Merck's Latest

The latest trial resulted in a victory for Merck (MRK) in the important category of alleged victims who took Vioxx for less than eighteen months. In this case, Richard Irvin had taken Vioxx for less than one month when he died of a heart attack.

A critical part of MRK's victory was a pretrial ruling by the judge that prevented an "expert" pathologist from attributing Mr. Irvin's deadly clot to Vioxx. This was a major departure from last fall's headline case in Texas where a doctor practically put Vioxx on the deceased's tombstone.

This legal process may go on for awhile. Another trial is currently under way in Rio Grande City, Texas (surprise) in what will certainly be a more plaintiff-friendly process. As headlines develop, investment opportunities may as well, allowing for increased investments on worse than expected verdicts.

"Challenging" Times at Johnson and Johnson

On the 2005 fourth quarter earnings conference call for Johnson and Johnson (JNJ), CEO William Weldon characterized the current environment as "challenging." Just as "bling" was the hot phrase last year and "in the loop" a few years prior, so "challenging" seems to be now. Providing depth to his analysis, CEO Weldon further commented that the people at JNJ were "hard at work." The defensive tone of management on the conference call was echoed by the frustrated sound of JNJ analysts. This misery reveals what excessive expectations do. JNJ finished the year as only one of six industrial companies with a triple-A rating and $13.5 billion of cash on the balance sheet. Even more, earnings increased by almost $2 billion (over 13%) to a record $10.5 billion. These numbers were not generated by simply cost-cutting, as JNJ increased research and development (r&d) expenses by 21%. So what's the problem? Apparently, the stock price - which has moved from a high of $70 last April to the upper $50s currently. Investors bid the price of JNJ up on the news of the Guidant (GDT) acquisition. When JNJ exercised discipline on the GDT purchase price, allowing Boston Scientific to "win" the bidding war, JNJ's stock price dropped, reflecting the apparently widespread lack of respect for money and monetary discipline.

Continuing Saga of Marsh & McLennan

Yesterday MMC announced results for 2005, a year that CEO Cherkasky described as "challenging." MMC has been under pressure since October 2004 when Attorney General Spitzer attacked a practice innocently termed "market services revenues," but more blatantly called "double-dipping" in Texas. The issue of representation is similar to the one I raised in yesterday's blog. Since MMC was receiving payments both from purchasers and sellers of insurance, it was unclear who MMC really represented.

The earnings conference call was unsurprising in its expressed "optimism" and its self-congratulatory tone. Also unsurprising, analysts spent their questions on updating their spreadsheets, not on understanding MMC's business model. Despite everyone's best efforts, some useful information came out anyway.

At the end of the presentation, the CEO commented that while the MSRs had always been around, they had actually been very small until recent years. Despite an acclaimed "new Marsh" (the "old" one being unaffordable), recent changes really imply a return to the more distant past.

I studied the issue and he's right. In reviewing the last twenty years, Marsh's operating margins were fairly stable at 20%, until about 1998. Suddenly, they started to push up to the mid-twenties. Based on Cherkasky's comments, the growth in MSRs caused the increase. So what's so bad about returning to "the good old days"?

Alot, if you bought the stock from 1998 to 2004. The seeming small increase in margins from 20% to 25% relates to an increase of about $500 million on $10 billion in revenue. But, in Wall Street's alchemy, the value of the company moved from roughly two times revenue ($20 billion) to three times revenue ($30 billion). That extra one-third value based on recurring MSRs is simply no longer there and represents a permanent loss for the 1998 to 2004 buyers.

The good news is that MMC is now moving to past margins. Large companies have had and will probably always need assistance in addressing their risk management needs. At those levels, MMC should be worth roughly two times revenues - a nice jump from today's one and a half times revenue valuation.

More About Wal-Mart

Today's article in the WSJ about Wal-Mart in the DFW area highlights the extraordinary challenge that Wal-Mart presents to grocery stores. The DFW market is the fifth largest in the U.S. Yet, in less than ten years, Wal-Mart has a 32% market share of the grocery business. With 104 stores including 60 supercenters, Wal-Mart employs over 24,000 people in the DFW area. Further, unlike popular perception, Wal-Mart's dominance has not depressed wages.

Although I live in the DFW area, I had no idea of Wal-Mart's size. I had seen the closures of a local Tom Thumb and a Minyard's further north, but I had attributed both closures to the growing presence of Whole Foods. Clearly, I had misattributed these seismic shifts in grocer trends, mistaking my own spending habits for those of others. It is almost unbelievable that Wal-Mart can roll over HEB, Tom Thumb, Kroger and Albertson's as easily as it used to roll over the mom-and-pop stores in small communities.

Where Do the Big Fines Go?

Today's WSJ announced that AIG will pay $1.6 billion for alleged accounting improprieties. This settlement will be the largest in U.S. history for a single company. The settlement will be divided between the SEC and New York authorities. What will happen with the money?

The SEC will receive $800 million, of which $700 million is disgorgement and $100 million is penalties. This money will "go to a fund designed to compensate investors who may have been injured or misled." Huh?

AIG's "alleged accounting improprieties" caused the earnings of the company to be smoother, but did not misstate the value of the company. So how are these "injured or misled" investors to be identified? How do they prove that they were "misled?" Is their investment incompetence alone adequate proof of injury? (This reminds me of the person injured by McDonald's for spilling coffee on himself.)

Next, about $375 million will go to AIG policyholders who may have been injured by the alleged bid-rigging in commercial insurance contracts. Huh? How does AIG's "alleged accounting improprieties" translate to paying their clients this vast sum? If my dry cleaners had false accounting that provided them with cheaper rent, should I get my shirts cleaned for free?

Then, about $344 million "is expected to be paid to state workers' compensation funds." Authorities allege that AIG short changed these funds in the 1990s. Rhode Island will get $100 million. Huh? So the poorly state run workers' compensation funds get replenishment for the mere allegation against AIG? What does state incompetence have to do with "alleged accounting improprieties?"

The remaining $81 million "will constitute fines." Where does it go? The Spitzer sue-more-companies and get elected-to-some-office fund?

The more I review this process, the more I admire Hank Greenberg's backbone for fighting these charges in court. If he had put directors on his board with similar backbone, AIG probably wouldn't be paying this ranson. Further, if these allegations were accurate (which is arguable), the resulting funds ought to be dedicated to strengthening accounting practices in the insurance industry and funding appropriate supervision.

Buffett's Prescription for Managers

With wonderful simplicity, Warren Buffett outlined his approach to his managers in the BRK 1998 annual report. He tells them to 1) act as if the division is 100% theirs, 2) view it as the only asset that they or their family have or will ever have, and 3) view that it will not be sold for at least a century or so. This long term thinking can be applied profitably to almost every area of our lives and seems especially productive for investing.

Technology Trends

In a recent presentation to students of the Stanford School of Business, Mary Meeker (Morgan Stanley, analyst) shared two overarching themes: 1) technology has recovered post 2000 meltdown and 2) the U.S. won't lead this time.

In support of her first thesis is the following startling pattern: the leading market capitalization of the top 5 global internet companies: was $ 2B of market value at pre-2000 IPO prices, $178B of market value at the Nasdaq peak (3/10/00), $ 32B of market value at the Nasdaq trough (10/9/02) and $262B of market value as of the presentation (11/11/05).

In support of her second thesis are the following facts. South Korea is the leading provider of broadband in the world with over 70% penetration. Denmark has VoIP minutes which are larger than landline minutes. The U.S. graduates 76,000 engineers annually compared to 1,007,000 globally (with China at 352,000). The U.S. corporations, in the latest study, spend more on tort litigation than on research and development (205B vs. 184B).

While her themes are arguable, her basic information is significant. I believe that technology market values are part of the broad bubble generated by low interest rates and high hopes. I also believe that the lower technology adoption rates in the U.S. reflect the presence of more defined structural development - giving rise to much of the tort litigation costs.