Wednesday, February 4, 2009

An Ursine Secular Age

We live in an ursine secular age. Not only is the economy imploding in the wake of the credit crunch. Just about every industry where you'd normally want to park your money is undergoing major historic problems. Even if the economy were growing, many would be doing badly on a secular basis. Today, I will take a look at these directly.

First, I will define some words.

"Ursine:" for those readers without a penchant for Latin, means "relating to bears," coming from the word urso for the animal. In the world of finance, bears are evil spirits that destroy the value of your investment portfolios. I for one believe the market will only turn around when we install a bear statue on Wall Street to compliment the bull statue. Angry ursine spirits haunting the market need to be honored.

"Secular:" This refers to long-term worldly movements. For instance, the rise of computers and digital cameras were secular trends that devastated the markets for typewriters and film. No matter how much the economy grows, they're not coming back.

"Cyclical:" This deals with the "business cycle." When the economy is growing and people are making more money, they buy new cars and spend more on items like travel and stainless steel refrigerators. That's why stocks like GM, Delta and Whirlpool are all considered cyclical, while companies like Kraft are not. People don't buy more macaroni and cheese just because they have more money... or so it seems.

Kraft's what we call a consumer staple, so let's start with them.

CONSUMER STAPLES: In the 2001 recession, companies like Kraft and Procter & Gamble were safe havens. This time things aren't working so well. Late last month, P&G warned of slowing sales and said it's only getting growth from raising prices -- not selling more products. Today, Kraft and Sara Lee followed with similar news.

Overall, these are very expensive stocks. Kraft and P&G both have an enterprise value/EBITDA ratio over 9x, compared with levels of 4-6x for the rest of the market. Traditionally, investors drool over consumer staple companies because of customers' brand loyalties. They spent billions of dollars and millions of hours building and maintaining the image of products like Tide and Kool-Aid. To understand how the business really works, a quick history lesson is useful:

Executives at these companies are following a model developed late in the 19th century by James Buchanan Duke, who built American Tobacco Co. before it was broken up as an illegal monopoly in 1907.

Duke invented what business historian Alfred Chandler called the "integrated industrial company." As I discuss at length at the end of this blog posting and this one this kind of business put marketing and production under one roof. Previously, manufacturers of things like clothing sold products to middle-men known as jobbers who then sold them to small retailers. The jobbers worked for themselves and had no loyalty individual factory owners, which made it hard for manufactures to control how much they sold. Without a reliable stream of revenue coming in, it was hard to build a truly large and efficient organization. So, even though many factories in the 19th century were using modern technology such as steam power and mass production, their marketing remained literally medieval.

Duke changed everything by uniting factory with sales and distribution. His marketing executives were organized geographically to push his brands only. Duke's people provided advertising and displays. They also took back unsold cigarettes, ensuring quality and making the merchant more willing to carry the products. This was a big improvement over dealing with less organized tobacco companies. This made local merchants more willing to carry Duke's products. And, when just being a nice guy didn't work, he also used rebates and other heavy handed methods to build market share, just like other trusts of the era such as Standard Oil.

Once these "distribution channels" were solid, Duke could count on a certain critical mass of sales every month. This allowed him to invest in larger production facilities to lower costs and widen profit margings. It also allowed him to raise capital and keep growing. In sum, customers had products they could trust, giving rise to brand loyalty. Retailers' lives were easier because they knew that as long as they carried American Tobacco's cigarettes, there would always be loyal buyers. Both were winners thanks to Duke. He made a fortune, endowed a major university and invented a business model that would remake American society.

This paradigm worked extremely over the following century and was drove the booming stock market of the 1920s. (Examples include GE, GM, IBM, Standard Oil, P&G, Campbell Soup etc.)

These integrated companies had a sustained advantage because they understood the market for their products. With thousands, if not millions, of customers, they became the nexus of information about sales and markets. This data was analyzed to produce new and better products and to minimize production costs. For instance, it was cheaper to purchase raw materials like tobacco and wheat etc in bulk. This arrangement created a virtuous cycle of even more growth and profits. In the process, it fed the rise of a new class of educated white-collar office workers. And, its need for publicity and marketing fed the growth of media and advertising. A big chunk of modern American culture as we know it all resulted from the cleverness of an impoverished Confederate veteran with a supply of tobacco and a rolling machine.

So, where's the bear? At the heart of Duke's model was information. Big integrated consumer companies monopolized information and used it to their advantage. Until recently, that required a standing army of army of clerks and sales representatives. It consumed huge amounts of paper, travel and long-distance phone calls. Any small competitor that tried to fight their way onto the shelves of stores found itself locked out by the Krafts or Pepsis of the world, which had strong relationships with retailers.

The Internet and other cheap forms of communications (such as viral marketing) change all of that. Despite decades building these sales organizations, I believe their intrinsic value are now declining as the competitive advantage of being big and corporate wanes. Furthermore, they were built on a big national economy/culture/society. They existed in a symbiosis with big media outlets like TV/radio/newspapers and big cultural events like NFL/MLB etc. They would sponsor these key events and capture a big slab of the country's attention. A relatively small number of institutions dominated the marketplace of ideas and cultural values. Only huge national organizations like Budweiser, Chevy and Coke could buy access. Their size allowed them to dominate.

Now culture is fragmented, with an ever growing multiplicity forums and outlets. For instance, I often watch youtube or Netflix instead of television and read news from any number of websites. Instead of reaching me by advertising on a small number of key outlets, a company like P&G can't even find me anymore.

These companies were once big fish in a small bond. But now they are getting washed downriver into a massive ocean where their earlier advantages count for less and less.

This same cheaper access to information will allow generic brands to better serve customers' needs. Instead of just churning out quasi-edible cheap junk, the generics are increasingly boosting the quality of their products. And, now the retailers will turn against the big integrated consumer product companies because the private-label items are often sold at wider profit margins than the name brands. (When you buy the name brand, you are basically paying for all the executives and advertising.) Throw in the rise of the local food movement, farmers markets and agricultural co-ops, and big food companies like P&G and Kraft face a long journey downward.

Getting back to this from a market point of view, investors have long been willing to pay a premium for these large "consumer staple" companies because of their solid market positions. That means they are heavily owned, and will be steadily sold as people realize they are both expensive and low growth. It's a bit like the newspapers, which once had premium valuations, with enterprise/EBITDA values of 12-13x because they had built "strong franchises." But now they're valued at about 6x. When the sands of the economy shift beneath the market's feet, the biggest castles fall the hardest.

Media & Publishing: As I just discussed, the rise of the Internet and online advertising is devastating to traditional media such as television, radio and newspapers. They face a double whammy of shrinking audiences -- especially newspapers -- as the number of competing media outlets proliferate like rabbits. It hasn't happened yet, but I am just waiting for someone to release the first Youtube-based sitcom or serial program. It's just a matter of time. And, as people increasingly watch video on phones, video quality will necessarily decline, reducing the need for expensive production techniques. Again, that will be one more competitive advantage that big-budget television will lose. And, even if newspapers are successful on line, the advertising rates are much lower compared with the old full-page spreads and classifieds.

Even worse than rising competition for viewers, TV/radio/newspapers face much stiffer competition for advertiser dollars. Previously, newspapers were packed with ads from companies like Macy's and other retailers. TV stations carried ads for all kinds of consumer products. Perhaps one in 10 or 20 readers or viewers would be interested in the women's sweaters, jewelry or soft drinks in question.

It was a bit like shooting a fly with a shotgun: expensive and wasteful. Furthermore, because most of the products didn't interest the viewer at any one moment in time, there was naturally an antagonistic relationship between audience and advertiser. Forcing people to sit through ads is confrontational and intrusive. Of course, when there was only TV to watch or only a handful of newspapers, people tolerated it.

One immediate danger to this model is the rise of digital video recording devices such as Tivo, which allow people to skip over ads. (For more on this trend, this article is worth reading.)

The much bigger problem is Google and the Internet. Now advertisers can reach customers directly based on what they're searching for on line. Web retailers like Amazon and Youtube can suggest things you might like because they track you purchases and searches. (I recently discovered a remarkable Janis Joplin video this way.)

This is the polar opposite of being intrusive and obnoxious. It makes advertising helpful and timely.

No longer must advertisers paying the salaries of journalists and athletes. No longer must they support expensive printing presses and foot the bill for tons of newsprint and gallons of ink just to reach one in 20 potential customers. Now they pay a much smaller amount and Google finds them a large number of people who are much more likely to want their product.

The next big danger to traditional media is wireless advertising. As I wrote in this blog entry last year, I anticipate a future when stores link their inventory to Google and ordinary people keep a list of things they want to buy. When you move within a certain proximity of a merchant carrying an item you want, your smartphone will tell you. This would be paradise for buyers and sellers alike.

Of course, these are all big pie in the sky ideas -- almost metaphical in nature. Let's look at the companies themselves to see if it's affecting them yet ...

New York Times Co.: Ad sales down 18%, the Gray Lady goes hat in hand to Mexico's Carlos Slim to help it pay back debt.

Viacom: The parent of Nickelodeon and MTV cut its profit forecast in October. Even though the company blamed the weak economy (a cyclical factor), its margins were eroding before this, revealing the deeper secular nature of its difficulties. This company was separated from CBS due to its allegedly better growth prospects, but equity investors never really got on board with the idea. Viacom also complained about falling DVD sales, which are haunted the Magic Kingdom as well:

Disney: The Associated Press had a good article on Disney's last earnings release that captured the key points well:
An aging DVD format and a proliferation of viewing options hurt home-video revenue in ways that could not be blamed solely on economic decline, [CEO Bob] Iger said. Studio revenue fell 26 percent from a year ago.
"The average U.S. DVD household owns about 80 DVDs already," Iger said. "That suggests that, economy or not, going forward people potentially will be more selective about what they buy."
He said that the abundance of viewing choices had also hurt the ABC broadcast television unit "and may have a long-term potential impact on the DVD business."
Analyst Anthony DiClemente of Barclays Capital said it was the first time Iger publicly acknowledged that the consumer shift from physical media consumption to digital was beginning to affect Disney's businesses. The shift has already plagued the newspaper and recorded music industries.
"The fundamental trends are on a slippery slope to the downside," DiClemente said after the call.
Analyst Alan Gould of Nataxis Bleichroeder Inc. echoed the concern.
"Those comments are a bit scary, frankly," Gould said. "DVDs, for the last 10 years, have been such an integral part of the profit stream of a movie. If you have DVD sales slowing down dramatically on a secular basis, that changes the whole economic structure of the motion picture business."

(Emphasis added. Click here for the source.)

Furthermore, Disney's credit ratings are now under pressure because of its big capital expenditure plans. Another problem facing the media industry is that most of these are old-fashioned companies with traditional pension funds that are now under pressure.

And, don't forget about companies like Young Broadcasting, which is now bankrupt, and yellow-pages companies like RH Donnelly, which is one step from the grave. More than a century of hard work by media executives is collapsing before our very eyes.

Retail / Consumer Discretionary: I don't think I even need to elaborate on this. Whether it's department stores or companies like Whirlpool, which earn most of their margin by slapping stainless steel on commoditized machinery, they're all in big trouble.

Utilities: This is traditionally a "safe haven" area, but I am still seeing bears. For one reason, they're all highly leveraged businesses that constantly need to borrow money. Even though I expect they'll be able to keep rolling over their debts, one cannot ignore the fact the credit market is uber-ursine. At some point the rising yields will push up their interest costs and squeeze profits. And, think about it like this: What happens to house prices when interest rates rise? Home prices typically would fall. What happens to the value of your utility operations when the cost of owning it (borrowing costs) go up? Moody's, for instance, recently cut Ameren's outlook from positive to stable because of its reliance on bank lines as lenders tighten credit. It's not a big danger, but the trend is moving in the wrong direction.

Furthermore, I believe we are entering a period of true deflation. Most people praise how the Fed is pumping liqudity into the economy, but I think their interventions will have the unintended consequence of poisoning the credit market with altruism and unintended consequences. See this posting for more on this subject. As the economy weakens and prices fall, utility revenues will get squeezed while expenses like interest payments will remain fixed.

Another problem for utilities is that they recently spent a lot of money on capital expenditures. Con Ed's capex rose 30% between 2005 and 2007, Public Service Enterprise Group's rose 32% Excelon's rose 51%, and PG&E's rose 53% -- to name a few. When companies spend money on things like upgrading transmission lines and towers, they spread the cost over several years using an accounting method called depreciation. Just like interest payments, this is going to be another fixed cost dragging on earnings at the same time people buy less electricity.

Utilities are also valued for their high dividends relative to other stocks. But now they must compete with rising interest rates on Treasuries and higher rates on various other bonds.

And, of course you have the weakening economy. We now face the real prospect of factories and shopping centers going dark. This caused Moody's to recently cut the rating on American Electric Power (AEP), a conglomerate with operations in struggling areas such as Michigan and Ohio.

One final concern is the future of coal-fired plants under a Democratic Congress and White House. This is less clear, but requires some awareness.

Aerospace / Defense: I don't know much about this industry, but know that it's been on fire for a long time and the country is facing big budget deficits. Lockheed Martin and Northrup Grumman, for instance, have cut their forecasts. Again, the Democratic control of Congress is a concern. And, the weak economy and slowdowns in emerging markets -- recently big plane buyers -- are also obvious headwinds.

Healthcare: This is a mixed bag. Biotech always has some kind of big winning story, so there are good secular things going on. One story I think that has been badly neglected is the complete collapse of hospital stocks like Health Management Associates and Tenet Healthcare because of their huge debt loads. These companies' ready willingness to borrow in search of higher shareholder returns was a sad and ignored consequence of the recent credit bubble. We also don't know what will happen to them under some kind of nationalized health system.

Another concern is Pfizer's purchase of Wyeth. We can assume the Pfizer has almost unlimited information on the industry, yet CEO Jeff Kindler was unable to find any small biotech company worth buying. Of course, he might just be a bad executive. But if Pfizer, with an insider's view of the industry, couldn't find any company worth buying, does the sector deserve any of your money?

Tech: This is the one area that everyone is talking about. I can see the positive case because many of these companies are much better run than they were in the late 1990s. But, I still see an industry that has reached maturity in many ways. Instead of seeking ever more powerful computers, consumers are now opting for less expensive "netbook" computers for using the Internet or doing word processing. Companies like Dell are trading close to liquidation value, and it seems like more and more of the semiconductor industry is getting totally commoditized. However, some names like Apple and Research in Motion seem to have positive secular stories underway.

Mining: These stocks are also a mixed bag. Gold is enjoying a completely new kind of bull market. Previously people bought gold as a way to bet against the dollar. Now both are rising together. I think we're seeing the ominous early signs that people are seriously questioning the long-term existence of the monetary system as we know it. But mining stocks themselves seem to be in a bad spot right now cylically because they spent a lot of money for expansion and now need to scale back. Secularly it's hard to determine whether they are worth buying. On one hand, if the global economy recovers and middle-class consumption grows in emerging markets as people expect, they'll prosper. An alternate vision is that the collapse of the U.S. housing market will cause another Great Depression because, in many ways, the global economy is just an extension of the American consumer. I personally think house prices will keep falling for another 5-10 years, as I explain in this posting. I think we've already entered another Great Depression because the Fed has waged guerilla war on the credit market, as I explain in this posting.

Financials: This is obviously an industry in a terrible place secularly. U.S. fixed income and credit -- Treasuries, corporates and asset-backed -- have flourished for almost three decades as the country's debt levels ballooned. It was probably the greatest bull market in the history of finance, and made possible surging prices for stocks and real estate. We obviously already know about the credit crunch and all the writedowns. It's hard to bet against a lot of these stocks right now because of the government's involvement. But I am comfortable saying that the financial bubble is broken, no matter how hard Ben Bernanke and Tim Geithner might huff and puff to reinflate it.

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