Backlogs Are Overrated

Just a quick note before I head out for the weekend. In the face of oil peaking at $135 per barrel in recent days we have seen many of the airlines cancel planned deliveries of new planes they were going to add to their fleets over the next few years. Those plane orders are now unnecessary as the carriers are cutting capacity.

The big point here is that investors often go gaga over industrial suppliers’ backlog. The longer the backlog the more predictable their revenue stream over the longer term, or so the investors would have you believe. Due to long lead times customers do have to place orders far in advance, often years ahead of time. Hence, the suppliers report their backlogs to investors to give them an idea of future business.

All of this appears to be very important, except for the crucial point that a customer (an airline for instance) can simply cancel their orders whenever they want since they are not binding. A large backlog may look really nice, until customers start canceling orders.

Now, would I prefer a large backlog to a small backlog? Of course. That said, I think backlogs in general are overrated on Wall Street since the orders are not binding. As a result, backlogs don’t always translate into revenues.

Housing Market Not Showing Any Life

Inventory levels of existing homes had been steady for several months but preliminary April figures show another spike to more than 11 months of supply. The housing market cannot improve until the supply and demand picture does and these numbers are pretty ugly. When supply is growing faster than demand, prices will continue to fall, so investors should keep this in mind when allocating investment dollars to anything that is dependent on home prices.

Are Legacy Costs Really AMR’s Biggest Problem?

Rubens writes:

“Can you give some specific advice to the big airlines on how they can cut costs and become profitable? I don’t think you really understand their situation. To compare the big airlines with the budget ones is like comparing a Ford and GM plant with a Toyota one. Ford and GM has massive legacy costs of high salaries and benefits, and so do the big airlines. American is one of the few (or is it the only one?) of the big airlines that hasn’t filed for Chapter 11 in recent years, which would have let them reduce costs and renegotiate legacy employee agreements.”

Thank you for the comment, Rubens.

Unfortunately, it simply isn’t true that legacy costs are the problem for American. In fact, Southwest actually spent more on wages, salaries, and benefits than American did in the first quarter.

As you can see from the Q1 summary below, American’s cost structure is higher than Southwest despite the fact that they spend less than Southwest on compensation expense. The difference in fuel costs is due to Southwest’s hedges (which tapers off over time) and it is too late to hedge those now.

However, AMR operating losses in Q1 amounted to 3.3% of sales, which just so happens to be the difference in “other” operating costs. So, if AMR could simply get their non-fuel cost structure in line with Southwest’s, they would have broken even in the first quarter.

UPDATE: I left off one statistic I meant to include. AMR employs 152% more people (85,500) than Southwest does (33,895) yet AMR only has 125% more in revenue. So staffing levels are another area they could cut to get their revenue per employee ratio down.

Full Disclosure: No positions in the companies mentioned at the time of writing

$130 Oil Leads to Irrational Moves at American Airlines

With oil prices surpassing $132 per barrel today for the first time ever, American Airlines (AMR) has reacted by raising prices. Most notably the airline will charge travelers $15 to check a bag. The company calls this a “revenue growth initiative” in their press release, but it is really just silly. When high fuel prices are pressuring an already bloated cost structure and a weak economy is reducing air travel, price increases are not going to help AMR. It simply does not address the problem.

In such a competitive industry, weak players increasing fees will only result in more people going to discount airlines, which are run far better than their larger counterparts. There is a reason Southwest Airlines (LUV) has been taking market share and has never lost money in any year since its founding more than three decades ago and it is not because they started to charge their customers for things like checking baggage. In fact, they have used those boneheaded ideas in their brilliant marketing campaigns:

The problem for AMR and the rest of the airlines that go bankrupt every five or ten years (this time will be no different) is that they rarely directly tackle the problems that are causing them to bleed red ink. Raising prices in a price sensitive industry reduces revenue and does nothing to address bloated costs. The airlines need to get their costs in line with their revenues. It is not rocket science; Southwest and JetBlue (JBLU) have done wonderfully over the years.

The AMR story is not very much different than the management of our federal government lately. Gas prices are crippling lower class Americans? Okay, then we will give them tax rebate checks and tell them to go out and spend that money on $4 gasoline. How does that solve the problem? As Dr. Phil would say, “money problems are not solved with more money.”

All the government is doing is paying us to buy gas when buying gas is exactly what is causing fuel prices to be so high in the first place. We are sending money straight to the oil executives and the nations who export their oil to us. This transfer of wealth, both from poor to rich and from the U.S. to the oil producing nations, doesn’t even begin to address the energy problems we face. As 5% of the world’s population using 25% of the world’s oil, paying our citizens to buy gas is the last thing we need.

As long as these are the things that AMR and the government are doing about sky-high oil prices, the investment strategy is not very difficult to pin down: stay long oil producers, foreign currencies, and the rich and stay short the airlines, the dollar, and the poor.

Full Disclosure: No positions in the companies mentioned at the time of writing

Election Worries Have Put HMO Stocks Like United On Sale

Owning healthcare stocks in an election year, especially one in which universal healthcare has taken center stage on the Democratic agenda, is not surprisingly a wild ride. With less than six months to go until our country chooses its next president, near-term headline risk for healthcare stocks should stay elevated for a while. That said, some healthcare names, most notably the health insurance providers, have seen their share prices get beaten down to levels that can’t help but get value investors’ attention.

A perfect example is United Healthcare (UNH), one of the largest health insurance providers in the country. The combination of political risk and a recent acceleration in healthcare cost inflation have investors nervous. The stock has fallen from a high of more than $59 in December and hit a new 52 week low on Thursday, trading below $32 per share. This dramatic 45 percent decline leaves UNH trading at merely 9 times trailing earnings. Such a meager valuation indicates that Wall Street is genuinely concerned that a Democrat in the White House could cripple the fortunes of the HMO industry.

History has shown, however, that wide sweeping changes are rarely accomplished in Washington DC, especially when the issue is as complicated as the broken U.S. healthcare system. Even small, productive changes are difficult to attain when politicians and lobbyists are involved in decision making that is trying to make life better for the American electorate. In other words, using history as a guide seems to indicate the current pessimism on Wall Street regarding the HMO industry may prove to be overdone. The near term headlines could very well spook investors further as the election approaches, but getting arguably the best managed HMO company in the country for 9 times trailing earnings looks like it could turn out to be quite a bargain.

Don’t get me wrong, I would like to see transformative healthcare reform in this country as much as anyone. I simply don’t think the political environment as it stands currently has a very high probably of accomplishing such a magnificent feat.

Full Disclosure: Long shares of United Healthcare at the time of writing


Taking Some Profits in Apple

Shares of Apple (AAPL) rose nearly $5 today to close at more than $188 per share. The company is faring very well during an overall weak time for consumer spending, thanks to a strong product lineup, and Wall Street is excited over the prospects for the company’s forthcoming next generation iPhone.

This overall bullishness is the polar opposite scenario we saw back in February when I wrote that Apple’s Valuation Looks Attractive Again amidst worries over a consumer-led recession and a lapse of new product introductions from the company. Since then the stock has soared from $119 to $188, for a gain of 58%. As a result, the shares have gone from very compelling from a valuation standpoint (22x 2008 earnings estimates) to fairly valued in my eyes (34x 2008 earnings estimates) and accordingly I have been taking some chips off the table at current prices.

Apple Stock Performance – 2008 Year to Date

This is not to say the fundamental outlook for Apple has changed (it hasn’t), just that the stock no longer looks extremely undervalued as it did several months ago. The company remains a reasonable core technology holding in my view, just no longer in any significantly elevated portfolio weighting.

Full Disclosure: Long shares of Apple at the time of writing, just in less quantity than before

Citigroup First Quarter Update, As Promised

JoJo writes:

“Now that Citigroup has posted its first quarter earning for 2008, do you still stand by your original analysis, or you think you have to revise it?”

Thanks for getting my butt in gear for the update I promised, JoJo.

As many of you may know, Citigroup (C) reported a loss of $5.1 billion in the first quarter, which hardly makes it easy to figure out what a more “normal” quarter would look like for them. While the losses and writedowns did go down in Q1, versus Q4, there is still plenty of cloudiness in Citi’s results.

Nonetheless, there is no point in shying away from digging through the numbers, even if they are complicated, which is why I even bothered writing about Citi in the first place. The first thing I did was update my spreadsheet showing Citi’s quarterly income results by segment going all the way back to 2007. This allows us to see the trend for the last five quarters. Then I added my prior forecasts from February (For those who don’t recall, I projected three scenarios — conservative, moderate, and aggressive — each trying to pinpoint the possible earnings power for Citi post-credit bubble). Here is the data:

Now, let’s go through it. As you can see, the biggest obstacle to valuing Citi is the Markets and Banking segment. That division lost $5.7 billion during the first quarter, which accounts for all of Citi’s total loss and then some.

It is going to take some time to really pinpoint if my projected “normal” profit range for the investment banking operations of ~$2-$4 billion is accurate. The reason is that much of the losses right now are one-time events, not recurring costs of doing business.

For example, Citi wrote down $3 billion in Q1 just on auction rate securities and monoline insurance exposures. That accounts for more than half of the investment bank’s losses for the period, but those issues won’t be around long term, as they are simply due to the recent credit crunch. As of right now, I’m sticking with my estimates for the investment bank, as nothing we know now leads me to think they can’t earn several billion in say, 2010.

As for the other segments, the numbers are actually not that far off. The International Consumer division’s trailing twelve month profit figure is right in between my moderate and aggressive forecast. U.S. Consumer is clearly strained right now, though they are not too far off from my numbers ($6.5 billion in profit for the past year, versus a conservative estimate of $7 billion). Global Wealth Management is also not too far off, so all in all I don’t see the need to change much right now.

Now, you may be asking why I am using trailing twelve month profits rather than annualizing the latest quarter. Well, I’m thinking that just as 2006 and early 2007 profits were overstated due to the credit bubble inflating, the results from Q4 2007 and Q1 2008 are understated due to the extreme strain in the credit markets. By using a rolling four quarter average, I can get a better idea of what an entire year might look like rather than extrapolating just three months. That said, this formula isn’t perfect either, and we will see a lot of volatility as the strong numbers from 2007 are anniversaried.

Full Disclosure: No position in Citigroup at the time of writing

Microsoft Played Brilliantly, Hands Off Negotiations to Yahoo Shareholders

This blog has been rather quiet recently, but things should pick up shortly. I am in the process of relocating and other things have limited my time lately.

This Microsoft (MSFT), Yahoo (YHOO) story just can’t get any more interesting. Now that MSFT has walked, what can we expect? Well, YHOO’s management team looks like fools, not only for misplaying their hand, but also for taking very lightly their fiduciary duty. Expect YHOO shareholders to revolt. I would not at all be surprised if YHOO is forced to do the deal, because the board really can not say anything to shareholders that remotely convinces them that the company is worth $37 per share or more. When the market thinks you are worth about $20 and someone offers you $33, you take it. End of story.

Even if MSFT really is out for good, this whole thing will help YHOO because it will have to work hard to make meaningful changes now that they balked at such a great buyout offer. The problem is that morale at Yahoo is probably at rock bottom right now, so any sense of renewed independent creativity is easier said than done.

I am still pretty surprised a deal did not get worked out by now, but I don’t think we’ve heard the end of it. If a deal does get done at some point this year, there will likely be an excellent entry point for MSFT created, so investors should keep that mind as this saga continues.

Anyway, the blog will get livelier soon, you have my word on that.

Full Disclosure: Long MSFT and YHOO at the time of writing