tires vs. chicken feet: the final judgment (almost)

tires vs. chicken feet…

A little less than three years ago, I wrote about a tariff the administration had just placed on imported tires from China.  The duty, the first of its kind, was imposed under special concessions granted to the US for allowing China to enter the World Trade Organization.  The idea was to give extra time for domestic industries that had prospered under protective barriers to adjust to competition–as if the many years of haggling about conditions for China’s WTO membership hadn’t been enough.

What struck me at the time as particularly odd was that no company in the domestic tire industry had asked for the tariffs. In fact, no domestic player wanted to be in the low-end tire business.   The action looked like payback to a union for political support.  Why this sort of payback still isn’t clear to me.

a basic economic error  

There’s, unfortunately, ample history of such tariff moves to show that they’re always economically disastrous.  Any first-year economics student can tell you why.  Yes, jobs in the inefficient industry may be preserved –though maybe not.  But everyone else suffers by the price rises that ensue.  In this case, less affluent Americans who are struggling the most in a weak economy, and who are the main users of low-end tires, are hurt the worst.  Also, WTO rules allow the country hit by tariffs to retaliate in kind, which means lost sales in other industries.

Two years ago, I wrote that, in a matching shoot-yourself-in-the-foot action, China had imposed tariffs on imports of US chicken feet (and some other body parts).

All pretty silly sounding.   I thought that was the end of the story.

…but no!

latest developments

Rather than trying to cover up the mess, President Obama actually highlighted this embarrassing incident in his 2012 State of the Union address as a signature move to “level the playing field” between the US and China.

In response, the moderate Republican Peterson Institute released an economic analysis of the tires vs. chicken feet dust-up.  Peterson concluded that:

–the tariff raised the price of the affected tires to US consumers by over $1 billion a year

–the resulting decline in purchasing power caused the loss of 3,000+ jobs in the retail industry

–the domestic  tire industry gained 1,200 jobs since late 2009, almost certainly due to economic recovery, not the tariffs.  If, however, we attribute all the job gains (and ignore the losses in retailing) to the tariffs, the cost of saving each job was about $1 million a year

–the countervailing duties caused an annual loss of $1 billion to the domestic poultry industry.

By the way, Chinese imports were mostly replaced by imports from Thailand and Malaysia, not domestic production.

that’s not the worst

Until I read a recent article in the Wall Street Journal, I hadn’t realized that, with help from China, one of the importers whose business was destroyed by the tariffs sued the government.

The company won.  Maybe it won on a technicality, but it won.  A Federal court ruled the tariffs were illegal.  Washington didn’t have the authority to impose them on China.

At the drop of a hat, Congress passed a law specifically authorizing the tariffs.

here comes the bad part   

Congress changed the law, retroactive to 2006.

In a pragmatic sense, it meant the government didn’t have to give the tariff money back.

a scary precedent

Changing the rules after the game has already been played is an action I’ve always associated with deeply corrupt third-world countries.   As a portfolio manager with a lot of experience in developing nations, I’ve (invariably correctly) regarded stuff like this as a signal not to get involved, or to take my money and get away as fast as I could.

in the context of the US, this whole affair is chicken feed,so to speak.

…not so much for the 3,000+ who lost their jobs or for the many citizens paying a lot more for their tires.  But the damage won;t move the needle on overall GDP performance.

I also think the world is writing off the tariffs and the legislation to back-room politics plus mindless pandering to anti-Chinese sentiment.  But the retroactive change to the law has got to make at least some people think twice before making new investments in the US, or to consider shifting elsewhere assets already here.  That’s not good for the economy.

Tiffany’s 2Q12: interesting stock market reaction

the report

Prior to the New York open on August 27th, TIF announced its 2Q12 (ended July 31st) results.  Earnings were up by 2%, year on year, at $92 million.  Eps were $.72/share, also up 2% yoy.  Ex non-recurring items, which depressed 2Q11 eps by $.16, the yoy earnings comparison was negative–down 17%.

Quarterly sales came in at $887 million, also a 2% yoy advance.   Negative currency effects–a 2% decline of Asia-Pacific currencies against the dollar, and a 9% fall of European, reduced that figure from what would have been a 3% constant currency gain.

EPS were a penny below the Wall Street consensus of $.73.

Although TIF said its 2Q12 performance met its expectations, it lowered full-year guidance for the seond time in two quarters.  The new full-year eps range is $3.55-$3.70 vs. guidance of $3.70-$3.80 announced with 1Q12 results.

The stock?  It rose by 7%+ on this news.

the details

the Americas 

Same store sales were down 5% yoy, and minus 9% in the flagship store in NYC.  All the weakness came from domestic customers.  Sales to foreign tourists were flat, with a falloff in EU buying offset by increases in Asian visitor purchases.

Florida, Texas, and Guam were notable areas of strength.

Asia-Pacific

Same store sales were down by 7%, two of those percentage points due to currency weakness.  Slight price increases, lower unit volume.

Japan

12% same store sales growth in local currency, offset somewhat by 2% yen weakness vs. the US dollar.  Continuing recovery from Fukushima-related weakness.

Europe

2% same store sales growth was more than erased by 9% currency weakness.  Continental Europe was stronger than the UK.  Foreign tourist buying made the figures look better than they would have been from local customers alone.

the balance sheet

It’s not something I’ve commented on before.  But the yoy change is remarkable.

During 2Q12, TIF raised $250 million in long-term debt, $60 million of which went to retire maturing borrowings.

Total debt now stands at $940 million, cash at $367 million.  A year ago, the figures were $694 million and $565 million.  Put another way, the company has gone from net debt of $129 million to net debt of $573 million, a $444 million negative swing, over the past twelve months.

The figure means TIF invested close to half a billion dollars in excess of funds generated by operations in business expansion.  Most seems to me to have been used to build inventories, with a modest amount for expanding the store network.

market reaction has been positive…

…even though there’s evidence of a continuing slowdown in high-end jewelry buying in both the US and China.  Nevetheless, TIF shares appear to have bottomed around $50 in June.  They’ve been rising steadily–and outperforming the overall market–since.

my take

TIF shares are up over 20% during July and August, despite the weak business outlook.  I hadn’t expected this.  I’d thought the stock would likely languish until there were clear signs of a pickup among either Asian or US customers.

Yes, the company is very well-managed.  The newly raised debt gives it a larger cash cushion, in case its business remains in the doldrums for an extended period.  It seems clear to me that TIF has, prudently, shifted out of rapid expansion mode and into a more defensive cash generation stance.  If this turns out to be the last downward earnings revision, the stock was inexpensive at $50.

Still, I think it’s interesting that the market is willing to pay for an anticipated recovery in TIF’s business so far in advance.  It conveys to me the suggestion of an underlying bullishness among market participants that contrasts sharply with bearish media sentiment.

As for TIF shares themselves, I’d prefer to wait either for a price in the mid-$50s or the 3Q12 earnings announcement rather than buy here/now.

operating leverage (III)

You may notice that I’m working my way down the income statement in discussing operating leverage.  Yesterday I wrote about the leverage that comes from product manufacturing.  The key to finding this leverage is identifying fixed costs.

All the profit action takes place between the sales and gross profit lines.  This is also the most important place to look for operating leverage for most firms.

operating leverage in SG&A

Today’s topic is the operating leverage that occurs in the Sales, General and Administrative (SG&A) section of the income statement.

The general idea is that large parts of SG&A expense rise in line with inflation, not sales.  So if a company is growing at 10% a year while inflation is 2%, SG&A should slowly but surely shrink in relative terms.  And the company will have an additional force making profits grow faster than sales.

For many non-manufacturing companies, this is the major source of operating leverage.

why this leverage happens

There are several reasons for SG&A leverage:

–most administrative support functions reside in cost centers, meaning their management objective is to keep expenses in check.  Employees here are not directly involved in generating profits, so they have no reason to demand that their pay rise as fast as sales.

–as a company gets bigger and gains more experience, it will usually change the mix of administrative tasks it performs in-house and those it outsources, in a way that lowers overall expense.

–a small company, especially in a retail-oriented business, may initially do a lot of advertising to establish its brand name.  As it becomes larger and better-known, it may begin to qualify for media discounts and be able to afford more effective types of advertising.  At the same time, it will be able to rely increasingly on word-of-mouth to gain new customers.  In addition, it will also doubtless be shifting to more-effective, lower-cost internet/social media methods to spread its message.

negative working capital

Strictly speaking, this isn’t a form of operating leverage.  It has its effect on the interest expense line.  And in today’s near-zero short-term rate environment, it’s not as important as it normally is.  But, on the other hand, one day we’ll be back to normal–when being in a negative working capital situation will be more important.  It’s also one of my favorite concepts.

If a company can collect money from customers before it has to pay its suppliers, it can collect a financial “float” that it can earn interest on.  The higher sales grow, the bigger the amount of the float.  If the company is big enough (or, sometimes, crazy enough) it can even use a portion of the float to fund capital expenditures.  The risk is that the float is only there if sales are flat or rising.  If sales begin to decline, either because of a cyclical economic downturn or some more serious problem, the float begins to evaporate, as payments to suppliers exceed the cash inflow from customers.

Lots of businesses are like this.  For example, you eat at a restaurant.  You pay cash.  But the restaurant only pays employees and suppliers every two weeks.  And it pays is utility bills at the end of the month.

Hotels are the same way.  Utility companies, too.  Amazon and Dell, as well.

operating leverage (II)

high fixed cost businesses

The most common and the most powerful type of operating leverage is present in companies with high fixed costs, or so-called capital intensive businesses.

(An aside:  Traditionally, the need to spend immense amounts of money on plant and equipment to be able to enter a business served as a big barrier against new competitors.  The major threat to the capital intensive firm is technological change.

Over the last forty years or so, change has been so rapid that capital intensity has suddenly turn into a millstone in many industries (think: Best Buy vs Amazon in retail).  Nevertheless, there are still many capital intensive businesses that remain attractive.)

Take a hotel as an example

How much do you think the out-of-pocket cost is for a hotel company to lodge a guest for one night?

It’s the cost of cleaning the room, changing the sheets and putting in new soaps.   Less than $20.  But the guest can easily pay $100 or $200 a night (in NYC, it’s more like $500) for his stay.

Having an “extra” (other jargony terms used:  marginal, incremental) guest in the hotel is almost pure profit.  After all, the hotel is open and staff are present, whether or not our guest is.  In practical terms, those costs are fixed.

Take an airline (please!)

Airlines have been a dreadful business for longer than I’ve been an analyst.  Same  question, though.  How much extra does it cost the airline to service one more passenger who is paying $5,000 in first class for an international flight?

It’s the cost of the meal(s).  The plane and the crew are going to be there whether our incremental passenger is on the flight or not.  So, again, he’s almost pure profit.

The trick with a capital intensive business is to sell at least enough of your product or service to cover your fixed costs.  The rule of thumb in the hotel business is that at 50% occupancy, you’re not making profits but are at cash flow breakeven (meaning you’re meeting all your out-of-pocket costs).  At 60%, you’re barely profitable.  At 70%, you’re making wheelbarrows full of money.

WSJ on airlines

Same thing with airlines.  Only the story here is a lot grimmer.  The Wall Street Journal had a really, really good article in June about air carriers’ cost structure, that was based on research by Oliver Wyman.  It concluded that on a 100-seat aircraft, the airline has to fill 99 to break even.  The carrier’s profits come from filling that last seat, where someone gets shoehorned in right next to the restrooms.

Think about it, though.  If the airline in the WSJ example could somehow scrunch the seats an inch and a half closer together, it might be able to fit in an extra row.  Assuming customers didn’t revolt, revenue would go up by 4% from the four extra passengers.  But profit would go up almost 5x!!!

That’s operating leverage.

don’t use percentages in analysis

If I have one criticism of the diagram “Decoding A Flight” in the article, it’s that it uses percentages, not actual figures.

I understand that this is the best (probably the only) way to illustrate the article’s point.  From years teaching securities analysis, however, I have a different perspective.  If you take the percentages shown and apply them to, say, a different airline or a bigger plane, profits will always be 1% of sales.  It’s because you’re using margin percentages, not the raw data.  Using percentages obscures operating leverage.

The article also gives a useful illustration of what securities analysts do all day.  They try to figure out, in as much detail as possible, the profit structure of the companies they follow.

a simple model

Let’s make up a company.  It builds a factory and puts machinery in it, at a cost of $40 million.  Assuming that everything will last for 40 years, each year the firm will enter a (non-cash–it has already spent the money) charge of $1 million on its income statement to represent recovery of this outlay.

That’s $250,000 each quarter.

Let’s say the company has a factory payroll of $100,000 each quarter.  So total costs are $350,000.

Finally, suppose the firm makes some item that uses $10 of raw materials and can be sold for $80.  That means each item earns an operating profit of $70.

Case 1.  The company breaks even in a quarter if it sells 5000 items.

Case 2.  What if it sells 4500?

Then sales are: $360,000

Costs are:  $350,000 + ($10 x 4500) = $395,000

Loss:  $35,000.

Case 3.  If it sells 6000, sales are $480,000 and profits are $70,000.

Case 4.  If it sells 7000, sales are $560,000, 16.7% higher than in case 3.  But profits are $140,000, or double those of case 3.

That’s operating leverage.

how do we find out what a company’s costs are?

Avenues to explore:

–the company’s 10-k, annual report and website

–the company’s investor relations department

–the industry trade association

–trade publications

–government offices

–the financial press–you might be incredibly lucky and see an article like the airline

–sell-side research, although most analysts don’t publish their detailed spreadsheets for fear their rivals will “borrow” the results.

Two other thoughts:

–look for a small company in the industry you’re interested in.  The firm’s structure might be simpler and more visible than is the case with a larger firm.  The small company’s IR department may be more willing to talk to investors, too.

a quick and dirty approach.  If the company is highly seasonal, figure out the extra sales in the high revenue quarter and compare it with the extra profit those sales bring with them.  Sometimes, a year-on-year or quarter-on-quarter comparison can also yield useful information.

More tomorrow.

 

 

 

 

 

operating leverage: what it is and how to look for it

operating leverage may be the key to stock selection

In my judgment, and given my growth-oriented way of looking at stocks, I think that operating leverage is the second-most important idea for potential investors in a company to understand.

(The first-most important concept is to make sure that the company is, and will remain, an economically viable entity–and that all shareholders will share in the profits the firm makes.  This isn’t usually a pressing issue for mid- and large-cap stocks in the US.  And it doesn’t take much time.  You can check out financial stability quickly in a service like Value Line–although you’re always better off looking at the financials yourself.  You have to be aware of the credit facts, in case that great start-up you own will likely run out of money before it can get a product to market.)

a key source of earnings surprise 

After you’ve put the issue of whether the company will survive behind you, the crucial issue for growth investors is the possibility of positive earnings surprise.  This means the chance that a firm’s profits will be growing faster than the market expects, for longer than the market expects.

That’s where operating leverage comes in.

what operating leverage is

Operating leverage is the idea that a company’s operating profits can rise and fall more rapidly than sales.  How can this happen?  I’ll go into detail in the next couple of posts, but the general concept is an easy one.

A company’s costs general fall into one of two categories:  variable or fixed.  Variable costs are those directly connected with the creation of the product or service sold.  Fixed costs are everything else.

In the world of manufacturing, where these distinctions were first made, variable costs are mainly the raw materials used in producing a product and the labor costs of the workers directly involved in making it.  Fixed costs are those that the company runs up whether it generates any output or not.

Fixed costs themselves are usually divided into two types:

–production related, like the salary of the plant manager, and the costs of building/leasing the factory and buying/renting the machinery in it; and

–SG&A, or Sales, General and Administrative.  These latter include the chairman’s compensation, as well as that of all others at corporate headquarters, plus the advertising/promotion budget and the cost of a salesforce.

variable vs. fixed–shades of gray

Yes, these are somewhat fuzzy concepts.  For instance, in return for a lower price, companies may have purchase contracts for raw materials that require them to pay for minimum deliveries, whether they take them or not.  Workers may also have employment contracts.  In neither case are expenses as “variable” as they might seem.  On the other hand, the firm’s salesforce and top management may be paid mostly in bonuses based mostly on sales/profit growth.  So these costs aren’t very “fixed.”

Still, such cases normally make only minor differences in a firm’s total results.

financial leverage is something else

Of course, there’s also another form of leverage a company may employ–financial leverage, which I’ve discussed in my recent post on return on capital vs. return on equity.

More tomorrow.

HP, Dell, Big Lots–what their results are saying about the US economy

a qualifier

Actually, this post is more about how I interpret their results.

There’s always ambiguity in any assessment of how companies are doing, including management’s own statements.  There may be issues that managements are unaware of.  There will likely also be others that, especially in the case of a weaker firm, the top brass will tap dance around when speaking to investors.

It’s possible they may be in denial.  But no one is going to turn his earnings conference call into an advertisement for competitors by revealing that, say, “Lenovo has better products than we do, so they’re taking market share from us wherever we compete.”  That just speeds the customer exodus.

We are , however, in a slow-growth world today, where there’s simply not enough business for all market entrants.  During a boom, the top firms don’t have enough capacity to meet customers’ demands.  So buyers who need a product now have no choice but to purchase from second- or third-tier competitors.   In the current environment, in contrast, the number-ones have capacity.  And customers have more time to study competitive offerings before they choose.

the PC business:  Dell and HP

Both are icons of the PC business in the US.  But neither has kept up with the market. True, Windows Vista certainly didn’t help to enhance the reputation of either.  And both have lost market share to Apple.  Also, the market for Windows machines is being negatively affected at the moment by consumers’ reluctance to buy Windows 7 machines because Windows 8 is just around the corner. But as an ex-Dell user (now writing either on a Mac or an Asus machine), I know Dells weigh a ton, run hot and don’t last very long.  Customer service is awful.  HP isn’t much better.

Asian giants Lenovo, Acer and Asustek don’t yet have the support infrastructure in the US that they do  elsewhere.  But the performance of the US incumbents seems to be an open invitation to these firms to take a lot of market share from HP and Dell here–as they are already doing abroad.

Anyway, what I think we’re seeing in the HP and Dell results is the loss of share that weaker players experience in times like these–not evidence of overall economic malaise.

Big Lots

…another company with weak results.  I don’t think Big Lots’ poor performance is indicative of macroeconomic weakness, either.  On the contrary.  I see it as more evidence that consumers are trading up, because their personal economic fortunes are improving.

Trading up and down are complex phenomena.  In bad times, the Saks customer may shop at Target, the target customer at Wal-Mart, the Wal-Mart customer at the dollar stores.  The dollar store customer may just not consume or buy at venues that are below Wall Street’s radar screen.

(Of course, trading down among retailers isn’t the only effect of recession.  Overall, consumers buy less.  They also buy more plain-vanilla, less expensive items that they can use for a variety of purposes.)

In good times, the opposite occurs.

But in both situations, only the merchants at the bottom of the chain and at the top see unambiguous results.

I think two forces are at work in Big Lots’ sales:  rainy day customers are trading up; and, unlike the more progressive of the dollar stores, BIG hasn’t expanded its offerings enough to hang on to more affluent buyers.

my bottom line

I see the results for HP, Dell and Big Lots as simply what happens to weaker companies in a US growing at 2% a year.  The poor numbers aren’t reasons to run out and buy the S&P 500.  But, equally, they’re not a reason to sell, either.

capital spending and the business cycle: BHP as an illustration

BHP’s fiscal 2012 earnings report

When BHP Billiton made its full (fiscal) year earnings announcement, it indicated that it is rethinking its planned $20 billion expansion of the Olympic Dam copper/uranium mining project.  It hopes to restructure the expansion in a way that costs less.  The company also recorded $3.5 billion in asset writedowns (“impairment charges”) for the year, the largest being a $2.8 billion reduction in the value of its US shale gas assets.

some perspective

To put these items in perspective, even after the writedowns BHP still made $15.4 billion for the twelve months and had operating cash flow of $24.4 billion.  So, for BHP the announcements aren’t a big deal.  But they do provide the occasion for making several important points about corporate behavior.

1.  Companies rarely outspend their cash flow, no matter what they may say to the contrary.  And if they do borrow to fund capital projects, it’s almost always just after the bottom of the economic cycle, when evidence is accumulating that business is past the lows and is accelerating.  Otherwise, if a firm sees that its projected cash flow over the coming year–sometimes longer–is going to be less than previously thought, it cuts the capital budget.  That’s what’s happening here.

Borrowing to fund capital expenditure adds an additional element of risk because the assets developed are long-term and illiquid, not stuff companies want to stock up on when the future is iffy.

2.  Cash flow isn’t always as available as it might seem.  Companies often have principal repayments on debt.  They can also have mandatory progress payments on capital projects already contracted for.  They pay dividends.  They may need to finance working capital–meaning they need money to buy raw materials, pay workers and offer trade credit to customers.  And (in BHP’s case a minor point, but not always) they may be “capitalizing” interest payments for ongoing projects (BHP capitalized $314 million of interest in fiscal 2012).  Capitalizing means the interest payments are parked on the balance sheet until the associated project is complete.  The money is paid to the creditors, but doesn’t appear as an expense on the income statement.

All this means a large chunk of cash flow is already spoken for each year.  Under normal circumstances, the easiest item to shrink is capital spending on new projects.

3.  Asset writedowns are a form of corporate housekeeping.  Many times–like this one, in my opinion–they occur when earnings aren’t so stellar anyway.  The idea is that more bad news doesn’t stand out so much.  That’s not the whole story, though.

Take the $2.8 billion writedown of shale gas assets.

Taken literally, the asset reduction means that BHP no longer believes the holdings are worth the amount it has invested in them.  They’re actually worth $2.8 billion less.  Conceptually, the firm is required to make the writedown once it becomes convinced this is the case.  Practically speaking, companies have a lot of wiggle room to use to avoid doing so.

Suppose it’s right that BHP has lost $2.8 billion through investing in shale gas.  It has two choices:

–it can either reduced the carrying value of the assets now, to the point where it can maybe make a slim profit in the future–and do so at a time when the business is slack and investors don’t really care, or

–it can keep the $2.8 billion loss on the balance sheet and show it little by little as gas is brought to the surface and sold.  Losses would continue for the life of the operations, until the entire $2.8 billion flows through the income statement.  Most of the red ink would presumably occur during better economic times, when investors are more eager to see earnings gains and would respond more negatively to the losses.

In other words, BHP is (prudently) wiping the slate clean while no one is looking.  In the non-commonsensical way that professional investors think, the writeoff is the mark of a good company.