Industrial Loan Companies

I have followed the topic of Industrial Loan Companies (ILC) for a few years. Initially, these entities would show up in obscure places within annual reports. The financial risk presented by ILCs was invariably difficult to capture and the presence of one at Harley-Davidson was a primary reason for its lack of appeal.

In 2006, while we were purchasing Wal-Mart (WMT) stock, ILCs were headlined after WMT applied for a charter to process credit-card transactions. Even though WMT's major competitor Target had an ILC, WMT's application was denied by pressure from the banking industry. (You don't need competition when you're so good at destroying yourself without it!)

The legitimate complaint, then and now, is that ILCs get to use the government's FDIC guarantee without having the same regulatory oversight as banks. In 2007, the U.S. House passed a bill that would subject ILCs to greater federal oversight and bar the charters from being granted to nonfinancial firms. The bill died in the Senate. However, Geithner has resurrected the issue as a piece of addressing the patchwork of regulatory gaps.

This is a sound approach. Much of the current furor is nonsensical; companies complain that credit will be withdrawn because of regulation. In fact, if these companies are so poorly funded that capital requirements are excessive, they should not be in the lending business anyway.

Is GM Necessary?

I have discussed GM's challenges in past posts. For awhile, it looked like GM might get it "in gear" when Kirk Kerkorian got involved. His presence got my attention, despite GM's clear "capital pig" characteristics.

Now we wonder if we need GM. My vote is yes. My parents purchased this GM product - a 1968 GTO, which still thrills me. Although some might not like it, I still think it's uniquely an American work and indicative of the kind of contribution the American spirit can make to the design of cars.

Ducking The Issue at AFLAC (AFL)

I have been studying AFLAC (AFL) for nearly ten years. So impressed by my studies, I have written reports recommending the purchase of its shares of stock for three years. When I saw the 40% price drop in its share price recently, I imagined that AFL must be an outstanding purchase. Not necessarily.

Stock analysts have pointed out AFL's nearly $8 billion exposure to "European hybrid securities" represents a significant capital exposure risk. The size of AFL's exposure is nearly the size of AFL's entire equity capital base.

When I saw this information, I thought I had not adequately read last year's annual report and 10K. I dislike hybrid securities enormously, as they seem to be a "heads you win, tails I lose" proposition (not at first, of course, but in due time). I pulled out these highlighted documents and did not find one single reference to the concept of "hybrid securities." Then I reviewed the first and second quarters of 2008 for a reference to "hybrid securities." Again, nothing.

Finally, in the third quarter of 2008, a short discussion about the SEC's opinion on impairments created a conclusion of a small write-down which AFL considered "immaterial." Nowhere was there any discussion of the size or characteristics of these investments.

AFL has always quacked about their investing prowess built on value principles. Here, it appears that they are ducking the issue. The earnings report next week will be very interesting.

Pfizer Pfizzle?

The recent announcement of Pfizer's (PFE) plan to purchase Wyeth (WYE) has been met with price declines in the shares of both companies. While investors acknowledge that PFE must replace a diminishing pipeline with new products, and further acknowledge that WYE brings the new areas of vaccines and biologics to PFE at a good price to PFE, the stock prices indicates investor dissatisfaction.

Stock price behavior can be meaningless over the short-term and analysts move into this area at their own risk, but I believe that some of the issues point out some of the current challenges.

PFE has one of the most secure financial positions I have ever studied as indicated by its triple-A rating. PFE has $24 billion of investable funds and a free cash flow of $13 billion a year - at least for 2009 through 2011. These funds almost total to the $68 billion purchase price alone.

With this kind of financial strength, not including the $12 billion of cash of WYE's balance sheet (albeit with higher debt levels than PFE), PFE should be able to command a low rate. However, the banks' insistence on a seemingly high 8% combined with strict back-out provisions and a one-year term on the loan may be making investors nervous.

These demands do indicate a return to pre-Housing Bubble standards. The banks are not attempting to buy business at minimally profitable levels. Even more, banks seem to be forcing businesses to pay up for deals. By raising the price of an acquisition, the likelihood is that deals done today will look smarter in retrospect. So, what seems to be a negative today may ultimately be viewed more favorably.

Lilly (LLY) White? Part 2

Yesterday I wrote a post about Eli Lilly & Co's (LLY) $1.4 billion dollar fine for promoting non-FDA approved uses of antipsychotic Zyprexa. I contrasted that with the 1980s when fines were significantly lower.

This fine was in addition to the $1.2 billion that had been paid to over 30,000 plaintiff at an average of $40,000 per individual. Today, Bloomberg ran an update on remaining lawsuits which may cost LLY billions more. 12 states remaining states, insurance companies, pension funds and labor unions have yet to come to an agreement; all want to get paid.

What is the message? Clearly the pharmaceutical companies understand the tremendous consequences of deceptive practices. Given that understanding, LLY's practice can only mean that such aggressive behaviors are well-entrenched in this industry.

As an analyst, I regularly see major companies with a laundry list of lawsuits. The companies regularly deride them as "without merit." Now I am paying a much greater level of attention to these suits described in SEC filings and adjusting my estimated investment value for significant liabilities.

Costs at Microsoft (MSFT)

Microsoft's (MSFT) second quarter earnings revealed a continuing trend of reducing the percentage allocated to research and development (r&d) and increasing the percentage allocated to sales and marketing.

When I started studying the expense structure of MSFT in 1999, I was amazed to see that over 17.5% of the revenues and 32% of the expenses were dedicated to r&d. These numbers have dropped considerably to r&d now consuming 14.5% of the revenues and 23% of the expenses.

Sales and marketing expenses, meanwhile, have risen from 17.5% of the revenues and 32% of the expenses to a current 21% of the revenues and 34% of the revenues.

These trends seem to indicate a long-term pattern of large companies, regardless of industry, whose resources are increasingly dedicated to the purchase of smaller companies whose products are then sold through a massive distribution system.

Most notably, as a commentary on today's environment, the general and adminstrative (g&a) costs were cut dramatically. G&A costs were a paltry 4% of revenues and 8% of costs back in 1999, before rising dramatically to 11% of revenues and 18% of costs in 2005. Now, in a return to pre-housing bubble euphoria, g&a costs are back to 5% of revenues and 9% of expenses. Who said that these aren't good times?

Lilly White?

Just two weeks ago, Eli Lilly and Company, (LLY) agreed to pay nearly $1.415 billion in fines for "off-label promotion" of the drug Zyprexa, a drug used to treat various conditions related to psychotic disorders, such schizophrenia and acute manic episodes. Not content with these revenues, LLY promoted the drug as a treatment for dementia, including Alzheimer's dementia in elderly people.

The sum includes a criminal fine of $515 million, which the Justice Department called "largest criminal fine for an individual corporation ever imposed in a United States criminal prosecution." The company will also pay up to $800 million in a civil settlement with the federal government and the states, and forfeit $100 million in assets. Commenting on this large fine, LLY stated that it plead guilty to one misdemeanor charge and "disagrees with and does not admit to the civil allegations."

Contrast this whole process to LLY's challenges in 1982. A LLY drug Oraflex was withdrawn from the market only one month after the FDA approved because a British medical journal documented five cases of death due to jaundice in patients. The FDA accused LLY of suppressing unfavorable research findings. In 1985, the Oraflex controversy culminated when the U.S. Justice Department filed criminal charges against LLY. The Justice Department accused LLY of failing to inform the government about four deaths and six illnesses related to Oraflex. LLY pleaded guilty to 25 criminal counts, which resulted in a $25,000 fine. All counts were misdemeanors; there was no charge against LLY of intentional deception.

Oraflex was a case with documented deaths, accusations of suppressed research, numerous charges and an admission of guilt, resulting in a $25,000 fine. Zyprexa was promoted aggressively for unapproved uses, one charge and no admission of civil guilt, resulting in a $1.4 billion fine. Was the issue of "intentional deception" such a distinguising factor between the size of these fines? Or have the times really changed that much?