Thursday, January 31, 2008

Kraft Squeezable

Kraft's earnings are out and they got quite the margin squeeze.

The sales were up significantly, 10.9%, and there were about 6% shares due to a share buy back, but that translated into zero growth in earnings for 4th quarter and a decline of 12.4% for 2007.

Kraft's margin declined by 4.1%. Nine out of the eleven largest commodity input costs are at record high levels. Kraft priced their products based on historical prices and therefore did not respond to the dramatically increasing input costs.

I might add that many investors are doing the same with how they are pricing their investments and how much they expect them to grow based on a historical prices, ignoring that input costs across the market are dramatically increasing and companies only have so many "tricks" to try and smooth them over.

An example of prices input increases for Kraft would be barrel cheese. It increases from $1.31 last January to $2.03 in November, or 54% at the peak. It is unlikely that kind of price increase can be passed on to consumers without losing a big chunk of market share. Perhaps this last round Kraft did not increase their price as much as the competition and that accounts for the increased market share.

A further potential problem for Kraft is that they have as much debt as 5 years ago because of the share buyback program. So in future quarters they should also have more interest expense.

Yuck... Kraft has one of those tax things where after taxes are "paid" earnings increase... When tax benefits are used up the "earnings" takes a major hit and the stock tends to trade down to reflect true earnings.

World grain stores have declined from 110 days around 2000 to 53 days currently so it is no surprise that wheat is at an all time high. Additionally, with the weakening US dollar any imports would be up considerably.

Other commodities coming from developing countries are likely to reprice to a more fair value for the workers. The prices were suppressed due to UN policies where they were all pushed into agriculture to help pay back the debt and it resulted in some commodities being priced at 30c on the dollar compared to 20 years earlier. It also resulted in worsening the poverty, yet North America gained with cheap imports. There has been an increase in replanting those highly suppressed crops with drugs and other cash crops, which is finally pushing the prices up to more reasonable levels.

The prices are likely to stay significantly higher.

So, Kraft raises prices to increase profitability, and they lose market share, or they remain the same and they just aren't as profitable.

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Sunday, January 27, 2008

World Economy Slow Down

I am looking forward to the next stream of financial and annual reports that will be coming soon. I predict that the press releases will focus on the annual earnings and completely gloss over the 4th quarter earnings, which I expect will not be rosy for any base metal company. However, the 4th quarter earning are probably more representative of the company's next quarter earning potential rather than looking at the full years.

In a recent post I was asking if base metals would fall off a cliff. There were many indicators that economic growth was slowing.

The US is of particular concern. According to Nobel economist Joseph Stiglitz the US has been drawing down home equity at a rate of $700 to $800 billion per year.

That's a lot of unsustainable US economy. Further, the US consumption economy is about $9.5 trillion. The home equity borrowing has been 7-8% of the consumption US economy. Now that lending standards have tightened, and home equities have declined, that borrowing is not likely to continue at anywhere near the same rate. It has to be a strong US slow down in the economy and the trickle down effects can not possibly be pretty.

Emerging markets are not likely to make up the slack. China's consumption economy is a mere $1 trillion, so $700 billion is 70% of their economy. Anyone who thinks China will pick up the slack is smoking something pretty strong.

This can't possibly be good for base metals. There are a lot of base metals that go into consumer goods. Additionally, commercial construction is rapidly declining as well, and municipal budgets that might do big capital projects that require base metals are in trouble because municipal budgets are in trouble due to declining revenue from declining home prices in the US. Cities are demanding all departments cut budgets.

Mining projects in the process of being developed do not just stop in the middle of hundreds of millions of dollars being committed to them, so increases in supply tend to strongly lag changing economic conditions. Data showing slow downs for material usage tends to be lagging rather than leading. In the US housing starting were going full throttle as late as last March, and all of the materials that go into housing would have continued to be used until some time in the fall or winter, yet by then housing starts had plummeted, but the actually declines in demand from that reduction will not be fully showing up in financial reports until the end of Q1, and it should be significant. So far Q4 earnings are down about 20% for companies that have reported Q4 earnings. That's gigantic and it is crazy to not think that that isn't have an effect on commodity demand.

Base metals have had enormous leverage of earnings from record commodity prices and they've been bid up in price, valuing the base metals stocks like a coca-cola stock, only base metals are at far more risk to supply and demand price fluctuations that demand a low P/E when prices are strong. When the market looks good and the company has good growth prospects I'd never give a second look to a base metal stock with a P/E of 12 or higher. It has room built in for down side risk and a opportunity to exit without wiping you out should the market turn, which it appears to have done.

There are numerous examples now of how the downward leverage affects earnings. From Q2 07 to Q3 07 FNX mining's revenues declined 28.3%, but earnings declined 64.3% despite the fact that "the total tons of ore, pounds of nickel, pounds of copper and ounces of precious metals produced and sold was were higher ... than in any previous quarter," according to the Nov 1, 2007 news release. According to google finance the current P/E is 21.7, but that has earning of $12.5 million (the last report), $35 million, $30.2 million and $19.7 million included. Go four quarters forward based on last quarter and you get $50 million per year of earnings compared to the current last four quarters of $97 million. It means the P/E for last quarter reported is about 43. Average nickel price was $11.65/lb and copper price was $3.57/lb. FNX is still richly valued despite being down 37% from its high. The $24.87 shares earned 15c/share last quarter. Even if you believe they can double earnings, the shares seem richly valued.

Teck Cominco's earnings declined from $2.01/share to $1.16/share for the same two quarters, only Teck Cominco did not get so insanely valued. Their revenues were down about 1/3rd yet earnings were down 42%. Their loss of leverage of earnings was not nearly as drastic as FNX. Teck's current P/E is 6.46 and forward P/E is 10.63. It is down 40% off its high. The $32.51 shares earned $1.16/share last quarter.

It is likely any base metal company examined will show a higher decline in earnings than revenue because of the leverage and it is also likely that all established companies will experience a significant decline in earnings due to the declines in commodity prices, which are at risk to decline further due to the economic slow the entire world seems to be experiencing.

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Sunday, January 20, 2008

Updated Links

The left sidebar of my blog has several frames, starting with who I am, then there are three posts that I consider of my best quality, then in my archive of posts. The "What I've been reading are news, blogs and items that I found interesting that I've added to my blog through Google Reader. I just click "share," and it shows up in this frame.

I updated my links today, starting with Mish's blog. I think he is one of the best economists that I read daily. The market is going through some serious problems and if you want to improve your understanding of what those problems are and how we got them, spend a few hours going through Mish's blog.

Safehaven has a series of writers appear on it. Some are exceptional, a few make no sense to me and there are some counter views on important topics.

Bespoken gives nice little summaries about various items around the market.

Calculated Risk looks quite a bit at the housing market and bond insurers for mortgages. It gives a lot of insight into the housing problem.

Economic Briefings gives short headlines and summaries of daily economic events.

Nouriel Roubini is an economist that has been warning of a hard recession well in advance, brought on by the mortgage crisis.

Market Ticker is one of my newer finds for me. I liked the few posts I read so I decided to include it.

Infomine gives all the information you'd ever need on commodities. They mirror my commodity posts, which have been few and far between lately. I have been distracted by the US housing crisis and economic unwinding because of it.

Stockhouse is a good source of stock information and you can create a portfolio of stocks of interest to yourself.

The Kirk Report was one of the first good blogs I found. I like the Kirk Report because this guy gives good advice on preserving capital and looking after your portfolio. If you follow his blog at all he's been saying his is mostly patiently watching the market since around last October.

Dollar Daze has quite a bit about devaluation of the dollar and commodities.

Seeking Alpha has a wide range of good contributors.

Pencil's blog is written by a high school student. I think he is around 16 or 17 now. I just find him an amazing young man.

Motley Fool Caps Game is a stock game predominately for US stocks.

Kitco Base Metals gives commodity prices and there are links for gold and silver prices.

After my links I have my page visit counter. When I am writing regularly I seem to get 100-200 visits per day and while I've been quiet it has declined to 30-40 visits per day.

Next I have a whole bunch of thumb commodity price graphs.

After I have labels. I don't think I use the labels all that well.

And finally, at the very bottom I have a US debt widget. The US federal debt is about $9.2 trillion right now.

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The Food Squeeze

I was just reading a blog by a writer from Alberta on his views on food inflation, which sent me looking a little closer at what is happening in the industry. It is yet another recession red flag.

Liverliss concludes with his analysis:

"My point is that we have not seen the impact of increasing grain prices being priced through into consumer food inflation. But we soon will. And when I see numbers like the above, where the cost of raising a hog right now exceeds the selling price by almost 100%, I become convinced that the inflation that we are about to see in foods is going knock everyone off their feet."

With that comment he is specifically referring to a commentary on about the price of raising a hog compared to the current selling price, pricing that has gotten way out of wack due to grossly increasing feed costs. The commentary suggests that farmers are currently loosing about $30/hog.

As with all things dealing with supply and demand, there was a shortage of pigs, which lead to fantanstic profitability, and now over supply that is particularly harsh due to the gross increases in feed costs. The article points out a one day slaughter record of 436,000. Pork is a commodity that can not be stored for very long, so it must be sold or it will spoil. Pork currently has enormous price power for consumers. It is extremely cheap relative to production costs. If you love pork and have capacity to freeze it, a good food cost saving strategy would be to be filling up your freezer as you see it on sale over the next few months as this incredible pork boom will lead to gross declines in production to the point the farmers will have the enormous price power and likely in a year or two we will be paying 50-100% more per pound of pork.

The commentary points to large eggs as a recent example, farmer were getting 50c/dozen and losing money, they cut back and now they are getting $1.50/dozen and making record profits.

I also found a more researched article on hog producers that outlines the cycle over the past few years and the forecast for 2008.

It goes back to 2004, which was the highest margin in 15 years. This draws investment inflow and higher capitalization in the industry -- that is what happens with supply and demand. 2005 had a lower margin but was still an excellent year. It says the return was $7.83/hundred weight, but that return declined to $1.21 for 2006, or higher feed costs and lower pork prices squeezed farmers by $6.62/hundred weight in a one year period. The squeeze on farmers has continued and it looks like break even or slightly negative margins for 2007. The article doesn't give any projected costs for 2008, but states negative margins are expected.

Looking at what is happening today, the record slaughter earlier this month gives the food packer the pricing power and ultimately the consumer. It only tells me what the packers were paying over xmas, not the change in the price from a month earlier, or a year earlier, but their "farmers math" says that it was an awful xmas for hog farmers and by next fall there will be a major correction to supply and demand that will hit consumers.

The US is in a no win situation. The Crammers of this world can scream about the need to lower interest rates, but that rapidly devalues the currency and dramatically increases input costs and hence inflation. The highly understated, manipulated, reported inflation came in at 4.1% for last year. When you consider the first 6 months did not show any significant increase, well it means inflation was considerably higher for the second half of the year. This was easily predictable from the devaluation of the US dollar. I did a very short post on the Canada/US effects from one day of devaluation. The US dollar devaluated relative to most currencies, significantly, and the price increases simply have not worked their way into the economy, yet.

There will be no economic stimulation when consumers find that their costs are increasing faster than their wages. There will be no wage leverage of workers when those not laid off are feeling grateful they still have a job when they see co-workers being let go. There will be no wage leverage when employers find themselves with 10 resumes for every job they offer.

Historically lower interest rates stimulate the economy in three ways:

1) By enabling people to reduce their repayment debt burden by refinancing and either enabling them to pay back debt faster (which foolish consumers did not do) and enable them to get out of debt sooner. Consumers with no debt have significant buying power and consumer choices.

2) Keep payments the same and increase disposible income now immediately stimulated the economy with more spending, but does little to increase financial security and tends to lead to living beyond one's means if it is all spent and none is put towards financial security. It is dismal is all is spent on option 3, which is what masses of Americans did.

3) Borrowing beyond ones means, which is what happened in masses. The average debt load has increased by one times the average wage in the US over the past 5-6 years. This option no longer exists from lowering interest rates as risk was not priced into this lending. The gross level of living beyond one's means was not immediately apparent, but is quickly becoming very apparent.

Today only options one and two exist and given that Americans were spending 30% more than their income over the past 5 years, the non-existance of option 3 means there is no longer stimulation from lowering interest rates. The only thing it can do is help people convert their debt to that which will not increase their burden down the line.

The inflation from lowering interest rate may very well make the lowering of interest rates more harmful than if they just left them because the inflation will likely be far greater than any reduction in interest burden.

The coming food squeeze in pork is but one example.

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Saturday, January 19, 2008

Increasing Whole Sale Prices

Consider that wholesale prices are up 6.4%. I am not sure the degree to which this is a problem, but I picked two stocks to have a quick look at. McAfee has a market cap of about $5 billion and 160 million shares. My first glance is that the wholesale price increases will hurt them less than other businesses. Their cost of revenue for the last five quarters, starting with 09/06 and going to 09/07 is 22.3%, 22.6%, 22.2%, 22.7%, 24.2%. It has taken a jump in the last quarter, but overall their cost of revenue is low so wholesale prices increase should not hit them as badly as say a company with say 60% cost of revenue. They have this "other" income that I haven't a clue as to what it is and I'm not inclined to spend hours trying to find out. It is about 30% of the earnings so it is a fairly serious wild card that has the potential to seriously hit the earnings.

So, looking at McAfee, my instincts are whole sale prices are a lesser issue with this company, but the "other" income could be. The taxes being paid is an enormously serious issue with this one. I just noticed it. Those same 5 quarters the percent taxes go 33%, 28%, 22%, 17% and 5%. With that "wouldn't we all like to see our tax burden decline like that" reduction in taxes paid for each of the past 5 quarters earnings have gone 0.21, 0.20, 0.27, 0.29 and 0.39. The number of shares is increasing every quarter, up to 165 million diluted shares now. With proportional taxes to a year ago last quarter's earnings would have been 27c/share, so this tax game has inflated the last quarter's earnings by 44%. Typically the executives of companies understand the short term nature of the inflation of earnings from tax benefits and use these events as a Richistan liquidity events, and cash out their options. They often also make the event even more lucrative for themselves by initiating share buy back programs which gives them an even greater spread on their stock options.

Ok, so the wholesale price isn't such an issue with McAfee, but the artificial inflation of earnings due to tax benefits is enormously serious. With an economic slowdown there should also be a bit of a hit to earnings and a slight margin squeeze. I haven't taken the time to really dig here, but I see that eps predictions for this year are $1.62 and $1.75 next year. Wanna bet the analysts are way wrong yet again? The lows are $1.37 and $1.53 with the highs at $1.62 and $1.75 respectively. I suppose if the tax benefit remains for the whole of next year, all of next year could be inflated earnings, but real earnings without the tax benefits is probably in the $1 range, making this about a $20 stock. Well, that look went off on a tangent...

The other one I picked to look at is Crocs. Their cost of revenue for the same last 5 quarters goes 41.8%, 42.3%, 40.5%, 40.9% and 39.4%. They've done a good job in actually reducing the cost of revenue in a highly inflationary period, but not enough to make up for the diluted number of shares increasing by 5.5% over the period. Their growth has been enormous, but it looks like that is coming to an end. They have 4 times as much inventory as they had a year ago.

I don't know about the rest of you, but for me, most footwear I buy lasts a few years, especially seasonal footwear. I think that Crocs has probably done the market penetration thing so that they have to wait a few years for repeat business and now they are relying far more on the "I don't care about a fad" kind of buyer. I don't have a pair of these things, but for me, if I did, either they are good enough that I wouldn't be buying because I have a pair and I wouldn't need another pair for a few years, or they were garbage so now I know where I don't want to spend my money again.

This enormous growth of inventory is potentially a problem. The product is too new to say for sure. I am very curious about what the next earnings report says. Last year from the 09/06 to 12/06 quarterly reports sales increased by about 1%, so essentially flat. Well, this past quarter the revenue was 2.4x the year earlier. What you have to be asking here is how much of the sales is to give the retailers a selling inventory and how much is actually being sold to consumers? How much did retailers sell at fire sale prices to clear space for other seasonal products? How much do retailers just leave on the shelf year round? How successful will they be with their higher priced spin-offs? I think this one has enormous uncertainty, but the next financial report will give a much better idea of which way this company is going. If they have over capacity for supply their earnings are going to hurt because there is a certain fix cost and should the overall sales volume decline, that will squeeze the margin, both in a proportional increase in fixed costs and a decline in revenue. Another tangent...

So, setting out to have a peek to see how wholesale costs increasing would show up in financial reports did not really show that with my look at a total of two companies...

However, in the macro economic picture, and with a simple mathematical model, this is how it should work. Consider 4 companies and the only variable is the wholesale costs. Each company trades at a P/E of 20. The wholesale costs make up, respectively, 20%, 40%, 60% and 80% of costs. The wholesale costs increase to 21.26%, 42.52%, 63.78% and 85.04%.

At a P/E of 20, the shares are trading at a price that has the earnings left over at 5% of the market cap. For simplicity, I will look at two examples, one where 10% of revenue made it to earnings and one where 20% of earnings made it to revenue.

For the 10% example, now you have 8.74%, 7.48%, 6.22% and 4.96% now making it to earnings, for declines in earnings of 12.6%, 25.2%, 37.8% and 50.4%. In order for the share price to correct to back to a P/E of 20 the share price must decline by these amounts respectively, or the new P/Es would be 22.9, 27.0, 32.2, and 40.3 respectively.

For the 20% of revenue making it to earnings the wholesale price increases are less damaging, causing declines in earnings of 6.3, 12.6, 18.9, and 25.2% respectively.

If the company is operating very tight and has say only 5% of revenue making it to earnings, well, these companies are in big trouble with the increases in wholesale prices.

So this very simple look at whole sale prices suggests that companies with the lowest cost of revenue and greatest percent of revenue making it to earnings will basically outperform the market, however, even though they will take the smallest squeeze on earnings, all companies will face some degree of squeeze on earnings. This is probably very good criteria to use to in deciding which stocks that are far more likely to be hurt with increasing wholesale costs. Of course there are many other variable to consider, such as debt, pricing power to offset costs, etc.

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Friday, January 18, 2008

My Home Selling Experience

My husband and I sold our home earlier this month. It was the third home we've sold and this home selling experience was probably the best in terms of the service we got from our Realtor, David Chan.

If you are in the Vancouver area, I strongly recommend David. Our home had about 50 potential buyers come through and look at it. David also completely respected our wishes and I always felt that he had our best interests in mind. And, we saved on commission.

A little on our first home selling experience; the Realtor put a tremendous amount of pressure on us to accept an offer that simply wasn't acceptable to us. With fees it would have left us with slightly negative appreciation over the two years we'd owned the home. We stood our ground and got 5% more, but there was nothing about this experience to suggest our Realtor was trying to do his best for us as opposed to just trying to get the sale out of the way.

Our second Realtor completely missed that it was rising market and we could have easily gotten an extra 3-5%. We had already purchased the our home that we just sold, so we were looking to sell, but with identical units selling for 5% more in the next 2 months, and 13% more in 6-8 months, well, he did absolutely nothing special for us. Indeed, he said he thought 2.5% more could be a challenge. The fees were high and there was absolutely nothing there to suggest that we got anything worthwhile for those fees. Interesting, the people who bought our second home were also selling about the same time we were. They ended up with a 6% higher increase on their home than we did, which really supports that our second Realtor did not really price our home as well. Both homes were in the same neighbourhood.

For our third selling experience we decided to go with David Chan at One Percent Realty. We knew our local market fairly well and as we wanted to sell, we set the price for about 3% less than what I figured was current market value based on recent home sales in the area.

An exceptionally important part of David's services, which is necessary in a highly competitive sales market, is the photos. David hires a professional photographer to take pictures and he puts top notch pictures and surround views of rooms in your home on the internet. The number one source of today's home sale traffic is the internet and how you have your home presented there is where you do not want to skimp. This service was included in the fees.

To get a perspective of the difference in photos that we took compared to the professional photographer David hired, well, below are three sets of photos of the same rooms, the first is our picture and the second is the professional one. I think you'd agree the professional pictures showcased our home far better than our photos and was money well spent.

Dining Room us
Our photo has washed out colours, only part of the room.

This photo shows the beautiful floors, fireplace, height and depth of the room.

Bathroom us
Again, the color is washed out and we didn't even close the toilet seat.

Bathroom Professional
Again, better colour, more depth, height and you can see the shower.

Bedroom us
Washed out again.

Master professional
This is a beautiful room, showing the vaulted sealing, the view...

David knows the most important thing to get your property sold and how to set it apart from others on the internet. Additionally, it was listed on the MLS and the extra information was linked to his web site from the MLS. Pretty much all buyers look on the MLS on their own these days, so you want to be "selling" your home from the minute potential buyers have their first look, and David's services do that. Indeed, as people look so much more on their own these days, the services offered by a buyer's Realtor have truly declined and proven to be unnecessary.

I honestly feel that many Realtors have justifiably earned a reputation for being, well, "slimy," and the buyers Realtors were just that, imho. We had three different potential buyers put in offers with their Realtors. Every single one of those Realtors put in that they wanted about an extra $8k on a separate form to change the terms of what we were offering. I am not sure how the buyers or their Realtor thought that doing that would be in either the buyer's or our interest. Perhaps if they had met our price without any subjects we might have accepted paying the additional extra $8k, but, when you offer your Realtor an extra $8k, the way I look at it, that's your negotiating room, not mine.

In the end we accepted $3k off our asking price, gave the slimy Realtor an extra $2k and spent about $1-1.5k fixing a few "subjects" for the buyers. We got a price for our home fairly close to our asking price and we were pleased with the result.

In summary, if you want to sell in a tight market, know the recent selling prices and set your property a little below those prices. Paying a Realtor high priced commissions is not necessarily going to be better for you. Assessing the actual services and what sets your Realtor apart is what you need to do. Assess the services from what you see because all Realtors will tell your they are the best. As soon as they have your listing most are working on trying to get the next listing as opposed to selling your property. The truth is that if there are buyers out there, they will come once the property is on the MLS. Get a Realtor that will showcase your property for internet viewing, professional photographs and listed on the MLS will set you apart. If you need to sell, and list with a more reasonably priced Realtor, well, expect the slimy buyer's Realtors to be wanting a bigger take for their one day of work.

But, on another point, if you are buying, why not increase your negotiating power to pay less by going directly to the selling Realtor rather than bringing a middleman that wants $10k for 1 day of work? Surely for that kind of price negotiation power you can research what is wise for you as a buyer to be putting in your contract. Better yet, pay a Real Estate lawyer $500-1000 to review your contract and put a subject to review of a lawyer.

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