Forum Insights

Opportunities in Spin-offs

Rachel2 — Thu, 05 Nov 2009 20:12:00 GMT

Justin Perucki and Michael Tian, editors of Morningstar's OpportunisticInvestor, are seeing opportunities in spin-offs, which have had a tendency to outperform over the past several years. Why? Because of low investor interest. Low interest stems from the fact that there is usually very little investor information about spin-off companies because they were previously imbedded in a parent company.

Furthermore, spin-offs do not have road shows like IPOs to pump up the stock, so they are usually cheaper.

Still, not all spin-offs are good buys. When evaluating a spin-off, Justin and Michael look for a unique and/or defensible business model, earnings power improvement potential, and good management practices. They like to see management incentives that are in line with company performance, such as stock options.

Their interest in AOL's spin-off from Time Warner is medium to low because they see a lot of risk. AOL's legacy dialup business is dying, and that's where most of the cash flow comes from. Also, the management team has proven not to be savvy with capital allocation in the past.

Enexus Energy, on the other hand, looks like a good opportunity. Enexus will consist of Entergy's merchant nuclear operations, and will be a high-quality wide-moat business.

The Big Picture: Economy Looking Healthier

M*_Jeremy — Fri, 06 Nov 2009 01:08:00 GMT

Macroeconomic trends have taken center stage as investors fret if the recovery in the stock market is backed up by the real economy.

Associate director of economic analysis Bob Johnson and associate director of banking Matt Warren see improvement in the economy. Here is there take on the big picture.

Don't be Too Focused on Jobs; Productivity Is Also Important.
Bob warns investors not to be too hung up on the jobs number. Unemployment lags the broader recovery, so by the time the number begins to looks better, the economy is already well on its way to recovery.

Productivity, which has posted sizable gains during the recession, is working to keep unemployment high. Businesses are able to do more with less people. Higher productivity might scare us in the short run, but combined with population growth it is the key to the expansion in GDP.

Signs of Life in Banking Market
Matt thinks that things are still bad in the banking world, but that there are plenty of signs of life. Credit card delinquencies are looking better, as are the leading edge of home foreclosures.

Interest Rates Are Key
One area of focus should be interest rates, mortgage rates, and credit spreads. One of the major issues of the credit crisis was the blowout in corporate credit spreads. It became nearly impossible for firms, even those with excellent credit, to borrow the money they needed. The Fed is currently taking unprecedented action to keep rates low. As the government pulls back its level of support, interest rate spikes could damage the recovery we are seeing.

Commercial Real Estate Is Not the New Residential
Commercial real estate has been the subject of much hand-wringing lately. Matt thinks these fears might have been valid a few quarters ago, but are now misplaced. Without a doubt, deals made at the top of the market are going to go bust, but the vast majority commercial real estate owners will be able to ride out the storm.

No New Normal
Bob doesn't believe that we are entering a new normal of lower growth and higher unemployment. He sees this as a severe recession, but one that is still following the normal cyclical patterns. Increases in employment in industries that are currently beaten down (like autos and housing), along with growth in new industries, will help pull us back to more normal levels of employment.

Overall, Bob and Matt believe the economy is on the mend. There are plenty of issues that might pop up, but the worst is behind us.

Three Stock Picks that Keep It Simple

Rachel2 — Thu, 05 Nov 2009 23:25:00 GMT

Paul Larson, editor of Morningstar's StockInvestor newsletter, offered portfolio strategy pointers and shared his latest stock picks at Morningstar's Stock Forum.

Paul bases his portfolio strategy on keeping things simple. The central criteria: finding stocks with wide moats. Fewer than 1 in 10 companies in our stock universe earn the designation.

He also stressed the competitive advantage of having a long-term focus and says he's OK with concentrated positions as long as you are confident in the company. In his words: “Fewer baskets, closer watching of eggs.”

Paul's latest picks:

Exelon is composed of two utility companies, ComEd, and PECO, and a nuclear power generation business, Exelon Generation. The utilities are only narrow moat businesses, but they are relatively stable. Generation, however, is a wide-moat business. Exelon is the largest nuclear power operator in the country, with 17 reactors. Only one other company has more than 10 reactors. This is also the most efficient nuclear fleet in the country. 93% of Exelon's generation has among the lowest costs and highest margins of any power generation source. Exelon’s valuation is also compelling. It should earn a little over $4 a share this year, about 12 times earnings, and we think the company can earn at least $7 per share in 2012 as rate caps expire.

Enterprise GP Holdings, a pipeline investment MLP, is also attractive. It receives royalties from operations of various companies it owns. They provide a minimal amount of incremental capital, but get a disproportionate amount of growth. It’s a stable, wide moat business. Taxable accounts are the preferred vehicle for MLPs.

Lowe's isn't the widest moat, but it has advantages stemming from economies of scale and a national brand. But its currently low valuation makes it really attractive. Lowe's has had a rough go of it during the housing struggles. Same-store sales have been weak, and operating margin has fallen. But we think same-store sales will go up 1% next year and grow at 5% for the next few years, and the operating margin will expand slightly (though not to its housing-bubble level). Current pricing at $21 assumes same-store sales and operating margin will stay depressed. We think Lowe's is likely to get past its hurdles.

Realty Income Sees No Consumer Discretionary Recovery

M*_Jeremy — Fri, 06 Nov 2009 16:16:24 GMT

Realty Income’s CFO does not see a big recovery in consumer discretionary spending anytime soon. With consumers still afraid of losing their jobs and home prices still seeking a bottom, no one wants to make big splashy purchases.

However, non-discretionary spending is holding up pretty well. Realty Income has not seen a precipitous drop in occupancy and its tenants that sell everyday items like gasoline and cigarettes are doing fine.

Realty Income, which had pulled back from acquiring new properties during the height of the property bubble, is now back in the market. Cash strapped retailers are looking for capital and there are few sources of it in this environment. This is allowing Realty Income to dictate terms and pricing. The three properties they bought last quarter were at yields exceeding 10%.

Health-Care Stock Picks that Should Weather Reform

Rachel2 — Thu, 05 Nov 2009 19:39:00 GMT

The outcome of health-care reform is still uncertain, but speaking at Morningstar's Stock Forum Thursday, analysts Bill Buhr, Debbie Wang, and Karen Andersen say some companies stand out as better able to weather possible outcomes.

More diversified pharmaceutical companies are most attractive in the face of uncertainty. Some favorites include:

Novartis has a large exposure to generics, which we think will be a winner from reform.

Abbott has done a good job making smart acquisitions. It has a strong product portfolio and less exposure to patent expirations than many pharmaceutical companies. Its diagnostics business should also buffer it from volatility in the drug market.

Johnson & Johnson also has a strong pipeline of drugs. It also has great free cash flow and device and over-the-counter businesses, which offer downside protection.

Biotech as a whole isn't as undervalued as pharmaceuticals, but we like Genzyme. Genzyme has had manufacturing issues that have opened the door to competitors, but we think the competitive concerns are overblown. It has a strong track record, and we think it can maintain market share. Genzyme has one of best pipelines in biotech and a history of making good acquisitions. We think it is positioned to continue growing and benefiting from trends toward personalized medicine.

In terms of devices, we think bells and whistles that do not make clinical differences will not be able to command the pricing they once did. But new developments that demonstrate a clinical benefit will still be able to command pricing. For example, Medtronic is working on an MRI-compatible pacemaker. Since 50%-75% of pace maker patients will eventually need an MRI, such a device should be able to fetch higher prices.

BB&T: Banking Going Back to Basics

M*_Jeremy — Fri, 06 Nov 2009 17:00:31 GMT

BB&T’s Treasurer Hal Johnson thinks that the banking industry is heading back to a traditional model. Banks will lend to creditworthy individuals and business, and then hold those loans on their balance sheets. Esoteric mortgages, securitizations and subprime lending are unlikely to come roaring back even as the economy recovers.

The bank recently aggressively expanded into the Florida market by buying the shuttered Colonial Bank with the help of the FDIC. The support of the government was key here. BB&T gets most of the upside, and the downside is protected. The bank has a long history of acquisitions, and management would be happy to keep doing these deals.

General Mills: Consumers Increasingly Eating at Home

M*_Jeremy — Fri, 06 Nov 2009 17:34:24 GMT

General Mills’ CEO Ken Powell sees a solid trend of consumers spending more on food at the grocery store versus going out to eat. People are trying to save money, but they still don’t have the time and desire to make meals from scratch. General Mills is trying to capitalize on this by creating new entrees that are ready quickly, but that still represent a decent value. Not surprisingly, there has been strong demand for both lower end brands like Hamburger Helper. But some higher end products are doing well as families still see the value of a complete meal kit versus going to a restaurant.

This echoes what we’ve heard from other CEOs at the conference today. The consumer is still scared and is trying to save money wherever possible. Even as the economy stabilizes, these fearful spending habits don’t look like they are going to turn around quickly.