Newsletter Q3 2001
July 17, 2001
Pushing on a String
The
Federal Reserve has made a valiant effort to counter the effects of the
telecommunications/technology bust.
On June 27th, the Federal Reserve lowered the fed funds rate
another 0.25% to 3.75%.
The Fed lowers short-term rates by increasing the monetary base.
Consequently, monetary aggregates (MZM, M2, and M3) have been
increasing in recent months at annualized rates of 10 to 20%.
The Fed cannot lower short-term rates much further without raising
inflation expectations.
In
contrast to the Fed's efforts, bankers are reacting to an increasing number of
problem loans.
About half of all banks have tightened credit standards in response to
an increase in nonperforming loans, according to a recent survey by the
Comptroller of the Currency.
Loan write-offs by banks increased 38% in the first quarter from the
prior year.
One
of the bright spots in the economy has been consumer spending.
However, consumer debt levels, corporate layoff announcements and
jobless claims are all approaching record levels, which may soon put a dent in
the consumer's ability to spend.
S&P
500 companies are expected to report earnings for the second quarter that are
18% lower than the prior year, according to First Call.
The technology and transportation sectors are expected to have the
largest declines: 66% and 61%, respectively.
Four sectors are expected to post positive comparisons: consumer
staples, energy, health care, and utilities.
Lower earnings have not had much effect on valuation levels.
The S&P 500 Index sells at 26.7X trailing earnings compared to
29.6X a year ago.
The median P/E ratio of Value Line stocks (a broader measure that is
not weighted by market capitalization) is at 17.7, near the high end of its
historical range.
I
expect the second half of the year to continue to be a challenging environment
for the U.S. financial markets.
On an opportunistic basis, I will continue to buy businesses that sell
for low multiples of free cash flow and will attempt to avoid businesses that
are susceptible to negative earnings surprises.
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Updates
The
Meditrust Companies (MT) changed its name to La Quinta Companies (LQI),
reflecting a change in focus to the lodging industry.
LQI intends to sell the remaining health care properties over the next
18 months. LQI
also intends to grow the number of lodging facilities, primarily through
franchising which offers higher margins and has minimal capital expenditure
requirements. Management expects 15 franchises to open by the end of 2001 and
another 35 to open in 2002.
For the first quarter, LQI reported RevPAR growth (revenue per
available room) of 3.4%.
Lodging industry RevPAR has declined during the second quarter but the
mid-scale category has fared better than the high-end category as travelers
attempt to economize.
Holly
Corporation (HOC) had a 2-for-1 stock split, effective July 9.
Gasoline inventories for the industry have increased during the second
calendar quarter due to high capacity utilization and imports.
Refinery margins are generally stronger in the West and HOC has been
able to maintain higher margins on gasoline that is reformulated to meet
California Resource Board standards.
HOC continues to sell at a low valuation of 4.2X estimated earnings for
the current fiscal year.
In
May and June, HOC filed claims with the Department of Defense under the
Contracts Disputes Act asserting that additional amounts are due to the
Company for jet fuel sales to the Defense Fuel Supply Center in the years 1982
through 1995.
The Company has not disclosed the amount of the claim but given the
magnitude of a judgment won by a small refinery in Texas in a similar dispute,
it could be significant.
General
Motors (GM) is reportedly close to finalizing a sale of Hughes Electronics (GMH)
to News Corp., the media and entertainment company headed by Rupert Murdoch.
Michael Smith, the Hughes chairman who opposed a sale of the company,
resigned in May and was replaced by Harry Pearce, who had been GM vice
chairman. Pearce
moved to Hughes to oversee "strategic restructuring alternatives."
Pacificare
Health Systems (PHSY) lowered its earnings expectations for the year as a
result of higher-than-expected medical expenses.
Because 80% of its commercial HMO business was priced before the claims
trends became evident, PHSY will have to wait until next year to increase
premiums. The
Company believes that political winds in Washington have become more favorable
lately and it may receive increased reimbursement rates for its
Medicare+Choice program. PHSY currently sells for 5.6X estimated free cash
flow and positions were increased for most accounts during the quarter.
Utilicorp
United (UCU) sold 20% of its Aquila subsidiary (ILA) in an initial public
offering. Aquila
is a wholesale energy merchant company that owns electric power generation
plants and natural gas processing facilities.
UCU will likely spinoff its remaining interest in ILA to shareholders
within 12 months.
UCU currently sells for 13X estimated earnings while ILA sells at a
higher multiple of 17X due to its higher earnings growth rate.
After the spinoff, the remainder of UCU should sell at a higher price
to be consistent with industry valuations.
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Additions
FirstEnergy
Corp. (FE) is an electric utility holding company that provides service to
over 2.2 million customers in Ohio and western Pennsylvania.
FE is in the process of acquiring GPU, Inc., which is also held in many
of your accounts.
The acquisition should be immediately accretive to FE's earnings.
New Jersey regulators and the SEC must still approve the transaction.
FE has excess generating capacity that GPU could use, and good cash
flow characteristics.
FE sells for 7.5X free cash flow.
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Deletions
Galileo
International, Inc. (GLC) was sold at a profit.
GLC agreed to be acquired by Cendant Corporation for $33 per share
(80.5% in stock, 19.5% in cash).
The deal is subject to regulatory approval and the approval of GLC's
shareholders.
GLC has been selling at a price that is close to the acquisition price
and I do not find Cendant attractive at the present time.
GLC shares have been retained in some accounts for the purpose of
meeting the required holding period for long-term capital gains.
If
you have any questions regarding your accounts, please do not hesitate to call
me.
Sincerely,
Robert G. Kahl,
CFA,
CPA, MBA
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Sabino
Investment Management, L.L.C.