. A flattening Yield Curve suggests economic slowdown, so score this indicator -1.

Manufacturers’ New Orders, Consumer Goods and Materials (7.7%). Real Durable Goods is depicted along with Consumer Sentiment (the strong positive correlation is evident). This is a tough one to score — Real New Orders are rising following the last recession, but the inflation-adjusted series achieves lower highs following each of the last two recessions. I had to inject a bit of subjective optimism to score this indicator +1.

Suppliers Delivery Index (6.7%). This index is trending downward for most of 2011, thus meriting a score of -1.

Stock Prices, S&P 500 (3.9%). The Real and Nominal S&P 500 is shown below. The long-term market trend looks flat in nominal terms, but registers as a secular bear market in real terms.

If you’re still not convinced, consider the S&P 500 Total Return since 2001 deflated by the value of the US Dollar. The dramatic loss of purchasing power for buy-and-hold investors is clearly evident. This series earns a score of -1. The secular bear market in stocks continues.

Average Weekly Claims for Unemployment Insurance (3.1%). Unemployment is deliberately measured with a positive bias, as workers too discouraged to keep looking are no longer counted. Nonetheless, the series is trending downward, and merits a score of +1.

Index of Consumer Expectations (2.8%). This series displays a sideways trend around a scarily low level, which justifies no more than a score of zero.

Building Permits, New Private Housing Units (2.7%). This series looks like the backdrop graph in a Dilbert comic strip. Too bad the process doesn’t allow me to score it less than -1.

Manufacturers’ New Orders, Nondefense Capital Goods (1.9%). Real Nondefense Capital Goods orders are shown below. The series is rising strongly, so I will score it +1, but this was a close call, as the long-term trend suggests inexorable slowdown.

All 10 Leading Indicators are shown in the table below. The scores of -10% and -11% suggest that the economy will find it difficult to extend the meager progress seen in late 2011.

Conclusion: The Lagging indicator score of +14% corroborates that the US economy was experiencing painfully slow growth during most of 2011. The Coincident indicator score of +25% suggests improving business conditions and accelerating growth late in 2011. The Leading indicator score of -10% suggests that the recent improvement in business conditions will not accelerate further, and the slow-growth environment will persist through the first half of 2012, at least.

Supplementary Indicators

Ratio of Corporate Profits to GDP. I find it fascinating that the “normal” ratio of Corporate Profits to GDP seems to have doubled during the lost decade in stocks. The “corporatization” of the US has not been good for Main Street.

Ratio of US Debt to GDP. By now, everyone is familiar with the Rogoff and Reinhart (2009) study showing that advanced economies with Debt/GDP ratios greater than 100% grow half as fast. The US is just about there, and borrowing more every time Congress is in session. The trend in total Federal Government Debt is asymptotic, and clearly unsustainable.

 U6 Unemployment + Underemployment. The spread between the unemployed and underemployed expanded rapidly early in the current economic recovery. The manner in which unemployment is measured is outdated, and intended to impart a deliberate positive bias to the unemployment numbers.

 Case-Shiller Home Price Index. Yet another sharp downturn for the Case-Shiller Index. Markets experiencing extreme real estate bubbles, such as Las Vegas and Phoenix, continue plunging.

Core CPI and PPI. The bean-counters that calculate inflation have done everything in their power to report misleadingly low inflation statistics, but they seem to be running out of tricks. Core CPI and PPI continue spiking to 1980s-type levels.

Real Oil and Gas Prices. Oil and Gas prices have been rising faster than the Energy CPI for decades. This functions as a tax on the US Consumer (collected by large, integrated energy companies). From 2009 through early 2011, commodities prices soared at every sign of global economic strength, which neutralizes economic growth in consumer- and automobile-oriented economies like the US.

Defensive Stock Sectors Led the Market in 2011

This article provides a snapshot of the best- and worst-performing US stock sectors in 2011. The classic defensive sectors — Utilities, Consumer Staples and Health Care — started the year on a positive note, began outperforming following the market’s February decline, and assumed full market leadership after the August market meltdown. These sectors ended the year with total returns of 13%, 11% and 10%, respectively.

Tightly-packed around mediocrity, with returns ranging from +4% to -2%, were the Consumer Discretionary, Energy, Technology and Industrial sectors. These sectors are the ones that would be expected to lead in a more vigorous economic expansion, which was conspicuously absent after being widely-touted by most pundits early in 2011. The graph below shows how these sectors led the way early in the year, but were eventually overtaken by the classic defensive sectors.

And, rounding out the field with total returns ranging from -11% to -18%, were the Telecom, Financial and Materials sectors, battered by competition, malfeasance and incompetence, and an abrupt shift to “risk-off” mode following the August meltdown, respectively.

After publishing an analysis of the Conference Board’s Economic Indicators and 2012 Economic Outlook later this week, I will opine on which sectors are likely to lead the way in early 2012. Stay tuned.

Datasource: Capital IQ

Categories: Market Commentary

Oracle is Fairly-Valued Following Its Price Correction on 12.21.11

This article presents a financial analysis of Oracle (ORCL), which sold off sharply in the 12.20.11 after-hours session after missing hard on top-line revenue and bottom-line earnings. The analysis shows that this recent price correction has compressed ORCL’s stock to fair value based on a discounted free cash flow model and a slow-growth future trajectory for the company. The stock merits a BUY recommendation at its 12.21.11 closing price of $25.77. Technical analysis indicates negative stock price momentum, however, so even more attractive entry points may lie ahead. ORCL has strong and growing EBITDA/share and NOPAT/share, generates large free cash flows, earns a return on capital well above its cost of capital, and is well-positioned to create value even if future growth downshifts to a new, slower trajectory. I do not expect ORCL’s stock to languish after this revenue/earnings miss like Cisco or Hewlett-Packard. The analysis shows that the company is not broken and can continue creating value in a slow-growth environment. If OCRL follows the MSFT and INTC model, investors will see large dividend increases in the near future, as the company puts more energy into growing dividends to compensate for its slower future growth.

ORCL has a market cap of over $147 billion, posts a return on capital of 15.6% (well above its cost of capital of 9.1%), and had a consensus analysts target price of $36.00 prior to its 12.20.11 price decline.

The stock now yields 0.5%, and its trailing P/E has compressed to a reasonable 14.2 times earnings. As shown below, ORCL creates large and growing economic value-added, and has large and stable free cash flow margins.

ORCL has a beta of 1.19 vs. the Nasdaq-100 index over the past 36 months, a slightly negative annualized alpha due to its higher volatility, respectable institutional ownership, and is one of the most lightly-shorted stocks in the market.

Over the past 2 years ORCL has slightly outperformed the Nasdaq-100 before adjusting for risk:

ORCL’s stock has strongly outperformed peer firms Microsoft (MSFT) and Google over the past 2 years:

ORCL posts strong revenue per share, comparable to a giant revenue producer like MSFT:

ORCL’s trend in EBITDA and EBIT is impressive, growing every year for the past 6 years:

EBITDA per share displays a similar trend, once again comparable with MSFT:

MSFT pulls slightly ahead in terms of EPS, however:

For a dividend-focused investor, MSFT makes more sense:

MSFT now has a respectable yield of 2.6%, vs. ORCL’s yield of 0.5%:

Both companies gross margins have contracted slightly in recent years:

MSFT’s operating margins are also in a slight downtrend, while ORCL’s are more stable in the mid-30% range:

Both firms have strong, stable net margins:

Our process favors stocks whose prices are strongly supported by fundamentals such as Net Operating Profit After Tax. Each companies’ NOPAT/share is shown below. Note the rising trend:

ORCL has invested more in recent years than MSFT, thus their lower FCF/share until the most recent fiscal year (both companies are now in their 2012 fiscal year):

ORCL has a strong ROIC, which only looks small compared with MSFT’s. The spread of each stock’s ROIC over their cost of capital is huge, which is a necessary condition for shareholder value creation:

Both companies create large and growing economic value-added per share.

ORCL has grown its market value-added per share recently due to its stronger stock price performance:

We projected ORCL’s financial statements using a slow-growth scenario that takes growth from 2013-2017 on a declining trajectory, beginning at 4.0% and slumping towards a 2.0% perpetual growth rate. Margins were held at their historical averages in the forecast:

Based on a 5-year beta of 1.09, the current 10-year yield of 1.96%, and a market risk premium of 7.0%, we estimate ORCL’s cost of capital at 9.1%:

A detailed valuation analysis is shown in the table below.

ORCL’s 12.21.11 pre-market price of $26.25 indicates slight undervaluation, based on a DCF fair value price of $27.74:

Technically, the MACD indicates ORCL’s price may drift even lower:

Conclusion: ORCL’s 12.21.11 closing stock price of $25.77  is well-supported by fundamentals and most likely represents a good entry point for the long-term buy-and-hold investor who does NOT require high dividends. Technical analysis indicates negative stock price momentum, however, so even more attractive entry points may lie ahead. The stock has strong and growing EBITDA/share and NOPAT/share, generates large free cash flows, earns a return on capital well above its cost of capital, and is well-positioned to create value even if future growth downshifts to a new, slower trajectory. I do not expect ORCL’s stock to languish after this revenue/earnings miss like Cisco or Hewlett-Packard. The company is not broken and can continue creating value in a slow-growth environment. If OCRL follows the MSFT and INTC model, investors will see large dividend increases in the near future, as the company puts more energy into growing dividends to compensate for its slower future growth.

Datasource: Capital IQ

Which S&P 500 Sectors Have the Highest Margins?

David Sowerby of Loomis Sayles gave an interview on CNBC last Friday (12.16.11, video available here). Mr. Sowerby cited the following reason for being bullish on stocks:

. . . if you look at the continued improvement in cash flow margins, that are about 20% today for most companies, still below the 24% peak levels for 2007, I think too many investors are focused on net profit margins, not focused on the statement of cash flows, that’s what can get stock prices higher . . .

Twenty percent free cash flow margin sounded a little high to me, so I decided to take a closer look. I calculated the equally-weighted and capitalization-weighted gross, net, and unlevered free cash flow margins for the S&P 500 from 1994-2011. The graph below shows that the average gross margin expanded dramatically from 1994-2000, after which it levels off and drifts slightly higher. Cap-weighting makes a difference, as large-cap firms have higher gross margins. I found it interesting that gross margins were largely unaffected by the 2000-2001 and 2007-2009 recessions:

Health Care, Telecom and Information Technology have the highest cap-weighted gross margins. Health Care’s cap-weighted gross margin now exceeds 60%:

Average net margins are also trending upwards, although net margins display pronounced declines during the last two recessions. Cap-weighting once again makes a difference, as larger-cap companies earn higher net margins. Further note how the cap-weighted series shows less of a decline during recessions.

The Health Care and Information Technology sectors also have the highest cap-weighted net margins, along with — surprise — Financial stocks. Notice how, until their demise in 2007, Financials squeezed the highest net margins out of their revenues compared with the rest of the S&P 500:

I also calculated the equally-weighted and cap-weighted unlevered free cash flow margin for the S&P 500, depicted in the graph below.

Mr. Sayles definitely gets a few things right. Unlevered free cash flow margins have been in an 18-year uptrend, and the equally-weighted series does indeed peak in 2007. Cap-weighting makes more sense, however, as an equally-weighted series places disproportionate weight on the margins of smaller firms. The graph above shows that the mean cap-weighted free cash flow margin of the S&P 500 is at an 18-year high.

The sectors with the highest cap-weighted unlevered free cash flow margins are once again Health Care, Telecom and Information Technology, ranging between 13%-18%:

Conclusion: S&P 500 gross, net, and unlevered free cash flow margins trend upwards from 1994-2011. Health Care has the highest gross and unlevered free cash flow margin, followed by Telecom and Information Technology. Surprisingly, Financial stocks’ net margins have rebounded sharply.

The mean cap-weighted unlevered free cash flow margin for the S&P 500 is only 12.2%, however, much lower than Mr. Sowerby’s estimate of 20%. One possible explanation for the difference in our findings is that the Loomis Sayles calculations refer to levered free cash flow margin, which we would expect to be higher. I propose that cap-weighted unlevered free cash flow margin is a better measure, however. Levered FCF arbitrarily places more weight on the margins of firms that use more debt, instead of weighting by the more traditional market cap factor.

Datasource: Capital IQ.

Categories: Market Commentary

Kinder-Morgan Energy (KMP) Represents Better Value for Dividend-Focused Investors Compared With Williams Companies (WMB)

The analysts at Sabrient had a Strong Buy recommendation on natural gas energy producer Williams Companies (ticker WMB) on Dec. 5. This rating was reduced to a Buy recommendation on Dec. 12 (report available here). Sabrient likes Williams’ price momentum and recent earnings increases. Additionally, the company has raised their annual dividend for 5 straight years, which is a strong vote of confidence regarding the sustainability of these higher earnings.

This article will take a closer look at Williams from the point of view of a fundamentals-oriented, dividend-focused investor. Our bottom-line conclusion is that Williams is inferior to alternative stocks such as Kinder-Morgan Energy Partners (KMP). The analysis below shows that KMP has stronger per share fundamentals, a higher dividend yield, a lower beta (thus a lower cost of capital), and better per-share valuation based on a discounted cash flow model. Williams’ return on capital is well below its cost of capital, which makes it a persistent value-destroyer. (Click on the link to download our one-page summary: WMB).

Below we see that WMB’s stock is up 70% in the past 2 years, handily beating rival firms like KMP and Anadarko Petroleum (APC):

The stock also outperformed the S&P 500 over the same period:

WMB’s total revenue continues recovering from its 2009 lows; the company’s profits are also recovering:

WMB’s EBITDA and EBIT display a solid uptrend since 2009:

Notice that WMB’s revenue per share remains depressed, and much lower than Kinder-Morgan’s:

The trend in WMB’s EBITDA/share is largely flat. Although KMP generates greater EBITDA/share, KMP’s EBITDA/share is in a 4-year downtrend:

While Sabrient’s analysts are correct in their assertion that WMB’s earnings have shown a nice recovery, especially compared to KMP, also notice the much higher volatility of WMB’s EPS (which explains much of the beta-differential between the two companies; WMB’s beta is 1.32, vs. only 0.37 for KMB):

While both firms managed to increase dividends each year for the past 5 years, KMP absolutely trounces WMB in terms of dividends per share:

KMP also has superior operating margins:

and net margins:

Given the trend in natural gas prices, we don’t expect margin expansion for either company any time soon:

While both stock’s dividend yields are trending downward, KMP’s yield of 5.8% is almost 3 times larger than WMB’s yield of 2.1%:

KMP is also superior in terms of return on invested capital:

and free cash flow per share:

Which explains why WMB keeps falling behind in terms of economic value-added per share:

and market value-added per share:

With small per share fundamentals and a high cost of capital due to their high beta, WMB measures up as extremely over-valued based on a discounted free cash flow model:

But KMP measures up as significantly under-valued due to their larger per share fundamentals and lower cost of capital:

Conclusion: With greater per-share fundamentals and ROIC, a stronger track record of value creation, a much higher dividend yield and a far lower beta, Kinder-Morgan Energy Partners (KMP) represents a better value for a fundamentals-oriented, dividend-focused investor than Williams Companies (WMB).

Datasource: Standard & Poor’s Capital IQ

Profits Are At Record Levels And Stocks Are Cheap, But Boards’ Reluctance To Raise Dividends is a Concern

My first contribution to the end-of-year market outlook season is a big-picture view of the S&P 500 (in billions, and percent where applicable). The market capitalization of all 500 stocks still lags its 2007 level, but total revenues and profits hit all-time highs in 2011:

Those record profits have not induced firms to restore payouts to shareholders, however. Dividends and repurchases remain at their depressed levels from 2008-2009:

Aggregating across all firms, I created pseudo price/earnings, price/sales, and price/book ratios for the S&P 500. The slow mean reversion of US stocks’ relative valuation is evident in the graph below. The ratio of Market Cap/Net Income (or P/E) of the S&P 500 = 13.3, the lowest it has been in 20 years:

As shown in the next chart, stocks’ earnings yield is 7.5%, the highest in a generation. Firms’ dividend yield remains stuck at 2.1%, however, and the dividend plus repurchase yield is only 3.2%:

Stocks are gradually becoming cheaper. Investors have apparently remembered the long-forgotten concept of the risk premium. Cheap stocks beget bull markets (1982), but overpriced stocks beget wailing and gnashing of teeth (1999). Valuations are re-setting. The process takes an agonizingly long time, but it’s happening, and from the look of things, we’re almost there.

But cheap stocks are not enough to make a bull market; stocks need to be cheap relative to the underlying companies’ future prospects. And there’s one key signal that has yet to flash “go” for US equities: corporate boards have let dividend payouts lag far behind their historical relation with earnings. Below I’ve graphed the historical spread between stocks’ earnings yield and dividend yield. The 2011 spread of 5.4% is quite high by historical standards:

Of course, finance theory proposes that executives’ reluctance to increase payouts in proportion with earnings signals their lack of confidence that recent profit levels are permanently sustainable (Weigand and Baker, 2009 and Fargher and Weigand, 2009). Until firms raise dividends enough to increase yields, markets have no reason to believe that the incredible profit surge from 2010-2011 is the real deal. Instead of jawboning about business confidence, boards should simply pull the trigger and raise dividends decisively.

— Data from S&P’s Capital IQ

Categories: Market Commentary