Saturday, December 22, 2007

Let the MBA's talk to themselves

Too many young MBAs spend more time on the squash court than at the foot of accomplished investors. How else can one expain the herd mentality and foolish investment decisions.

Let’s examine some conventional investing wisdom:
1. New capital, even expensive preferreds, is positive even as it dilutes current shareholders. Therefore push the price up.
2. Taking a large write down on securities that no one can understand is a signal that management, or new management, is on top of the situation and the stock has now bottomed. Therefore, don’t run for the hills or sell short, buy and push the price higher.
3. Agree with the economist fraternity and ignore rising food and energy costs and only concentrate on the “core rate.” People don’t eat or drive so non-core inflation won’t produce the same result as a tax increase. Therefore, keep cheering for lower short term interest rates and push all stocks up as rising prices aren’t as powerful as lower rates.
4.Emerging markets are growing so fast that a slowing American economy will not affect the Third World. Therefore pile into U.S. multinationals and Emerging Market companies and expand their valuations far past what their gowing earnings justify.
5. The list could go on for pages.

The ramblings above lead me to Citicorp. This money center bank hasn’t had good leadership for a number of years, its CEO was a former house counsel! It excelled at following trends and was willing to not only sell, but own securities that it didn’t understand. Its risk manaement was definately NOT crusty.

As I opined early on, the losses will keep coming ala Continental Illinois. The risk culture permeates the institution and it doesn’t only reside in the subprime mortgage portfolio, the CDO portolio, or the SIV that holds lots of asset backed commercial paper. The same management and risk managers that allowed that debt to reside on the balance sheet wasn’t able to discriminate and prevent poor credit from filtering into the LBO and Bridge loan portfolios, the home equity lines, unmonitored credit card portfolio, hedge fund lending, and aggressive merchant banking investments. Now that the auditors and regulators have started looking closer the other cockroaches will come out of the closet.

Selling high coupon preferred to Arabs may keep capital OK for awhile, but it is expensive and ,when converted, is dilutive. That capital won’t be enough to compensate for future losses attributed to the above problem areas that will develop. The dividend will need to be cut or eliminated as it represents billions of dollars of potential capital. Cutting the dividend may hurt shareholders, but so does dilution and both cause a reduction in share price.

I’ve had puts on Citi and think that bet remains a good one. It is likely that the dividend will be cut and the new president will announce losses greater than anticipated so that they are attributed to former management. The housecleaning won’t be enough though and losses will continue and capital will be strained for several years. Owning puts or being short is the place to be as the price will continue downward in 2008.

Saturday, December 15, 2007

2008 won't be anywhere near average

I haven’t written with any investment thoughts lately as I haven’t had any. As I wrote earlier, the market was likely to rally pre mid-December and then trail off as tax loss selling and economic realities set in. Amazingly, that has occurred.

My positions are mostly behaving in a good fashion. I used the rally to sell some positions at good prices and start more puts/shorts at much higher levels than earlier in the month. The flight to quality by institutions has caused my blue chip holdings to perform well. The only problem of late is in very short term bonds and I still have a good profit at these levels and I’m sleeping well at night. So all is well.

Now how do I make a good return next year if the “market’ isn’t going to give me an average year. First, I’m going to expect less and be happy withcoupon-like returns. Second, I’m going to continue to “time the market.” I usually don’t do that as I generally just ride through any correction as the trend has been upward for years. This time I think we have more negatives at work and the upward trend resumption may take longer. I’m willing to pull money off the table as it will get reinvested in fixed income investments at rates that will be rising. The safety feature of government bonds will only hold appeal for so long and then inflation and a weak dollar will demand higher returns. That evolution could happen quickly as inflation has been rampant and the media has only recently noticed and the Fed has only recently acknowledged that “headline” inflation affects consumers. I could get a large portion of my 2008 return from rising rates.

My negative bets are self explanatory. As they go down I make money. And as long as everyone flocks to multi-national blue chips that have an overseas presence, that portion of my portfolio will do well.

Wednesday, December 5, 2007

I may be the "greater fool" sellers are waiting for

This position started as a hedge to my MLM puts. The thought process was that if construction materials rallied and my puts lost value, then the RMIX position gains would minimize my pain. Luckily I did well on MLM and didn’t need the hedge. But, I fell in love with this little company and it has been a rocky relationship. The stock has dropped steadily and now resides at about $3.50, down considerably from where I entered the position. I’ve averaged down some, but those purchases are also underwater.

I think this company is too cheap. I don’t think it is a world class outfit and it doesn’t have a pristine balance sheet. Earnings have ben erratic and a significant portion of its business is tied to residential construction. It won’t dramatically improve margins and growth next quarter, or the one after. But it has been hammered worse than homebuilders!
So why do I like this little company and stay with a losing position? I ask myself the same question every day it retreats. It’s time to put the reasons to paper again and see if they still are valid.

First, I recognize that they are consolidators and as such have lots of goodwill on the balance sheet and around half of their capitalization is long term debt. So far I think they have done okay with their purchases. The last two have been bought for 1Xs and that isn’t astronomical. In the process they’ve bought market leading positions in the Bay Area of Ca, Sacramento, Detroit, West Texas, Dallas, and New Jersey.If add-on acquisitions are worth 1 X sales, then market leading positions have much more value.

They will make $.35 for 2007 and analysts say $.41 next year. So they make money, but not tons. They do throw off decent cashflow. Free cashflow after capital expenditures and debt service will be $20MM per the CFO. That means that as the debt has been serviced, the $140MM market cap earned $20MM and all the equipment was maintained. That 14% return looks good to me. They can control their cap-ex since they don’t need to replace as many trucks if they aren’t delivering as much concrete, so sell more and buy more mixers or sell less and you don’t wear out the fleet.

As I said, RMIX has bought two companies recently at one times sales. You can buy US Concrete today for about 1/2 sales. You won’t be able to, but the market has priced the stock that way. Take the value up to the $850MM sales volume and you need a stock price of near $10. An acquirer would get market leading positions in 6 markets, an up-to-date plant and equipment, and be able to get a market cap boost of their own stock since VMC, MLM, CX, CRH all are valued at much higher than 1 X sales. I like $10 much better than $3.50!
Finally, the CFO recently bought 15,000 shares with his own money and I’ve listened to him on presentations and he seems very competent.

Since the company is connected to homebuilding, it could continue to decline along with housing headline risk, but there isn’t a whole lot of downside left and if I have concluded correctly there is much more upside. I plan to continue to add to my position.

Friday, November 30, 2007

Another overdone resource play?

Charles Dickens, in his A Tale of Two Cities, didn’t know he was describing the stock market when he wrote: “it was the best of times, it was the worst of times.” But he was prescient in his unknown description of investor behavior. We are operating in a market that has no memory! We have returned to a goldilocks economy aided by upcoming Fed rate cuts. Soon we’ll change our minds and concentrate on why the Fed is cutting rates and credit issues.

I mused a couple of days ago that Deere, while an excellent company, looked like it may have gotten way ahead of itself in the latest batch of euphoria. Deere splits its stock on December 3rd and in our present elated state, the stock may run upward in a 1990’s type behavior even though the split doesn’t change any economic value. Besides I found a better candidate to cheer against.

AGCO has run faster than Deere in the last three months. While De is up 30% and CNH Global [Case] is up 25%, AG has climbed 60% in three months and all three were behaving alike on prior charts. It will probably move with DE upward when DE splits. Over the next 6 months I think it is vulnerable.

AG, while not as solid as Deere, is a good company. But selling to farmers hasn’t been terribly steady or lucrative in past history. The good times have been few. Has ethanol in the US and Brazil and a growing middle class worldwide changed agriculture for good? I don’t think so. Would you pay 21X forward earnings, DE trades at 14X, and 14X cashflow for a farm machinery manufacturer? Evidently momentum investors will chase AG as long as it is moving upward. Other ag manufacturers like Valmont haven’t surged in the past three month. At some point AG will come back toward the other stocks.

My thought process is the same as with MLM. A good company in a solid industry that has moved further than it should have. MLM hit $170 and visited $118 within 3 months. It ought to be valued around $100 and it will get there before long. I exited at $120 and the Dickens Christmas gift has pushed it up to near $130, so I’ll start that process over again. AGCO is a very similar situation. The company isn’t going broke, it is just going to go down . I can’t ever pick when and the carrying costs can become expensive, but agricultural earnings won’t grow at 20% forever and forecasts won’t always be rosy. When the momentum buyers become dissatisfied they leave in a hurry and hopefully I will have made a few dollars to make up for poker, golf, a new remote control boat cover/lift.

Wednesday, November 28, 2007

Blast off, then Back off

When I last wrote, November 21st, my last paragraph forecasted a rally possibly led by large foreign M & A activity before mid December. The Dubai investments in Citicorp and Sony has provided new hope to stock investors and we’re off to the races. I haven’t followed the Sony deal other than hearing that it is a minority stake, as is Citi’s. The Citi deal is being cheered and the common has rallied even though the Dubai deal is a preferred that pays 11%. If Citi craters in the next two years they have a preferential position and are being paid 11% in the interim. Our Arab brothers aren’t stupid. Given the terms, Citi was either in extremely bad shape or their managers were stupid.

Look upon this rally as an opportunity to re-balance your assets. The economy is getting worse, internationally as well, and credit markets haven’t reflected all the sins of the last 5 years. As I wrote in my missive about derivatives, they are terribly complex and the impact hasn’t been felt yet as we haven’t had counterparty defaults and the havoc that will ensue.

The follow through on this burst of enthusiasm may be strong and last for several weeks. The larger the move the more I will like it. But any move upward can’t be sustained. The economies of the world need a pause and they will take one. It may not last long with central banks pouring money into the fray, but the markets will anticipate, or follow, the economies downward and I intend to increase my negative bets.

Besides betting against bank ETFs and the construction materials, Deere, an admittedly good company, as is Martin Marietta Materials, is worthy of a close look over the next several days. It closed at an all time high today and now sells at a very high multiple of cashflow and other benchmarks. Can ethanol keep this rocket going? I’m starting to wonder as I remember the mid-to-late 1980s and the decline that Deere endured. I need to look closer, but I’m intrigued.
Crusty is generally a “long investor”, but as any reader can discern, I’ve become much more cynical and grown comfortable on the “dark side.”

By the way, crusty has lost at both poker and golf in the last two days so read my meanderings at your own peril.

Wednesday, November 21, 2007

Small caps are having a tough time

Sentiment seems to have changed from the seesaw pattern of the last 90 days to almost complete pessimism. The Russell is down over 6% YTD and short selling seems to be accelerating. Investors are selling their small caps and moving into large cap multi-nationals [ Pepsi, P & G, J & J, etc. ]. Until we get another sentiment shift, the smaller companies are not the place to be. If you want to see the short selling acceleration, go to the NASDAQ site and find the monthly short positions on any small cap you own. There won’t be many that haven’t been heavily sold.

As I’ve mentioned before, I have moved a significant amount of my capital to shorter term bonds and puts, with the remainder in large multi-nationals with the exception of the US Concrete, which started as a hedge, and Jones Lang LaSalle. Luckily for me the market sunk fast before I could accumulate much JLL. I’m currently waiting for a lower entry point, but still like the company.

The short interest in RMIX has actually decreased quite a bit! That along with the recent CFO stock purchase may indicate that this company’s price slide is near an end.

I’m staying with both of these small companies.

I’ve thought that we’d get an early December rally before the tax selling begins mid month. What could be the catalyst amidst all of the current pessimism? My guess is announcements of a couple of M & A deals of American companies and dollar flush foreign acquirers. That is apt to be followed by tough talk by Secretary Paulsen on a stronger dollar. Both activities could foster a large rally before recession thoughts re-emerge. So, I think the market will give investors another chance to reduce positions at higher prices, or short or buy puts for the New Year.

Wednesday, November 14, 2007

RMIX CFO buys 15,000 shares

I got interested in betting against MLM when I noticed the CEO selling shares. He not only sold, but exercised relatively new options that still had several years till expiration. It’s very rare to see someone sell before an option expires as the hope is always that the company will have several more years of quality earnings and increases in share price. Plus the investment continues to compound tax free. In the MLM CEO case he accelerated the payment of tax by exercising and selling. The only conclusion I could draw was that he thought the stock price had gotten way ahead of itself and there was no need to wait for expiration and run the risk of the share price decreasing with a slowing economy.

The opposite happened yesterday. The CFO of US Concrete bought 15,000 shares using his own money. The size of the buy was significant and no one should know the company’s financial situation better than the numbers guy. When CPAs buy, pay attention.

In week or so since I bought some shares as a quasi-hedge on my MLM puts, RMIX is down about 20% to $4!! Luckily for me MLM also fell and I closed them out at the $120 level for a 70% gain since they were put on in April. The RMIX losses reduced that gain, but the combined plan worked fine. I still think the trend is down for MLM based upon valuation and I’ll buy puts again soon.

I didn’t close out my RMIX position when I closed the MLM puts so I’m now long US Concrete and will add to that position after the recent decline and the CFO’s confidence.

Friday, November 9, 2007

Commercial Real Estate’s Best Operator

I sold this company several months ago at it’s peak, around $125, not because I was worried about its performance or high valuation, but just to raise cash and reduce my equities position. Since that time I’ve watched it trend down to the $85 range even as it reported record earnings and doubled it’s semi-annual dividend. The worry is evidently its involvement in real estate. Specifically, that commercial real estate will be the next shoe to fall in the credit crisis.
Commercial could be next. Values have risen and buildings were subject to some of the same shoddy lending and securitization as home mortgages. Big commercial and investment banks have been active in this segment of the CDO market and there isn’t much reason to expect that they maintained discipline here when they sure couldn’t on the consumer side.
So, while JLL operates in this marketplace, it doesn’t lend, securitize, insure, or own real estate for it’s own account. It operates as a service company for owners of, and investors in, commercial real estate. It helps in the sale, acquisition, management, and investment in commercial properties worldwide. It’s business is nicely spread between those segments and also nicely represented in all areas of the globe. It’s foreign earnings benefit from the stronger foreign currencies and increase eps. Like an investment bank, JLL is a people talent business. It’s main assets ride up and down on the elevator daily and are the true value of the company.
JLL earns a superior ROE, has virtually no leverage, and sells for a modest multiple of cashflow for a growth company. If commercial craters next, many companies will come to JLL to find a solution for their problem.
It’s share price may continue downward if the market swoons. But if the market stages a late year rally, it will rise quickly and significantly. I’ve gotten back in this name as I think that even in down markets there will be winners and i believe JLL is likely to be one.

Tuesday, November 6, 2007

The Media never gets it

I’ve been on the road for the past four days heading to Mount Dora. Along our route, we take a different route to and from Omaha each Fall and Spring, we visited several wonderful small, historic communities. Hermann and Ste. Genevieve in Missouri were great river towns with structures dating from the 1830s.We found Mobile, Alabama to have a downtown that was a vibrant, smaller version of Savannah. Apalachicola and Cedar key in Florida were once the biggest ports in the state and Civil War era economic powers. Both are now reborn with artists and interesting restaurants.
Each evening I’d catch some news and start giggling to myself as the current news was usually the opposite of the prior day’s concern. One day we were going to hell in a handbasket because Citicorp was rumored to need a larger loan write-off, the next was filled with euphoria as the employment report showed more jobs were created than had been expected. Recession one day, continued global expansion the next. A rate cut is good for stocks one day and indicative of a slowing economy the next. What is one to believe? The talking heads and cub reporters won’t help you understand because they don’t understand.
Crusty says we’re going to have a recession and a fairly severe one.The seeds have already been sown and the Fed’s rate cuts aren’t going to be the panacea, by the way we also drove through Panacea, FL on the way down. Cheap money in the U.S. and around the world encouraged easy credit and speculative behavior. Credit fueled the economy. But it wasn’t productive credit and it’s asset pricing was based upon the greater fool theory.
The air needs to come out of this credit induced asset bubble and it is in process now. Everyone has read of the subprime mortgage debacle. But easy credit didn’t stop with mortgages for the uncreditworthy, it flowed to home equity lines on over-inflated homes, condo developers whose market was mostly flippers, credit card companies that have continued to finance consumers now that they can’t refinance their homes, land developers and home builders, private equity to take companies private at ridiculous valuations, and finally the funding of the huge leverage of the hedge funds that has been used to create another bubble in commodities. The commodities run up began as an emerging markets growth story, but it evolved into a place to park cheap money.
How can an economy not suffer when it’s banks are no longer interested in lending, it’s consumers feel poorer as the value of their real estate decreases and real inflation makes day-to-day living more difficult? Gasoline will soon follow oil up and the transition to $4 gas won’t be as “easy” as our acceptance of the move to $3. The prospect of the Democrats winning in November and raising taxes will encourage selling of stocks as investors capture today’s lower capital gains taxes.
The economy’s direction is down, but that doesn’t mean that stocks will immediately decline. It is likely that there is another move upward before yearend. After the new year starts I think the direction is down and for quite awhile.If you are young I wouldn’t do anything as 2-3 years from now the market will have recovered. If you’re crusty like me, take some money off the table. You maybe save yourself some heartburn if the rest of your portfolio declines and you will save yourself some tax by selling at the pre-Hillary capital gains level.
Crusty has moved about half of his portfolio out of equities and into short term treasuries and short-like positions. The remainder is in large cap, multinationals and international stocks. As the yearend nears, and I worry less about an irrational rally, I may increase my bets against the market.
Conservative stock pickers like to say that they wait for a “fat pitch”, well, I think the economy is setting up to be a fat pitch on the downside.
Time to meet my daughter and granddog for dinner.

Wednesday, October 31, 2007

U.S. Concrete [ RMIX ], a hedge

Ouch! When I left yesterday for the golf course, MLM was down $3. When I returned it had completed a $10 swing and finished up the day plus $6+! To make matters worse, I lost $7 on the course.

Happily my puts are still profitable, just less so. I listened to both the VMC and MLM conference calls and still think that residential development won’t recover as fast as they believe and was encouraged that MLM saw a “slowing of commercial construction growth.” Zelnack termed that area as a”big uncertainty.” Vulcan still hadn’t seen any negatives in the non-residential area. I think it’s happening now and it will be noticeable in the current quarter.

So, I’m going to ride this horse a little longer. But, I’m going to hedge my bet somewhat.

I’ve been buying some U.S. Concrete [ RMIX ] as a hedge. If MLM runs upward, hopefully US will also and that profit will help offset the drop in value on the MLM puts.

US is a smaller redi-mix concrete company that has additional operations in aggregates, concrete block, and precast concrete pipe. Their big markets are the Bay Area in California, Dallas, Memphis, Detroit, and New Jersey. They have been growing by acquisition and their efforts have been on integrating and acquiring, not wringing out profits. That should come in time.

In the last three or four months the stock has moved down from $9.50 to $5. It sells at a forward P/E of 10X and a PEG ratio of 1.23X. You’re buying it at a Price to sales ratio of .23 and a very conservative price to book ratio of .72. Enterprise value to EBITDA is 6X. They need to start making some more money and generating more cashflow to make me a long term owner, but it suffices as a hedging devise and if they do start improving their earnings they can stay in my portfolio as I like the industry and will buy both VMC and MLM later.

Tuesday, October 30, 2007

MLM’s results better than VMC

Kudos to Steve Zelnak and his team at Martin Marietta Materials. When comparing their performance to rival VMC, Martin clearly came out ahead this quarter. While Vulcan could do no better than flat earnings in the face of the housing downturn, MLM grew earnings significantly. They increased net sales by 4% and earned $2.12 per share. The earnings figure had $.12 of tax benefit included and I’m not sure if the analyst community had that factored into their consensus figure of $2.04. Results could be either a Beat or a Miss depending on if the tax impact was expected, or not. Either way it was one helluva quarter. Better than I was expecting. My guestimate of 10/27/07 overestimated income taxes as the company actually had a tax rate for the quarter of 26%.
The conference call should shed more light on the future, but Zelnak did state that they are seeing a “pause” in some types of commercial construction in addition to the residential carnage. They are still looking for a good finish to the year. no word about 2008 yet.
Today will be interesting as VMC was down $5 in the premarket and both of these companies will be having conference calls. At to that all the Fed interest rate cut chatter and who knows what MLM’s share price will be by market close. The good news for my Puts is that while MLM had a good quarter, they didn’t say that shipments were increasing and the construction slowdown was over. I still don’t think they can hit the 2008 projections that analysts are counting on so I’m content to wait.

Monday, October 29, 2007

Vulcan falls far short of expectations

I’ve been waiting for Vulcan [ VMC ] to report earnings as they are MLM’s most direct, national competitor. The numbers are out and they, like TXI, EXP, and RMIX, were not good. Their performance, similar to what I expect of MLM, continued to be among the best of the construction suppliers, but not what wall street was expecting and worthy of a healthy P/E ratio.
Revenue was down 3% to $905M. Analysts had been expecting $952M, Residential construction continued to be a drag and commercial and infrastructure couldn’t take up the slack as all major product lines had lower shipments. The bright spot was gross profit as margin was up to 33% from 32%. The result of the lower volumes was flat net income of $1.38 per share vs $1.39. Analysts had been expecting $1.59. The strong pricing/growth story is coming to an end for the next several quarters and with it a lower earnings multiple.
MLM reports before the market opens tomorrow.Given Vulcan’s performance, matching what analysts expect will be an accomplishment.

Buffett’s view on derivatives

Yesterday I wrote a missive about the current credit crisis and why I was confident that it would end badly using the Penn Square/Continental Illinois bank failures as a history lesson. The derivatives, CDOs, and Asset Backed Commercial Paper Programs are so complicated and illiquid that determining price has been a problem. Beyond what is the proper balance sheet treatment, the imperative question is can I sell the security at anywhere near par?
Warren Buffett’s experience with General Re’s derivatives portfolio gives us a clue to the magnitude and difficulty of the problem. Keep in mind that those derivatives were an early vintage portfolio, Berkshire’s General Re had the luxury of time that capital provides, and the Oracle of Omaha was assisting in the winding down. Many of today’s financial institutions won’t be as fortunate as Buffett.
From page 14 of Berkshire’s 2006 Annual Report: “You will be happy to hear—and I’m even happier—that this will be my last discussion of the losses at General Re’s derivative operation. When we started to wind this business down early in 2002, we had 23,218 contracts outstanding. Now we have 197. Our cumulative pre-tax loss from this operation totals $409 million, but only $5 million occurred in 2006. Charlie says that if we had properly classified the $409 million on our 2001 balance sheet, it would have been labeled “Good Until Reached For.”
“Good Until Reached For” is what the world’s financial institutions are struggling with today. Who is going to absorb the losses and what will be the unintended consequences? Right now, the banks don’t know, the regulators don’t know, CNBC and the media doesn’t know so stay far, far away from financials and don’t buy the financials on the dips.

Sunday, October 28, 2007

La Salle Street; home of the former Continental Illinois

As I read the daily articles about the “credit crisis”, my banking experience tells me that this crisis will not end painlessly. Lower rates on Fed Funds, a more accommodating Discount Window, and a Super SIV sound like they will solve the crisis, but they will only delay the inevitable. The inevitable result is the failure of the worst offenders of credit risk disregard. Many of the world’s largest financial institutions played the game. All will be hurt, the most egregious violators will fail. In addition to the shareholders of the failed institutions, we all lose as most financial companies will have lower earnings, credit is curtailed, and the economy slows.
When a credit bubble develops it appears to affect only a certain industry. That is rarely the case as it couldn’t develop if the tried and true standards of controlling risk were adhered to. Subprime real estate lending was at the forefront of our current crisis and initially it appeared to be a minor irritant for the economy. We are now seeing that decisions at the CEO level of commercial banks, investment banks, hedge funds and other investment companies, around the world, fed the spread of loose credit throughout the economy.
Not only have we seen buckets of poorly underwritten subprime mortgages, we’ve seen the home equity market decline, the Alt-A ARMs approach reset disaster, and asset backed commercial paper become unmarketable. With a sputtering economy and no home equity to refinance, credit card portfolios will soon have major delinquencies. Commercial credit looks okay today, but when the music stops there will be problems there also. The first indication of those problems was when the bank’s, all of a sudden, woke up and decided they had been too easy on LBO credit and couldn’t find participants for their commitments.
The headlines always bring me back to the 1980’s and a booming oil patch. A small Oklahoma City bank, Penn Square, failed due to loose lending. It’s problems appeared contained to Oklahoma. They wasn’t. Penn Square originated loans, other bank’s letters of credit guaranteed the loans, Continental Illinois and other big banks purchased the loans and resold participations to smaller banks and insurers.Everyone was happy. Growth was robust, yields were high, and why worry, the nation’s 7th largest bank was involved.
Penn Square failed. Bank’s issuing the guarantees failed. Continental thought the problem was contained to their oil patch lending division until they started looking closer at all of their lending. They had relaxed their risk controls throughout the bank and the result was problems across all lending platforms. Is this starting to sound familiar?
People thought that CINB was too big to fail. The Fed loosened it’s discount window rules and kept the liquidity flowing. The problem was too large. The FDIC closed the bank and reopened it as Receiver. Chicago lost it’s biggest bank, shareholders were creamed, bank regulators were embarrassed, and prudent lending rules, though old fashioned, were proven to be of value.
But we easily forget, and a new generation of whiz kids create new products [ derivatives CDO’s & conduits ] that disregard the risk inherent in them. Citicorp, Merrill, Barclays or some other large financial institution will fail. The ones that feasted the most will disappear, all will develop a renewed appreciation for calculating the risk inherent in loan repayment.
As the banks start to slow their lending, coupled with very expensive oil, the economies of the developed world will cool. Earnings will come down and so will stock prices. It won’t be the end of the world, but investors will need to be good stock pickers and it will help overall portfolio results if one has a moved a decent amount of net worth into short term bonds. A 4% T-Bill won’t look bad compared to falling equities.
Steer clear of financial stocks, raise some cash, and be aware that times will become more difficult over the next 24 months.

Saturday, October 27, 2007

Martin Marietta Aggregates [ MLM ] remains overvalued

Long term I like this industry and this company. They have become much more efficient through the use of automation, accessed new markets through the use of rail and panamax vessels, and recognized that while rock is everywhere a new quarry or mine is very difficult to permit. No one wants to have blasting or rock trucks creating dust clouds near residential areas. So, if you already have the locations you have a valuable asset.
Company management has been very adept at telling Wall Street this story and backing up their thesis with significant, regular price increases that far exceeded covering any rising costs. The result has been dramatically increased net earnings and an expanding P/E ratio.
Generally I’m a buyer of stocks and tend to hold for long periods. In this instance I can’t buy the stock because it is significantly overvalued. Once again, MLM is an excellent company and one that I would gladly own, but at a lower entry price and I think I will see that more rational opportunity.
Why do I believe that MLM is/was priced too richly? Management has oversold the rock scarcity story and analysts have an average eps for 2008 of $7.76. Actual earnings for 2006 were $5.19 and the 2007 estimate is still $6.41.
The 2008 estimate is a 21% growth over ’07 and 52% over the ’06 results. I don’t think the last six months of 2007 will be good enough to earn $6.41 and the ’08 number is going to have to come way down. The economy isn’t cooperating and MLM needs a true “goldilocks” economy to come close to growing earnings by 20% again.
MLM’s business has three major components: residential, non-residential, and infrastructure. The fact that residential development has tanked is no secret. So far, in ’06 and interim ’07, the other two categories, plus price increases have allowed earnings to continue to grow in spite of the disaster in residential. On the last conference call the company noted that non-residential was flat, no longer growing and highway projects were being delayed. The CEO stayed by guidance and promised continued margin expansion. Zelnack, the CEO, sits on Beazer Homes board of directors so he isn’t unaware of the terrible housing situation. He remains confident.
However, on numerous occasions during the past 6 months, both he and SVP Sipling have sold large blocks of stock. While that isn’t normally a red flag, in these cases I believe it is. On multiple occasions, they exercised options that had 5-7 years of life left and elected to exercise, sell, and pay tax on millions early. You don’t see that very often, even near retirement. Buffett would advise that you should compound your money and delay paying your taxes till the last minute. Why sell millions of dollars worth of your stock early if you didn’t think the best of times were behind you. Not necessarily operating best of times, but irrational stock pricing best of times.
For years, this company has been run conservatively. With their recent pricing power they have garnered operating margins of 18% and a ROE of 24%. They’ve spent their cashflow to modernize and expand their facilities.
While not outright wild, the balance sheet has been leveraged up this year and debt now stands at $1.2B for a debt/equity ratio of 1.3:1. The proceeds of $500M borrowing during the last two quarters was used to retire stock. The company bought back over 3M shares for an average cost of $138 per share. So far, the current price is near $124, not a good use of cash other than juicing the eps number since less shares are outstanding. Interest expense will be rising also in the third quarter after the debt issuance.
In the past few days both TXI and EXP have reported their quarterly numbers. While the former is a major cement manufacturer and the latter is a wallboard leader, they both have divisions that sell aggregates and concrete so they are comparable to MLM. Volumes were down and pricing wasn’t robust like in prior quarters. They both have some operations in Texas, a big MLM market. Additionally RMIX, a concrete and aggregates operator, just pre-announced that they would miss analysts estimates and they too have a large Texas presence.
EXP reported that revenue for concrete and aggregates was down 11%! Operating profit was down 18% in that division. Concrete shipments were down 11% and aggregates shipments declined 20%! Rock pricing was up only 1% over third quarter ’06! while concrete managed to maintain 5% higher prices. The 18% operating profit decline is the troubling number.
TXI fared modestly better in aggregates and concrete. Aggregates revenue was down to 40 M from 43M in ’06. Concrete sales were 80M vs. 73M last year. Combined the division grew sales by 3%. TXI didn’t breakout operating profits so we can’t tell if costs grew by more or less than 3%.
Three somewhat similar companies and the results are not measurably better than the same quarter in 2006. Granted, these companies are not exactly comparable, but they do demonstrate that the residential decline is impacting the companies more than the non-residential and government work can compensate for. MLM is priced at a high P/E multiple and a huge Enterprise Value/EBITDA and that cannot continue if earnings aren’t growing at a robust clip.
VMC reports after the market closes on Monday and MLM announces before the open on Tuesday. Neither has pre-announced any shortfall for the third quarter. Whether they miss or hit expectations, the real important information will be available on the conference call. Future expectations and construction market conditions will be key to how well the share price behaves.
MLM could meet the analysts expectations of $2.04 for the quarter. Using TXI’s 3% sales growth produces Revenue of 622M.If they can maintain their 2nd quarter 29% gross profit they will have $180M to offset $39M in SGA, $18M interest, and $9M in inventory re-evaluation they won’t have this quarter. The company has announced that they will have a 2% lower tax accrual, 29%, so they could have net income of $85M. After the buybacks there are approximately 42M shares outstanding. The above scenario produces $2.02 eps vs. the Wall Street consensus of $2.04. But given the difficulty of RMIX, EXP, and TXI odds of a miss is significant.
While I think they may miss, I think they will likely guide lower or hedge somewhat which will cause concern. Current ’08 estimates are for a 21% increase in eps.You can’t be awarded with 20+ P/E if you aren’t growing earnings at a good clip, no matter how low bond rates are. There is virtually no residential development starting and significantly reduced housing starts so residential volumes are continuing to decline. Tighter credit standards are bleeding over into commercial construction and that will become noticeable as 2008 progresses. The public sector is still building, but even government bodies are showing “some” restraint in face of falling property values. Volumes will decline again in 2008 and I don’t think, after 2 years of out-sized price increases, that pricing will cover rising costs from here forward. Less business will cause competitors to become price sensitive to cover ongoing expenses and still make good money, although not as good as a public company will need to keep a high share price.
How have I played this investment? Not knowing when my thesis would prove correct, I purchased Jan’09 140 Puts. At MLM’s current $125 price I’m doing fine as I’ve been gaining “in the money” value faster than I’ve been losing “time value.” Obviously this can change quickly if results are as expected and the conference call is positive. The Fed could produce a big pop for MLM as well on Wednesday. The LEAP puts give me the luxury of time to continue to monitor the situation.
Now here’s something interesting. Within the past 6 months Goldman Sachs, an Egyptian billionaire, John Skully’s SPO, and, worst of all, highly respected, Ruane Cuniff have all taken very large, reportable positions in MLM. I’m confident, I’m crusty, and I’m keeping my position until I see something that changes my mind. But I wish it were 28 year old Harvard MBAs that had taken those big positions.
Come back for my interpretation of the VMC and MLM results.
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