Newsletter Q1 2002
January 2, 2002
Can the Fed Do its Magic?
During 2001, the Federal Reserve expanded the money supply rapidly in order to revive the economy. Monetary aggregates (MZM, M2 and M3) have increased by 10 to 20 percent compared to a year ago. Usually, increases in money growth lead credit growth, which benefits the economy. This time, however, the economy's response to the Fed's stimulus has been muted.
The Fed has a difficult task because the economy is now characterized by supply excesses, poor pricing power, and weak demand. During the last four decades, the economy benefited from the increased willingness of consumers to borrow money to increase their consumption. Corporations also borrowed money for capital expenditures and share buybacks. Balance sheets have deteriorated steadily since World War II and ratios of debt to income are now at historically high levels for both corporations and consumers. This creates a potential drag on the economy if corporations and consumers use cash flow to reduce debt levels.
The Conference Board announced that its Help-Wanted Advertising Index, a key leading indicator for U.S. job growth, dipped again in November to 46. This compares to a level of 75 one year ago and represents the lowest level since 1964. The Conference Board survey includes 51 major newspapers across the country. The weakness may reflect market gains from internet recruitment sites such as Monster.com but it strongly suggests that a higher unemployment rate can be expected. An economic expansion without job growth is unlikely.
The S&P 500 Index currently sells for 41X earnings for the last four quarters. The price level of the S&P 500 implies that many investors expect a strong economic and corporate profit rebound with near certainty. I remain skeptical of such a scenario and continue to be overweighted in sectors that are less economically sensitive such as healthcare, energy, and utilities.
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Updates
Sirius Satellite Radio's (SIRI) stock price has moved up during the quarter. In November, Joseph Clayton was appointed as CEO after David Margolese resigned. The company also announced plans for the introduction of their service in Phoenix, Houston and Denver on February 14, 2002. The service should be available in 48 states, excluding Alaska and Hawaii, by the end of the third quarter of 2002. SIRI has become a large position in some accounts due to the price increase but I believe the stock offers further upside potential and do not plan to sell anytime soon.
MFC Bancorp (MXBIF) announced that its Board approved a distribution of 0.6 shares of Mymetics Corp. (MYMX.OB) for each share of MXBIF. This has been a positive surprise for shareholders and the price of MXBIF has responded accordingly. Mymetics is a development stage company involved in the research and development of human and animal vaccines, including a treatment for AIDS. It is currently traded on the OTC bulletin board. MYMX will represent a small position in your portfolios and I will decide whether or not to keep it after I get additional information on the company.
ITLA Capital Corporation (ITLA) announced that it signed an agreement and plan of merger with Asahi Bank of California. The acquisition is the initial step in the company's plan to convert its charter from a California industrial bank to a commercial bank charter. ITLA will then have an operating platform and systems to convert Imperial's savings branch operations to commercial and retail platforms. ITLA management believes that conversion to a commercial bank charter will reduce the cost of funds and benefit the stock price.
UtiliCorp United (UCU) and several other utilities declined in price during the quarter in response to Enron's problems. UCU will have to increase it allowance for uncollectible receivables in the fourth quarter due to Enron. UCU holds $31.5 million in unsecured promissory notes from Enron. Aquila Inc., its 80% owned subsidiary, has a trading exposure of $40 million. Although Aquila has energy trading activities, the business appears to be sound and should actually benefit from the absence of Enron as a competitor.
Holly Corporation (HOC) reported earnings of $1.30 for the first fiscal quarter ended October 31. Earnings should be lower in the second quarter due to a major refinery turnaround. The company has a strong balance sheet with $88.5 million in cash as of October 31 and the Board approved the repurchase of up to $20 million of the Company's common stock. In its annual report, HOC stated that its claim against the Department of Defense for jet fuel deliveries between 1982 and 1995 amounted to $210 million. It will probably be a few years before the dispute is resolved but it could prove to be a significant windfall for HOC shareholders as the current market capitalization of the company is $298 million.
Some fixed income closed-end funds have been sold in recent months as the discounts to net asset value have declined towards the low end of their historical ranges. Cash levels may temporarily be higher than normal as I wait for some bargains to emerge.
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Additions
Equity Inns (ENN) was added to many accounts during the quarter. ENN is a real estate investment trust (REIT) that is focused on the extended stay, all-suite and midscale limited-service segments of the hotel industry. The hotels are franchised and include the following brands: Hampton Inn, AmeriSuites, Residence Inns, and Homewood Suites. ENN suspended their quarterly dividend in the fourth quarter due to lower revenue after September 11 but expects to pay future quarterly dividends in 2002. ENN sells for 6.2X estimated funds from operations for 2002.
Elan Corp., PLC (ELN) develops and markets pharmaceutical products and diagnostic services for patients with neurological disorders. The company is headquartered in Ireland although nearly half of its sales are from the U.S. Strong revenue growth is expected to continue as ELN has 19 new product candidates in Phase II or Phase III clinical trials. One of the drugs in Phase II trials is AN-1792, a potential blockbuster drug for the treatment of Alzheimer's disease, which affects about 12 million people worldwide. ELN sells for 19X estimated earnings for 2002.
Several issues of Genetic Engineering News have highlighted the looming bottleneck in biopharmaceutical manufacturing capacity. As the FDA approves a large number of biopharmaceuticals within the next five to ten years, product requirements are forecasted to exceed production capacity. Consequently, pharmaceutical companies are increasingly turning to outsourcing. Two companies that should benefit from future outsourcing are Genzyme Transgenics Corporation and Large Scale Biology Corporation.
Genzyme Transgenics (GZTC) develops and produces therapeutic proteins using transgenic technology. Specific DNA sequences for a protein are inserted into the genetic material of an animal embryo, usually goats, which directs the production of the desired protein in the milk of the transgenic offspring. GZTC estimates that their production process can deliver therapeutic proteins at one-half to one-third the cost of traditional manufacturing plants. At the end of the third quarter, the market capitalization of GZTC barely exceeded the $93 million in cash and marketable securities on the company's balance sheet. This represented a bargain price for the company's technology.
Large Scale Biology Corporation (LSBC) uses proprietary technologies in proteomics, functional genomics and biomanufacturing to develop and manufacture drugs, vaccines and diagnostics for identification and treatment of disease. Genomics is the study of genes, which determine when and how an organism makes particular proteins. Proteomics involves the study of proteins, especially the changes in amount or character of specific proteins that occur in disease or as a result of drug effects. LSBC has completed its first version of its proprietary human proteome database, the Human Protein Index(tm), which covers the protein products of 18,000 human genes. The company has also demonstrated how the combination of a plant and transgenic virus can be used to produce therapeutic proteins and single-chain antibodies which can be tailored to specific patients. LSBC's manufacturing process offers significant cost advantages over traditional methods of manufacturing biopharmaceuticals. LSBC has not generated much revenue yet but I expect that to change within the next few years as a result of their strong technological position.
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Deletions
La Quinta Inns (LQI) was sold at a profit. LQI has performed well during the last two years, but the stock now offers less upside potential and it was used as a source of cash for other opportunities.
General Motors (GM) was sold at a loss. GM has had strong sales in recent months with the assistance of sales incentives such as 0% financing that have lowered profit margins. The sales incentives may result in reduced revenues in future quarters as customers have accelerated buying decisions. Other risk factors include the possible underfunding of retirement plans due to poor investment performance, the probable exercise of a put option by Fiat for the other 80% of the company that GM doesn't own, and the possible failure of the Echostar deal due to antitrust issues.
If you have any questions regarding your accounts, please do not hesitate to call me. Best wishes for a happy and prosperous new year!
Sincerely,
Robert G. Kahl,
CFA, CPA, MBA
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Sabino
Investment Management, L.L.C.