First Quarter Report 2013
Our year-end letter to clients predicted the stock market would reach new highs, and this business might be fun again. This quarter, the Dow Jones did hit new highs, and the S+P 500 is very close to doing so. We sense investors starting to trust the market again, but it is a fragile relationship.
Most conversations with clients and non-clients begin with an individual saying, “When should an investor take profits?” Rarely (never?) do investors comment, “This is a great time to be in stocks and what are you buying?” But what we constantly hear is, “I don’t want to go through another 2008 again.”
I can assure you, we don’t either. We spend a lot of time trying to decide when the wind is no longer at our backs, but in our faces. With those comments in mind, this short review explains why we are still in the market and our forecasts for it.
So far this year, the Federal Reserve printed on average $2.83 billion a day, flowing out into the world seeking a home. On a smaller scale, the same can be said about Japan, Great Britain, Switzerland, and all of Latin America. The exception is the ECB, which is refraining from printing money at this time. Otherwise, global printing presses are wide open.
Last quarter, we predicted most of the new money would end up in the world's stock markets, which has been the case. We do not foresee anything on the horizon to alter our earlier opinion. Central banks flood the world with money to drive up asset prices and to counteract investors' fear of the unknown. The bond market is usually the first asset class to respond, which it did in 2008. The stock market is typically the next asset class to rally, and it is now up over a 100% from the March 2009 lows.
What has been difficult for us to time and predict are when this excess money will leave the financial markets, go into the real world, and trigger inflation. According to the government's CPI stats, it hasn’t happened yet. But when it does, currency printing will slow, if not end--one of our clues to reassess the financial markets.
The U.S. Federal Reserve has said a 6.5% unemployment rate would cause them to slow down the printing presses. We think the rate would be closer to 7%. The balancing act we are working with at Trend Management is which comes first: unemployment near 7%, or a market going to a short-term, overvalued position?
Right now, the market is at fair value, based on the last five years' earnings. In 2015, when we get rid of 2008's and 2009’s earnings, fair value would be 1700 to 1900. So should we sell at 1550 today on the S+P 500, while the Fed continues printing tons of money? Or hold out for a higher target? Until we detect signs of a change at the Fed, we're aiming for a higher target. But nothing in this paragraph should be cast in stone. We reserve the right to change our position but for now we are 100% long stocks.
On a happy note, this quarter, we had new highs in the following stocks we own: Wells Fargo, Berkshire Hathaway, WalMart, USG, Lincoln Electric, DirecTV, Nucor, Illinois Tool Works, Cintas, and Winnebago. Because we like to focus on which stocks are not working out, versus which are, this quarter our attention is on problematic stocks: Maxwell Technologies, Level 3, and American Public Education.
Let’s talk about our badly performing stocks this quarter. The first is Maxwell Technologies (see chart A at the end of this report). By Maxwell's gross profits, operationally things are going pretty well. By its stock price, things are not.
In October 2012, Maxwell released a downbeat assessment of their guidance for the fourth quarter, due to uncertainty of how many UltraCapacitors it would sell to Chinese bus makers. Every 10 years China changes leadership. Maxwell didn't know how committed the new leadership was to fighting air pollution. It cautiously assessed future electronic bus sales, until the new leaders' priorities could be determined.
On December 18th, the Chinese leadership authorized the purchase of 5,000 electric busses--a huge order, and a good sign for Maxwell. The purchase was not announced on Maxwell's website and is not well-known by the Street. For those with knowledge of this order, the wind seemed to be at Maxwell's back. Entering into February, the stock rallied 50%.
Unfortunately, Maxwell's audit committee caught salesmen illegally booking 12 million-dollars’-worth in sales, (4% of annual sales) before Maxwell received the proceeds. Sales were booked at the end of the quarter to make quota, before ownership of the product changed hands. (This behavior goes back to 2011 and 2012.) When the audit committee identified the error, Maxwell's management decided to restate past earnings—always a disaster for the stock price. This time was no exception.
Maxwell has collected $8 million of the $12 million, and will recoup the balance by Q2, 2013. The company will not lose any money on the salesmen's misdeeds. It just recognized sales in an earlier quarter that should have been accounted in later quarters. (The sin it committed we know of.)
From an earnings perspective, this restatement is no big deal. From a psychological standpoint, it’s a giant mess. To add insult to injury, after we had bought some more stock, the accounting firm who audits Maxwell's books resigned the account, which subsequently hammered the stock, too. Maxwell will be sued by every Wall Street law firm to net easy paydays from the screw-up. We are guessing the settlement costs with trial lawyers will be between $5 and $7 million.
We had been buying the stock on the first news of the restatement, because we view what is going on in China more important than the “Twelve-million-dollar stuffing of the channel.” The accounting firm's resignation will put a hold to buying, until we have more clarity on this situation. Sometime in April, Maxwell will report. We expect the guidance to be better than investors think, due to the Chinese bus orders. Because China represents over 40% of Maxwell's sales, these orders are important.
To date, we have not played our hand well here, as we did not anticipate the accounting firm's resignation. We deserve some abuse for buying too soon. We don’t view this as a long-term impairment of the business, but just a complication that won’t clear up, until later in the year.
Maxwell has hurt our performance this quarter, but we expect it to add to our returns in the future, or we wouldn’t own it today. We will update you on this situation in our next report.
On to Level3 (see Chart B at the end of report). Just like Maxwell, the chart shows cash flow (EBITDA) is ramping, and the stock price isn’t. What happened to Level3 this quarter is familiar. It promised a 20- 25% cash flow gain for 2012, and came in at a gain of 18%. The market was not happy with that miss. (Cash flow growth at 18% is outstanding, unless you promised 20%.) Analysts decided to punt, and the stock sold off from $24 to $20.
Level3’s guidance for this year is cash flow growth in the low double-digits, which is very good, but the market understandably doesn’t believe anything these guys say, anymore. When you have a crisis of confidence in leadership, a change at the top is not unusual. This month, Level3 CEO James Crowe announced he is stepping down at year's-end.
We hope he leaves earlier. We have had enough of him. The question is, now what do we do? This year, Level3 will again have record cash flow, and we think eventually that matters to investors. Lately, cash flow and the stock price have not correlated, but over time they almost certainly will. With Crowe's departure, there may also be renewed interest in Level3. Three investors own over 50% of this company. If they conclude it is a lost cause, they will sell it. I doubt they will, but if they sell, they will accept the highest possible price, and we will benefit from the sale.
If I am wrong, and they are wrong on Level3's future, they have the ability to cash in and get us out at the best possible price. Again, I don’t think they will, but it is the benefit of having controlling shareholders who can make a change, if they choose. We will continue to hold this investment, as the cash flow ramps up.
American Public Education: (see chart C at the back). This investment makes me the angriest. American Public is an online education company, whose niche is the fields of military education and law enforcement. Its tuition rates are 20% lower than the average state school, and much cheaper than all for-profit education companies. What hurt American Public Education in Q1 was the sequester.
Our government recruits soldiers ensuring them $4500 per year in tuition assistance to go to school. The Department of Defense pays $250 a credit hour, which is the rate American Public charges its students. Two weeks ago, the military decided to suspend military tuition assistance, until the sequester debacle is resolved. Apparently, our government decided to renege on their word to our soldiers.
The total cost of military tuition assistance is $500 million a year. We give the Republic of Congo $1.5 billion a year in foreign aid, yet we can’t find $500 million to fund tuition for people willing to die for our country. Despicable. Just despicable.
We think it's a political ploy to draw attention to the sequester. It will blow over, but will last long enough to affect American Public's earnings the first half of 2013. Thirty-five percent of American Public's sales link to tuition assistance. Soldiers can use their VA benefits, the GI Bill and Title IV funds to fill the 35% hole, but it takes time. I anticipate earnings for Q2 and Q3 are anybody’s guess, until this problem does blow over. In the meantime, American Public announced it would buy back another $15 million in stock, while it’s down. The figure represents about 3% of the company's value. Over $100 million more in cash sits on the balance sheet with no debt, if it decides to buy more.
We didn’t expect the Department of Defense to do this to its soldiers, but I guess we need to be prepared for anything, anymore. Should the stock drop to the mid-twenties, we would consider buying more. If the Department of Defense changes its plans, the stock will rally quickly, because in normal times, fair value to us on this stock is above $50. This stock will be in a holding pattern, until we see what happens to the idiots running the Department of Defense. [Note: On Thursday, March 21, Congress voted to reinstate military education benefits. Although it is the right thing to do, American Public stock will still be affected in the next quarter.]
In closing, we'll share a few things we are thinking about. Obamacare kicks in January 1, 2014. How it will affect the economy is difficult to handicap. We have read and are observing companies are not hiring workers today to keep from paying the higher healthcare costs the ACA mandates. Labor- intensive businesses who pay low wages face a real dilemma. Should they raise prices on what they sell? If they can’t raise prices, should they cut their gross margins to compensate for the added health care costs, or just get out of the business?
I think one reason U.S. job growth has been poor the last few years is the total insecurity businesses have with this subject. It is possible corporations have already reduced head-counts as much as they can, and when 2014 hits, this will be a non-issue. We wanted you to know, we are thinking about the prospects, but haven't drawn firm conclusions, yet.
We also want to point out, we haven’t changed our stance on China. We remain very bearish on China’s economy, in general. A "60 Minutes" piece broadcast this quarter documented what we mentioned a year ago: China building cities with no one in them. China does this to generate GDP and jobs, but it destroys money and can’t continue. We think a lot of these cities' developers hide their bad debt in the government-owned banking system. High-ranking government officials own the major export and construction companies, and benefit from the money spent on “cities to nowhere.”
The Chinese people really don’t benefit from this, long term. What would help China's citizens most would be raising the currency's value. By doing so, food would be cheaper, and people would have more discretionary income to spend. The reason it hasn’t happened lately, is raising the currency would hurt export companies the Chinese leaders own. Currently, 83 billionaires occupy the Chinese version of the U.S. Congress. Do you think they got so rich from farming?
Inflation in China will also worsen, due to the amount of currency the U.S. continues to print. At some point, we expect a one-time change in the Chinese currency valuation, (10-to-20%) which poses serious ramifications for U.S. exporters and the U.S. economy. When it occurs, you want to be out of the bond market, because U.S. rates will take off to the upside, while declining in China. We can’t predict when this will happen, other than we think it will occur sooner, rather than later.
Thanks for your continued support and feel free to call us at 417-882-5746. Sincerely,
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR