mauldin letter
Et Tu, Dell?
To P/E or not to P/E?
The Capitulation Tango
Bush and the Dollar Woes
I See Disney World in My Future
By John Mauldin
For the past two weeks, I have presented a host of evidence that
Price to Earnings (P/E) ratios would have trouble improving, even as
actual profits and earnings grow in a modestly recovering economy.
Changes in accounting standards, corporate governance and public
perception will so change the rules as to how we measure profits,
that public corporations will be fighting a strong head wind to show
improved P/E ratios. Since this is a primary measure of the value of
a stock, this "new profits era" will be a major downward pressure on
stock prices for several years.
This week, several articles crossed my desk which illustrates this
point perfectly. I bring them to your attention so that we can then
explore the search for the bottom that seems to occupy so much of
the thought process of analysts and economists.
Et Tu, Dell?
First, the indefatigable Dennis Gartman (more on him later) brings
this absolutely stunning and deeply disturbing analysis of the
earnings of Dell Computer. I quote at length:
"APPLAUD BRILLIANCE, BECAUSE IT IS RARE: A year ago, we noted work
done by our very good (and very wise friend) Mr. Mike Lyons of
ScotiaMcLeod in Toronto which brought to our attention that the
options programs in effect really did "steal" wealth from non-
employee shareholders. Mike has taken the time to look again at
Dell's options program, and we are taking the time to bring it again
to our clients' attention, for this is real wisdom, worthy of our
time:
".... people are just now waking up to the fact that they've been
duped for years by the option game. I use Dell as an example only
because it is so clear with Dell in that they not only issue massive
amounts of stock options but they also repurchase similar amounts of
stock in the market to avoid dilution. This gives me the opportunity
to quantify the cost of the game. Companies that only issue options
but don't repurchase stocks are still, in my opinion, stealing
wealth from non-shareholders but it is harder to calculate exactly
what this figure is.
For the fiscal year ended February 1, 2002, Dell reported total net
income of $1.246 billion. They definitely know how to make and sell
computers profitably. Unfortunately, they don't know how to husband
those profits so that the poor [investors] who own the stock can
reap any benefits. We can see this by looking at the statement of
cash flows and the statement of stockholders equity to see how the
option buy back program worked. For the year, Dell issued to
employees 69 million shares and received total benefits of $853
million (this includes the tax benefit U.S. companies receive upon
option exercise).
"In the same year, they bought back 68 million shares for a total
cost of $3.0 billion. On average, they paid $44 per share and
received $12 per share for a realized, book and pain in cash loss...
of $2.169 billion. For the year, the loss from the options game
exceeded the profit from operations!!! Unbelievable... and as far as
I can see, unmentioned on Wall Street.
"Investors let Dell get away with this, preferring to believe that
the company is making money and working on their behalf rather than
acknowledging the horrific truth--- they were mere pawns in a
management enrichment program. These are strong statements to be
sure; however, has Dell ever paid a dividend to its shareholders?
No. Has Dell stock appreciated since July of 1998? No. Has Dell at
least grown its book value for shareholders, independent of how the
market treats its stock? Again, no.
"Though it has reported enormous profits over the last four years,
Dell has been unable to grow its book value per share. Why? Because
options accounting is a difficult and currently quite imperfect
matter and companies have taken advantage of that situation to
portray themselves in a far more flattering manner than the
underlying truth. Most worrisome is that I can make all these
statements about Dell, one of the best run companies around. Imagine
how much worse it gets at some other companies."
As Gartman adds, "This is powerful information. It is brilliant, and
sadly it is true. Dell is the best of the lot in our estimation. It
tried not to allow for dilution; imagine what has happened to the
money in Enron, World Com, etc. If the best is bad, what then of the
middle of the pack? What then of the worst?"
Let me illustrate how devastating this is to shareholders. Let's say
you and I own 10% of a company that makes the ever popular widget.
Management comes to us and says, "Mike has been doing an incredible
job for us, and we want to give him 10% of the company so he will be
happy and keep doing a good job." The part of the company that you
and I own is now diluted to 9%. That means we get 10% less profit-
sharing at then end of the year.
You and I are clearly losers in that game, unless Mike really does
something great to increase profits. But under current accounting
rules, the fact that these options to Mike have clearly diluted the
value of our holdings is of no importance. So companies get to
report a profit to shareholders, even as their shares are worth less
in terms of book value.
Interestingly, when the company reports earnings to the IRS, they
deduct the value of these options from profits.
But what if, as in the case of Dell, management realizes dilution
may not be in the best interest of shareholders, so they go to the
shareholders and ask if any of them will sell their stock so they
can give 10% to Mike without diluting any shareholders? Now, they
take profits that should be distributed to you and me or re-invested
in the company and use them to buy stock.
I am a big proponent of the principle that "the laborer is worthy of
his hire." I believe in incentives and performance based pay. But I
also believe that shareholders and investors must be fairly
compensated for their risk. The reason those options have value is
because investors are willing to buy the shares of a company. It is
the responsibility of the board of directors and senior management
to return value to shareholders.
To P/E Or Not To P/E?
Porter Stansberry in the Daily Reckoning brings us yet another
egregious example of a major company where management is using the
company to line its own pockets at the expense of shareholders (I
have taken the liberty of editing Porter). Please note that this
company has a market cap of $13 billion, so it is in a lot of
technology portfolios:
"Options allow executives to hide the effect of their enormous
compensation packages from the bottomline. For example, the CEO of
the Maxim Integrated Products (MXIM) realized over $57 million in
compensation from exercising options in 2001. That was more than 25%
of his company's net profits for the year. Meanwhile, on the income
statement, only his $300,000 salary counts against earnings.
"On average, over the last six years, this CEO made $32 million per
year. Almost none of that expense showed up on the income statement.
Companies would never dream of paying executives so much money,
except for the fact that investors don't see the effects of this
compensation on earnings.
"According to current GAAP accounting standards, MXIM produced
outstanding EPS growth - 168% over five years. Even in 2000, when
the market tanked, this company still grew earnings by 21%. Because
of this growth and its status as a leading big cap stock, you can
perhaps understand why the stock still trades at outlandish prices:
78 times earnings and over 10 times sales.
But, if you deduct the expense of options grants using the Black-
Scholes method to determine the value at the time of issue, you see
an entirely different picture. After you expense the value of the
options granted, instead of 168% growth over five years, earnings
only grew 39% over five years. Hardly remarkable, especially for a
high tech company with great position in the market. After all,
there was a high tech boom, remember?
Accurate accounting also shows that, like most companies in the
sector, Maxim had a sizeable decrease in earnings in 2001. As should
be reported to shareholders, earnings after stock compensation fell
by 29% in 2001. You have to wonder how the market would price this
"growth stock" if shareholders knew that really, counting all costs
to shareholders, the earnings per share didn't grow by 21%, they
fell by 29%!
Here's what else the market apparently doesn't recognize about
Maxim: Options expenses are rising. Employees' options that will
vest in the next ten years now equal more than 25% of the entire
capital stock of the company. If employees choose to exercise their
options, there will be a 25% tax on earnings growth as the number of
shares grows.
"...Maxim made $223.8 million from operations in the last six months
of 2001, according to its most recent filing with the SEC. But,
during the same period, it repurchased $354.4 million of its own
stock...which was trading at prices that today look, well, slightly
expensive: 20+ times book value, 100+ times sales and 140+ times
earnings.
"If management thought its shares were attractive enough for the
company's money...why are the same shares not attractive enough for
management to even hold?
"In the last six months, management has sold nearly 1 million shares
of stock. And, despite 20 years of large-scale option grants,
insiders own less than 1% of the total shares outstanding.
Incredibly, the founder and CEO of the company in question currently
don't own a single share of stock. Nor, according to SEC filings, do
five of the company's Vice Presidents.
"If stock options were truly meant to align the interests of
management and shareholders, the management would at least hold some
of the shares they're granted. But, these managers don't. Instead
they cash out of every single share.
"What's more, Maxim is in the highly competitive analog
semiconductor field. It's been the dominant company in this sector
for a long time. Rapidly changing technology requires huge capital
investment for research and investment. Yet, while the company spent
$350 million on its own stock in the last six months of 2001, it
only parted with $250 million on research and development - for all
of 2001." (End quote.)
Both Dell and Maxim are profitable companies who are leaders in
their market sectors. They produce high quality products at
competitive prices. They will be in business, and probably will grow
their business, over the next decade.
Yet, are these good stocks to own? Maxim will have to spend, by my
calculation, over $3 billion (at today's prices) in stock buybacks
over the next ten years just to keep from diluting current
shareholders. They will have to substantially grow net income in
order to do that.
Understand, these are companies which are highly regarded. When you
search for reports on Maxim and Dell, you get glowing praise. But
when investors start to realize these companies make little or no
money after options are accounted for, how long do you think their
stocks will trade at outrageous multiples. Maxim is at a P/E of 82,
and today, as the market melted 400 points and the NASDAQ fell 3.5%,
Maxim actually rose in price. Investors clearly think this is one of
the best run companies with bright prospects.
The question that will be on the investor's mind in the future, as
we progress into a secular bear market and accurate accounting
standards, will be just who is the benefit of such bright prospects?
If Dell and Maxim are the best, what do the average and poor
companies look like?
If Intel used proper accounting, its profits would drop 80%.
Microsoft's would drop 40%. Cisco would have no profits. All Cisco's
35,900 employees get stock options. Cisco spokesman Steve Langdon
said, "Expensing options is not a good idea and would prevent
companies from offering stock options to their rank-and-file
workers."
It is hard for me to believe that all 35,900 workers are so critical
that salaries alone are not enough to keep them. If options are
truly such an important component of their pay that employees would
not work there without them, then Cisco is selling products for less
than it costs to make them. It seems to me that options at Cisco are
preventing the workers from offering profits to their shareholders.
The Capitulation Tango
And that brings us to the topic de jour: capitulation.
The pundits on TV and the press tell us the bear market can't end
until we get to some magical condition called capitulation. This is
that wonderful state of affairs when all the wimps and fearful sell
everything including the kitchen sink and there is no one but
optimists and strong investors left. That is when we see the bottom
and the next phase of the bull market will start.
Massive sell-offs are the sign of this state of capitulation, and
this weekend we will see many pundits tell us that the 700 point
drop in three days certainly looks like capitulation. Now we can get
ready to enjoy the summer rally.
The problem is that there isn't much historical precedent for
capitulation. Bear markets don't end in explosive sell-offs. They
end with massive indifference on low volume days when no one cares
anymore.
Weeks like this last one are typical of the middle of bear markets,
not the end. I was discussing this with Dennis Gartman this morning,
and he reminded me of the vicious drops and rallies in 1974. The
bear continued for quite a bit longer.
We will soon have a bear market rally (I hope), and I think it could
be something to behold. I note in passing that short selling
interest is up, especially among smaller investors. Just like day-
traders piled in bidding everything up in 1999, now we have a new
breed of short-seller ready to make money on the way down.
And after the rally, the market will sell off again. This cycle
will keep repeating itself for quite some time. It will be like
watching a couple doing the tango, back and forth, across the room,
sometimes flowing effortlessly, and sometimes with hard stops and
violent movement.
But the Capitulation Tango will not end until the Dells and Maxims
of the world begin to deliver true shareholder value.
Bush and the Dollar Woes
Dennis Gartman is one of the premier investment writers in the
country. He writes a daily letter, The Gartman Letter, which goes to
about 400 institutions for $400 per month. He is widely read among
traders and major financial managers, as a solid source to keep up
with a broad view of the markets and the world economies.
He argued early on that the Bush steel tariffs would tank the
dollar. He feels the psychological damage done to the markets is
serious. When the rest of the world sees the biggest proponent of
free trade essentially cave in to political interests, and then
follow that up with decisions on lumber, textiles and agriculture,
what are they to think? If free trade has been the engine for world
growth, what will be the result of a new era of protectionism?
I wrote in 2000 that I was afraid for the world economy if Gore was
elected, because I felt he would implement protectionist policies.
Such a move would be a huge mistake, similar to those taken in the
aftermath of 1930, and could have the same results.
I am an ardent supporter of Bush in most things, but in this, I
agree with Gartman that the President and his advisors (that's you,
Karl) are wrong. We are sending the wrong signals at precisely the
wrong time.
Gartman says the following, and I can't say it better:
"We've argued, and we'll argue in the future, that the dollar's
weakness stems from the Bush Administration's ill advised decisions
on steel, textile and lumber tariffs and/or restrictions. The dollar
will continue to fall as long as the US continues to abrogate its
responsibility as the world leader in free trade. So too the US
stock market.... and so too the prospects of the Republican Party at
the upcoming elections in November. We are and we have been long
standing, overt, very public supporters of this President and his
administration, but we find these decisions on trade inordinately
ill-advised. Would that the President went before the nation and the
world, admitted the errors involved, reversed the decisions
immediately and accepted responsibility for them. That, however, is
very wishful thinking."
The steel tariffs in particular have cost more jobs than they have
saved, and driven up costs. The decisions to invoke tariffs were
made with an eye to help with the fall elections. I have sat in
private briefings with his political advisor Karl Rove (an extremely
bright man) where he has pointed out that you can't change policy if
you can't get elected. He is right.
But the direction of the dollar and the markets is not going to help
Republicans win this fall. This political move has back-fired with a
host of unintended consequences. I think it is no coincidence that
the world markets, including the US markets, along with the dollar,
began their recent slide with the announcement of tariffs. The
sooner we reverse these policies the better.
Since the euro has risen over 20% from its bottom, as well as many
of the currencies of other steel producing nations, Bush could save
face with a repeal by noting that the currency moves have
strengthened the position of Big Steel vis-à-vis the rest of the
world, and they no longer needs government protection.
Just as I was hitting the send button, in comes a note from Greg
Weldon. He points out that the trade deficit reaches an all-time
high, and when you look at the details, the cross European numbers
are horrendous. Those looking for a dollar rebound will need to look
for some other source. With the conservative Bank Credit Analyst
telling us the dollar is still over-valued by 15%, those readers who
bought euros from Everbank when I first mentioned them last spring
are quite happy today.
Greg points out further evidence that the Fed will not tighten comes
as inflation continues to drop. In February inflation and the Fed
rates were roughly equal. Today, Fed fund interest rates are 0.65%
above inflation. This means monetary policy is tightening, and is
actually pushing us toward deflation. That is not what Greenspan
wants, and thus unless inflation starts to come back, the next move
the Fed is likely to make is to lower rates. But more on that and
other fronts next week.
I See Disney World in My Future
It seems I have to make a last minute business trip to Orlando next
Friday. (What a place to headquarter a hedge fund!) That means #2
son gets to go with Dad, and while I work, he will do Universal, and
then we will do other parks on the weekend. And since I save $1200
airfare by coming back late Monday, it seems logical to find a golf
course Monday morning. I can test my new swing and see if I can
find enough length to out-drive my 13 year old son.
We are putting up new features on the web site, and soon will have a
wide array of services and features. I hope to be able to have a
section where I post the 3-4 articles I read each week (out of
several hundred) that I think of are important and that I don't get
to comment on. If you have any other suggestions, please let me
know, as we are in the designing stage. Next week's letter will
come out on Thursday.
Your can't believe he criticized President Bush in public analyst,
John Mauldin
John@2000wave.com |
