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US Savings Rate: Ignore It

We are always hearing about the negative US Savings Rate and how we are “living on credit”. It is only a matter of time before our bubble bursts and we are plunged into recession / depression or what ever else negative “sion” they can come up with. Let’s just ignore the number you see. Why? The method used to arrive at number we always see, while accurate 50 years ago, in today’s investor economy gives us a false number. Here is how.

Today savings is calculated as:

Income – Federal taxes – Expenditures= Savings

sound easy enough correct? Wrong and here is why.

1- Excludes capital gains

Let’s say I bought 300 shares of Sears Holdings (SHLD) in 2004 for $23 a share spending $6,9000. Wanting to pay for my kids college, I sold them last month for $180 a share pocketing $54,000 or a profit of $47,100.

According to the current savings calculation, that $47,100 is not counted as income..

2- Includes all Federal Taxes

Now, Of that $47,100 I now have to pay 15% long term capitol gains taxes of $7,050. That tax bill is included in the “taxes paid” portion of the saving equation even though the income that generated it was not.

3- Includes the spending of the gain

The remaining $40,050 that is sent to the college, is now counted as an expendtiture in the calculation..

so for what I just illustrated, the income and expenditures and taxes all equal out to zero BUT, for the National Savings Rate, it looks like this:

Income = 0
Federal Taxes = $7050
Expenditures= $ $40,050

This gives me a NEGATIVE savings on this transaction on $41,000 when in reality, it should be zero.

Another factor? 401k’s

How many retired people are getting an income from a 401K? If you are that numbers is NOT being counted as income, BUT the things you buy with it are being counted as expenditures, giving you an artificial negative savings rate.

Own a home? Has it increased in value? The increase in that value is NOT counted as savings either. When you sell it and have a gain you then roll over into another house, you have the same mythical spending with no income from our stock transaction. The money you put down on the new house and the taxes you may pay on the sale of the old are counted as expenditures but the gain on the sale of the old house is not counted as income.

Perhaps this is then reason that even though we have a “negative savings rate” as a nation, our household wealth is at all time highs?

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Lowe’s (LOW): Getting Enticing

This past holiday weekend I was talking to my 4 year olds and they said that they wanted to get another bird feeder for the house. I asked them where they wanted to go and they both said “Lowe’s (LOW)”. Hmmmmm. “What about going to Home Depot (HD)?”, I asked. They replied that they did not want to go to Home Depot, they wanted to go to Lowe’s. “Why?”, I asked. “There is more light and people help us in Lowe’s” they replied. Now, if a four year old feels this way, I am going to guess millions of other folks out there do also.

This comes off news that Lowe’s recently increased it’s market share in 17 of 19 business categories last quarter. They also announced that they are increasing their dividend 60% and, here is a big one, adding $3 billion to their share buyback program. Last quarter Lowe’s repurchased $650 million of shares and could buy more. This is a company that produces over $2.1 billion from operations each quarter and after all it’s capital expenditures, share repurchases, debt reduction, still had a cool $250 million left to add to it’s piggy bank.

The new buyback announcement means they have a total of $3.8 billion worth of stock they are authorized to repurchase. At today’s prices that will take about 119 million shares of the 1.5 billion total or over 7% of off the market. That is a significant amount. The real beauty of this is that is can easily be done over the next year and a half with very little impact on operations or by adding any additional debt.

The dividend. At it’s new level, Lowe’s will yield about 1%. This is poor when you compare it to the over 2% yield from Home Depot. Lowe’s will spend about $450 million over the next 12 months on dividends (depending on the rate of the share buyback) at the new rate and while significantly higher than the $87 million it doled out in 2004, more is needed.

Now, the buyback will help and let’s look at why. Let’s assume for a minute that Lowe’s does not increase the dividend and keeps it at it’s 20 cent annual level. Currently that means they will return $300 million to shareholders at the current 1.5 billion shares outstanding. After the buyback, there will be about 1.38 billion. This means that all thing being equal, Lowe’s would only need to spend $276 million to keep the dividend at its’ current rate. It also means that at the new rate (32 cent a share) they will be spending $441 million vs the $480 million they would have spent without the share buyback. So buybacks help both us shareholders, buy allowing more of a companies profits to be available to us (higher EPS) and allow the company to increase the dividend without a direct dollar for dollar impact. A win -win.

The only thing stopping me from buying share now is the anemic dividend. In a rather mature industry, I would like to see more of a commitment to shareholders here. Lowe’s is kind of a “tweener” in this respect. It is not really a growth company anymore and it does not yield much for potential investors. But, were shares to get hit and dive under $30, they would be very tempting for me. Very tempting

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Bespoke: Great Research

From the site.

“Bespoke Investment Group, LLC applies this same “tailored” concept to financial research with MyBespoke. Until now, customized market analysis has been available only at the institutional level — and at enormous costs. Bespoke has altered the landscape for customized research by allowing anyone — from large institutions to the most modest investor — to receive the specific in-depth analysis they need in a cost efficient and timely manner.”

“Formed in May 2007 by Paul Hickey and Justin Walters, formerly of Birinyi Associates and creators of the acclaimed TickerSense website, Bespoke’s research platform will enable any interested party to gain the data and knowledge necessary to make intelligent and profitable investment decisions. As evidenced by Bespoke’s Think B.I.G. website, users gain access to some of the most original content and intuitive thinking on the Street.Bespoke Investment Group, LLC applies this same “tailored” concept to financial research with MyBespoke.

Until now, customized market analysis has been available only at the institutional level — and at enormous costs. Bespoke has altered the landscape for customized research by allowing anyone — from large institutions to the most modest investor — to receive the specific in-depth analysis they need in a cost efficient and timely manner.Bespoke Investment Group, LLC applies this same “tailored” concept to financial research with MyBespoke.”

I have been receiving the daily emails from Bespoke for a few weeks now and they are good. I like the “Morning Lineup” email. It gives a very concise and informative capsule of the upcoming day and arrives about 8:30 am est. Now, eventually they will begin to charge for this service so the “value” of it will then be determined. I have no idea of any potential pricing so I will not even attempt a guess.

You can go the the site and request a “Sample” and they will email it to you in a pdf format. I suggest you do it as the information is detailed and different that the normal research out there. I specifically enjoy the work they do on sectors and the overall markets and the economy. It is “big picture” items and worth the look.

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Top Stories Month To Date From Value Investing News

Here they are. Please visit George’s site Value Investing News as it has great information from many different sources and is a truly democratic site as registered users vote on stories. There is no webmaster cherry picking going on here. Here are the top 5 for May to date:

1- Sears Holdings: A “Techinical” Look– ValuePlays

2- Financial Blog Watch: Controlled Greed– Radio.wallst.net

3- Monish Parabi 13-F for 3/31/2007– sec.gov

4- Wally Weitz on Berkshire Hathaway and Dell– youtube.com

5- Seth Klarman: World Class Warrior- nytimes.com

Good Reading and have a safe holiday….

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Owens Corning (OC) Insiders & Officers Buying Up Shares

Since Owens Corning (OC) emerged from bankruptcy last October, there have been 19 transactions from corporate officers of shares and all 19 of them have been buys. As Peter Lynch famously said “There are a multitude of reasons insiders sell stock, there is only one reason they buy, they think the price is going up.”

Corporate officers spent $1.9 million of their own funds to pick up over 68,000 shares. The big fish was 10% owner Harbigner Capital Partners, who bought $35 million worth for 1.04 million shares.

Officers:(rounded)

Chairman Mike Thaman- $505,000
CEO David Brown- $505,000
DIR. James McMonagle- $160,000
VP Dean Roy- $65,000
VP Charles Dana- $74,000
VP Brian Chambers $74,000
DIR. Ralph Hake- $93,000
VP Sheree Bargabos- $99,000
VP Joseph High- $50,000
VP David Johns- $74,000
VP Stephen Krull- $74,000
VP Frank OBrien- $50,000
VP Charles Stien- $50,000

I have been recommending Owens since January and am up over 20% so far. It would seem like my enthusiasm is shared by those with the most intimate knowledge of its operations and prospects, management.

Similar to George Soros’s recent purchase of ADM shares seeing folks purchasing a stock you have been invested in does reassure you of your picks and when you are in the stock well before their purchases and at much lower prices, it does bode very well for the future of your investment.

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Dow + DuPont = Drama

Talk about drama. The SEC initiated an investigation into whether or not a senior executive and a board member at Dow Chemical (DOW), both of whom have been fired by the company, secretly attempted to put the company in play, the New York Times reported today. The investigation might also probe Dow’s attempt last autumn to buy DuPont (DD)in a deal worth over $40 billion. At the time, neither company disclosed that Dow had approached DuPont. DuPont turned Dow down, but its stock rose 15% between September and December. The SEC is also examining the unusual trading that resulted from their actions in both companies stocks. Another question that will need to be answered is who at JP Morgan let the “cat out of the bag” to folks who then piled into shares of DuPont or, was it only Krienbeg and Reinhard since it appears JP Morgan was working both deals simultaneously?

Dow says the speculation, and the accompanying stock price spikes, were fueled by the actions of Romeo Kreinberg and J. Pedro Reinhard, who held “multiple meetings” about a takeover. JPMorgan Chase, who was working on the unauthorized takeover proposal of Dow, admits it met with both men. Both executives deny the accusations and have countersued Dow for defamation. Another question that will need to be answered is who at JP Morgan let the “cat out of the bag” to folks who then piled into shares of DuPont or, was it only Krienbeg and Reinhard?

The SEC probe and the lawsuits will hinge on testimony from JPMorgan CEO James Dimon, who told Liveris that Kreinberg and Reinhard had held talks with JP Morgan about a Dow takeover. It would be hard to imaging nobody at JP doing anything wrong after looking at the activity of both companies stocks, so Dimon will essentially have to throw some of his folks to the wolves.

The really big news here is the attempted Dow and DuPont merger. This story is going to have a ton of twists and turns to it in the coming months and ought to keep us occupied in an other wise slow summer. Dow has long coveted Dupont’s seed business an the offer was an attempt to get it. Since that seems to have failed could a Monsanto (MON) joint venture be coming? It would be a way for Dow to get heavily into the seed business and provide Monsanto cheaper building blocks for its products and cash to reinvest in it’s business as it has stated it wants to.

Stay tuned to this one

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Notes From Sherwin Williams (SHW) Investors Conference

On May 22nd. Sherwin Williams (SHW) held an investor conference at the company’s headquarters.

Lead Paint was the first topic: Inside Council Dale Normington addressed the gathering after CEO Chris Connor stated, “While Rhode Island has been a little bit of a hiccup, we think there is a light at the end of the tunnel”

Mr. Normington:

Rhode Island:
“It would seem inappropriate to say, but I do take great pleasure in announcing that after almost 8 years we finally get this out of the hands of the judge who was handling this in Rhode Island and to the Supreme Court. There is no question the court will hear our appeal and that will happen in the next year.” (8 to 10 months)

The appeal will be five parts running concurrently:
1- Contingent fee
2- State is appealing win Arco got
3- state will appeal contempt citation against RI AG
4- Appeal of legal issues by Sherwin
5- Appeal of trial issues by Sherwin

“For those who saw the trial and seen the judge’s opinions”, according to Normington there are a “plethora of issues” both legally (market share, product identification, contingency fee, public nuisance) and from the trial (jury instructions, issues with witnesses, evidentiary rulings and opening and closing arguments and more) to address.

Issue of remedy(Special Master). “There is no plan in place and there will not be one for quite a while.” The scope of any remedy “I can assure you will be thoroughly debated”

Two full days of oral arguments are expected in Q1 of next year and he expects a decision before they adjourn in June 2008.

A “win” is a new trial or a reversal based on legal issues of allowing trial to go forward to begin with.

“Sherwin Williams currently has third party action against landlords and judge has not announced when those trials will go forward”

Ohio:
“Localities heeded the siren call of Motely Rice”

Asking for a Federal Constitutional review of Trade Association (LIA) involvement being a function of free speech. Sherwin is claiming free speech activities cannot be a basis for liability.

“Ohio product liability law prohibits prosecution without product identification and there is no product identification available in lead paint cases” Meaning there is no way to identify the maker of the paint that may have poisoned children. Localities have argued this law does not apply here, Sherwin obviously feels it does. Common sense would lead one to believe it does also.

Federal judge in Ohio will review contingency fee legality. A decision is expected in 30 days.

“If Federal judge rules contingency fee illegal under federal constitutional grounds, we can argue that ruling enjoins all localities from using contingency fee council”

California:
“Judge ruled cities cannot use contingency fee council. Localities may not be able to go forward without contingency fee council”

“Cities have requested a stay pending review”. Judge will rule this week or next on stay request.

The Business:
CEO Connor: “We have lots of opportunities ahead of us”. Perhaps giving insight into future plans for Sherwin, Connor then said, “Our model transports to other regions of the world.”

Paint store expansion has been “very successful” and will continue “for the better part of the decade”.

My takeaway:
Official at Sherwin are actually relieved to be in the appellate process and seem very confident in the direction the lead pain litigation is headed. Why? I guess it may be because when all is said and done, they did nothing wrong and eventually truth and what is right always wins. It may not be easy or quick, but it happens.

The tone of the business talk was one of expansion. Whether it be through the acquisitions of more local dealers to expand the paint stores or international to open more markets, Sherwin is not sitting still. While not specifically stated, it is clear that Sherwin is intent on being the #1 paint and coatings company in the world. They plan to “aggressively pursue” expansion in China and India, markets where the current coatings landscape in very “fragmented” and ripe for consolidation. According to Connor, the companies affirmation of guidance and Q1 share buybacks should illustrate their confidence in both the results and the value of shares.

This is a very exciting time to be a Sherwin shareholder. The company is on the cusp of finally ridding itself of the lead paint albatross and is correctly looking towards the future. I think one will look back at this period of time several years from now and view it as the seminal point in which Sherwin vaulted itself from a huge regional to a huge worldwide presence.

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Credit Suisse Downgrade Of Dow Chemical (DOW): Nonsensical

NEW YORK, May 23 Analysts at Credit Suisse downgrade The Dow Chemical Co (DOW) from “outperform” to “neutral.” The target price is set to $50. In a research report, the analyst Mark Connelly wrote that he likes Dow’s strategy, but sees only moderate upside after speculators recently drove up shares on buyout rumors. He has a $50 price target on the stock, up from $49. He also downgraded the overall major chemicals industry to “Underweight” from “Overweight” on expectations of slowing demand growth. This does not make sense. If you used his numbers, over the next 12 months DOW will return an almost 15% gain to shareholders when you add the 11% share price increasehe expects and the almost 4% dividend DOW will pay to shareholders. How is that bad?

What is it going to “under perform””? The market? Does he think the The Ratings For Sectors

Overweight: Industry expected to outperform the relevant broad market benchmark over the next 12 months.
Market Weight: Industry expected to perform in-line with the relevant broad market benchmark over the next 12 months.
Underweight: Industry expected to underperform the relevant broad market benchmark over the next 12months

Now the Individual Company Ratings

Outperform: The stock’s total return is expected to exceed the industry average* by at least 10-15% (or more, depending on perceived risk) over the next 12 months.
Neutral: The stock’s total return is expected to be in line with the industry average* (range of ±10%) over the next 12 months.
Underperform**: The stock’s total return is expected to underperform the industry average* by 10-15% or more over the next 12 months.

So what do we have? The Chemical sector being downgraded to “under perform” means that is will lag the S&P in 2007. Dow’s neutral rating means that is will match that performance plus or minus 10%. Some math is now necessary. Let’s say S%P advances 10% in 2007. This guy is right and the chemical sector “under performs” and only advances 8%. That means that Dow’s neutral rating means that shares will be between $44 and $53 from their current $45. The more the sector lags the market, the more the downside risk. If the chemical sector only advances 1% in 2007, his expectation is shares will trade between $41 to $50.

Here is the best part: “In an effort to achieve a more balanced distribution of stock ratings, the Firm has requested that analysts maintain at least 15% of their rated coverage universe as Underperform. This guideline is subject to change depending on several factors, including general market conditions.”

Translation? “We have to put a certain number of firm in a category whether they warrant it or not. A depending what the market does, if we are going to look foolish we reserve the right to arbitrarily change that.”

Is anyone getting where i am going with this? He has no idea where shares are going to trade..

Please ignore them…

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Sprint Nextel (S): An "F" In Customer Service

Sprint Nextel(s),the #3 wireless carrier behind AT&T and Verizon was formed by the merger of Sprint and Nextel in 2005 with a stated goal: “Two great traditions of bold innovation have come together in a new company with a clear mission: To be No. 1 in providing a simple, instant, enriching and productive customer experience. Nice tag line but the company is failing at this goal at such a magnitude it makes one wonder if they even realize it is a stated goal. When Sprint bought Nextel they purchased quite possibly the single best wireless carrier at the time. It had an incredibly loyal customer based and it’s “walkie-talkie” feature was at the time the single most significant breakthrough for the average cell user. It allowed people to not use minutes when communicating to each other over the Nextel network. This caused families and businesses in mass to make the switch to Nextel for the cost savings this provided.

Aside from it’s features, what set Nextel apart from every other provider was it’s customer service. It had bar none the best in the industry. When one called customer service at Nextel you left the conversation feeling that they not only valued your business, but were thankful to have it. A call to customer service was actually a satisfying and enjoyable experience. I would actually receive calls from customer service out of the blue thanking me for doing business with them and giving me 100 or 200 free minutes that month to use. The call was not a “make good” due to a problem, it was just a thank you. They would even call me to offer a free upgrade to another phone, just for being a customer. When was the last time a company called you with a freebie that had no strings attached? Their efforts lead to shareholders being handsomely rewarded as the stock climbed from $3 in 2002 to $30 when the merger was announced.

All that changed with the combination of the two companies. A call to customer service today is only slightly less maddening than listening to Palestinians and Israelis argue about “whose fault it is”. The person on the other end not only does not speak English as a first language, I am not even convinced they are vaguely familiar with it. I know what the critics are going to say “you just cannot understand people with an accent”. Aside from not being true, the problem is that they cannot understand me and my dialect is about as vanilla as they come. The most glaring problem? The connection we have always, for lack of a better word… sucks. No matter if I call from my cell phone, home phone, business phone or pay phone the connection is always lousy and Habib and I spent 90% of the conversation asking each other to speak up so we not understand each other more clearly. How can a phone company have a lousy connection?

Another recent experience in which I attempted to switch from the Nextel to the Sprint network entailed 3 trips to the Sprint store (because the people at customer service in Bangladesh told me to go there, which was wrong), a phone delivered two days late to the wrong address and 1 hour on the phone trying to actually place the order. I could have refinanced the house quicker. The single most infuriating part? Apparently the folks at the Sprint store are not allowed to sell you the phone and switch you to the Sprint network!! Is this one company or not? Now, they can switch me from Verizon or AT&T to either Sprint or Nextel, but not from Nextel to Sprint, okay…. Understand this is two years after the merger.

Now, understand this is not just me, a recent JD Power Survey gave Sprint the lowest grade among the major cell providers for customer service.

The effect of this continued fiasco are felt in an consistent decrease in subscriber growth for the combined company. Sprint has tried to explain this by saying “it has been focusing on higher-quality customers, which has resulted in the losses”. Am I the only one who just cannot see the logic in this argument? If the customer you are going after is resulting in increasing losses, how can they be of “higher quality?” Remember, prior to the merger Nextel was a very profitable company.

Shares, after hitting a high of nearly $27 in July of 2005, current trade at $21. 2006 EPS fell 7% from 2005 and Q1 2007 EPS fell 150% from 2006 levels (6 cent profit to a 3 cent loss). It has been over 2 years and this is clearly not working.

Rather than focusing on “higher quality” customers and ignoring the rest of us, how about focusing on higher quality (or just competant) customer service? It worked wonderfully for Nextel.

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Bio-diesel Producers: Ethiopia Wants You

After reading my post about Brazilian coffee bean producers turning part of their crop into bio-diesel in Forbes, I received the following request. Ethiopia is looking for any way to profit from its coffee crop and is looking for interested parties to look to Africa as a source of Bio-Diesel production.

“Ethiopia is the largest coffee producer in Africa. As a large (population about 75 million) but extremely poor (per capita GNP is the $100/year range) country, there might be interest in biofuels from an available resource. I would be interested in knowing more about this possibility, particularly some idea of capital requirements, required support infrastructure (e.g. reliability of the technology, need for highly skilled personnel, etc.), minimum size/capacity of a viable operation and expected output (gallons/liters of biodiesel).”

“Any of your readers with an interest in the Horn of Africa are welcome to add their email addresses to the list. The focus of the list is political/economic/developmental, with only very occasional items about coffee or biofuels.”

“Shlomo Bachrach”

Any interested parties can email me information and I will forward them to the necessary parties.

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Home Depot (HD) vs. Lowes (LOW): Go With Oprah

With both home Depot and Lowe’s reporting numbers in the past two weeks after the dust has settled, what should you do? After all, both have disappointed with earnings falling 29% for Home Depot (HD) and 12% for Lowe’s (LOW). Both have lowered expectations for the remainder of 2007 and both stocks have been losers over the past year with investors seeing their investment flat lined. Now, eventually we all know that housing will turn around because nothing stays down forever and let’s be honest, folks do need a place to live and there are more of us every year. There is built in demand here. Neither Home Depot or Lowe’s will need to convince people they need to buy the products they sell, what they do need to do is convince them to get those products from them, not the other guy.

Enter Oprah. Probably the single most important endorsement a company or person can get today is one from Ms. Winfrey. The mention of a book on her show instantly makes it a best seller. A personal trainer or self help personality featured on the show will find their schedule instantly filled at whatever rate they demand. In short, if Oprah gives you the thumbs up, welcome to instant success. Love her or hate her, her impact is undeniable. You are probably asking yourself what this has to do with Home depot and Lowe’s.

Oprah shops at Lowe’s. This spring has featured various home improvement episodes like the most recent one in which Oprah did a favor for her neighbors by sprucing up their Chicago balconies. Who did the work and got essentially an entire show long infomercial and thumbs up from Oprah? Lowe’s.

The effect of this can be seen in the latest earnings report from Lowe’s when they reported that 17 of 19 company segments experienced market share gains during the last quarter and while customers are spending less per trip, more of them (to the tune of 5.9%) are choosing Lowe’s when they shop. While this number may seem small, it is staggering when you consider Home Depot experienced a 20% drop in store traffic during the most recent quarter.

Eventually housing will turn and the big winner will be the one with the most customers, thanks to Oprah, that will be Lowe’s.

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iPhone: Apple (AAPL) Making All the Wrong Moves

After my first post on the iPhone last week in which I opined that the AT&T (T) lockup was a mistake for Apple (AAPL) and that the real winner in all this was AT&T. The #1 response from readers I received (other than I was a moron)was that this “was a short term arrangement that all carriers do, within 6 months the iPhone will be available to all carriers.” Hold the phone (pun intended), it would appear that the iPhone will only be available to the 47 million AT&T subscribers for the next 5 years!

USA Today reports the supposed half-decade deal also precludes Apple from developing a CDMA handset in that time. It would also appear that the arrogance and dismissive attitude Apple took with carriers during negotiations may come back to bite them. Word is that the #2 carrier in the US, Verizon will introduce it’s own version and is claiming it will be an iPhone-killer. According to Denny Strigl, Verizon CEO, “We do have a very good response in the mill. You’ll see that from us in the late summer.”

Rather than have a market all too itself for some time buy playing nice with all carriers, the attitude Apple took has caused a rush to introduce like versions to co-inside with it’s launch. Now not only will the iPhone not be available to the other 140 million plus US cell phone users, but those folks will be able to get their own version from other carriers this summer. Anyone want to bet it will be available for far less than the $500 -$600 the iPhone will be?

Now, any Verizon offering will not have the iPod application that the iPhone will have but if my many critics are to be believed, that was not going to be a major selling point anyway so the elimination of it will really be an insignificant factor to those purchasing these phones from Verizon. What will matter? Price. If consumers are able to avoid cancellation fees, can get a similar phone at a cheaper price and already have an iPod, there is zero incentive to rush out and get the iPhone.

This also means that the 10 million units Apple plans to have sold by the end of 2008 will be done to 47 million AT&T subscribers meaning 1 in 5 will have one? Doubt it.

How long does anyone think it will be before RIMM’s (RIMM)Blackberry has a version out there that will be available through all carriers?

When entering a new business, it is not really a good idea to strut in and tell folks who have been doing it for many years how much better you are than them and why you are going to dictate what they can or cannot do. All reports out there indicate this is what Jobs did and in the process seems to have focused the efforts of the other carriers into competing against him rather than working with him. Bottom line, he needs their networks for his product, he seems to have forgotten or chose not too recognize it.

I said before that the iPhone, as things are currently configured will be nothing more than a niche product and that it will be Apple’s first stumble after a string of hits in recent years, if the USA today article is correct, the AT&T deal all but assures it.

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Eddie Lampert Speaks at Investor Conference

The following are remarks from Eddie Lampert, Chairman of Sears Holdings (SHLD) to a conference held at the Third Avenue Mangement Investors Conference in 2003. It should be noted that this is prior to the Sears aquisition that created the Sears Holdings we today know. It should also be noted that Third Avenue was also a large investor in Sears along with Lampert. His insights into the Kmart deal almost creates the bluprint for the reasoning of the Sears one. These items are so informative when delivered by people the likes of Lampert of Buffett. The educational value of them alone is invaluable.

Overview and Summary of
Remarks by Edward S. Lampert
Founder and Manager of ESL Investments
Delivered at
The Third Avenue Management Investor Conference and Luncheon
November 18, 2003
Summarized/Edited
by
Kaushal B. Majmudar
Managing Partner
The Ridgewood Group
(www.ridgewoodgrp.com)
[Ed. Note: Edward S. Lampert of ESL Investments is an intelligent investor that we admire. As he has traditionally maintained a low profile, we were pleased to have the opportunity to hear from him at a recent event. We hope that others seeking to learn about intelligent investing can benefit from his thoughts as much as we did. This is a selective and personal record of what he said and so should not be taken literally.] Edward Lampert: [Comes to the podium after being introduced by Marty Whitman]. I will make some brief comments and then take questions.
About ESL
I started my firm in 1988 and began investing. I was inspired by Warren Buffett’s letters while still working on the Arbitrage desk at Goldman Sachs. We consider ourselves “Aggressive Conservative” investors [Note: A lot like Marty Whitman’s “Safe and Cheap” motto]. In investing, we seek to do a few things well, namely
1.) Understand the Business
2.) Understand the People Running the Business and
3.) Get safety from the price that we pay
Generally speaking, we focus on absolute returns in making investments. By the way, past performance as a measure of quality is wildly overrated. It would make a lot more sense to place more emphasis on and think about the people that put the track record together and the quality and value of the portfolio that they are managing.
About KMART
We invested in Kmart. Kmart was one of the worst managed companies in its industry. It was clearly distressed. Marty is one of the more sophisticated distressed securities investors and he was buying.
The standard Retail Bankruptcy process model is well established. People wait until Christmas and see what happens and then close the worst performing stores. Then the company hobbles along until the following Christmas and does the same thing again closing even more stores. It can be a slow process. Surprisingly, most of the Boards of Directors that put the company into bankruptcy stay in place until the company finally emerges under new ownership [pursuant to a plan of reorganization].
In the Kmart deal, neither I nor Marty were on the board or the creditors committee initially. Meanwhile, the professionals were making $10 to $20 million PER MONTH while the company was in bankruptcy. With that kind of money coming in, there would be low incentive to push to come our immediately. ESL and 3rd Ave. spent a lot of time trying to understand the existing process. They wanted to know the Company’s plan to emerge and the goals of the creditors committees.
Finally, Brandon (??) who works with Marty at 3rd Ave got onto the creditors committee. Their agenda (ESL and 3rd Avenue’s) was to have KMART emerge out of bankruptcy as soon as possible but with little debt.
The “Experts” said that KMART would never emerge from bankruptcy. The press was also extremely critical. As much as possible, everyone let Marty deal with the press because he is so frank and his comments on the matter were dead on. Most of the players involved in the process lacked urgency. This included many banks
and landlords (except those who actually wanted their space back). Lots of the players involved also probably had conflicts to deal with.
I have learned that it often comes down to who makes the decisions and also where the benefits and consequences fall – who benefits if the decisions work and who pays the price if it does not work. The large annuity aspect for advisors making $10 to $20 million per month made it less urgent for them to make it come out of bankruptcy. It was a difficult situation and a difficult process. However, ESL and 3rd Ave were able to influence the situation. Their power and leverage came from their willingness to put more money into the reorganized company as part of the plan (this was their source of power). In the process, they were able to force the shutdown of about 300 stores.
The plan they worked out was to take out the banks with cash (using money they invested). Trade creditors actually wanted the new equity. The Company ended up coming out of bankruptcy with $1 billion in cash and no debt. Because of Kmart’s consumer nature, perception was important. Now when it emerged from bankruptcy, the experts who said that it would never happen were wrong. However, they changed their tune and now started talking about how the Company would go right back into bankruptcy, a so called “Chapter 22” filling [i.e. Chapter 11 times 2]
More recently, they have been focused on trying to improve the operations and execution by KMART. There were already policies and procedures in place that people had not been following. People made a lot of improper decisions, but actually a big part of the problem was that they had been operating with the wrong “frame” for decision making. For any company, you need to have an overarching PHILOSOPHY to guide operations for profitability.
At KMART, they are trying to instill a teaching and learning culture by going back to first principles. This is challenging because in their case, they need to communicate to 170,000 people. They are simultaneously trying to improve the look of the stores and change the employee mix. They are thinking like owners in their approach to KMART. A lot of the successful companies in retail actually had owners (i.e. owner operators).
However, it is definitely an uphill battle. The Press does not understand what is going on at KMART. However, the Customers do and they have started getting compliments (from customers) again. Still they do have a lot of challenges.
ESL was established to invest like owners. The last 20 years has been about CEO as politician (e.g. Rumsfeld/Cheney) versus CEOs as owners. There is a whole system today that supports the rights of agents instead of the rights of shareholders. The Shareholder representation system is broken. Many of the recent SEC proposals are trying to introduce reforms to better align company, management and
shareholder interests. Good managements should be paid lots and lots of money because it is a hard job, but
only if they perform. You cannot pay people irrespective of performance. KMART was helped by the owner mentality that was possible because of presence and involvement of the large interested shareholders. Activist owners like ESL and 3rd Avenue help foster the proper balance between management and shareholders. This balance benefits all shareholders and not just the agents as is so often the case [in the
status quo today].
Q&A (selective)
Q#1 Someone asked about the Capital Structure of KMART at the time of the ESL investment.
A: There was approximately $1 billion in Bank debt, $2.3 Billion in Bonds, $800M in preferred stock, and some amount of common which was essentially worthless. Also about $4 billion of trade creditors were outstanding. In contrast, in the quarter ended July 2003 (post reorganization), the company had $1.2
billion in cash. $50 million of mortgage debt and a $2.0 billion 3 year line of credit (not drawn) Also, post reorganization there were 90 million shares initially issued at around $10 per share but now trading at $27 or 28 per share for a nice gain.
Q#2 Is future profitability for KMART based on repositioning the entire strategy or just better operations?
A: A lot of KMART’s problems were self imposed. They had a lot of possible assets and a good sized customer base. However, they needed to get back to basics and EXECUTE better and deliver a better in store experience to their customers. People like winners and they give winners the benefit of the doubt. The same people
who will wait in line at WALMART because WALMART is perceived as successful would get really pissed off if they go to a KMART and have to wait. However, expectations were so low that improvement was possible.
Q #3) There seems to be a pattern of ESL making investments in retail given positions in companies like KMART, AUTOZONE, and SEARS. This seems surprising since Buffett would consider retail to be one of the not so great businesses. What do you see that Buffett does not and why do you like retail so much?
A: Actually, investing in retail for ESL has been an opportunistic thing and a relatively recent phenomenon. I would agree with you about the general characteristics of retail not being that attractive. ESL was started in 1988, but their first retail investment (probably AUTOZONE) was made in 1997 and a few other opportunities
since then.
For more on Intelligent Investing, please visit us at The Ridgewood Group(www.ridgewoodgrp.com) or give us a call at 973-544-6970. Also visit our Blog at www.ridgewoodgrp.com/blog. For more on value investing please visit www.valueinvesting.info and www.indexvalue.com.
Copyright © 2003 by Kaushal B. Majmudar

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Coffee, Cows & Corn All Hurting Starbucks

Starbucks recently met its expected earnings number of 19 cents per share, representing 18% earnings growth. Great, right? But does that make it worth paying 36 times earnings? I’d say no.

Let’s look closer. In the first quarter of 2007, Starbucks (SBUX) bought back $50 million worth of stock. In the second quarter, that number exploded to $513 million, or 17.1 million shares. This represented 2.1% of diluted outstanding shares and was the reason Starbucks met expectations. After all the negative publicity recently, a miss would have led to a share sell-off and more stories about the “end of the line” for Starbucks.

While I applaud share buybacks as a way to enhance shareholder value, Starbucks cannot continue to spend $500 million a quarter to reach earnings estimates. One also has to consider that Starbucks’ margins will be under pressure from higher costs, and that store traffic growth is anemic.

Domestic same-store sales transaction growth was a paltry 1%, leading me to wonder when CEO James Donald will finally admit McDonald’s (MCD) coffee offerings are affecting sales. He never had to address the issue, as not a single analyst’s question on the earnings call broached the subject.

After the earnings announcement, in an interview on CNBC, Donald said “we do not really consider or discuss our competition.” He’d better start. They are stealing his business. Attracting only 1% more people per quarter will not fuel the long-term growth rate of 21.9% that analysts expect.

Another problem for Starbucks is ethanol–hardly what investors might expect to trip up the coffee company.

This year, the U.S. ethanol industry will produce over 5 billion gallons and use more than 1.5 billion bushels of corn, pushing prices near $4 a bushel. Dairy farmers are seeing the cost of feed jump and are finally able to pass that on to consumers. After years of flooding international markets with surplus milk products, the European Union, under heavy pressure from within, has curtailed its $59 billion annual subsidy system, at least where dairy is concerned. Combine that with drought conditions in New Zealand and Australia, two big milk-exporting countries, and it makes for tight supplies worldwide–and higher demand for U.S. product. Milk farmers, who collected 12.3% less for their milk in 2006, are fully intent on making that up this year.

“The price this year is not just going to beat the record by a few cents. It’s going to knock it out of the park,” Michael Suever, senior vice president for milk procurement at Chelsea, Mass.-based HP Hood, told the Boston Globe in April. Prices for raw milk are expected to rise at least 25% this year.

Starbucks, which uses an estimated 93 million gallons of milk a year, is looking at a $279 million milk bill in 2007. While it may not seem a lot to a billion-dollar company, it does equate to 36 cents a share, an increase of about 9 cents, or about 10.3% of profits, over 2006. This does not include the price increase to be incurred from changing the percentage of hormone-free milk from 27% to 37%. Starbucks does charge 50 cents more at some locations for this milk, so it must cost considerably more, no? When you are guiding 83 to 87 cents a share and 18% growth, the 10% of that in milk costs is huge.

We need to now look at biodiesel. Currently, Brazil is famous for two things: coffee and ethanol. Its national ethanol program has allowed it to become independent of imported oil, and now it’s turning its sights on biodiesel. Researchers have found an economically viable way to turn coffee beans into biodiesel. The oil-extraction from coffee bean rate, now at 92% to 94%, means the project will begin next year, and this year’s harvest will be affected, as coffee bean supplies are built up in anticipation. The project will enable coffee producers to produce enough biodiesel to power all their farm and agricultural equipment.

Why does this matter to Starbucks? Brazil is the world’s largest coffee producer and exporter, and this study contends that up to a fifth of coffee production will be used to produce biodiesel.

Let’s go back to Econ 101: When you constrict the supply of an item and have constant or increasing demand, price must increase. Starbucks, which already gets $5 for a cup of coffee, will feel the pinch. How much are people going to be willing to pay for a cup of coffee? Like all products, raising prices depresses demand. In the case of Starbucks, I think the effect of price on demand is more dramatic than commonly thought, as quality coffee can now be had at McDonald’s for a fraction of Starbucks’ prices. All coffee producers and sellers will be affected by the price increase, but when you are at the top of the price ladder and have painfully slow growth that is already a result of those lower McDonald’s (MCD) prices, that pain may be more immediate and severe.

When you add the Brazil situation to the recently announce Ethiopia settlement that now has Starbucks paying additional royalties for coffee from that country, Starbucks is now facing an onslaught of input price increases with not much wiggle room on the revenue side. When consumers are looking at $4 a gallon for gas, will they cut back on the $5 latte and go for the $3 one at McDonald’s? I bet they will.

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iPhone To Boost Blackberry Sales

Here is a post I found from another blogger. His argument is almost identical about the iPhone. At is current pricing level, it will just not sell to the masses. He agrees the big winner will be AT&T and then takes the discussion one step farther and states it will actually increase Blackberry sales. The Blackberry sales increase angle is a concept I did not go into but do agree with.

From Big Ben’s Investing Blog:

There is no question that the late June debut of the Apple (AAPL) iPhone will create a lot of stir. Much of the hype is already priced into the stock. Or at least most of the hype will be priced into the stock before the iPhone debuts in about a month. I still think you a can stay long Apple until the release. Apple will have a tough time selling the iPhone. An initial $500 price tag for a 4 GB music phone and a $600 price tag for a 8 GB phone will be too steep for most consumers. Still many iPhones will be sold and I remain bullish on AAPL.

Who Else Will Benefit?

1. Research in Motion (RIMM): Many of the same features of the iPhone can be had for a lower monthly fee and lower upfront cost with a Blackberry. The Blackberry Pearl runs between $59 and $149 depending on the carrier. Plus the data fees are $10 less per month than the iPhone. I believe consumers will upgrade their cell phones this summer and choose RIMM over the iPhone.

2. AT&T (T) will be a winner no matter what happens. AT&T is the exclusive carrier of the iPhone and will gain wireless subscribers. More importantly more consumers will add media bundles to their wireless plans when they upgrade to a “smartphone” in order to use all of its features. This is a homerun for AT&T, as the average revenue per user should increase with more “smartphone” subscribers.

3. Motorola (MOT) is my sleeper pick. Hovering near its 52 week low, I see lots of value MOT. Motorola has the RAZR 2 set to debut in July and the Q9 smartphone also set to debut shortly. The Q9 will put added pricing pressure on the iPhone and Blackberry Curve & Pearl.

One important thing to remember is that these cell phone upgrades come in cycles. I would never “invest” for the long haul in any of the above names. These are simply 6-8 month “trades.”

The “apple-holics” can scream at the blogger here: