Monthly Archives: July 2012

dividend-paying stocks in the US (I)

July 17, 2012 By in Current Market Thoughts, Dividends, Stock ideas Tags: , , , , , , , , Leave a comment

then…

I remember a brokerage house strategist(from Lehman?) making a sales call in 1984 on the money management firm I was working for.  The main point of his presentation was his belief that there was tremendous predictive value in the level of the dividend yield on the S&P 500 index.  According to the strategist, the dividend yield on the S&P rarely fell below 3%.  It never stayed that low.  Therefore, the dividend yield on the index falling below 3% was the strongest possible sell signal that stocks could give.

As it so happened, the yield had just dipped below the fateful 3% line.  So the strategist’s strongly held conviction was that clients should reduce exposure to the stock market, and should rotate any holdings that remained into a very defensive posture.

Three years later, the index had doubled–and the strategist was out of a job.

Where did he go wrong?

Admittedly, hindsight makes it easier to see, but he missed just about all the important economic influences in play during the period.    Specifically:

–the decade of the 1980s saw great structural economic change in the US, including the emergence of women in the workforce, the widespread move of families to the suburbs, the rise of specialty retailing as competition for department stores, and the change from the mainframe to the PC.  Companies were also expanding rapidly abroad.

The result of all this was that most firms were reinvesting all their cash flow into growing their businesses.  They didn’t want to raise dividends.  In some cases, it would have been a condition of getting new bank loans that they not do so.

–the emergence of discount brokers, along with the move to self-directed 401ks and IRAs, made equity investing accessible to young Baby Boomers who were much more interested in making capital gains than earning income.  We didn’t want income.

–interest rates were in the early days of a quarter-century decline.  This secular movement made capital gains easier to achieve, and current income worth less. (Of course, during the accelerating inflation period of the late 1970s, investors of all stripes actively shunned dividend stocks.)

…and now

Other than for a short period in early 2009, when the dividend yield on the S&P reached 4%–and, by the way, gave a strong “buy” signal in doing so–the yield on the index hasn’t spent any significant time above 3% since 1984.

The dividend yield on the S&P is currently about 2.1%.

Economic conditions also changed substantially since that day in 1984.  In particular,

–the dramatic positive effect on the US of the entrance of women into the labor force has passed, as have the boosts caused by changes in retail and the development of the suburbs.  As a result the trend growth rate of the economy has slowed (from 3%+ to maybe 2.5%); consequently, reinvestment demand for corporate cash has waned.

–many of the iconic firms of the Eighties and Nineties have matured (MSFT is the poster child for this phenomenon) and are generating tons of excess cash.

–the Baby Boom is starting to retire and is less interested in investing for capital gains than to receive steady income.

–at the moment, short-term interest rates are at the emergency low rate of essentially zero vs. what the Fed thinks should normally be around 4.5%.  This is to help the economy heal itself of the wounds caused by twelve years of policy blunders in Washington, widespread regulatory failure and fraud perpetrated by major domestic financial companies.  So income investors can’t achieve their goals by buying government bonds or money market funds.

dividend stocks as underperformers

Stocks whose attraction is solely, or mostly, their ability to pay steady or rising dividends to shareholders have been chronic market underperformers throughout the thirty + years I’ve been involved in the stock market.

But changes in investor preferences, combined with the lack of higher-yielding fixed income alternatives and the increasing propensity of publicly traded companies to pay dividends, have caused a mini-renaissance in dividend stocks over the past couple of years.  Yes, dividend stocks have still been underperformers during the market bounceback that began in March 2009.  But not so much recently.  And, as they usually are, dividend stocks had been substantial outperformers during the market decline of 2007-2008.  So the fact that they lagged in the early part of the current cycle is understandable.

where we are today

According to the most recent Factset Dividend Quarterly:

–400 of the S&P 500 constituents are now paying dividends, the highest percentage since before the Internet bubble burst

–growth in dividend payments is outpacing growth in S&P 500 earnings

–the S&P payout ratio (the percentage of after-tax earnings devoted to dividends) remains at 28.0%, about 10% below what has been typical over the past ten years

–the valuation of dividend-paying stocks vs. their non-dividend counterparts appears to be stretched.

The raw data on this last point are stunning.  According to Factset, the PE of dividend-paying stocks is now 244 basis points lower than the PE of non-dividend stocks.  If we take monthly readings of this statistic over the past twenty years, the median discount is 1304 basis points.  So it would appear on the surface that the multiple on dividend stocks has expanded by over a thousand basis points vs. non-dividend stocks.  …uh oh.   …run?!?

That number is misleading, though.  In rough terms, the 1160 point spread would probably be cut in half if we factor out the crazy valuations applied to so-called TMT (tech, media, telecom–mostly non-dividend) stocks during the Internet bubble.  We might clip off another 100 bp or so if we adjusted for the fact that many companies have changed stripes away from non-dividend to dividend payer over the period we are considering.

Even so, there has been a substantial upward readjustment of the relative valuation of dividend-paying stocks in the US market over the past couple of years.

Is there anything left to go for?  or is the dividend stock phenomenon all played out?

That’s my topic for tomorrow.

the dividend yield on European stocks? … 5.5%!!!

July 16, 2012 By in Current Market Thoughts, Portfolio management, Stock ideas Tags: , , , , , , , , , , , Leave a comment

the MSCI Europe index yields 5.5%

That’s according to the analytic services company Factset, in a news release about a week ago.  Yes, the data are from the end of April, so they’re a bit dated and may be off slightly.  But, still…

Why so high?

1.  investor preferences

Historically, investors in European equities are much more income oriented than those in, say, US or Asian shares.  In fact, “growthier” European companies, which tend to plow back the cash from operations into expanding their businesses–rather than paying it out in dividends–may try to go public in venues like New York or Hong Kong instead of on their home ground.  Doing so gets them a more sympathetic/compatible audience, and therefore a higher price earnings multiple (meaning a lower cost of equity capital).

As a result, the European bourses are top-heavy with bank and telecom shares.  The former yield around 12%, the latter about 8%.

2.  the ongoing financial crisis has beaten down European stock markets…

…which have declined sharply over the past year.

Consider what current dividend yields in the EU are saying today:

–Two-year government bond yields in Germany and the Netherlands are currently slightly negative.  In both cases, you have to pay €1001 today in order to get €1000 back in July 2014.  Buying a telecom stock instead gets an investor an income pickup of over 8%–an extraordinarily high amount.

–Over the past ten years, the yield on the MSCI Europe index has averaged 4%  It has only been higher than today on one occasion–a brief period in early 2009, when panic selling of equities pushed the yield to 6.5%.

–The dividend yield on MSCI Europe is typically higher than that on the S&P 500.  The current 3.5% spread is, however, the widest gap seen in the past decade.

what does this mean?

On the most basic level, the numbers say to me that European equity investor confidence is completely shattered.  At the nadir for world stock markets in early 2009, German two-year bonds were yielding 1.5%.  The MSCI Europe was yielding 6.5%.  So the spread between the two was 5.0% then.

Today, the spread is 5.5%+.

Buying the MSCI Europe index, which would return 11% over two years, assuming no change in either stock prices or dividend payments.  Investors are choosing instead the safety of a German bond that they are assured of losing money on.

Put a little differently, the expectation built into today’s stock prices is that they will lose more than 11% over the next two years, wiping out the entire yield pickup–and more.  This would presumably come through some combination of dividend cuts and price declines.

Shades of Japan in the 1990s!

what to do

This view strikes me as excessively pessimistic.

Nevertheless, this doesn’t mean Europe is a screaming buy. The experience of Japan since 1990 may also be applicable here.

To my mind, there are several lessons that may be appropriate:

–although extremes of fear can’t be sustained, at least mildly negative views about equities can persist for a surprisingly long period, especially when the domestic investor base is relatively old and therefore particularly risk averse

–negative sentiment affects the prices of all stocks in a given market to some degree, not just the basket cases

–companies whose main virtue is their high current yield are probably not going to be the big relative winners.  In my view, and also the way I read developments in the Japanese market over the past twenty years, the real winners are well-managed companies which are growing quickly and whose profits come mainly from non-domestic (meaning, in the case of Europe, non-EU) sources.  Better if they pay a current dividend, but the rate of earnings growth is more important.

Feeling for a bottom in Europe is not a task for the faint of heart.  Nor is it anything one should do with more than a small fraction of his portfolio.  Still, it seems to me that we’re at, or near, a degree of negative sentiment that’s excessive and can’t be sustained for long.

INTC and ASML (III): the structure of the agreement

July 13, 2012 By in Industry Analysis, semiconductor manufacturing, Stock ideas, Technology Tags: , , , , , , Leave a comment

six months in the making

ASML says it began negotiations six months ago with its largest customers about  their contributing to R&D and making commitments to purchase next-generation machines.  As far as I’m aware, no one has yet said who initiated the talks.  It wouldn’t surprise me if INTC got the ball rolling.  The salient points would be that:

–INTC needs next-generation equipment in four years, not six;

–it would contribute a significant amount of money to the required R&D effort; and

–it was going to partner with someone, but would prefer that the partner be ASML.

Because every supplier studies his customers extremely carefully, it’s equally possible that ASML anticipated INTC and made the first move, giving the same rationale.

the major provisions of the agreement

1.  A group of customers will provide up to $1.7 billion in R&D money to ASML.  The funds will be spent on next-generation lithography and on migration from machines that use 12″ silicon wafers to 18″.  Part of the money will be treated as an advance on purchase of next-generation equipment and will be returned through a lower price on machines bought.  Part won’t.  We don’t know the proportions.

By doing this, ASML reduces the amount it will have to put up itself of the several billion dollars it will cost to develop the new equipment.  At the same time, it locks in customers for its next-generation equipment.  ASML scientists will doubtless get excellent access to its partners’ R&D staffs, as well.

INTC, which has agreed to put up 60% of this money, estimates it will get next-generation machines two years earlier than it would otherwise.

ASML is still talking with TSMC and Samsung–and possibly with others.  In my view, it’s not a sure thing, however, that any others see the same pressing need INTC does.

2.  ASML intends to sell up to a 25% ownership interest in itself to the R&D partners, at a fixed price of €39.91 per share.  The share purchase will presumably be proportionate to the R&D commitment.

INTC has agreed to buy 60% of this stock, or about $3 billion worth.

The stock that customers purchase will be restricted by being placed in a special trust.  Under normal circumstances, the stock will have no voting rights and will not be transferable to another party.  So the customers will truly be passive investors.

We’ll know more clearly why the equity sale is necessary when the trust documents are available.

My take is that this is a provision insisted on by INTC, not ASML.   I see it as protection against the possibility that current management might lose control of the company, either to an activist investor group or to a bid from a semiconductor equipment conglomerate.  The worry would be that the R&D partners might lose access to the fruits of next-generation research, or that a new owner might slow down the pace of progress or shut down the next-generation project altogether.

3.  ASML won’t keep the money it gets from the stock sale.  It will distribute it instead to shareholders (ex the customers).

Why?

ASML’s market cap would be about $25 billion after the share sale, if it did nothing–and if the stock continued to trade at yesterday’s price.  The company would have net working capital, after repayment of all debt, of around $8 billion.  Most of that would be cash.  I think the temptation to a prospective acquirer of a large acquisition-funding cash pile would be too great to pass up.  And ASML doesn’t need the money.

4. ASML will conduct a “synthetic buyback” of shares from existing shareholders in the same amount it sells to customers.

Here’s where things get a little weird.  But ASML has done this before, in 2007.

I think I understand what’s going on, but don’t count on it.

With shareholder approval, ASML will

–use accounting legerdemain to transform the proposed payment to shareholders into a return of capital, meaning (I think–but don’t bet the farm on my read) it won’t be subject to tax

–make the distribution

–proportionately reduce each shareowner’s holding (ex the customers) through a reverse split, so that the number of outstanding shares will be the same as before the sale to customers.

The result of all this will be to transfer ownership of up to 25% of the company away from existing shareholders to the customer group, without triggering any tax effect.  So existing shareholders will be able to lighten up, near the peak of this semiconductor equipment cycle, and at a price about 4x the low of late 2008–all without having to pay tax.  Who’s going to complain about that?

what to watch for

I think this is a really good deal for both INTC and ASML.  I’ll be interested to see if TSMC or Samsung sign up as well.

They might not.  They could do nothing.  Or they could cut a similar deal with another lithography company.  Yes, the others would be Japanese, who are notoriously difficult to deal with and who are part of a legal and cultural environment that is not friendly to foreigners.  But the Netherlands is no walk in the park for an outsider, either.

How the others act will give us a good read on how much of a lead, if any, ASML has in EUV or 18″.

For what it’s worth, I think ASML is a great company, but I haven’t owned it for years and have no intention of buying it now.  I do continue to own INTC, though.

 

 

INTC and ASML (II)

July 12, 2012 By in Industry Analysis, semiconductor manufacturing, Stock ideas, Technology, Wireless Tags: , , , , , , , , Leave a comment

recap

INTC has agreed to pay $3 billion to acquire a 15% ownership interest in ASML.  In addition, it is pledging to make a $1 billion contribution to ASML’s R&D efforts to develop next-generation semiconductor lithography tools.

Yesterday, I wrote about the deal in general and about what ASML gets from it.  Tomorrow, I’ll write about the specifics of the arrangement, as far as they’re known.  Today’s topic is why INTC is interested.

a little history:  evolutionary threats to INTC

A semiconductor factory costs, say, $3 billion to build and outfit.  It will spew out maybe $8 billion worth of annual output.

Who has that kind of money to spend?   …INTC and Samsung, and basically no one else.

More important, who has a high enough level of sales to use the plant effectively, once it’s up?    …the same two, INTC and Samsung.

On the surface, this huge capital investment requirement represents a significant barrier to entry into the semiconductor-making business.

It did once.  No longer, however.

The industry evolved.

Specifically:

–foundries like TSMC have started up.  They own semiconductor plants but don’t manufacture products they design.  They specialize in making chips under contract from third-parties.  The fact the foundries aren’t direct competitors makes semiconductor design firms much more willing to trust their intellectual property to them.

–an intellectual property company, ARMH, began to develop and sell standardized chip designs to others, plus toolkits to customize them.

This laid the groundwork for lots of little semiconductor design firms to spring up, who create innovative enhancements to the basic ARMH design and have the chips made through foundries.

ARMH-based chips don’t have as much computing power as INTC offerings.  But they’ve smaller and more flexible.  They generate less heat and use less power.  In other words, they’re perfect for use in the smartphone/tablet business they’ve enabled.

Over the years ARMH chips have also been gaining in computing power, to the point where they’re now beginning to be designed into PCs and low-end servers.

the INTC response

Just as ARMH chips have been adding computing power so they can enter traditional INTC markets, INTC has been working to make its chips smaller, cooler and less electric power-hungry.  That way it plans to become a presence in the burgeoning mobile market now dominated by ARMH.

the Cloud is a plus

News on the mobile front isn’t all bad.  The storage and computational limitations of mobile devices means they have to be backed up by very big and very agile servers in the “Cloud.”  Virtually all Cloud servers run on INTC chips.

INTC thinks it has already pulled even with ARMH…

..in terms of small size, low heat and low electricity use for the chips it intends to be used in mobile devices.  It’s done this both through chip design and by very aggressively adopting new semiconductor manufacturing technology.  Most industry observers think INTC has at least a 1-2 year advantage in process techniques over foundries like TSMC.  We’ll be seeing the first INTC-based smartphones and tablets late this year or early next.

where to from here?

This is where the ASML deal comes in.

Let’s assume that INTC presently has a two-year lead in process technology over other chip makers and that it anticipates needing next-generation manufacturing equipment four years from now.  Will that equipment be available?

Maybe not.

If I were ASML and I thought I’d make some sales of next-generation equipment in 2017, but that no one else would be ready to buy until 2019-2020, I’d be in no rush to complete my research and development in the shortest possible time.  I’d go to a lot of extra expense to do that, but I wouldn’t be able to really cash in until a couple of years later.  And of course, I’d have the additional risk that rivals would reverse-engineer my machines and have better ones available when the the big market ultimately developed.

So I don’t think ASML has any natural incentive to speed up its R&D to suit INTC’s schedule.  Therefore, without the ASML deal, INTC risks seeing its semiconductor manufacturing advantage frittered away as it is forced to wait for new machinery to be perfected.  That’s why $4 billion may be a reasonable price for INTC to pay to eliminate this risk.

funding will come from offshore

INTC intends to use cash it has permanently invested outside the US to pay for the ASML deal.  Were that money repatriated to the US, it would be subject to federal income tax of about $1.4 billion.   So finding a potentially high-return use of the funds is in itself another plus.

That’s it for today.  Tomorrow, the deal structure.

INTC and ASML

July 11, 2012 By in Industry Analysis, semiconductor manufacturing, Stock ideas, Technology Tags: , , , Leave a comment

broad outlines of the deal

Yesterday INTC and ASML announced an agreement under which INTC will pay ASML a bit more than $4 billion over the next five years.  The money, which will come entirely from balances INTC has on deposit outside the US, comes in two piles:

–$3 billion+ will go to acquire a 15% ownership interest in ASML, and

–$1 billion+ will be a contribution to ASML’s R&D efforts.  Part of this will be purely a research expense; part will be a prepayment on the future delivery of the tools that research will enable.

ASML’s goal is to raise a total of $6.7 billion through such deals.  It’s now in talks with its other two big customers, TSMC and Samsung.  INTC’s commitment brings ASML 60% of the way to its goal.

three posts

I’m going to write about this deal in three posts.  Today, I’ll look at it from ASML’s perspective and tomorrow from INTC’s.  On Friday, I’ll write about the deal itself in detail, including some of its more eccentric aspects.

Here goes…

from ASML’s perspective

who ASML is

ASML is a Netherlands-based maker of semiconductor production equipment.  Its specialty is lithography machines, devices that place the semiconductor design onto the silicon that will ultimately become the semiconductor chip.

ASML has two traditional rivals, Canon and Nikon.

increasing capital intensity

The increasingly capital-intensive nature of semiconductor manufacturing has several implications for ASML:

–R&D budgets are getting bigger.  ASML will spend at least several billion dollars developing the next generation of machines.

–the machines themselves are getting more expensive.  Top-of-the-line lithography machines can cost $70 million apiece today.  Next generation ones will probably cost $100 million+.

–as a result of the big capital requirements, ASML has only three really important customers.  They are:  INTC, TSMC and Samsung.

today’s inflection point

INTC is currently using lithography machines that can “write” the lines of a chip design onto silicon as close to one another as 22 nanometers.  TSMC is at 28nm.  INTC is planning to be at 14nm next year.  As a general rule, the smaller the line spacing the faster the chip, the less power it uses and the less heat it throws off.  So smaller is (very) good.

The semiconductor equipment industry is starting to work on next-generation lithography machines, using an Extreme Ultra Violet (EUV) process that will allow lines to be drawn within 10nm or less of one another.  The industry expectation is that they will be available in about six or seven years.

At the same time, semiconductor equipment makers are also starting work on the less expensive task of increasing the maximum size of the silicon disks they can handle from the current 12″ to 18″.  That has the potential of doubling the number of chips that one disk will yield, and dropping unit costs by 30%-40%.

Q:  bet the farm or not?    A:  not.

ASML is in a boom or bust business.  It’s currently in boom.  At the end of 2011, the company had net cash of over $3 billion.  The current stock price is 4x its level during the bust days of late 2008, when ASML was losing money.

The company thinks that, in addition to the cash flow it expects to generate, it will need to spend close to another $2 billion to develop EUV and 18″ products.  Should it bet the farm and take on the expense alone–possibly having to do an equity offering to raise funds?   …and without any assurance that customers would buy the new machines?   Or should it try to get the three big semiconductor producers to help fund development and agree in advance to purchase  ASML’s next-generation output, rather than that of a Japanese rival?

It has chosen the more conservative course.  INTC is the first to sign up.

cashing out existing holders

Raising the needed R&D money from customers rather than raising it from existing holders through a rights issue is one thing.  But ASML is going a step farther.  It’s proposing to use a “synthetic buyback” to distribute to existing shareholders the entire $5 billion it gets from issuing new stock, while reducing their equity interest from 100% of the company to 75%.  It’s kind of like a rights issue in reverse.

Presumably, major Netherlands holders have already given their okay (telling you something about what they think of today’s ASML stock quote).

More on this on Friday.