Benefits Of Boring

People have often marvelled that Warren Buffett comes from the Midwest, as if he succeeded despite his location. Recent study of mine seems to indicate that he succeeded because of his location, or at least the culture he came from.

During the past several years, I have struggled to find a bank to invest in. As the 80s and the 90s and the new century showed banks to supremely outperform all other investments, I looked for a way to get on the train. Fortunately, it never slowed long enough for me to hop on board.

But two banks stood out above the rest: Wells Fargo (WFC) and U.S. Bancorp (USB). So I was quite surprised to learn that both had the same genesis. During the prosperous 1920s, the nation's farmers did not share in the good times. Many banks that had overextended credit to farmers ran into serious trouble. In the Upper Midwest, 1,500 banks became insolvent. With this backdrop, just months before the stock market crash of 1929, two banking associations were formed in Minneapolis/St. Paul, Minnesota: Northwest Bancorporation - later known as Wells Fargo, and the First Bank Stock - later known as U.S. Bancorp.

As someone who grew up in the Upper Midwest, I can testify to its conservative and pragmatic culture. Like other areas in my life, distance and time have enabled me to see the merits of boring.

IBMpressive

My first post dealt with some wise financial maneuvering by IBM. At that time, IBM was freezing its pension plan, reducing the growth of these onerous, but underappreciated employee benefits. I marvelled at the lack of an outcry.

IBM again showed its prowess in the fourth quarter results. Although IBM's fourth-quarter revenue came in a little shy of expectations, falling 6.4 percent from a year ago, the company also managed to cut costs by 3-4 percent. A lower tax rate also helped.

IBM is dealing with the reality of a top-line challenged world (read excess capacity) by reallocating efforts to top line growth (managers become sales people), outsourcing non-selling functions and controlling tax costs. Look for other companies to follow, if they're smart.

UK Leading The Way?

When it comes to financial markets, I have often noticed that the UK seems to lead the US directionally by about 6-12 months. US interest rates, stock market movements and real estate patterns often have been preceded by similar patterns in the UK. I hope this pattern does not persist when it comes to banking.

While President Obama was mesmerizing the country with his inauguration, the prices of bank stocks were falling to new historic lows. Investors were asking themselves, "what is causing all of this?" The answer was in the UK. There is a movement for complete nationalization of Lloyd's Banking Group and the Royal Bank of Scotland. But the question of "what happens then?" is not clear.

The following graph illustrates the national debt level as it exist in the US:



This graph is disturbing as it indicates a level of borrowing which is unprecedented. When, and if, the government programs "kick in," there will remain an astonishing level of debt. This level of debt must be addressed through increases in profitability - a long term solution. The short run is the problem at hand.

Fortunately, the US and the UK do have different issues with external debt to GDP ratios. "External debt" is defined as the total public and private debt owed to nonresidents repayable in foreign currency, goods, or services. In this respect, US debt levels are 100%, while UK is close to 400%. This level is greater than the debt level listed for the overall US debt. Scary times for the UK, but not necessarily leading the way for the US.

Pensions Plans Rejiggering

My first post was on IBM's decision to freeze its pension plan. Subsequently I posted on the GAO's study of pension plan underfunding. It is significantly frustrating for analysts to study companies, to spot dreamy thinking and have no ability to correct it.

Pension plan assumptions have been a leading concern, after stock options and management compensation agreements. Today's International Tribune Herald put it succinctly: "That 8 percent annual return on investment you and your pension fund manager were banking on is looking almost as optimistic as Bernard Madoff's magic 12 percent, as deleveraging and deflation bite."

The article quotes, "David Zion at Credit Suisse in New York estimates that the pension funds of the S&P 500 companies could be underfunded by $362 billion, a drop of $420 billion in the year. This is far worse than back in 2002, after the last stock market slump, and leaves 70 of the 500 with underfunding equivalent to more than 10 percent of their market cap."

Based on earlier studies, I think this number is optimistic and could well exceed $500 million. If forced, these companies will be forced to take a hit to earnings to more fully fund. However, I believe that companies will find a way to do as IBM has - to freeze benefits and reconfigure employee commitments to a lower level.

Having A Citi (C) Day

Citigroup's (C) stock continues its downward path. The dramatic downward movement has beaten the management of C into a state of reasonableness: bigger is not simply better.

From the inception, C's dreams of "synergies" have been murky. The architecture was created by sprinking Weill dust into the eyes of analysts who saw nothing but higher and higher earnings. The piles of poorly contrived investments are simply the result of a culture of push created long before the Prince arrived. But all is not lost.

Today's NYT has the following graphic:



There are now logical investors for each piece. The pieces on the left confirm C's natural business: a global banking franchise. C has tremendous clout and, if run by a banking culture, should be able to regain leadership in a wide-open space. The pieces on the right all have significant value and might each do very well.

Importantly, each piece on the right has a culture unrelated to a banking culture. To put the process of banking with its "just say no" driving principle into the mix with any other business with its "go for it" driving principle is to create the outcome we are experiencing. Breaking up is hard to do, but here we could look back on and see tremendous benefits of being forced to do the difficult on these Citi days.

Generic Drug Activity

Significant changes have been developing in the world of generic drugs. Two major players, Actavis - an Icelandic-based generic company owned by the former billionaire Thor Bjorgolfsson and Ratiopharm - a Germany-based generic company owned by the recently deceased Adolf Merckle are both up for sale.

The ultimate sales price will be interesting. Teva, one of the major generic companies, acquired Barr for about 2.5X sales and 12X EBITDA. Actavis would need to get close to this price to simply pay off the Deutsche Bank debt. Ratiopharm has similar challenges with the financing problems at the crumbling Merckle empire.

My bet? A deal with either Pfizer or GlaxoSmithKlein at roughly 10X EBITDA or 2.2X sales. An acquisition in this space would help these companies cost-effectively transition to generics that might allow for more profitably moving off patent expirations. More importantly, there are no financing challenges with either company.

Walgreen (WAG) Downsizing

Today's announcement that WAG is cutting 1,000 management jobs seems to exhibit classic human behavior: overextend when times are good and overcontract when times are bad. I have personally experienced these cycles, wondering "what was I thinking?"

But WAG is not my small business and would seem to have better controls in place. I have long admired WAG with their corporate motto of "crawl, walk, run," which embodies a sure-footedness and a preference for organic growth. WAG has not had a history of making acquisitions because they did not fit the existing culture. The result has been steady, quality performance.

What to make of this pruning? It would indicate either WAG has changed strategies or lost control during the fun times. Neither is good. Personally, as an investor, I would rather see earnings take a hit and maintain organic focus than do the slash and burn routine.