Newsletter Q4 2000
October 7, 2000
Market
Overview
The
financial markets have recently become more sensitive to earnings
disappointments. Many technology
stocks continue to be priced at high valuation levels and further declines can
be expected in that sector of the market.
In contrast to 1999, the utility sector has been the best performing
Dow Jones sector in 2000 as it has increased 39% year-to-date.
Investors will most likely continue to shift money to companies that
are able to generate more cash for their investment dollar. While the S&P
500 Index is currently selling for 27X trailing earnings, some good businesses
are available at more appealing valuations.
The
value of the dollar will continue to be a potential drag on the financial
markets in the coming year, as it may effect both investment and consumption
behavior. The European Central
Bank (ECB) has increased interest rates by 2.25% since last November and
recently intervened in the currency markets to support the euro.
In spite of the ECB's efforts, the dollar remains the currency of
choice for many international investors.
The economic fundamentals, however, favor the euro.
During the last twelve months, the U.S. had a trade deficit of $412
billion compared to a trade surplus of $32 billion for the Euro-11 countries. Another factor favoring the euro is that GDP growth rates for
the U.S. and the Euro-11 are expected to converge next year.
In a recent poll by the Economist, economists forecast the GDP growth
rate in 2001 to be 3.3% for the U.S. compared to 3.1% for the Euro-11.
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Updates
ArvinMeritor
(ARM) announced that the company had exceeded its goal of post-merger cost
savings by 33 percent in the first year, with $40 million of after-tax savings
identified so far. The cost
savings will come from eliminating duplication and adopting best practices in
administrative areas. Potential
cost reductions in operational areas are excluded. ARM has also targeted
revenue enhancements that are expected to generate an additional $450 million
by 2003. The revenue enhancements
are now possible due to the creation of integrated systems that were not
viable prior to the merger. ARM
currently sells for 4X the consensus earnings estimate of $3.85 per share for
FY 2001.
Gehl
Company (GEHL) announced that it now expects revenues to be 10% to 12% lower
for the full year 2000 compared to 1999 as a result of unfavorable market
conditions. GEHL is now expecting
earnings of $1.55 to $1.64 per share for the full year.
The construction equipment business has been subject to industry-wide
reduced demand due to the decline in residential construction activity.
Demand for GEHL's agricultural equipment is also down as dairy farmers
are now receiving milk prices that are approximately one third lower than last
year. Although I am disappointed
by the turn of events for GEHL, I will continue to hold it because of the low
valuation and the past success of the company.
The
price of General Motors (GM) stock recently rose after the company issued a
press release stating that Carl Icahn was seeking to buy as much as 15% of its
stock. The value of GM's 28.1%
interest in Hughes Electronics (GMH) has continued to rise and is currently
valued at nearly $22 per GM share. GM
Vice Chairman Harry Pearce recently said in a public statement that General
Motors will decide in a matter of "months, not years" what to do
with the Hughes Electronics Corp. satellite-TV unit, DirecTV.
DirecTV accounted for 65% of GMH 1999 revenues and now has
approximately nine million subscribers. The
spinoff or sale of Hughes would be highly accretive to GM earnings because
Hughes has a market capitalization in excess of $41 billion although it does
not currently have earnings.
The
Meditrust Companies (MT) are on track to achieve the goals outlined at the
beginning of the year in its Five Point Plan.
MT recently sold additional healthcare assets, generating total
proceeds of $959 million since January. Total
debt due in 2001 has now been reduced to $676 million from $1.4 billion at
December 31, 1999. The book value
of MT's remaining healthcare assets available for sale is approximately $1
billion. The company should be
able to restore its dividend in 2001 and possibly repurchase shares.
In the meantime, MT continues to sell for a little over 2X funds from
operations.
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Additions
P.H.
Glatfelter Company (GLT) manufactures specialized printing papers, along with
tobacco and other engineered papers. The
company has identified $40 million in sustainable cost savings to be realized
within 18 months through its DRIVE project. Most of the savings will be from procurement and process
improvement. Analysts should be
increasing their earnings estimates as the cost savings start to be realized.
GLT currently sells for 6.5X free cash flow and has a dividend yield of
5.8%.
Federated
Department Stores (FD) has over 400 department stores in 33 states that
generated over $17 billion in revenue during 1999. Its divisions include Macy's, Bloomingdale's, Burdines,
Stern's, and Fingerhut. Loose
credit terms at the Fingerhut division during the last two years resulted in
additional reserves for bad debts of $150 million during the second fiscal
quarter. FD has stated that
additional bad debt write-offs of $200-250 million are possible in the fall.
As a result, the stock price dropped to a 5 year low.
Naturally, the company has tightened their credit standards for the
division since then and expects significant improvement in 2001.
FD now sells at 7.1X next fiscal year's consensus estimate. In the past, the P/E ratio for the company has consistently
been in the mid-teens.
Autodesk
(ADSK) develops and markets software for architectural design, mechanical
design, mapping and animation. The
company had solid revenue growth in the second quarter as it released
web-enabled versions of several CAD products.
Two internet divisions, Buzzsaw.com and RedSpark, will likely be spun
off in the first half of 2001. ADSK
currently sells for 8.3X estimated free cash flow for the current fiscal year.
PacifiCare
Health Systems, Inc. (PHSY) owns and operates HMOs, including the largest
Medicare risk provider, Secure Horizons (62% of revenues in 1999).
The price of PHSY has dropped recently due to reductions in earnings
estimates. PHSY's medical loss
ratio increased slightly (0.8% in the second quarter vs. a year ago) as more
hospital providers have requested payment on a fee-for-service basis in recent
years. Contributing to a higher
medical loss ratio is the federal government's reluctance to raise Medicare
premiums enough to keep up with costs. As
a result, PHSY and other HMOs are withdrawing from some rural areas and
raising premiums or reducing benefits in other locales.
Since HMOs have been able to lower the cost of Medicare for the federal
government, Congress may eventually come to its senses and raise Medicare
premiums paid to HMOs. In the
meantime, PHSY sells for 3.5X estimated free cash flow for 2001.
Kulicke
& Soffa Industries, Inc. (KLIC) manufactures production equipment for the
semiconductor industry. In early
August, KLIC announced that a customer had deferred an order to 2001 due to
space constraints and material shortages.
As a result, the price of the stock declined more than 50%.
Nevertheless, the company and industry analysts expect demand for
semiconductor capital equipment to remain strong for at least the next two
years. KLIC now sells for 5.3X FY
2001 estimated earnings.
Galileo
International, Inc. (GLC) is a leading provider of electronic global
distribution services to the travel industry.
Approximately 41,000 travel agencies and other users in 107 countries
utilize Galileo's computerized reservation system to access schedule
information and book reservations. GLC
earned booking fees from airlines, hotels and rental car companies that
totaled nearly $1.5 billion in 1999. A
potential catalyst for the company's stock is Quantitude, GLC's recently
launched telecommunications division. When
the company upgraded its virtual private network, it decided to sell excess
capacity to other multinational companies that require security and
reliability. By eliminating
multiple telecom intermediaries in different countries, the company believes
that it can profitably price its service 20% below other carriers.
Some analysts believe that Quantitude will be able to generate $1
billion in revenues within three to five years.
GLC currently sells for 4.2X estimated free cash flow for 2001.
Several
utility stocks were added during the quarter.
GPU, Inc. (GPU) provides electricity through its holding companies in
New Jersey and Pennsylvania. GPU
agreed to be acquired by FirstEnergy for $36.50 per share, which will result
in a total return greater than 20% if the deal is consummated.
UtiliCorp
United Inc. (UCU) provides electricity and gas in several Midwest states.
Its nonregulated Aquila energy marketing division is one of the largest
energy merchants in the U.S. UCU
sells for 7.6X estimated free cash flow for 2001 and has a dividend yield of
4.9%.
Xcel
Energy Inc. (XEL) is the result of a recent merger of Northern States Power
and New Century Energies. It has
six public utility subsidiaries that transmit and distribute electricity and
gas to customers in several states. XEL
has a 82% interest in publicly traded NRG Energy, Inc. (NRG), the sixth
largest independent power production company in the world. At the current price, NRG has a market capitalization of $5.4
billion, or $13.11 per share of XEL. A
spinoff of NRG to XEL shareholders is probable but the company will wait two
years to comply with requirements for pooling of interests accounting.
First
Australia Prime Income Fund (FAX) is a closed-end fund that invests in
Australian and Asian fixed income securities.
94% of the Fund's securities have an investment grade credit rating and
71% are rated AA or better. FAX
has recently been selling at a discount of 18% below net asset value.
The Fund utilizes some leverage, with adjustable rate preferred stock
that accounts for 29% of the capitalization, and has a dividend yield of
13.8%.
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Deletions
Positions
were eliminated or reduced in Abercrombie and Fitch (ANF), UnumProvident (UNM),
and AmeriSource Health Corporation (AAS).
All three stocks appreciated substantially during the quarter as they
regained favor with investors. As
a result, the projected returns are now lower than they were at the time of
purchase.
Positions
in Xerox (XRX) were eliminated. Competition
from Canon and others has increased in the high end of the market where XRX
has its highest margins. Management
now expects a loss for the third quarter and analysts are lowering estimates
for next year.
The
Board of Directors of Dreyfus Strategic Governments Income, Inc. (DSI)
approved a proposal to merge the Fund into Dreyfus A Bonds Plus, Inc., an
open-end fund. Consequently, the
Fund's price moved to a small discount to net asset value.
Dresdner
RCM Global Strategic Income Fund, Inc. (DSF) was selling at a 9% discount to
net asset value and was used as a source of cash for the purchase of First
Australia Prime Income Fund (FAX).
If
you have any questions regarding your accounts, please do not hesitate to
call.
Sincerely,
Robert G. Kahl,
CFA, CPA, MBA
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Sabino
Investment Management, L.L.C.