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Monthly Archives: September 2012
watch the currencies!–what they’re saying now
three key pieces of data for investors
Over the last several weeks, two pieces of information have emerged that have potentially great importance for equity investors. A third may develop from the US Federal Reserve today.
They are:
1. the Case-Schiller index, which is very influential in the US, despite being a lagging (also called confirming) indicator of the state of the housing market, has finally signalled that overall residential prices have bottomed and are on the mend. The five-year slump is over.
Although I think the revival of the housing market gives a second wind to the domestic economic expansion, in the counter-intuitive way Wall Street works, it also has a darker side. Other than Washington suddenly starting to do its fiscal policy job, which would be a huge positive surprise, it’s hard for me to see what new positive market-moving economic development could happen in the US over the coming months.
2. The European Central Bank has announced a broad support plan for the bond markets of the weaker members of the Eurozone. Yesterday, the German high court rejected litigants’ assertions that the German government was barred by that country’s constitution from participating in the plan. Germany is slated to provide over 25% of the financing of the Eurozone rescue plan, so this decision was crucial.
The implication is that EU economies will be stronger over the coming year or so rather than weaker.
3. The Fed may announce further unconventional measures today to support the US economy. The Fed has repeatedly said that fiscal policy would be a much more effective engine to spur growth, but apparently sees about the same chance as I do of that happening.
Two measures are possible. One is additional bond buying, intended to flatten the yield curve. The second is a commitment to hold short-term interest rates at today’s emergency low levels for the next three years. Yikes! Three more years of nearly no income from CDs and money market funds?
I think the second would have the more significant effect for Wall Street. It would give two contrary signals: it would say that there’s no need to flee the bond market anytime soon; and it would imply that the only liquid investment that will provide significant income for savers any time soon is the stock market.
three places to see their effects
1. the performance of general stock markets in their local currencies.
The S&P 500 is up 9% over the past three months. I think the recovery of house prices, which is the major source of wealth for most Americans, is the main reason. EU growth should also have a positive rub-off effect on US firms involved in foreign trade, as well as the many S&P firms with substantial operations in Europe.
The Eurostoxx 50 is up 19% over the same span. Broader indices are up in the mid-teens. Most of the outperformance of the S&P has come in the past month, when Eurozone rescue plans have been publicized. Dollar-based returns on the EU indices are much larger.
2. You can also changes in the lists of sectoral winners and losers, as I’ve written about on the Keeping Score page on PSI. Generally, the US investor has shifted away from defensive sectors toward IT and Consumer Discretionary, two moderately bullish areas, while not to sectors like Materials that would benefit from a strong general economic upsurge.
3. Most US investors generally ignore the third area–currency movements. I think it’s certainly true this time. But from mid-July until now, the € has risen from a value of $1.20 each to $1.29, or 7%. True, the ¥ has been rising since March, when holder had to pay 84 to get $1. But it has also recently risen above the 78 level that the Tokyo government had been trying to defend.
To my mind, the Japanese economy still has nothing much going for it. Seeing that currency rise at all–which normally happens only in a healthy country–really says something.
the message?
If we add a currency gain of 7% to, say, a 14% rise in European stocks, the total return to an American investor in the past month is more than 20%. If we have indeed made a major turn in the EU, the party is far from over, in my judgment.
Many European stocks still have strikingly high dividend yields–certainly a temptation to income-oriented investors but also a warning of potential risk.
I’ve been advocating having a severe underweight in the EU, with exposure only to companies listed there but with significant operations elsewhere. I haven’t made any changes yet, but I’ve got to at least reconsider my position.
Conversely, US-listed companies with large businesses in the EU may not be having great local currency sales at the moment, but they’re enjoying a big boost in dollar terms.
The rise in the ¥ tells me that at least a part of what is happening is not foreign currency strength. It’s dollar weakness. That may be because of continuing fiscal policy failure here, or just the perception that all the potential good news is already out.
The much greater € strength suggests that real economic improvement is expected in the EU. I’m still mostly convinced that Greece will be forced out of the Eurozone (and the EU). But markets may not be willing to wait for this final shoe to drop.
To sum up: we may be in the early stages of a significant shift in the attitude of global equity portfolio managers about where they want to place their clients’ money. If so, I think the clearest sign is coming from the currency markets–it’s mildly against the US, strongly for the EU.
the Intel (INTC) 3Q12 preannouncement: studying operating leverage
the preannouncement
As I wrote about yesterday, INTC preannounced weaker than expected 3Q12 earnings. The main culprit? …worldwide general economic slowdown.
The company said it now expects revenues of $13.2 billion for the quarter, down by 7.7% from the $14.3 billion it guided to when it announced 2Q12 earnings two months ago. The gross margin will come in at 62% instead of 63%. Virtually all other cost items will remain the same.
looking at leverage
This isn’t much data. But it’s enough for us to see two things about the company, manufacturing leverage and leverage on SG&A (Selling, General and Administrative) expenses.
manufacturing leverage
two kinds of costs
In the simplest terms, in every accounting period employees get paid and the accountants apportion costs for the use of the factory and the machinery in it, whether or not anything gets build. So, in a sense these are indirect costs of manufacturing. In the short run, they’re relatively fixed.
In addition, there’s the cost of the materials–electricity, gas, silicon, who knows what else–that get used up in making INTC chips. These are direct costs. Their total in any period is variable, depending on how many chips get made.
Accountants assign each chip a total cost that depends on two factors: the out-of-pocket cash (variable cost) spent making it plus its share of indirect costs, a figure that depends on how busy the factories are.
gross margin
Total cost ÷ sales price = gross margin.
separating the two
Is there a way to find out how much of the total cost is variable and how much depends on how well sales are going in a given quarter? In INTC’s case, yes.
Management has just told us that sales will be $1.1 billion less than anticipated and that this fact will lower the gross margin by a percentage point. That’s not because the variable cost of making a chip has changed; it’s because the indirect (or fixed, or overhead) costs of running the factories are being distributed over a smaller number of chips. (It’s a little more complicated than that, but not a worry in this case.)
Another way of saying this is that in order to get to the new, lower, sales and operating profit estimates, INTC has subtracted the sales price of the extra chips it won’t sell and only the variable cost of making those chips. If we calculate the change in estimated gross profit and divide by the change in sales, we’ll get a variable cost margin for those “extra” chips.
Here we go:
$13.2 billion x .62 = $8.18 billion in gross profit
$14.3 billion x .63 = $9.01 billion in gross profit
The difference is $.83 billion, the gross profit lost from lower sales. This gross profit ÷ $1.1 billion in lost sales = 75.5%.
Therefore, 75.5% is the profit margin from producing/selling an extra chip during the quarter. That’s the manufacturing leverage INTC gets at current production levels for getting/losing additional sales.
Note, too, that the new operating profit is 9.1% less than the original estimate. That compares with a 7.7% drop in sales. So, while there is operating leverage in the manufacturing operation, but at current production levels it’s not huge.
SG&A leverage
INTC has two types of SG&A. One is R&D. The other is the typical SG&A that any industrial company has. The two items are roughly equal in size. This quarter they’ll amount to $4.6 billion.
Let’s subtract that from both the original gross profit estimate and the new guidance.
$8.18 billion – $4.6 billion = $3.58 billion in operating income
$9.01 billion – $4.6 billion = $4.41 billion in operating income
Now calculate the percentage drop in operating income that our 7.7% decline in sales produces.
It’s 18.8%!
To recap, the 7.7% fall in sales produces a 9.1% drop in gross profits and an 18.8% contraction in operating profits. Of the 11.1 percentage point differential, 1.4 comes from the manufacturing process, 9.7 from SG&A leverage.
In other words, the operating leverage at INTC is coming from SG&A, not manufacturing. If INTC wanted to reduce costs in a way that would affect current reported profits the most, it would attack either R&D or “normal” SG&A.
Intel (INTC) preannounces weaker than expected 3Q12 results
the INTC preannouncement
INTC intends to announce 3Q12 results on October 16th. But it already knows that its earnings will fall below its previous guidance by a substantial amount. So, while the company still has to dot the is and cross the ts, it issued a short press release stating this on September 7th.
INTC now expects 3Q12 revenue to be $13.2 billion rather than $14.3 billion, and for its gross margin (that is, its profit margin after subtracting all direct costs of making its products) to be 62% of sales rather than 63%. Basically, all other costs remain the same.
By my back-of-the-envelope calculation, this means INTC will likely report 3Q12 eps of $.52-$.54, rather than the $.63-$65 or so it had been expecting when it issued its guidance two months ago. 3Q11 eps? …$.69, on revenue of $14.3 billion.
what’s going on?
The unofficial (though pretty much binding, nonetheless) protocol for such announcements is to list the reasons for the earnings revision in order of importance, with the most important going first. That would mean:
1. customers worldwide are not fully replenishing their stock of INTC chips as they sell products containing them. This is a standard response to weakening demand, especially if PC manufacturers believe they can quickly get supplies if needed. Let INTC hold the inventories, not them. Therefore, slower economic activity is resulting in lower sales.
A reasonable guess is that INTC’s 8% slide in sales vs. its prior expectations breaks out into 4% due to weaker end-user demand and 4% defensive behavior by PC makers.
Operating leverage is making the bottom line look considerably worse.
2. one customer group sticks out: corporations are slowing their replacement of employees’ aging PCs (but not their spending on servers or on the cloud).
This almost goes without saying. Corporations rarely outspend their cash flow. If they sense cash flow contracting, they cut discretionary spending.
3. one geographical area does, too: slowing demand in emerging markets (which had been a pillar of strength earlier in the year).
Presumably the supply chain is longer in emerging markets than in developed ones, as well as harder to get good information about. So the slowdown in end-user demand may have been going in somewhat longer in emerging markets than in developed.
To recap, my interpretation of the release is that global economic weakness is the main cause of the preanouncement. Emerging market slowdown is a factor worthy of note, but the least important of the three elements cited. Windows 8 isn’t really an issue, since INTC had already accounted for a pre-release buying pause in its previous guidance.
the stock is down almost 8%…
…since the INTC announcement. As an owner of the stock, I’m not happy. As an observer of the stock market, I think the selloff is overdone. But it’s not entirely crazy, either. I regard INTC as a “show me” stock in the high $20 range. At, say, $27-$28, I think the “old” INTC business of selling mostly PCs is fully valued.
For the stock to break into $30-land, I think it has to demonstrate some success in penetrating the mobile market–smartphones and tablets. If you think INTC has no shot–and I think that’s the consensus among Wall Street analysts and the media–the stock is mildly undervalued today, but that’s all.
On the other hand, if you think INTC has a reasonable chance (that’s my opinion) you get the possibility of some upside, a low-risk option on substantial upside if INTC’s newest chips crack the mobile market, plus a dividend yield above 3% while you wait.
Although it sounds odd at first, it’s also possible that the current slowdown is good for INTC, if it buys extra catchup time to get the company’s 14nm chips on the market.
a case of operating leverage
That’s my topic for tomorrow–how this situation presents a good analytic opportunity to see operating leverage analysis in action.
the Employment Situation report for August 2012
the report
On Friday September 7th at 8:30 EDT, the Bureau of Labor Statistics, part of the Labor Department, released its monthly Employment Situation report for August 2012. The headline figure is that the US economy gained 96,000 jobs last month.
That’s disappointing in several respects:
–it’s below the economists’ consensus of +120,000-140,000 new positions
–it’s considerably less than the +201,000 job additions reported by ADT earlier in the week
–it’s under the 150,000 or so new jobs needed each month to absorb new entrants into the labor force–meaning it’s not enough to eat into the number of long-term unemployed
–it suggests that the more favorable report for July (+163,000 jobs) is as much an outlier as the much weaker numbers from May and June.
the details
The 96,000 jobs consist of 103,000 new hires in the private sector, offset by -7,000 layoffs by state and local governments. The service sector continues to be a strong generator of new jobs. Construction seems to be bottoming. But for the first time in a while, the manufacturing sector is beginning to shed jobs.
the revisions
As regular PSI readers know, the ES report is revised in each of the two months following its initial release.
The initial figures for July were +163,000 jobs (+172,000 in the private sector, -9,000 state and local government layoffs). That has been revised down in the August report to +141,000 (+162,000, -21,000).
The figures initially reported for June were +80,000 (+84,000, -4,000). They were revised down in the July report to +64,000 (+73,000, -9,000). In the August report, the numbers were revised down again to +45,000 (+63,000, -18,000).
my take
the surprising thing about this report is that the S&P went up on the news.
After all, it seems to dash hopes that the US economy is going to accelerate from the current lackluster pace. To the contrary, it suggests that what we are seeing now is as good as things are going to get for employment–and chronic high unemployment is going to be a fact of life.
At the same time, the US stock market is holding above the 1420 line that has represented a very substantial barrier to advance.
What could this mean?
On the most elementary level, investors appear to have returned from the Hamptons with their buying shoes on.
I don’t think anyone can possibly believe that additional Fed action will make any substantial positive difference for the US economy. Nor do I think that current economic conditions domestically or in the EU or China or Latin America are a cause for joy.
It could be that investors have suddenly awakened to the fact that bonds are very expensive and stocks very cheap. But that’s been the situation for a very long while.
What I think is going on is that sentiment is changing. Investors appear to be starting to believe that the worst is over in world economies. Two implications of this belief: stocks aren’t going to get much cheaper, and it’s okay to buy at today’s prices anticipated earnings improvement in 2013-14.
The big imponderable is how long the current bullish mood will last.
my bottom line:
We should enjoy the ride–which might represent a crucial, positive, turning point for stocks–but be very wary for signs that the curent mood change is just a passing fancy.