Mid-February finds us enjoying the late innings of another Texas winter. Weather experts have warned that the La Nina pattern that set the stage for last year’s epic drought is still in play, but so far this winter couldn’t be more different from last year’s. That one saw innumerable bitter cold days and nights that overtaxed the power grid, almost no precipitation and a nearly instantaneous transition to an endless succession of brutally hot windy days that went on until September. This year has been more like an endless Spring, with (so far) only two or so nights that dipped below freezing, and above normal rainfall. So much for La Nina, and for expert opinion on big picture issues.
While we wait for the flowers to erupt, we also find ourselves waiting and wondering what will cause the proverbial shoe to drop on this inexorable Market rally. Who knows, considering how long it has been since animal spirits of the Bull variety slipped their leash (a good number of the financial service industry’s recent hires weren’t even in high school when we defined what it meant to “party like it’s 1999”), we could be setting up for a big surprise to the upside. That will happen at some point, but more likely, we will first be treated to another stretch of time where we wish we had raised cash more aggressively in the days leading up to it. I might end up leaving some money on the table, but I am going to assume that Sell in May (at the margins, not completely) and go away will once again be good advice. Indeed, I have already raised my cash holdings by about 5%, to about 11% of investable assets, and expect that to edge upward until we get another episode of fear-based pricing.
So what might precipitate the next fire sale? It is looking less and less likely that it will be last year’s imponderable uncertainty, the European debt crisis. The substance of that crisis, which is really nothing more than entropy having its way with erstwhile principalities that were past their prime generations ago (if they ever had a prime), will be with us for the rest of our days. The ability of the keepers of what passes for news to use it to strike fear into the hearts of investors at the margin has subsided. The bogey-man that was Sovereign Debt default seems to have been neutered. It’s all going to work out, at least for a while, and much more interesting events are taking shape. As I ponder what is likely to rouse the VIX from its slumber, something to do with Israel, Iran and Straits of Hormuz come to mind. (That Madonna fans have implored Mr. Netanyahu to wait until after her concert in Tel Aviv suggests that this might be the worst kept military secret ever.) My sense is that if the Israelis do attack the nuclear facilities, the US Navy will be positioned to foreclose any attempts to disrupt the transit of oil beyond a few “precautionary” days of delay. But to a lot of “investors” at the margin, it will be too scary to sit and wait it out. This, from the vantage point of today, is only the most probable catalyst for a sell-off that we can think of. We can be sure that whoever it is who seems to have the influence to “change the cue cards” that exacerbate investor reactions to ever changing circumstance will come up with something. In the mean time, let’s enjoy the rising tide, try to be a net seller of equities (trimming the “good” positions, pulling the plug on at least a few of the one’s that have disappointed, and having a very high hurdle for any purchases) and wait to see what they come up with.
Speaking of sitting and waiting, I had an interesting encounter last weekend that provided an insight into why the US economy has been recovering at a rate well short of half-step. Anecdotal evidence needs to be handled lightly, but this was the microcosm that goes a long ways in explaining the macrocosm. I ran into a fishing guide I had spent a little time with on the Texas coast last year. When I asked about a plan he had to expand his operation, he said he was doing a few little things, but anything major was going to wait until after November. He went on to say that it wasn’t about him, allowing as how listening to talk radio on the ride up to Austin had gotten under his skin. (I advised him, as I advise anyone so aroused, that the Off button can be your friend.) Rather,it was his clients, which would be a slice of relatively but not supremely well-off households, whose good fortunes are more likely than not derived from some involvement with an energy play such as Eagle Ford. It instantly dawned on me that there must be at least a million, probably several million, decision makers out there who are similarly on hold. From tiny operators like this guy up to the private equity titans plotting their next moves, the heightened uncertainty brought about by an unabashedly intrusive State is causing the producers of goods & services to sit on their hands and wait. Even the rent-seekers who have enjoyed this Administration’s fondness for crony capitalism must be hedging their bets at least a little. I can’t help but wonder if herein lies the basis for the next time the Bull goes large. Perhaps an unleashing of a whole lot of pent up hopes, dreams and expansion plans (not to mention in-sourcing of at least some manufacturing back from venues that turned out to be not as low cost as they had seemed) could trigger an economic boom that gets money flowing back into equities in a way that reminds us that debauch that ended over twelve years ago.
It is quite possible, in my opinion, that that November outcome that so many are waiting on has just been sealed. I am referring to the HHS mandate with respect to insurance of contraception, etc. that has lit up the opinion pages of late. The Administration’s decision to proceed with this mandate is either something too politically shrewd for me (or anyone) to grasp, or the dumbest move in history. They seem to have thought they could make it about contraception, a subject on which reasonable people, including faithful Catholics, can disagree on. It’s not. All they had to do is listen to the bishops. It is about freedom of conscience, something sacred not just to Catholics but to all persons of good will. Does the term “endowed by their Creator with certain inalienable rights” ring a bell? By framing it this way, the bishops have instantly drawn in allies from leaders of other faiths and from persons of no religious faith whatsoever. And they didn’t just come up with this stance when the mandate hit the wire. Well over a year ago, the USCCB (Conference of Catholic Bishops) formed an ad hoc Committee on Religious Liberty, comprised of ten bishops and a wide array of consultants, attorneys and lobbyists.
It matters that these men were formed, spiritually and philosophically, under the papacy of a man who knew totalitarianism, at its onset, in full bloom and in its dotage, first hand. The bishops consider this mandate to be an unprecedented attack on freedoms that were enshrined in our Constitution. There will be no backing down. It will remain a hot topic, begging the question of what else is in that abomination that calls itself the Patient Protection and Affordable Care Act is waiting to pop out and remind us why our Founding Fathers devised the checks and balances that power mad Nanny Staters wish would go away. A lot can happen in the 260+ days and nights between now and November 6, but this issue has more than enough moral weight and emotional fire to tip the balance decisively in the favor of a prospective leadership that would promise to not be so damn menacing towards people who just want to get on with their hopes and dreams. Perhaps the Markets is discerning a glimmer of this possibility.
Wednesday, February 15, 2012
Tuesday, January 31, 2012
Puffing Along the Road to Web 2.0
As the first month of the New Year gives way to the month in which we acknowledge if not quite honor past presidents and the patron saint of lovers, bee keepers and happy marriage, the Market is going through the motions of a long overdue pause. Volatility seems to have gone on sabbatical even as the media labors to amp of the drama of Greece’s refinancing. This will be a week to see if, as we have suspected in the previous Musings, that concocted boogyman that is the European debt crisis has started losing its power to trigger tradable “risk-off” days. Based on its frozen rope trajectory of the past several weeks, the Market is certainly vulnerable to a bout of profit taking, but it keeps showing the kind of resiliency that makes this long time observer feel that this is a Market that really wants to go up.
Much of that resiliency is due to what the earnings releases have been showing a global economy that took a licking and kept on ticking. Sure, there were exceptions, there always are, where the earnings came up a little short of expectations and the stock has a real bad day ahead of what will likely be a months long stay in the proverbial doghouse. Within the “major bets” of High Road Value, our aerospace bet hit just that sort of “miss”- induced air pocket. At least within the high-end metallurgy world, where Allegheny Tech and Precision Castparts are our chosen vehicles. My strong sense here, informed by having followed the likes of PCP since it was PCST and had only a couple of million shares, is that companies didn’t so much miss as the analysts guessed too high. There was strong momentum in the industry in the June and September quarters as the OEMs started stepping up production rates on (mostly narrow-body) legacy commercial programs. This marked an early phase of a long ramp up that, strictly speaking, is neither a step function nor a continuous function, but a slightly unpredictable blend of the two. The momentum rendered palpable by the midyear acceleration did not abate in Q4, but it didn’t pick up speed either (That will be coming along shortly.) So couple a little overestimation of a ramp rate with the undoing of a squeeze in raw material prices (i.e., nickel reverting to a more normal price, which provides an incentive for customers to purchase as little as possible ahead of quarter-end surcharge adjustments) and you get the kind of disappointment that just sent a few marginal holders to the exits. Pity them. We are still in the very early innings of what is shaping up to be the greatest commercial aircraft build rate ramp ever, with “bump-ups” coming like clockwork more or less every quarter for a couple of years at least.
A more sanguine picture emerges around earnings reported by the companies that make up our rather old school bet on Web 2.0. Specifically, that part of the tech food chain defined by Intel, its enablers (capital equipment providers) and hangers-on. But as impressively as Intel has been at confounding its naysayers, the most lip smacking piece of the pie has been our bet against the imminent demise of the hard disk drive (HDD). To be fair and honest about it, the outsized nature of my present bet (about 18% of my investable assets in STX, WDC and supplier HTCH) is more than anything due to Seagate having quite literally been at the right place at the right time (i.e., unlike WDC, Hitachi and Toshiba, having all of its production outside the flood zone in Thailand). Completing its acquisition of Samsung’s HDD assets, which cemented an alliance between these technology leaders that will get very interesting over the next few years, as well as the first moves in a broad, impressive and seemingly long overdue product refresh, helps a lot, too. But hats off to WDC and its suppliers, including HTCH, for a magnificent recovery from the adversity of coming in and finding a big portion of one’s equipment under 6+ feet of greasy, stinky water. Much work remains to be done to bring the HDD supply chain back to normal, a projects that including the rebuild of buffer stocks will carry into next year. The Market has already applauded the adroit execution that has taken prior “worst case” scenarios off the table. The question is what will there be to applaud about once things are back to normal.
My sense is that the Thai Flood Crisis has lent even more impetus to the idea that the HDD world will find itself with a new and improved “normal” on the other side of the ongoing consolidation. We, and most importantly, the customer base, just got a whiff of just how not-to-be-taken-for-granted the availability of hard disk storage might become. One would think that the big buyers of HDD got a glimpse of what the world would be like if this supplier base which they have used and abused for so many years unto decades were to lose its ability or will to re-invest in itself. The consolidation was about to make it clear that a price-taking HDD industry can no longer be taken for granted. The flood induced shortage is driving home that point.
Pricing and so margins will recede as capacity comes back into balance and inventories are replenished. This is not a question of Whether or even When but to Where relative to what in the era consolidation (wherein aggressive pricing might have long term, strategic benefit to compensate for short term pain) was considered normal. “Normal” is going to be very different when Seagate and WD have upwards of 80% of the market. Even if WD’s “remedy” for the EU’s purported concerns about the HGST acquisition (just how a discrete increment of capacity can be severed from such an integrated undertaking remains to be seen) were to spawn a new competitor, it would still be a technology follower at a single capacity point with marked economic disadvantages. The big drama over the next several quarters, the one that will be hyped for all its worth by the multitude of analysts who follow this industry, will be couched in terms of where ASPs end up relative to before the flood. And that, in my estimation, is in the hands of the management team of the producer presently at the margin, which is WDC. I believe it will boil down to whether they are sufficiently competent and judicious to manage the latter phases of their recovery in a way that balances the near term needs of the customer base with the long term growth in value for the owner base. Having listened in on the last dozen or so conference calls (and sized up more managements than I care to even think about), I am as confident as an investor can be that Messrs. Coyne, Leyden and Nickl are more than smart enough to split this difference in a way that the Market will stand up and cheer. If so, then for at least that three-to-five year future that purportedly matters so much for serious investors, the new “normal” is likely to be gross margins in a narrow band not far off of 30%, rather than that recent range that tended to drift down into the teens and get stuck there, and commensurately higher net margins and so EPS. End users will continue to benefit from, and probably take for granted, that this industry has made data storage “almost free and getting more so”, and are not likely to notice that they are paying a few dollars more per device. And who knows, these stocks might even find their way of their bizarre parallel universe where a single digit P/E ratio is considered normal for a growing, dominant and cash rich enterprise.
Obviously, such a margin re-set, coupled with even modest growth in units and adroit deployment of surplus cash along the lines of what Seagate is already doing (dividend boost and aggressive share repurchase) should boost both WDC and STX much further than recent analyst “Target Prices” would suggest. But what about suppliers like HTCH? Owing to a long list of surprises, this one has ended up being one of those “problem children” we always seem to have at least a few of. Potentially life threatening challenges have been met and largely overcome, albeit at the cost of the balance going from seemingly pristine to a source of concern. HT’s position with the customer base appears to be programmed to improve in each of the next several quarters, which in my estimation will drive the volume necessary for a return to profitability. The flooding may have been a setback in their plan to become the low cost producer of suspension assemblies, but it was only a setback. Indeed, the value of their diverse locations gained currency as a result of the flood. Assuming that HTCH continues execute on its debt refinancing plan, recognition should start to set in that HTCH does not deserve the “left for dead” status implicit in its recent share price. I am expecting “back from the dead” appreciation over the next couple of years akin to what happened in the latter half of 2009.
Investing in HDD companies right now could be compared to finding a very old cigar butt. The naysayers (led by investment bankers who would rather shill for companies that need gobs of capital rather than ones that have too much of it) say that at 50+ years old it is a worthless has-been that should be tossed away. Like the “visionaries” I recall from thirty years ago who said that technology would bring about a “paperless office” and so doom the paper industry, someday they will be right, and disk storage will go the way of the crank starter on automobiles or the mimeograph. But that someday is nowhere in sight, and there are even signs that the purportedly supplanting technology is actually boosting demand for mass storage the way things like faxes, cheap printers and then email did for a couple of decades before “paperless” starting happening in earnest. If HDD is an old cigar, it still has at least one might fine puff left on it.
Much of that resiliency is due to what the earnings releases have been showing a global economy that took a licking and kept on ticking. Sure, there were exceptions, there always are, where the earnings came up a little short of expectations and the stock has a real bad day ahead of what will likely be a months long stay in the proverbial doghouse. Within the “major bets” of High Road Value, our aerospace bet hit just that sort of “miss”- induced air pocket. At least within the high-end metallurgy world, where Allegheny Tech and Precision Castparts are our chosen vehicles. My strong sense here, informed by having followed the likes of PCP since it was PCST and had only a couple of million shares, is that companies didn’t so much miss as the analysts guessed too high. There was strong momentum in the industry in the June and September quarters as the OEMs started stepping up production rates on (mostly narrow-body) legacy commercial programs. This marked an early phase of a long ramp up that, strictly speaking, is neither a step function nor a continuous function, but a slightly unpredictable blend of the two. The momentum rendered palpable by the midyear acceleration did not abate in Q4, but it didn’t pick up speed either (That will be coming along shortly.) So couple a little overestimation of a ramp rate with the undoing of a squeeze in raw material prices (i.e., nickel reverting to a more normal price, which provides an incentive for customers to purchase as little as possible ahead of quarter-end surcharge adjustments) and you get the kind of disappointment that just sent a few marginal holders to the exits. Pity them. We are still in the very early innings of what is shaping up to be the greatest commercial aircraft build rate ramp ever, with “bump-ups” coming like clockwork more or less every quarter for a couple of years at least.
A more sanguine picture emerges around earnings reported by the companies that make up our rather old school bet on Web 2.0. Specifically, that part of the tech food chain defined by Intel, its enablers (capital equipment providers) and hangers-on. But as impressively as Intel has been at confounding its naysayers, the most lip smacking piece of the pie has been our bet against the imminent demise of the hard disk drive (HDD). To be fair and honest about it, the outsized nature of my present bet (about 18% of my investable assets in STX, WDC and supplier HTCH) is more than anything due to Seagate having quite literally been at the right place at the right time (i.e., unlike WDC, Hitachi and Toshiba, having all of its production outside the flood zone in Thailand). Completing its acquisition of Samsung’s HDD assets, which cemented an alliance between these technology leaders that will get very interesting over the next few years, as well as the first moves in a broad, impressive and seemingly long overdue product refresh, helps a lot, too. But hats off to WDC and its suppliers, including HTCH, for a magnificent recovery from the adversity of coming in and finding a big portion of one’s equipment under 6+ feet of greasy, stinky water. Much work remains to be done to bring the HDD supply chain back to normal, a projects that including the rebuild of buffer stocks will carry into next year. The Market has already applauded the adroit execution that has taken prior “worst case” scenarios off the table. The question is what will there be to applaud about once things are back to normal.
My sense is that the Thai Flood Crisis has lent even more impetus to the idea that the HDD world will find itself with a new and improved “normal” on the other side of the ongoing consolidation. We, and most importantly, the customer base, just got a whiff of just how not-to-be-taken-for-granted the availability of hard disk storage might become. One would think that the big buyers of HDD got a glimpse of what the world would be like if this supplier base which they have used and abused for so many years unto decades were to lose its ability or will to re-invest in itself. The consolidation was about to make it clear that a price-taking HDD industry can no longer be taken for granted. The flood induced shortage is driving home that point.
Pricing and so margins will recede as capacity comes back into balance and inventories are replenished. This is not a question of Whether or even When but to Where relative to what in the era consolidation (wherein aggressive pricing might have long term, strategic benefit to compensate for short term pain) was considered normal. “Normal” is going to be very different when Seagate and WD have upwards of 80% of the market. Even if WD’s “remedy” for the EU’s purported concerns about the HGST acquisition (just how a discrete increment of capacity can be severed from such an integrated undertaking remains to be seen) were to spawn a new competitor, it would still be a technology follower at a single capacity point with marked economic disadvantages. The big drama over the next several quarters, the one that will be hyped for all its worth by the multitude of analysts who follow this industry, will be couched in terms of where ASPs end up relative to before the flood. And that, in my estimation, is in the hands of the management team of the producer presently at the margin, which is WDC. I believe it will boil down to whether they are sufficiently competent and judicious to manage the latter phases of their recovery in a way that balances the near term needs of the customer base with the long term growth in value for the owner base. Having listened in on the last dozen or so conference calls (and sized up more managements than I care to even think about), I am as confident as an investor can be that Messrs. Coyne, Leyden and Nickl are more than smart enough to split this difference in a way that the Market will stand up and cheer. If so, then for at least that three-to-five year future that purportedly matters so much for serious investors, the new “normal” is likely to be gross margins in a narrow band not far off of 30%, rather than that recent range that tended to drift down into the teens and get stuck there, and commensurately higher net margins and so EPS. End users will continue to benefit from, and probably take for granted, that this industry has made data storage “almost free and getting more so”, and are not likely to notice that they are paying a few dollars more per device. And who knows, these stocks might even find their way of their bizarre parallel universe where a single digit P/E ratio is considered normal for a growing, dominant and cash rich enterprise.
Obviously, such a margin re-set, coupled with even modest growth in units and adroit deployment of surplus cash along the lines of what Seagate is already doing (dividend boost and aggressive share repurchase) should boost both WDC and STX much further than recent analyst “Target Prices” would suggest. But what about suppliers like HTCH? Owing to a long list of surprises, this one has ended up being one of those “problem children” we always seem to have at least a few of. Potentially life threatening challenges have been met and largely overcome, albeit at the cost of the balance going from seemingly pristine to a source of concern. HT’s position with the customer base appears to be programmed to improve in each of the next several quarters, which in my estimation will drive the volume necessary for a return to profitability. The flooding may have been a setback in their plan to become the low cost producer of suspension assemblies, but it was only a setback. Indeed, the value of their diverse locations gained currency as a result of the flood. Assuming that HTCH continues execute on its debt refinancing plan, recognition should start to set in that HTCH does not deserve the “left for dead” status implicit in its recent share price. I am expecting “back from the dead” appreciation over the next couple of years akin to what happened in the latter half of 2009.
Investing in HDD companies right now could be compared to finding a very old cigar butt. The naysayers (led by investment bankers who would rather shill for companies that need gobs of capital rather than ones that have too much of it) say that at 50+ years old it is a worthless has-been that should be tossed away. Like the “visionaries” I recall from thirty years ago who said that technology would bring about a “paperless office” and so doom the paper industry, someday they will be right, and disk storage will go the way of the crank starter on automobiles or the mimeograph. But that someday is nowhere in sight, and there are even signs that the purportedly supplanting technology is actually boosting demand for mass storage the way things like faxes, cheap printers and then email did for a couple of decades before “paperless” starting happening in earnest. If HDD is an old cigar, it still has at least one might fine puff left on it.
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