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Thursday, June 24, 2010

How's the Economy Doing? Under the Hood in June + Portfolio Strategy and Long Ideas

This is an update of our "How's the Economy Doing" periodic series and follows recent posts around economic data and divergent views. As a reminder, while our our investment strategy focuses on bottom-up analysis of individual companies, we think awareness of overall macroeconomic conditions is helpful since trends may impact certain companies or sectors.

In recent months, we shared a number of headlines from the global shipping industry highlighting positive developments. Let's look at some hard data across other sectors:
  • Railroads - from Association of American Railroads on 6/17/10: "For the week ended June 12, 2010, U.S. freight railroads continue to post traffic gains over 2009 levels. U.S. railroads originated 288,973 carloads last week, up 10.5 percent from the comparable week in 2009. However, carloads were still down 10.3 percent from the same week in 2008. Intermodal traffic totaled 223,075 trailers and containers, up 17.7 percent from last year but down 2.3 percent from 2008. Compared with the same week in 2009, container volume increased 20.1 percent while trailer volume rose 5.9 percent. Compared with the same week in 2008, container volume was rose 6.2 percent while trailer volume fell 33.3 percent. Sixteen of 19 carload commodity groups were up from last year, led by an 88.9 percent jump in metals. Combined North American rail volume for the first 23 weeks of 2010 on 13 reporting U.S., Canadian and Mexican railroads totaled 8,463,154 carloads, up 10.2 percent from last year, and 5,940,938 trailers and containers, up 12 percent from last year.".
  • Trucking - from American Trucking Associations (yes, ATA is plural) on 5/28/10 for the month of April (reporting lag): "The American Trucking Associations’ advance seasonally adjusted (SA) For-Hire Truck Tonnage Index increased for the sixth time in the last seven months, gaining another 0.9 percent in April. This followed a 0.4 percent increase in March. The latest improvement put the SA index at 110.2 (2000=100), which is the highest level since September 2008. Over the last seven months, the tonnage index grew a total of 6.5 percent. Compared with April 2009, SA tonnage surged 9.4 percent, which was the fifth consecutive year-over-year gain and the largest increase since January 2005. Year-to-date, tonnage is up 6 percent compared with the same period in 2009. ATA Chief Economist Bob Costello said that the latest tonnage reading fits with a sustained economic recovery." 
  • Air - from IATA on 5/27/10: "The International Air Transport Association (IATA) announced international scheduled air traffic results for April 2010. Passenger demand slumped by 2.4% as a result of massive flight cancellations centered in Europe during the six days in April following the eruptions of an Icelandic volcano. The fall in traffic interrupted the industry’s recovery from the global financial crisis. International scheduled cargo traffic, less impacted by the cancellations, saw the pace of its recovery slow to 25.2% growth in April (down from the 28.1% improvement recorded in March). The scale of the ash crisis saw global load factors drop to 76.9% from the 78.0% recorded in March. Freight load factors also dipped to 55.3% from the 57.1% recorded in the previous month. While March traffic was within 1% of pre-crisis levels for both passenger and cargo, this slipped to 7% for passenger and 3% for cargo in April.
  • Semiconductors - from SIA on 6/10/10: "The Semiconductor Industry Association (SIA) today released an updated industry forecast that projects worldwide chip sales will grow by 28.4 percent to $290.5 billion in 2010. The forecast projects 6.3 percent growth in 2011 to $308.7 billion, followed by 2.9 percent growth in 2012 to $317.8 billion.“Healthy demand in all major product sectors and in all geographic markets drove sales of semiconductors to record levels in the first four months of 2010,” said SIA President George Scalise." We note that this forecast is highly sensitive to GDP and, therefore, can change quickly
  • Residential Housing Permits and Starts - from US Department of Housing and Urban Development on 6/16/10: "PERMITS: Privately-owned housing units authorized by building permits in May were at a seasonally adjusted annual rate of 574,000. This is 5.9 percent (±2.2%) below the revised April rate of 610,000, but is 4.4 percent (±2.6%) above the May 2009 estimate of 550,000. Single-family authorizations in May were at a rate of 438,000; this is 9.9 percent (±2.1%) below the revised April figure of 486,000. STARTS: Privately-owned housing starts in May were at a seasonally adjusted annual rate of 593,000. This is 10.0 percent (±10.3%)* below the revised April estimate of 659,000, but is 7.8 percent (±9.7%)* above the May 2009 rate of 550,000. Single-family housing starts in May were at a rate of 468,000; this is 17.2 percent (±7.9%) below the revised April figure of 565,000. 
So, aside from volcanic eruption impacting air travel, essentially all other areas are seeing Y/Y growth, including the still challenged real estate sector with positive permits and starts Y/Y. Of course, we have yesterday's news on new home sales - from the AP via Yahoo! Finance (YHOO): "sales of new homes collapsed in May, sinking 33 percent to the lowest level on record as potential buyers stopped shopping for homes once they could no longer receive government tax credits." AND, in the other areas - as we've noted in the past -- we're up against easier Y/Y comparisons.

FURTHER, we now have a growing realization that individuals, corporations, and governments can't borrow into perpetuity. On this point, let's bring in a synopsis from Annaly Capital Management's (NLY) monthly commentary (released 6/8/10):
  • "We begin this month's commentary with the same sentence we used to close our last one: In case anyone needed a reminder, the financial crisis is not over. The uncertainty over Greece has spread to other corners of Europe and prompted deep soul-searching and grudging action by the central planners of their monetary union. Here in the US, Congress gets down to brass tacks on finalizing a financial regulatory reform bill that was conceived in the middle of a crisis with little apparent regard for potentially negative unintended consequences. (One example: the capital required for 5% risk retention by mortgage originators will likely impede meaningful recovery of the securitization market and won't help underwriting standards. Another example: the amendment to require banks to spin out their derivatives operations lives on despite the protests of Bair, Bernanke and Volcker, people who presumably know better.) And signs appear that the economic recovery might be built on sand after all, with the housing and job markets flashing yellow and the risk of deflation rising."
Thus, no question -- as if the ongoing monstrous oil spill wasn't enough -- Annaly succinctly provides a perspective to keep everyone awake at night and negatively pressure Market psychology.

Fortunately, looking at corporate fundamentals, we continue to see favorable results and forward guidance. Our expectation, similar to that espoused by Bob Dole of Blackrock in his WSJ opinion article (and shared in our Maria Bartiromo post), is that better fundamentals can support share prices and, potentially, surprise to the upside in the second half of 2010. Recall that valuations are directly related to underlying earnings, as pointed out by Peter Lynch in the 1990 video we shared the other day. The risk to this view is if psychology becomes sufficiently negative to impact consumer and corporate purchasing/investment behavior. Also, we admit that the job market remains tenuous and may stay this way as a result of (1) creative destruction and (2) incessant corporate streamlining (related to point number one). We'll see what happens.

If you need some "good" consumer news to provide comfort/confidence, look no further than 1Q10 results (*acknowledge: prior to debt crisis) and commentary from Pier One Imports (PIR) on 6/17/10:
  • Comparable store sales growth of 14.3% versus last year’s decline of 7.5%
  • Merchandise margins were 58.6% of sales compared to 54.2% last year
  • Gross profit improved to 37.4% of sales compared to 30.2% last year
  • Operating income of $8.3 million compared to an operating loss of $26.7 million last year 
  • CEO says: "... Store traffic, conversion rate and average ticket all increased during the quarter – our customers are clearly enjoying our merchandise, our stores and our customer service. We experienced strong performance in all merchandise divisions and all areas of the country. Our confidence level is high and we know how to keep the momentum going...." 
AND from Select Comfort (SCSS) on 4/21/10:
  • Net sales for the quarter totaled $158.0 million, an increase of 13 percent on same-store growth of 29 percent, compared to $139.6 million in the first quarter of 2009. 
  • The company reported net income of $7.8 million, or $0.14 per diluted share in the first quarter of 2010, compared to a net loss of $2.7 million, or $0.06 per diluted share, in the first quarter of 2009.
  • CEO says: "... We took advantage of an improving consumer environment and positive in-market testing to increase media investments behind our proven value messaging. The result was sales growth across all company-owned channels. While still cautious about macro-trends for the balance of the year, we anticipate an improved outlook for 2010 based on our continuing momentum, and consequently are increasing our earnings guidance."
The improved operating performance for both companies is reflected in incredible share price recoveries over the past year:

Scratching your head? Yes, the results from Pier One Imports and Select Comfort might be considered counterintuitive relative to the steady flow of negative media headlines around the weak consumer and economy. We come back to something we wrote in our long thesis for BIDZ (BIDZ) last August:
  • People like to shop – while the average American consumer is struggling, we submit that Americans will always be consumers, with some arguably addicted to purchasing products from TV channels such as QVC.com (LINTA) and HSN.com (HSNI), as well as Web sites like Bidz.com. A growing middle class elsewhere in the world also brings more consumers.
From a portfolio perspective, our strategy hasn't changed: as always, we need to pick our spots with a preference for very low multiples of current earnings and growth.

We continue to sleep well owning franchise type businesses that are currently generating significant excess cash flow and have limited to no debt. As in the past, examples in this category include eBay (EBAY), PetMed Express (PETS), 1-800-Flowers.com (FLWS), and Weight Watchers* (WTW, *has what we see as a manageable debt load). Click company name for our prior commentary.

Finally, per our Approach caveat #2, we may sometimes purchase out of favor or off-the-radar companies that offer a meaningful margin of safety relative to current liquidation value and/or normalized asset values. There remain names that have not participated in the torrid market rally, but offer what we believe to be significant margins of safety. Our ownership positions in container shipping companies Seaspan (SSW), Global Ship Lease (GSL), aircraft leasing company Babcock and Brown (FLY), and waste services company Casella Waste Systems (CWST). Micro-cap Sonic Foundry (SOFO) also falls into this bucket because we continue to believe the company is trading at a meaningful discount to the private market value that would be assigned to Sonic's growing Mediasite franchise by an informed strategic buyer.

Happy investing,

Jeffrey Walkenhorst


© 2010 Jeffrey Walkenhorst
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