What Happened to Synergies
The big corporate news this week was Tyco's announcement that it would sell-off three businesses and spin-out the other. Analysts are mixed. Most of Wall Street views this as the best way to unlock shareholder value. But, I thought the allure of Tyco was that it could acquire a company, then through cost cutting, synergies (and fancy accounting), get incremental growth.
Prudential is about the only Wall Street firm that has come out negative on the deal. Ironically, Prudential is the only major firm that does not have an investment banking division. Coincidence? Prudential believes that the "recapitalization plan seems less likely to unlock hidden shareholder value than appease debt holders." Furthermore, "equity shareholders likely to shoulder majority of risk for higher interest rates or lower market valuations."
Last week, amid the turmoil surrounding Tyco, Merrill Lynch issued a research report reiterating its Buy recommendation with a $90 target. It is interesting that two of the reasons cited were due to Tyco being an acquiring conglomerate:
- Tyco continues to operate its game plan as it always has. They continue to acquire, they have issued stock, debt, etc., which means that they remain highly visible.
- Many, if not all, of Tyco's acquisitions are undermanaged businesses that Tyco turns around very quickly. Margins improve dramatically because highly incentivized managers are focused on producing growth and earnings, which is achieved through a better utilization of assets, new products, geographic penetration and market share gains.
Merrill Lynch immediately came out supporting the recapitalization plan, citing that the sum of the parts is worth $70-$80 per share (Tyco closed the day before at $46). It its sum of the parts calculation, Merrill used multiples on 2002 earnings ranging from 12 - 14 times (Tyco Capital) to 22 - 25 times (Tyco Electronics). But, last week Merrill had thought the whole company deserved a multiple of 24 times 2002 earnings, or $90 per share.
Earnings season is about half over. The biggest earnings surprise so far is the profit reported by Amazon. A GAAP profit! The main reason for the surprise is the analysts following Amazon had forgotten what GAAP earnings meant. Amazon was able to obtain its holy grail by good old-fashion cost cutting. Amazon slashed expenses by over 50%.
First Call has joined the second half recovery club based on an analysis of pre-announcements. Warnings are 8% below last year's level and 20% below the levels of the past three quarters. Additionally, 1Q02 warnings are running 55% below the pace of the previous three quarters. While First Call is forecasting a recovery later this year, it doubts it will be very meaningful. In fact, it seems they have been reading the commentary on this site. First Call comments that:
"it is even more difficult to predict the slope of this recovery since the recession was so different from the other post-WWII recessions. This recession was likely brought on or at least fueled by, the easy money policies of the Fed in the late 1990's. The result was excessive capital spending for many projects that were well ahead of their time, or in some cases, never should have been undertaken at all. The Fed may have been forced to have an expansionary policy because of problems like the Long Term Capital and Russian financial crises and Y2K, but the net result was too much investment in capital equipment."
Last Friday, with 23% of the S&P 500 having reported fourth quarter results, First Call estimates fourth quarter earnings will decline about 20%. This compares to a 21.6% year-over-year decline posted in the third quarter. First Call also forecasts that 1Q02 earning will decline by 16%. Since analysts are predicting an 8% decline, analysts are likely to reduce first quarter estimates.
One factor that will weigh on the first quarter is the amount of sales that were pulled forward due to heavy promotional activity. Another much less discussed factor is the amount of economic activity from the third quarter that was delayed into the fourth quarter relating to September 11. Gartner estimates that 8% of PC sales in the fourth quarter were pushed into the quarter from the third.
Also out of Prudential Securities is a report that defends their underweighting of technology stocks. Prudential goes through several of the bullish arguments and thoroughly dismisses them. First Prudential dismisses that tech stocks are cheap. During the internet boom, companies got away with being valued on revenues. After all, how can you do traditional analysis on a company that does not even have positive gross profits and come up with a "Buy" rating? Now that profits are scarce throughout the technology realm, investors are trying to say that at 3 times sales technology stocks are cheap. Granted, they look cheap compared to the boom period when valuations got as lofty as 6.55 time sales in 1999, but the average price-to-sales for the first five years of the 1990s was only 1.08. Prudential adds, "We have never been big fans on P/S as a valuation metric Firm value is based on its ability to generate earnings (more specifically, cash) at a rate higher than its cost of capital. Sales without earnings have no value, except to the degree that sales are increasing and can be reasonably expected to exceed the break-even level and lead to rapid profit growth soon."
Price-to-sales multiples can be artificially high during periods when margins are low and are expected to increase. Prudential estimates that technology margins for 2001 were 5.3%. While that is substantially below the 10.5% and 10.6% in 1999 and 2000 respectively, it is only about 1% below the average margin for the last 17 years. Furthermore, there can be lengthy periods of very low margins. From 1991 to 1993, margins were less than 2%. There is also the perception that technology companies always grow faster than non-technology companies. This again just is not true. Since 1993, technology companies have blown away their non-tech counterparts with an average earnings growth rate of 42% compared to non-tech 13%. But that is not the case when looking over a longer period. Technology companies actually grew slower for the period 1984 to 2001, 5.7% vs. non-tech average earnings growth of 8.7%.
With pro-forma results attracting more scrutiny, it is likely that less and less will be able to be excluded from pro-forma results. Last week, the SEC launched "cease and desist" proceedings against Trump Hotels and Casino Resorts for making misleading statements is its 3Q99 earnings announcement.
Layoffs continue. Levi is planning on shutting down two Scottish plants and an undetermined number of US plants. LSI Logic is cutting 20% of its employees, or 1,400 workers, as it eliminates two businesses.
Office space in technology dominate areas continues to get pounded. I have mentioned the northwest corridor area of Denver several times as vacancies continued to climb through the recession. I last mentioned the area in August when realtors expected vacancies to reach 31% at year end. The area continues to get hit and now estimates are calling for a 59% vacancy rate after two large office projects open. Chris Phenicie, a broker with Commercial Colorado, is much more concerned that in the previous stories. Last August Phenicie predicted the area would recover and finish 2002 with a vacancy rate of 8%-10%. Now here is Phenicie in his own words:
"This market is dry, as dead as it has ever been," Phenicie said. "I hate to be a pessimist. But I don't see what the catalyst would be for this market to turn around. I'm looking for a reason for this market to recover, and I don't see it. I don't think we're going to see a shovel in the ground for years and years. There's no niche that needs to be filled by a new building."
While companies are indicating that business is/has/will bottom now/Q1/Q2, it is important to remember that even if the economy is bottoming sometime between now and the second quarter there is no evidence to support the notion that the economy will come roaring back. With stocks still selling near record valuations, there continues to be substantial risk for equities.
I need to make one clarification to my commentary two weeks ago. November's increase in consumer credit was $19 billion, which was the largest since the Fed started keeping track in the early 1940s. In 1940, total outstanding credit equaled only $6 billion, and the $19 billion increase in November had to be the largest ever. Currently, consumer credit is in excess of $1.6 trillion.