Black Gold - Chunky Style

By: Chad Hudson | Wed, Mar 28, 2001
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US Coal Price
Broad Money Supply (M3)

California finally bit the bullet and raised electricity rates. With California accounting for almost 14% of the entire US economy, this inflation is bound to spread. While the California ordeal is gaining worldwide attention, the situation in the Pacific Northwest is just as dire. We have discussed the increase in electricity prices in the Northwest due in part to the California situation. Now the Bonneville Power Administration (BPA) is considering raising rates as much as 60%. This is having a detrimental affect on the nations aluminum industry, which has almost half its production located in the region. As energy prices have soared over that past year and imported aluminum proving more competitive due to a strong dollar, more than half the area's capacity have been idled - some of it permanently.

Now it looks like more of the country is about to get hit with higher energy prices. As the price of natural gas climbed last year, utility companies moved to coal generation to help keep cost down. Now prices of coal are at the highest level since 1989. Even though the price of coal has been increasing for the past year, utilities buy coal under long-term contracts so these price increases have not been passed on to the utilities. That is about to change. Arch Coal, the second-largest U.S. coal producer, will soon begin negotiations with utility companies for 2002 supplies. With most states allowing fuel cost to be passed on to the customers, utility companies will avoid the California clammily. But consumers will be hit with increases much quicker.

Well I spend all last week trying to figure out Agere's IPO and they change it on me. I must give a Morgan Stanley a pat on the back for creating one of, if not the most convoluted equity IPO I have ever seen. Last night, Agere finally was priced at $6 per share, a far cry from the original $16-$19 range. It begs asking, why Lucent did the deal if the terms deteriorated so much. That is were it gets interesting, but simply put - Lucent needs cash. Cash was such a vital aspect of the deal, Lucent "asked" its underwriters for lines of credit. Those who agreed were retained to underwrite the deal, those who did not were replaced by those who would. Dow Jones ran a story three weeks ago reporting that Lucent dropped Goldman and CSFB. These firms were replaced with J.P. Morgan Chase and SG Cowen, which agreed to lend Lucent $942.5 million and $320 million respectively. By the way, neither Goldman nor CSFB offered Lucent a loan. Just how much cash was Lucent able to secure? $6.5 billion. Which coincidentally was the estimated value of the Agere spin-off at the time.

The biggest lender was Morgan Stanley. Morgan has been helping Lucent by buying commercial paper from Lucent over the past several months. The original plan called for Morgan to buy $2.5 of Lucent paper. To reward Morgan, Lucent would hand over 200 million shares as an over-allotment to Morgan, which would pay off the commercial paper. Since the deal has been reduced, Lucent has been paying the paper as it matures. Now Morgan is only holding $840 million of Lucent's paper and only received a 90 million share over-allotment.

What is even more interesting is while Lucent was to keep all the cash from the financing, Agere was going to be stuck with at least a portion of the debt. I have not been able to find new numbers, but the original plan was to saddle Agere with $2.5 billion in debt that carries some hefty covenants, namely all of Agere's assets to securing the loan.

In its filing statement, Agere disclosed that 21% of revenues came from Lucent. Not surprising given that it was a part of Lucent. Not only does Agere depend on Lucent for a substantial portion of revenue, but the following 9 companies account for another 31% of revenue:

Apple Computer Cisco Systems Maxtor Corp.
Motorola, Inc. Nortel Networks Quantum Corp.
Seagate Tech. 3Com Corp. Tycom Inc.

Since Nortel is a rather significant customer, I'm sure neither Lucent nor Morgan saw the humor of Nortel pre-announcing an earnings miss for the first quarter just minutes after Agere's pricing was announced. Also, today S&P put Lucent on CreditWatch Negative.

While Nortel commented that it has no visibility of the future, John Chambers, president and CEO of Cisco, stepped up to the plate. In an interview with the Financial Times, Chambers said he expects the US economic downturn to last for "at least three more quarters." Furthermore, he has seen problems expand to Asia and Europe. In January Chambers warned that the current downturn would last for two quarters or more.

In light of the current technology collapse, Chartered Semiconductor (the third largest chip maker) is continuing to add capacity. Yesterday, Chartered sold $500 million of convertibles. These funds will be used to equip its latest plant. Earlier this month, Chartered said it plans on raising $4 billion in the next two years in order to keep pace with the rest of the industry. The arms race continues.

The Heartland bond fund snafu took a turn for the worse last week. In case you cannot remember the story. Three Heartland high-yield bond funds changed to a fair value pricing method that chopped the value of three funds dramatically. These three high-yield funds landed in SEC receivership last Thursday due to the inability to file audited financial statements. Heartland's auditor was not able to determine an accurate value for some of the issues held in the funds. We are concerned that this is not an isolated incident with hedge funds being the largest group that hold high-yield bonds, usually using leverage. If these bonds are so illiquid that auditors cannot determine a value for them, what happens when hedge funds start trying to sell?

Monday, investors awoke to the news that the ECB is likely to cut interest rates as soon as Thursday. However, economic data released this week seems to indicate that the ECB need not be in such a rush. Monday, German import and producer prices rose more than expected. Import prices rose 0.6 percent with producer prices increasing 0.3 percent. Expectations were for increases of 0.3 and 0.2 percent respectively. Inflation in Euroland increased to 2.6% in February, up form 2.4% in January and has been above the ECB's target of 2% for nine consecutive months. Then today, M3 money growth came in at 4.8%, higher than the current target of 4.5% (nice to see a central bank acknowledge money supply). While down from previous months, several economist do not think it is slow enough to prompt a rate cut, especially after Germany's import and producer prices also showed stronger than expected growth.

Yesterday, Taro Aso, Japan's economics minister, "pledged" that the Japanese government would address the banking crisis "within six months." Some investors were hoping that the situation would receive higher priority. Today, Aso scrapped all hopes as he said those comments were made over lunch and do not constitute an official pledge.

The surprising news this week continues to be the resiliency of the American consumer. Economists were shocked by the rebound in consumer confidence. The March reading of 117 was the first increase after five consecutive declines. Most of the gain was due to the expectations component, which jumped 13 points. Also to the surprise of most economists the housing market continues to enjoy tremendous strength. New home sales continue to increase at better than a 900,000 annualized rate. Existing home sales are also showing no signs of letting up. February home sales came in at a 5.18 million-unit rate. The average of the past two months, 5.2 million units, is ahead of last year and on course with 1999, which was a record year. Another testament to the housing market is the continued increase in prices. The national median price of an existing home sold rose 4% to $133,800, while the median for new homes increased marginally to $167,000. There still are pockets of extreme strength around the country such as the Twin Cities. The Minneapolis / St. Paul metro area posted a whopping 15% increase in existing home sales and 14% increase in the median price from last February.

Borrowing a term from Bill O'Reilly, the Most Ridiculous Item has to be the report from the National Association of Business Economist. In a report released Monday, 34% of NABE's members believe that the Federal Reserve has been too restrictive. Please scroll back up and take a look at the M3 chart.

The next couple weeks should be very interesting as to how companies guide going forward. Will technology companies join John Chambers and say "things look horrible" or will they hide behind the fog of "no visibility"? Will retail stores continue to report dismal same-store sales growth, while posting solid total sales gains, proving the point of retail over-expansion? To paraphrase Mark Twain, so far it does seem the death of the consumer has been greatly exaggerated.

Selected emailed questions or comments will be addressed on Bears' Chat.


 

Chad Hudson

Author: Chad Hudson

Chad Hudson
Mid-Week Analysis
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